The dictionary defines forecasting as predicting, calculating in advance, and conjecture as to something in the future.
The dictionary further defines budgeting as an estimate of expected income and expense beforehand and to plan operations based on such estimates.
With relation to business, these definitions differentiate the two terms nicely. With forecasting you predict, with budgeting you plan for the future of the business based upon the forecasts.
With a manufacturing business, we can use the following example to help understand the process and role of forecasting and budgeting.
Let us say that a company would like to purchase machinery and they anticipate a million-dollar project. This piece of equipment would enable the company to produce another product line that would utilize materials from production that is now considered waste.
Our fictitious company would first need to find out what the demand would be for that product and forecast the market for that product; the demand, time, sales.
Next, they will need to predict the unknown such as the recovery of materials, labor, and so forth. Local economic trends are important as well.
The company would want to look at the local standpoint.
Would more jobs be offered? Is the economy stable?
Will the product benefit local citizens?
Will local freight companies benefit? Will there be a reduction in freight costs by contracting new hauls with the new product?
Are there environmental factors present? Can current plant processes be streamlined by the investment? What is the return on the investment?
Once the information is compiled and it is an accurate representation of anticipated results. The information would then be put through the budgeting process.
As stated earlier, budgeting is comprised of estimating the expected income and expense.
Once a company is secure that there is a market for the product and they can afford to install the machinery, now it is time to see what kind of estimated profit will come from this. In my opinion, it is best to be conservative.
By inputting the projected sales and expenses into the budget, the profit or loss can be calculated. At this point, the financial department will; crunch the numbers; if you will.
Profit and loss can be calculated under different variables. It is also beneficial to look back at the company’s historical data as well. This will reflect past trends in similar markets.
These steps are important because if the company were to install the machinery and produce a product to present to the public without forecasting and budgeting they would be acting upon a leap of faith. This would open the door to certain failure.
In addition, a large expenditure can take years to recover from. The budgeting process will help management decide if the investment is worth it.
Perhaps they may determine that it will take six years to actually see a profit from the investment, or perhaps only a couple of years.
If it is leaning toward six years management may decide to begin construction at a particular time or year.
There are so many factors that play into forecasting and budgeting that it is impossible to mention them all. The bottom line is that what a company does now will impact the future health of the business.
It is imperative to forecast and budget before indulging in new ideas for the well being and longevity of the business. Forecasting and budgeting provide a conservative approach to managerial decisions.