Although it's impossible to accurately forecast all of your business expenses and earnings, it's still useful to make plans and predictions and then evaluate your numbers to make better forecasts in the future. The process of budgeting and performance evaluation is an ongoing cycle of planning and adjusting. It involves educated guesswork about business activities and retrospective analysis once you see how circumstances actually unfold.
TL;DR (Too Long; Didn't Read)
Budgeting and performance evaluation are forecasting tools that can prepare your business for upcoming events such as infrastructure upgrades and new product introductions.
The Budgeting and Performance Evaluation Process
- Creating a budget. To create a budget, consider all of your company's revenue streams, such as wholesale sales, retail sales and rental income and all of your types of expenditures, such as rent, payroll, taxes, utilities and materials. If your business has some operational history, use past numbers to make future predictions, adjusting for known upcoming events such as materials shortages or new product launches. If you're starting a new business, do some research and make the most realistic forecasts you can.
- Using a budget. Your budget should provide guidelines for how you will spend your money and targets for pacing your earnings. Refer to your budget as you plan operations but don't follow it strictly if there are opportunities to leverage or emergency expenditures to make. Rather, make cautious adjustments as needed.
- Evaluating a budget. It is exceedingly rare for business activities to precisely correlate with financial activities laid out in a budget. Sometimes these discrepancies can be traced to circumstances that could not have been foreseen, and sometimes they are the result of faulty forecasting. The budget evaluation process measures the degree of discrepancy and tries to identify inaccurate assumptions so you can forecast more accurately in the future.
Benefits of Budget Forecasting and Evaluation
Creating a budget helps you to anticipate cash-flow shortfalls and plan for major expenditures. If you can foresee when your business is likely to be short of cash, you can seek financing in advance, and if you can identify the time of year when you'll likely be flush, you can plan capital improvements to coincide.
The process of budget forecasting is also an opportunity to set aside time to focus on understanding how your business works financially. If your payroll figures add up to a consistent percentage of your revenue over time, you can use that percentage with confidence for making forecasts. If your payroll percentage swings wildly from one end of the spectrum to the other, the budget forecasting process is an opportunity to research and identify the variables behind these divergences and then make changes to achieve greater consistency.
The budget evaluation process forces you to take a close look at your assumptions and to consider whether you've simply encountered unforeseen circumstances that led to unforeseen outcomes or whether your understanding of the financial variables in your business was incomplete. If you made flawed assumptions, the evaluation process creates a space and process for revising your thinking.
Disadvantages of Budget Forecasting and Evaluation
The process of budget forecasting can give you a false sense of security if you compile your numbers and everything seems to be on track. This complacency can be dangerous if it causes you to let your guard down and stop regularly looking for threats and opportunities.
Budget forecasting and evaluation can also be time consuming and expensive. You may end up spending too much time looking for trends and problematic assumptions and not enough time getting your day-to-day work done. In addition, the evaluation process may identify variables that were part of the current business cycle that don't have much relevance beyond the present circumstances.