Wednesday, August 26, 2009

Bridging the Gap Between the Financial Model and Budget

bridging the gapA financial model and an operating budget are two different things, but the two should correlate with and complement each other. I’m going to briefly discuss the differences, what each is used for, and how to use them both more effectively to run and improve your business.
THE DIFFERENCES
Financial modeling/forecasting usually takes a big-picture approach and avoids too many details. The model is used to assess opportunities and the cause and effect of major business decisions. The model is often expressed in terms of yearly performance.
An operating budget, in contrast, is mired in the details. It needs to tie directly to the accounting system’s general ledger, or chart of accounts for QuickBooks users, and is usually a month-by-month forecast of the activities of each account for the next 12 to 24 months. Use of the operating budget includes analysis of the budget vs. actual performance each month.
HOW & WHY SHOULD THEY CORRELATE?
A business needs to have both a financial model and an operating budget. An operating budget without a long-term model/forecast leaves a company pretty directionless and lacking the ability to understand the impact of business decisions on financial performance. A financial model without an operating budget is a “pie-in-the-sky” dream that is not founded in reality. There is no way to track progress towards accomplishing the goals and objectives, if they are even outlined, and it is almost impossible to hold anyone accountable. Every business should have both.
The place where many companies go wrong is that they do not actively use both of them and ensure they “feed” into one another. For example, let’s assume we have modeled $5,000,000 in sales for 2009 but our operating budget calls for $3,500,000. This discrepancy is large and invalidates one, the other, or both!
The operating budget needs to validate and complement the assumptions made in the financial model, and vice-versa. In fact, the monthly review of the budget vs. actual performance can often generate valuable information about our assumptions and can justify changes and updates regularly to the financial model.
For example, let’s assume we project a 50% gross profit in our 5-year financial model. Due to changes in the economy, increasing material prices, and a slight change in mix of products, our gross profit is coming in every month at 45%. We find and track this in our operating budget analysis each month. Since the trend seems to be consistent, we may make a decision to update the gross profit assumption in our financial model.
CONCLUSION
With an understanding of the differences between a financial model and operating budget, we can see the need to bridge the gap between the long-term planning and short-term budgeting so that they complement each other. While this requires some effort and often the expertise of a CFO, the result is always a competitive advantage in terms of a more effective execution of our business model. That means more cash flow and better profitability that your competitors, which results in a sustainable competitive advantage.