Forecasting errors are an inevitable part of the budgeting process. Understanding and addressing these errors is crucial for effective budget management.
Quickly identifying forecast errors in your budget is not a sign of failure, but an opportunity for improvement. There's no such thing as a flawless budget. The goal is not perfection, but a continuous improvement that aligns your financial planning with the always-changing realities of your business environment.
Read on to learn about how errors can throw off a financial forecast, and how to mitigate these errors to enhance your budgeting strategy and positively impact your company's bottom line.
Forecast error: Definition and Types
In the simplest terms, forecast errors are the difference between predicted values and actual outcomes. Such errors are an inherent aspect of any FP&A forecasting process: your actuals will almost never precisely match your projections. While such errors can't be avoided, their accurate detection and assessment is a crucial function of the finance team.
There are different types of forecast errors, each with unique characteristics. Common types include:
Mean absolute error (MAE): Measures the average absolute value of the errors between predicted and actual values.
Mean squared error (MSE): Squares the errors before averaging, giving more weight to larger errors.
Mean absolute percentage error (MAPE): Expresses errors as a percentage of the actual values, providing a relative measure.
These errors are potentially important because they directly impact the accuracy of your budget predictions. Any change from the plan can cause financial problems that, in the worst case scenario, cascade through your organization. By identifying and understanding errors in your forecasts, you gain insight into the reliability of your financial projections and make them more accurate and resilient over time.
It's important for finance teams to quantify the nature of these errors or misses. If an error is recurring by nature (that is, it will not only impact the current month being evaluated, but all future months), it has a greater impact than missing a one-time item. Practically speaking, this could be missing a new hire salary as part of the budget cycle (meaning you bust your budget during month one of the budget cycle) vs. missing a one-time spot bonus to be awarded to an employee.
Dealing with errors in the forecast
Minimizing forecasting errors is a key aspect of budget optimization. There are a few ways to reduce these errors, or at least minimize their negative impact on the business.
Continuous monitoring: Regularly review and update your forecasts based on the latest information and market trends. (More on this below.)
Advanced modeling techniques: Implement forecasting models that account for a broader range of variables. Developing different scenarios (bad/good/great) helps flush out errors by exposing the drivers that feed these outcomes.
Collaborative decision-making: Involve multiple stakeholders in the forecasting process to gather diverse perspectives and insights.
Putting forecast errors into perspective
It bears repeating: these errors are inherent to FP&A, and complete elimination of these errors is an impractical goal. Rather than sweating the differences between your budget vs actuals, focus on putting the errors into perspective. Assess the magnitude of errors relative to the overall budget, and focus your effort on areas with the most significant impact.
How to identify and quantify forecast errors
Here are a few steps you can take to systematically hunt these errors down within your budget:
Compare actual vs. predicted values: Regularly compare your budgeted values with the actual financial outcomes. This is also referred to as budget vs actuals reporting.
Forecast error calculators: Leverage forecasting tools and calculators to automate error calculations and streamline the process.
Cumulative sum of forecast errors (CUMFE): Analyze the total sum of forecast errors over time to identify patterns and trends.
How finding forecast errors improves your budget
Regularly identifying and analyzing the forecast errors in your budget is not just about correcting those numbers — it's a strategic move toward long-term financial resilience. Acknowledging and addressing forecast errors as you create a new annual budget or reforecast pays dividends down the road.
Enhances accuracy: Minimizing errors leads to more accurate financial projections, enabling better decision-making for the finance team and leadership.
Limits risk: Spotting forecasting errors early allows you to proactively address potential risks and uncertainties before they get worse.
Optimizes resources: As your forecasts become more accurate over time, this allows your organization to more efficiently allocate resources as you avoid unnecessary expenses or missed opportunities. Finance teams should strive for near-term predictability to ease resource planning, and extend that forecasting accuracy horizon so they can spend more time on strategic items.
Strategies to improve the accuracy of your forecasts
Consider the following strategies to refine your forecasting process:
Continuous data analysis: Regularly update and analyze data to ensure your forecasts are based on the most current information. Economic conditions, market trends, and internal factors can change, impacting the accuracy of your predictions. By staying vigilant and incorporating the latest data into your forecasts, you increase the likelihood of making informed decisions and reduce the variance between your budget and actuals.
Scenario planning: Integrate scenario planning into your forecasting process to account for various potential outcomes. By creating multiple scenarios based on different assumptions and variables, you gain a more comprehensive understanding of the range of possibilities. This proactive approach better prepares you for different eventualities and minimizes the impact of unexpected changes.
Collaborative forecasting: Engage key stakeholders from different departments in the forecasting process. Combining diverse perspectives and expertise can lead to more robust and accurate predictions. Collaborative forecasting not only enhances the quality of input, but also fosters a sense of shared responsibility for the budget, promoting collective ownership of financial outcomes.
Quarterly or monthly reforecasting: Embrace a dynamic approach to forecasting by reevaluating and adjusting your predictions on a quarterly (or even monthly) basis. This allows you to respond quickly to changes in the business environment, and to spot variances early. Monthly or quarterly reforecasting enables you to make strategic decisions based on real-time insights, making your FP&A process more agile and responsive. How often teams forecast depends on their capacity, but understanding the fundamental business drivers (what makes or breaks a business) is paramount to ensure the time they do have is spent on the right activities.
Supercharge your forecasting with dedicated FP&A software
By incorporating these strategies into your forecasting process, you not only reduce the magnitude of forecast errors, but also build a more resilient and adaptive budgeting framework.
The catch is that collaborating on your forecasts with multiple stakeholders, or regularly reforecasting 4 to 12 times a year might put too much strain on your team, especially if you're doing everything in Excel.