This article considers a case study from a laboratory testing company, which changed its approach to...
If I had to guess, I would assume that most FP&A professionals had already built a shadow budget but instead referred to it as the Finance Department’s model or something along those lines. Loosely defined, a shadow budget is a financial model used by FP&A professionals to “gut check” the consolidated budget rolled up from the business decision units.
It is typically created in parallel with the official budget and often includes more detailed information based on historical performance and trends. Comparing the shadow budget model to the budget submitted by the business decision-makers can identify where sandbagging may occur or when over-optimistic/pessimistic assumptions were made.
What Is a Shadow Budget?
A shadow budget is typically structured in the same way as the official budget but may go even more granular to include G/L line-item level data. Depending on what is needed, a shadow budget may provide:
- More detailed forecasts of revenue and expenses
- Sensitivity analyses
- Scenario Planning
- Risk assessments
- Performance benchmarks
The shadow budget could be the monthly financial forecasting model or turn into one after the official budget has been finalised.
What Are the Benefits of a Shadow Budget?
The shadow budget can help FP&A professionals advise executive leadership in decision-making by providing them with more information about the financial implications of different options before launching the official budget process. A shadow budget can also help identify the key drivers and information needed when creating budget templates for business decision-makers to complete. For example, the shadow budget can be used by the CFO/CEO to evaluate the impact of different pricing strategies, marketing campaigns, and investment decisions that will eventually be used as the base assumptions included in the budget templates that are sent out.
Not everything needs to be budgeted at the same time. When distributing templates, you may get the SG&A department heads to provide a quick turnaround, but business unit heads are slow to respond. You committed to a timeline at the beginning of the process. By creating a shadow budget before the official budget process kicks off, you can fill in the missing information with the data you have as a “best guess” at the time. Depending on how good you are at forecasting and/or how much a line item fluctuates year to year, you may not even need to request feedback for certain budget line items. For example, does the CAO have greater insight into next year’s audit costs than you? If they have historically increased by 5% yearly, the best guess would be to simply take last year’s audit cost and add 5%.
Sandbagging happens; it’s human nature. Because hitting a budget number is typically tied to a compensation metric, business leaders have an incentive to keep revenue growth conservative and expense growth higher. Having a shadow budget allows FP&A professionals to work with business unit leaders to get input on where certain numbers may be more flexible than others. It can be beneficial at the onset but also months later. If the company hits a rough spot and is at risk of missing their targets, knowing where it makes the most sense to cut or where greater upside opportunity may exist becomes critical, positioning the FP&A professional as a resource that can quickly add value.
The shadow budget can be used to develop more sophisticated forecasting models that consider factors such as seasonal fluctuations, economic trends, and competitive activity. Sales rarely ever increase at a constant rate. Using a shadow budget allows FP&A professionals to perform various time-series, regression and even Monte-Carlo analyses to quickly provide executive leadership with probabilistic outcomes given certain assumptions while holding the official budget constant.
More efficient use of resources
FP&A is at the heart of resource allocation within a company. Understanding the challenges and benefits of being able to guide a company’s executives to the decisions that maximise corporate performance to the benefit of investors and stakeholders is critical. To this end, a shadow budget can be used to identify departments or business units that are underperforming or not aligned with the organisation’s strategic goals.
What Are the Challenges of Using a Shadow Budget?
Time and resource constraints
Creating and maintaining a shadow budget can be time-consuming and resource-intensive. FP&A professionals need to be able to collect and analyse large amounts of data to create a meaningful shadow budget. Since the shadow budget will most likely be created in Excel, the use of dynamic arrays and the Power Query tool set may be needed to accumulate the necessary information from disparate systems throughout the company.
Buy-in from stakeholders
Before creating a shadow budget, the FP&A professional needs to get buy-in from senior leadership (the C-suite). They need to understand how the shadow budget will be used and what value they can derive from it. If the value that a shadow budget conveys is not effectively communicated, the C-Suite may not see the point in it, and all the work creating it will be discouraged.
Data accuracy issues
The shadow budget is only as accurate as the data used to create it, and the data used to create it are historical actuals. We like to think the past will look like the future, but that is not always the case. For example, the US federal government pushed back the annual tax filing dates during COVID. This caused a change in the seasonality of historical data. Applying the context to the assumptions based on “known knowns” will help increase data accuracy.
Recommendations for Using a Shadow Budget Effectively
- Start small. It is better to start with a simple shadow budget and add complexity over time as needed.
- Get buy-in from stakeholders. This will help to ensure that the shadow budget is used effectively.
- Apply context to historical data. Make sure to use accurate and up-to-date data when creating and updating your shadow budget. Given this context, consider how the future may not look like the past.
- Review the shadow budget regularly. The shadow budget should be reviewed regularly to ensure that it is up-to-date and that it meets the needs of the organisation.
Despite the challenges, the shadow budget can be a valuable tool for FP&A professionals. By carefully considering each, companies can decide whether or not a shadow budget is right for them.