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Financial planning requires analytical techniques that can accommodate the risk and uncertainty associated with decisions regarding the commitment of scarce resources.


Various indicators, derived from accounting records, have been used to measure the well-being of business with respect to liquidity, leverage, profitability, and the utilization of assets.

Such data often go unchallenged because officials lack the specialized knowledge to verify their authenticity.

Strategic Funds Programming

Cash flow analysis can help to identify sources, flow, and uses of discretionary funds and to show where potential adjustments must be made to implement new programs.

New funds can be generated from three sources:

Baseline funds are used to pay current operating expenses, provide adequate working capital, and maintain current plant and equipment.

Strategic funds are used to (a) purchase new assets, such as equipment, facilities, and inventory; (b) increase working capital; and (c) support direct expenses for research and development, marketing, advertising, and promotions.

Key decision points are encountered (1) when funds available from internal sources have been consumed, and (2) when available credit sources have been exhausted.

Computer-Assisted Financial Planning

Computer-based methods of analysis have become a significant tool for financial planning.

Models can be developed and used to: (1) project financial statements, (2) analyze cash flow requirements, (3) optimize financial leverage, (4) compare lease versus purchase options for different depreciation schedules, and (5) evaluate the impact of proposed mergers/acquisitions.

Available software packages also make it possible to perform sensitivity analyses to determine how an optimal solution might change if some of the key variables in the model should be altered and to introduce and analyze risk and uncertainty.


No program decision is free of cost, whether or not the decision leads to the actual commitment of resources.

Factors Influencing Future Costs

Management Planning and Operations Scheduling

The timing of costs often is a critical factor in management decisions.

If a program or project is to be implemented successfully, three elements must be coordinated into a program plan and operations schedule:

Basic requirements for the application of program planning techniques are the ability to:

Network Analysis and the Critical Path Method

Network analysis produces a visual display of activities to be performed, providing a basis for determining the order in which activities should be undertaken and critical linkages among them.

Activities--the basic building blocks of a network analysis--may represent a process, task, procurement cycle, or waiting time or simply a connection or interdependency between two events (nodes) on the network.

An arrow diagram is composed of a series of sequential relationships or paths. which should be completed in the indicated sequence

Each arrow (activity) in the network has a time estimate called its duration--the amount of time required to complete the activity--which has resource requirements and associated costs.

Beginning at "start," the time duration for each path (series of connected arrows) should be summed to determine:

The EPO of the final activity node has added significance--it is the earliest possible completion time for the entire project.

The latest possible occurrence or LPO is the latest time that all of the activities terminating at a given node can finish without causing the project duration to exceed the originally determine project duration.

The EPO is the longest path from "start" to a given node; the LPO is the shortest path from the termination of the project back to a given node.

Float is the difference between the EPO and the LPO.

"Critical" activities have zero float and form a continuous path, starting at the first activity and ending at the last one.

Once the program is implemented, the critical path can be continuously monitored so that potential delays can be identified before they occur

Delays can be avoided by shifting personnel, materials, or other resource inputs to the critical path from those paths that have "float."

By utilizing the float of various tasks to make "early starts," it should be possible to keep the project on schedule, within bounds of the limited staff resources, and achieve a more even distribution of staff commitments.

Monetary Costs

Research and development involve "front-end" costs which, if incurred explicitly for a given project, should be included as a project expense.

Investment costs are incurred to obtain future benefits and vary primarily with the size of a particular program or project, but not with its duration.

Recurring costs include operating and maintenance costs that vary with both size and duration of the program such as: salaries and wages, employee benefits, maintenance and repair of equipment, miscellaneous materials and supplies, transfer payments, insurance, and direct overhead costs.

Marginal or incremental costs of increasing the size or scope of a program or project.

Fixed costs are the same regardless of the size or duration of the program; as a project increases in size or scope, these costs are distributed over a larger number of service units.

Variable costs may change significantly as the scope of the project or program is increased.

Economic Costs

Opportunity costs occur if resources committed to one program preempts their use elsewhere.

Associated costs are any costs involved in utilizing facilities or services; for example, the cost that users must pay to travel to public recreational facilities, or the cost that government incurs to provide highway access to such facilities.

Social costs are subsidies that would have to be paid to compensate persons adversely affected by a project or program for their suffering or "disbenefits" and can be treated as:


Most accounting systems capture and distribute costs by one of the following methods:

ABC: A Process-Oriented Approach

The Activity-Based Costing (ABC) model re-configures how organizations manage costs by attaching costs to activities carried on in support departments.

ABC is a process-oriented method that recognizes labor-intensive processes may represent the single largest contribution to the increasing cost of doing business.

ABC recognizes that the pro-rating method used in traditional cost accounting does not truly account for the usage variance in process costs that may exist in different units.

ABC provides a more representative distribution of resource use since cost allocations are based on the direct cost drivers inherent in work activities.

Cost drivers are any events that cause changes in the total cost of an activity..

Costs must be traced from the traditional cost accounting structure (which identifies what resources are being used) to the activities (which relates why resources are being consumed--for what purpose).

The allocation basis is called a first-stage driver (e.g., square feet of floor space).

The next step is to quantify the volume of each activity's output, either as an actual (historical) volume or as a projected volume (define an output measure).

Performance measures are identified to determine the results achieved by an activity or activity center (e.g., average cost per patient treated for a particular ailment).

Activity-based costing represents a new way of doing business, but can complement and extend the benefits of both process reengineering and responsibility center management.


Cost-benefit analysis requires that estimates of the direct and indirect costs and the tangible and intangible benefits be translated into a common measure, usually a monetary unit.

Benefit Investment Analysis

Discounted cash flow techniques apply principles of compound interest to take into account differences in the worth of money over time and to examine the future negative and positive cash flows (costs and benefits) required to produce the desired returns.

The net present value (NPV) method gives the algebraic difference of both outward cash flows and inward flows of income or benefits.

The formula for calculating net present value can be expressed as:

whereby I represents the initial investment, the present worth of the terminal value is calculated by multiplying (T) times the appropriate discount factor, and K and R are multiplied by the present worth factor of a uniform series.

The equivalent uniform annual net return (EUANR) combines all investment costs and all annual expenses into one single annual sum that is equivalent to all disbursements uniformly distributed over the analysis period.

The EUANR formula can be represented as follows:

whereby the initial investment (I) is multiplied times a capital recovery factor, the terminal value (T) is multiplied by a sinking fund factor, with K and R representing uniform annual expenses and uniform annual income respectively. R includes return on investment (depreciation and net profit).

Basic Components of Cost-Benefit Analysis

Cost-benefit analysis involves an identification of: (1) an objective function, (2) constraints, (3) externalities, (4) time dimensions, and (5) risk and uncertainty. [1]

Selecting an objective function involves the identification and quantification of the benefits and costs associated with each alternative.

Constraints are the "rules of the game"--the limits within which a solution must be sought. Solutions that are otherwise optimal frequently must be discarded because they do not conform to these imposed rules.

Projects may have externalities or spill-over effects--i.e., unintended consequences that may be beneficial or detrimental--which may be difficult to identify and measure and may be excluded from the analysis initially in order to make the problem statement more manageable.

Two common bases for discounting to accommodate the time dimensions of the analysis reflect both local conditions and the marketplace for investments:

Criteria for Analysis

Three choices for a composite criterion for analysis are:

A benefit/cost ratio is defined as the present value of benefits divided by the present value of costs (or average annual benefits over average annual costs).

The net benefit/cost ratio is a variation on the basic benefit/cost ratio which emphasizes the return on invested capital by segregating operational costs and subtracting them from both sides of the ratio.

Net benefits measure difference, whereas benefit/cost calculations produce a ratio.

Limitations of Cost-Benefit Analysis

Cost-benefit analyses provide only limited assistance in evaluating programs of relatively broad scope or in comparing programs with widely differing objectives.

Other factors must be considered in selecting an appropriate or "best" decision, including:


The effectiveness of a program is measured by the extent to which, if implemented, some desired objective will be achieved --either (1) a desired level of performance at the minimum cost or (2) the maximum level of performance possible for a given level of cost.

Output Orientation

Costs can ordinarily be expressed in monetary terms; levels of achievement are usually represented by nonmonetary indexes, or measures of effectiveness, i.e., direct and indirect effects of resource allocations.

Cost-effectiveness analysis must move from some base that represents existing capabilities and existing resource commitments.

The objective is to determine what additional resources are required to achieve some specified additional performance capability.

Effectiveness measures involve a basic scoring technique for determining increments in output achieved relative to the investment of additional increments of cost, often expressed in relative terms--e.g., percentage increase in some measure of educational attainment or percentage reduction in incidence of a disease.

Supporting analyses required under the cost-effectiveness approach include:


Certainty can be defined as a state of knowledge in which the specific and invariable outcomes of each alternative course of action are known in advance.

Uncertainty can be defined as a state of knowledge in which one or more courses of action may result in a set of possible specific outcomes, the probabilities of which, however, are neither known or meaningful.

Risk is a state of knowledge in which each alternative leads to one of a set of specific outcomes, each outcome occurring with a probability that is known to the decision maker.

Risk and uncertainty must be confronted from two primary sources:

Establishing a probability function can bring problems within more manageable bounds by reducing uncertainty to some level of risk that may be tolerable, depending on the risk threshold.

Uncertainty and Cost Sensitivity

An expected value approach often must be applied when the environment is uncertain.

In mathematical terms, expected value (EV) can be expressed as:

where P stands for probability, $ stands for the value of an outcome, and P1 + P2 + . . . Pn = 1.

Techniques utilizing the concept of expected value have been developed to analyze uncertainty about the future state of events include:

Uncertainty, Risk, and Expected Utility

The values for the probabilities will be unique for each individual and not unlike the values of utility that might be assigned to an individual through a study of his or her social preferences.

Determining strategic choice under uncertainty is a threefold process. [2]

Reduction of uncertainty may cause the risk associated with a particular choice to:


Techniques used by for-profit organizations to analyze financial data often are difficult to apply to nonprofit organizations, since the basic objective of such organizations is to "break even."

However, asset utilization ratios--involving some measure of volume of activity or workload divided by some measure of cost or time--can be applied to nonprofit organizations.

A cash flow analysis helps to identify sources of discretionary funds and to show where potential adjustments can made by distinguishing between baseline funds and strategic funds.

Computer-based models can be used to (1) project financial statements, (2) analyze cash flow requirements, (3) optimize financial leverage, (4) compare lease versus purchase options for different depreciation schedules, and (5) evaluate the impact of proposed mergers/acquisitions.

Network analysis techniques produce visual displays of the activities to be performed, provide a basis for determining the order in which activities should be undertaken, identify critical linkages among activities, and offer excellent tools by which to communicate roles and responsibilities.

It often is appropriate to look beyond monetary costs--research and development costs, investment costs, and the costs of operations, maintenance, and replacement--to include opportunity costs, associated costs, and social costs in financial analyses.

Cost analysis must also distinguish among: (1) fixed and variable costs, (2) recurring costs, and (3) marginal or incremental costs.

Activity-Based Costing techniques provide a more representative distribution of the use of resources since cost allocations are based on the direct cost drivers inherent in work activities.

The need to adopt an extended time dimension has led to the development of cost-benefit analysis.

Cost-benefit and cost-effectiveness analyses can be applied at two pivotal points:

Various methods have been developed for converting uncertainty to risk--including the use of objective and subjective probabilities and the techniques of sensitivity analysis, contingency analysis, and a fortiori analysis.


[1] Otto Eckstein, Water Resource Development (Cambridge, MA: Harvard University Press, 1958).

[2] Edith Stokey and Richard Zeckhauser, A Primer for Policy Analysis (New York: Norton, 1978), p. 252.