IV. ANALYTICAL TECHNIQUES FOR FINANCIAL PLANNING
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:
(1) Regular operations and other internal sources (such as profits after taxes, depreciation, disposition of excess inventory, increased revenue through adjusted tax levies).
(2) Expansion of short-term debt consistent with the organization's financial structure (e.g., extended lines of credit, leasing equipment, factoring accounts receivable).
(3) Changes in the financial structure of the organization to permit the addition of new long-term debt or equity funds.
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.
o On-line, real-time decision support systems (DSS) can be used to test the assumptions on which a plan is based, to consider the risk associated with different available alternatives, and to explore a range of possible decision scenarios.
o Computer-assisted methods can be used to fine tuning plans to adjust to unanticipated events that may arise as the plans are implemented.
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.
ANALYSIS OF COST DATA
No program decision is free of cost, whether or not the decision leads to the actual commitment of resources.
o Tendency is to consider costs strictly in terms of dollar inputs--the fiscal resources required to support personnel, equipment, materials, and so forth.
o Future cost that cannot be easily measured in dollar terms all-too-often are dismissed as noncost consideration, but may have implications beyond their monetary value.
Factors Influencing Future Costs
(1) Scope and quality of the services or products to be delivered.
(2) Volume of activity required to deliver these services or products.
(3) Methods, facilities, and organizational structure required to carry out the program.
(4) Qualities and types of labor, materials, equipment, and other cost elements required by the program.
(5) Price levels of the various cost elements.
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:
(1) Operations: the things that must be done (activities or jobs), each with a sequential relation to other operations and each requiring resources for some time period.
(2) Resources: the things utilized in a program or project, normally reduced to a common standard of cost, but including personnel, equipment, materials, and time.
(3) Constraints: conditions imposed by outside factors, such as budgetary limits, completion deadlines, availability of resources, inputs from other units, and so forth.
Basic requirements for the application of program planning techniques are the ability to:
(1) State a work program (including the delineation of specific activities, jobs, or work elements) direct toward one or more defined objectives; and
(2) Attach cost and other resource requirements/constraints to each activity.
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:
(1) The earliest possible time that an activity that terminates at a give node can be completed--known as the earliest possible occurrence or EPO.
(2) How long it will take to complete the entire project (project duration).
(3) Which activities establish and control the project duration (the critical path).
(4) How much leeway (float) exists for those activities that do not control the project duration.
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.
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:
(1) External costs and subtracted from the market value of the output of the project to obtain a net social value, or
(2) Opportunity costs, by examining the potential benefits to those who are likely to be adversely affected if the project funds were spent on some other program.
Most accounting systems capture and distribute costs by one of the following methods:
o Organization-based accounting system s: direct costs are applied to the elements/units of the organizational structure, while indirect costs are paid in a central account with no attempt to further distribute these costs to the various units o Budgetary accounting systems: capture commitments, undelivered orders, and expenditures, the major objective being to fully use assigned resources rather than enhance productivity or to reduce expenses.
o Cost accounting procedures: capture and distribute costs to the output goods or services, using the cost distribution model designed around the major factors of production: direct labor, direct materials, and overhead.
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..
o Inputs are the resources that are consumed by activities (usually measured as costs).
o Outputs are the products (goods or services) that an activity supplies to its customers (internal or external).
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).
o Total cost divided by total volume determines the average cost per unit of output.
o The output measure (e.g., cost per unit of output) is a second-stage driver rate.
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:
NPV = -I + T/(1 + i)^n - K [(1 + i)^n - 1/i(1 + i)^n] + R [(1 + i)^n - 1/i(1 + i)^n]
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:
EUANR = -I [i(1 + i)^n/(1 + i)n -1] + T [i/(1 + i)^n -1] - K + R
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:
(1) Cost of borrowing the capital necessary to finance a project or program, and
(2) Rate of return based that could be realized if an equivalent amount were invested for the same period of time.
Criteria for Analysis
Three choices for a composite criterion for analysis are:
o Maximize benefits for given costs.
o Minimize costs while achieving a fixed level of benefits.
o Maximize net benefits (benefits minus costs).
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:
(1) the time stream of costs and benefits and the time preference for present as opposed to future consumption of goods or services;
(2) limitations imposed by revenue (budgetary) constraints; and
(3) whether goals and objectives can be specified in sufficient detail to permit a fuller identification of direct and indirect costs and benefits.
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:
(1) Cost-goal studies identify feasible levels of achievement by approximating the sensitivity of costs (inputs) to changes in the level of goal achievement (outputs).
(2) Cost-effectiveness comparisons relate incremental costs to increments in achievement in an effort to identify the most effective program alternative.
(3) Cost-constraint assessments determine the cost of employing less than the most optimal program by comparing the program costs that might be adopted if no constraints were present with the cost of the constrained program.
CONVERTING UNCERTAINTY TO RISK
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:
(1) Statistical uncertainty, and
(2) Uncertainty about the state of the real world in the future.
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:
EV = P1$1 + P2$2 + . . . Pn$n.
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:
o Sensitivity analysis--measures (often quite crudely) the effects that variations in uncertain decision elements (i.e., costs) may have on the alternatives under analysis.
o Contingency analysis--examines the effects on alternative choices when a relevant change is postulated in the evaluation criteria; also can be used to determine the effects of a major change in the "ground rules" within which the problem situation exists.
o A fortiori analysis (from the Latin, meaning "with stronger reason")--a method of deliberately "stacking the deck" in favor of one alternative to determine how it might stand up in comparison to other approaches.
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]
(1) Alternatives must be assessed to determine what probabilities and payoffs are implied for individual members of the organization and its clientele.
(2) Attitudes toward risk of these individuals must be evaluated to determine the certainty equivalents of these probabilities and payoffs.
(3) Having estimated the equivalent benefits that each alternative offers to different members of the organization, the decision maker must select the preferred outcome.
Reduction of uncertainty may cause the risk associated with a particular choice to:
(1) Remain unchanged;
(2) Decrease (where a reduction in uncertainty permits the assessment of more definitive probabilities); or even
(3) Increase (when the additional information reveals risk factors previously unknown).
SUMMARY
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:
(1) In the planning stage, based on anticipated costs and benefits, and
(2) After a program or project has been implemented and shown to have a significant impact to assess whether the costs of the program are justified by the magnitude of net outcomes.
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.
Endnotes
[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.