Financial Planning Cycle
Effective financial management requires the application of planning and analytical techniques to accommodate the risk and uncertainty that are inevitable in future-oriented decisions. Risk is taken no matter what the decision--even the decision to do nothing involves the risk of lost opportunity. An effective financial manager, whether in the public or private sector, must be aware of how opportunity, innovation, and risk are interrelated and must be willing to take risks appropriate to his or her level of responsibility.
No program decision is free of cost, whether or not it leads to the actual commitment of financial resources. An organization is likely to encounter many different costs in choosing among alternate approaches to achieve its objectives. Costs include not only the expenditure of money but also the consumption of physical resources, the employment of human resources, and the use of time. Factors that influence cost (identified in Exhibit 5) should be considered throughout the financial planning and management process: (1) in developing of plans and programs; (2) in preparing of budget requests; and (3) after commitments have been authorized, in implementing programs or projects.
Exhibit 5. Factors Influencing Future Costs
o Scope and quality of the services or products to be delivered.
o Volume of activity required to deliver these services or products.
o Methods, facilities, and organizational structure required to perform these activities.
o Qualities and types of labor, materials, equipment, and other cost elements required by these programs.
o Price levels of the various cost elements.
Costs can be measured in various ways, depending on the information requirements of management. Whatever the basis of measurement, costs must be weighed against anticipated benefits. The basic concepts of cost are summarized in Exhibit 6. As these definitions suggest, some program costs are fixed, that is, they are the same regardless of the size or duration of the program. Other costs are variable and may change significantly as the scope of the project or program is increased. Because total costs are often difficult to predict, particularly if the project has a relatively long duration, it is important to consider the marginal or incremental costs of increasing the size or scope of a program.
Exhibit 6. Basic Concepts of Cost
o Cost can be defined as a release of value required to accomplish some goal, objective, or purpose.
o Fixed costs do not change in total as the volume of activity increases but become progressively smaller on a per unit basis.
o Variable costs are more or less uniform per unit, but their total fluctuates in direct proportion to the total volume of activity.
o Costs also may be semi-fixed, described as a step-function, or semi-variable, whereby both fixed and variable components are included in the related costs.
o Overhead usually is defined as all costs other than direct labor and materials that are associated with the production process.
o Direct costs represent costs incurred for a specific purpose that are uniquely associated with that purpose.
o Indirect costs are costs associated with more than one activity or program that cannot be traced directly to any of the individual activities.
o Controllable costs are defined as those costs subject to the influence of a given manager for a given time.
o Noncontrollable costs include all costs that do not meet this test of "significant influence" by a given manager.
o Marginal or incremental costs represent the cost of providing one additional unit of service (or product) over some previous level of activity.
Research and development costs, investment costs, the cost of operating, maintaining, and replacing programs and facilities are commonly reflected in cost analyses (see Exhibit 7). At times, however it may be necessary to look beyond these monetary costs to what economists call opportunity costs, associated costs, and social costs..
Exhibit 7. Monetary and Economic Costs
o Research and development costs incurred explicitly for a given project should be included as a project expense. General R&D costs that benefit more than one project, however, are considered to be sunk costs.
o Investment costs are incurred beyond the "start-up" phase to obtain future benefits. Frequently in the form of expenditures for construction or capital equipment, investment costs may be a function of the number of units planned (the greater the number, the higher the investment costs).
o Sunk costs can become an inheritable asset if previous investments can be used to the particular advantage of one alternative over another.
o Recurring costs include operating and maintenance costs that vary with both the size and duration of the program; they include salaries and wages, employee benefits, maintenance and repair of equipment, miscellaneous materials and supplies, transfer payments, insurance, and direct overhead costs.
o Opportunity costs occur if the commitment of resources to one program preempts the use of these resources elsewhere.
o 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.
o Social costs may be defined as the subsidies that would have to be paid to compensate persons adversely affected by a project or program for their suffering or "disbenefits." Rarely is such compensation actually paid (except perhaps when affected individuals enter into litigation and are awarded damages). Social costs often carry emotional overtones and, therefore, may be difficult to evaluate.
The first step in controlling costs is to determine how costs function under various conditions. This process--called cost approximation or cost estimation--involves an attempt to find predictable relationships between a dependent variable (cost) and an independent variable (some relevant activity or program), so that costs can be estimated over time based on the behavior of the independent variable. Formulation of sound cost approximations in the financial planning cycle is a primary responsibility of financial managers.
Traditional methods for cost analyses record and distribute costs by one of the following methods: (a) organizational units/elements; (b) budgetary accounts; or (c) traditional cost accounting with direct and indirect cost allocations. Each of these methodologies has advantages and disadvantages and each has met the past needs of organizations. Yet, each fails to meet the full requirements for financial planning and management.
With the recent advent of activity-based costing, it has become apparent that traditional methods for analyzing costs can create significant differences in output cost because of the manner in which overhead costs are allocated to output on a pro rata basis rather than actually traced to output. This difference in distribution can skew the ultimate price of the output and lead to poor management decisions.
Cost-Benefit and Cost-Effectiveness Analysis
The techniques of cost-benefit and cost-effectiveness analysis can be used to: (1) determine if proposed programs are justified, (2) rank alternative approaches relative to a given set of objectives, and (3) ascertain optimal courses of action to attain these objectives. Such analyses are conducted within an extended time horizon and, insofar as possible, consider both the direct and indirect factors involved in the allocation of resources. The basic components of cost-benefit analysis are outlined in Exhibit 8.
Exhibit 8. Basic Components of Cost-Benefit Analysis
o Selection of an objective function involves the quantification (in dollar terms, to the extent possible) of costs and benefits to facilitate the comparison of alternatives.
o Constraints are the "rules of the game"--that is, the limitations within which a solution must be sought. Frequently, solutions that are otherwise optimal must be discarded because they do not conform to these imposed rules.
o Externalities are side effects, or unintended consequences that may be beneficial or detrimental. Often difficult to identify and measure, they may be excluded from the analysis initially in order to make the problem statement more manageable.
o In examining the time dimensions of various alternatives, it is necessary to delineate life-cycle costs and benefits. Costs are not incurred on a uniform basis. A time lag often occurs between the initiation of a project and the realization of the first increment of benefits.
o The present value of both costs and benefits must be determined by multiplying each by an appropriate discount factor. Benefits that accrue in the present are usually worth more to their recipients than benefits that may occur in the more distant future. Funds invested today cost more than funds invested in the future since one alternative would be to invest such funds at some rate of return that would increase their value.
For the results of a cost-benefit analysis to be valid and reliable, all relevant components that reflect the economic effects of the project must be included. If certain costs are omitted, the project will seem more efficient. When important benefits are disregarded because they cannot be measured, the project will appear less efficient than it is. The results are misleading in either case.
Cost-effectiveness analysis can be viewed as an application of the economic concept of marginal analysis. The effectiveness of a program is measured by the extent to which, if implemented, some desired objective will be achieved. The analysis must be built on some base that represents existing capabilities and existing resource commitments. The analytical task usually is to determine the alternative that will either: (1) produce a desired level of performance for the minimum cost or (2) achieve the maximum level of effectiveness possible for a given level of cost. The supporting analyses required under the cost-effectiveness approach are summarized in Exhibit 9.
|Cost-Goal Studies||Concerned with the identification of feasible levels of achievement. Cost curves are developed for each program alternative, approximating the sensitivity of costs (inputs) to changes in the desired level of achievement (outputs). Outputs are usually represented by nonmonetary indices, or measures of effectiveness.|
|Cost-Effectiveness Comparisons||Assist in the identification of the most effective program alternative by defining the optimum envelope formed by the cost curves. A desired level of effectiveness may be specified and cost minimized for that effectiveness level. Or effectiveness may be maximized for some level of resource allocation.|
|Cost-Constraint Assessments||Determine the cost of not adopting the most effective programs available. The impact of such factors as legal constraints, limits in technical capacity, employee rights, union rules, and so forth, are examined by comparing the cost of programs that might be adopted if these constraints were not present.|
Cost-benefit and cost-effectiveness analysis can be applied at pivotal points in the financial management process. In the planning stage, such analyses may be undertaken on the basis of anticipated costs and benefits. After a program or project has been implemented, cost-benefit and cost-effectiveness analyses may be applied to assess whether the continued costs of the program can be justified by the magnitude of net outcomes. And after a program has completed critical phases in its implementation, these analytical techniques can be used to evaluate the overall program performance in terms of the resource commitments.
A budget is a control mechanism to assure accountability, financial integrity, and legal compliance; a management tool to achieve operating economies and performance efficiencies; and a planning component to assess the overall effectiveness of government programs in meeting public service needs. Fiscal authority and responsibility can be delegated through the budget process, while appropriate central control can be maintained.
The budget process involves: (1) executive preparation; (2) legislative review, modification, and enactment; (3) budget administration; and (4) post audit and evaluation. The budget document should provide a clear and concise picture of both the programs to be carried out and the fiscal basis to support these activities. On the basis of public hearings, the governing body may amend the budget and the proposed revenue measures and then approve the budget by resolution or by an appropriation ordinance. Steps in budget administration include appropriation, allocation and allotment, expenditure control, and budget adjustment. Sufficient information should be maintained to anticipate requirements for budget amendments during the fiscal year.
Several alternative budget formats have been developed over the years to meet the broad objectives of financial management: (1) line-item/object-of-expenditure budgets: (2) performance budgets; (3) program budgets; and (4) zero-base (or service level) budgets. Each of these budget formats arose from the financial management needs at a particular point in time; each reflects varying decision-making capacities; and each have varying management information needs and output capacities (see Exhibit 10). Budgets are inevitably affected by past commitments, established standards of service, existing organizational structures, and current methods of operation.
|Characteristics||Objects of Expenditure||Performance Budget||PPBS/Program Budget||Zero-Base Budget|
|Role of Budget Agency||Fiduciary||Efficiency||Policy||Effectiveness|
|Information/Decision Flow||Bottom-Up Aggregative||Bottom-Up Aggregative||Top-Down Disaggregatiive||Iterative|
|Information Focus||Object Codes||Activities||Programs||Decision Packages|
|Key Budget Stage||Execution||Preparation||Analysis||Analysis|
|Appropriation/Organization Linkages||Direct||Activity-Based||"Across-the-Board"||Budget Units|
Adapted from: Allan Schick, "The Road to PPB: The Stages of Budget Reform," in Planning Programming Budgeting: A Systems Approach to Management, edited by Fremont J. Lyden and Ernest G. Miller (Chicago, Ill.: Markham Publishers, 1968), p. 50.
The object-of-expenditure budget has two distinct advantages over other budget formats: (1) accountability--an object classification establishes a pattern of accounts that can be documented, controlled, and audited; and (2) control mechanisms for enforcing allocation and allotment limits are supplied through such devices as line-item allocations, periodic budget reports, and the independent audit at the end of the fiscal year. Since personnel requirements are closely linked with other budgetary requirements, the management of positions can be used to control the whole budget. Controls may also be applied to the use of specific funds and/or prior approval may be required for proposed transfers between major budget items.
Although seldom practiced today in its pure form, many character-istics of performance budgeting have survived. Performance measures--workload and unit cost measures--and the concept of levels of service have been incorporated into many contemporary financial management applications. The focus on cost-efficiency--a hallmark of performance budgeting--has its parallel emphasis in current budgeting and accounting formats. Cost accounting systems also are being used more widely in government and nonprofit organizations.
Program budgeting combines a planning framework with the basic functions of management and control. Under this approach, multi-year program plans are developed to identify anticipated outputs of services and facilities according to the program objectives. Program objectives describe how and where specific resources will be used: (a) to eliminate, contain, or prevent a problem; (b) to create, improve, or maintain condi-tions affecting the organization or its clientele; or (c) to support or control other identifiable programs. Program objectives must be consistent with available (or anticipated) resources.
The formulation of precise, qualitative statements of objectives is often difficult. The tendency is to describe what the organization does, instead of stating why these activities are appropriate to achieve the long range goals of the organization. The "output" of many organizational activities may be difficult to define and measure. Therefore, secondary measures often must be used to test alternative approaches and evaluate costs.
The basic objective of zero-base budgeting is to circumvent the shortcomings of incremental approaches to budgeting. However, current applications have taken a somewhat more modest and more realistic approach as compared to earlier efforts in the mid-1960s. The detailed analysis of programs "to the zero base" has been replaced by the concept of levels of effort.
Service level analysis seeks to identify essential service levels so that a jurisdiction can maintain and deliver--and be held accountable for--such services in a more efficient and effective manner. Labeling a service as "essential" is not the same as defining its supporting expenditures as "fixed." Essential services can be provided more efficiently (at less cost) or more effectively (with greater benefits). This analytical approach is applicable to all programs in which some discretion can be exercised as to the course of action pursued.
Capital Facilities Planning and Programming
Resource commitments may involve relatively short-term decisions. If a particular public program does not achieve the anticipated results, basic changes can be made, or the activity can be abandoned altogether. Decisions affecting capital facilities are not so easily altered or adjusted, however. Once resources have been committed, the location of a public health clinic, an elementary school, or a firehouse, for example, can be changed only at considerable public expense.
The term capital facility refers to any project having a long life (usually a minimum of 15 to 20 years), involving a relatively large investment of resources, and yielding a fixed asset for the community or organization. Capital facilities require a comprehensive approach in their planning, financing, programming, and debt administration.
Capital facilities planning should be built upon a continuous assessment of community/client preferences, demographic estimates, economic forecasts, and projections of development expectations. Demographic data and other vital statistics must be analyzed to determine changes in client groups. Assumptions concerning population growth or decline are correlated with expected economic activities. Information concerning future economic conditions is also essential in determining the financial capacity of a community to pay for capital improvements.
In all likelihood, for any given budget period, the overall cost of capital projects proposed will exceed the available fiscal resources. Therefore, proposed projects must be evaluated and ranked in some manner and should be rated against an explicit set of evaluation criteria.
When all proposed projects have been examined and analyzed, a composite capital improvements program (CIP) should be prepared, usually spanning a five- to six-year period. This time frame provides sufficient lead time for the design and other preliminary work required by such projects. Projects included in the CIP should be arrayed according to their priority ranking.
Capital facilities can be financed in a number of ways, as summarized in Exhibit 11. These financing method must be evaluated in terms of overall fiscal policies and in light of the particular capital facility involved. A sound long-range revenue program seeks to develop an appropriate mix among these three methods of financing capital improvements.
"Pay-as-you-go" financing encourages a community or organization to "live within its income, minimizes premature commitment of funds and conserves the capacity to borrow for times of emergency when amplecredit may be vital. The pay-as-you-go approach also avoids the added cost of interest payments, making it less costly than borrowing.
On the other hand, the burden of financing a facility may have to be spread over the life of the improvement to achieve user-benefit equity. The general assumption is that future economic and population growth will offset the increased liability and make the payment of debt service (principal and interest) more feasible. A sound borrowing policy is one that seeks to conserve rather than exhaust credit. The ability to borrow when necessary on the most favorable market terms is an objective that applies to governments just as it does in business and industry.
Exhibit 11. Methods for Financing Capital Facilities
o Financing capital projects from current revenues--on a "pay-as-you-go" basis--is more feasible when capital expenditures are recurrent, either as to purpose or as to amount, as for example, the paving of streets or the acquisition of neighborhood recreation areas. It may be easier to finance required public improvements out of current taxes once the infrastructure of the community has been established.
o In financing capital facilities through a reserve fund (sometimes called a capital reserve), a portion of current revenue is invested each year in order to accumulate sufficient funds to initiate some particular project in the future.
o Long-term borrowing may be appropriate under the following conditions: (1) the project will not require replacement for many years, e.g.,, major health facility or sewage disposal plant; (2) the project can be financed by service charges to pay off revenue bonds; (3) needs are urgent for public health, safety, or other emergency reasons; (4) special assessment bonds are the only feasible means of financing improvements; (5) intergovernmental revenues may be available to guarantee the security of the bonds; and (6) for financing projects in areas of rapid expansion, where the resource demands are comparatively large and unforeseen.
A bond is a promissory note ensuring that the lender will receive (1) periodic payments at some predetermined interest rate and (2) at the due date, repayment of the original sum invested. Interest earned on municipal bonds is exempt from federal taxes, and usually from state taxes in the state in which the bond is issued.
|General Obligation Bonds||Backed by the "full faith, credit, and taxing power" of the issuing government.|
|Revenue Bonds||Backed by a pledge of revenues to be generated by the facility that is being financed.|
|Municipal bonds can also be classified according to the method of redemption|
|Term Bonds||Become due in a lump sum at the end of the term of the loan; all bonds in the issue reach maturity and must be paid off at the same time. The lump sum principal payment is met by making annual payments to a sinking fund.|
|Serial Bonds||Retired by annual installments directly from tax revenues or, in the case of revenue bonds, from earned income. Serial bonds have simpler retirement requirements and offer greater flexibility in marketing and in arranging the debt structure of the community.|
|With annuity serial bonds, the debt service payment is approximately the same each year (as with a home mortgage). The portion of the annual payment that covers interest is higher in the early years of the issue but declines as payments toward principal are made (that is, as the outstanding principal is retired).|
|Straight serial bonds require annual payments of principal of approximately equal amounts. Interest payments are large in the early years and decline gradually as the bonds approach maturity.|
|Stepped Coupon Bonds||Use a serial maturity schedule, with coupon rates that start at lower levels and progressively increase to higher levels, even though all the bonds in the issue are sold at par.|
|Zero Coupon Bonds||Sell at a discount and take advantage of federal tax laws which entitle bondholders who forego tax-free income over the life of their investment to receive tax-exempt capital gains upon maturity.|
|Compound Interest Bonds||Return to the investor at maturity the principal plus interest compounded at a specified rate.|
|Tender Option Bonds||Offer the investor the option of submitting the bond for redemption before maturity. Investors usually may redeem a bond (or "tender their option") five years after the date of issue or on any anniversary date thereafter.|
|Flexible Interest Bonds||The yield changes over the life of the bond, based on some interest index printed on the bond itself--most often used is the average weekly rate of Treasury bills or bonds issued during the preceding interest period.|
|Private Activity Bonds||Used either entirely or partially for private purposes and must meet the test of qualification outlined within federal tax law to obtain tax-exempt status.|
Debt administration refers to the management of funds for the construction or acquisition of fixed assets. Capital project funds account for the resources used to build or buy specific capital facilities. These resources come from the issuance of bonds or other long-term obligations, from intergovernmental grants, or from fund transfers within the government unit. The capital project fund is terminated when the project is completed, and the accounting results are transferred to other fund or account groups--the debt service fund and the general long-term debt and fixed assets accounting groups. The resources from which principal and interest are paid and the investment and expenditure of those resources are accounted for in the debt service fund. A sinking fund spreads the cost of repayment over the life of the bond issue to avoid large, irregular demands on the organization's annual budget.
Maintaining accurate debt records is vital to short- and long-term financial operations. Auditable ledgers should record the identity, purpose, and amount of debt commitments associated with capital projects and the principal and interest payments made. Accurate reporting develops confidence on the part of investors and the general public as to the management of the financial affairs of the jurisdiction or public organization. The investment of time and expense in preparing such reports may be repaid many times over through lower interest rates.
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