Building a Useful Annual Forecast
July 5, 2016 – Mike McCann
We started this series on forecasting by looking at some of the outside factors, such as inflation and deferred maintenance, that finance professionals must consider in the process. Then we turned to the internal processes, challenges, and tools the practitioner uses in this critical work. Today we will discuss some specific suggestions for constructing a solid and useful Annual Forecast.
Every professional forecaster can build an Excel worksheet or other financial model to suit her needs. You have developed your own ways to collect and organize the data and effectively format results. Hopefully this post will validate some of your own ideas and suggest additional explorations and refinements.
The Annual Forecast is a firm, defensible, detailed, usually account level, estimate for the upcoming year. We offer a dozen suggestions for handling many of the major revenue and expense drivers considered in the forecast:
1. We should consider each major element of the forecast independently of other unconnected elements; property tax receipts trends won’t change no matter how badly we need them to rise to cover known increases in negotiated labor costs.
2. We should conduct forecasts at an appropriate level of detail. Third-party specialists who can validate detailed business tax returns commonly complete sales tax analysis because they have the best knowledge of new businesses entering and leaving the market, and watch trends in retail across the country.
3. CIP spending estimates at a summary level are less valuable than well-constructed lifetime project budgets with current year plans and specifically identified funding sources. We should expect CIP teams to review long-range plans each year and identify planned next-year activity clearly.
4. Generic inflation increases may be appropriate for some categories of revenue and expenses, but should be used carefully with fully disclosed sources. Classes of accounts which have specific cost drivers or need manual reconsideration should be systematically excluded from the general calculations for inflation. For example, recreation class fees and routine building maintenance costs recur every year. Their variation according to controllable and known plans is more accurate than application of a generic inflation index.
5. Characteristics of each revenue and cost need to be understood and accounted for:
- Many accounts carry routine activity that recurs year after year in the normal operations of the government. These can be forecast routinely from historical trend lines, and are influenced broadly by inflation and economic expectations.
- Other significant costs are unique: Bond proceeds or refinancing, sale or purchase of major capital assets, natural disasters, annexations and other changes in the government itself. Past major events must be isolated from trend analysis, and known future events must be specifically provided for in forecasts.
- Less major, but still irregular, activity can distort trend lines and predictions. Removing or adjusting for anomalies like departmental project accounts, unusual revenues (hundred-year civic anniversaries), or changes in retirement plan structures, help the forecaster refine historical predictions.
6. Personnel costs are 70-80% of most operating budgets. They are often forecast separately, in their own worksheets or system. Forecasts may be done at an overall percentage level (by labor unit) or in detail by salary, retirement, and benefit element. Detailed work using specific changes in tax law, benefit and retirement plan contracts, and labor negotiations yields the most accurate forecasts. However, many governments find that simpler percentage models provide are more manageable and provide acceptable accuracy. Major known changes in labor agreements, retirement, tax and benefit costs should be considered in any forecast.
7. Personnel costs totals are driven by both cost elements per employee and by the number of budgeted employees. Most governments control the personnel forecast centrally in the finance or human resource department. The budget team asks all departments to forecast changes in FTEs, other staff counts, and the levels of positions. The costs of these changes are then calculated in the personnel budget and add to the annual forecast.
8. Forecasters should include the government’s strategic plans and initiatives in the forecast and clearly describe the linkage. Tying specific revenue and spending to the big-picture, long-range strategy helps everyone understand how the forecast’s individual elements align.
9. The forecast may call out use of reserves to cover expected revenue shortfalls, or add to reserves when revenues exceed planned uses. Maintaining healthy reserves allows some level of smoothing in the face of swings in the overall economy or local disturbances. Prudent forecasting includes maintaining reserves according to local policy over future periods.
10. We have discussed zero-based budgeting (“ZBB”) before. In terms of forecasting, it may be most useful in isolating accounts which should neither be subject to general inflation nor flatlined, but are more susceptible to management when times are tight, or growth when revenues allow operations to catch up on previously deferred projects.
11. Many forecasters use a term like “budget savings” as a revenue line item in forecasts. The concept is that the current budget will not be fully expended for various reasons: New positions may be hard to fill, vacancies may remain open longer than anticipated, projects may get off to a slow start, or worst case scenarios may not play out. A 2-5% savings estimate may be reasonable for many governments.
12. Five-year and other out-year forecasts help frame the Annual Forecast. We have discussed one way to tackle longer-range forecasts at a summary level. While inflation indices and other trend analysis takes a more prominent role across longer time spans, the careful forecaster still takes time to consider the effects of nonlinear costs in their models. Economic cycles, changes in bond and tax profiles, and capital outlays all distort general curves.
In the end, there is no perfect answer, no single right number to be found. Forecasting is both art and science. Experience can be a cruel teacher and most of us have made forecasting mistakes that still make us cringe. Prudence, accounting conservatism, a broad view, and just plain hard work are all part of the solution, and what makes this work so challenging.
We will survey some of the literature and best practice advice available to the practitioner today in upcoming posts. We will conclude the series with a conversation with a prominent data scientist working in the field of predictions and forecasts.
Mike McCann moved into government service in Ukiah, then Monterey CA, after beginning his career in corporate (ADP, Wells Fargo Bank, Blue Shield of CA), not-for-profit (Blue Shield of Ca, Mendocino Private Industry Council), and start-up accounting. For the last 20 years, Mike has been hands-on with budget, financial reporting and accounting operations, including City budgets and CAFRs. He holds a B.S. in Accounting from SJSU and M.S. in Instructional Technology from CSUMB.
Contact Mike with questions or comments at firstname.lastname@example.org.
Category: Government Finance