How to Walk the Forecasting Tightrope
June 28, 2016 – Mike McCann
June 28, 2016
Last week we looked at some of the outside factors, such as inflation and deferred maintenance, that finance professionals must consider in the forecasting process. This week we turn to the inside processes, challenges, and tools the finance professional uses in this critical work.
The formal Annual Forecast used in strategic planning and budgeting is a key finance responsibility and forms the basis for much of the government’s planning process. Last week we talked about some of the key technical issues in developing quality forecasts. It is also important to understand that forecasting is both a political and technical exercise.
- Estimating revenues from sources outside the local government’s control requires prudent professional judgment, using the best available information and tools. Of course, political opinions influence every observer’s view of economic conditions, so the professional seeks to use a wide range of neutral and quantitative inputs in making forecasts.
- Estimating the next year’s expenses requires sound professional evaluation of both outside cost drivers and decisions made on local priorities and policies. Strategic plans and budgets are essentially political instruments, in the best sense of the term. They represent the will of the people as expressed by their elected representatives and the professional managers those representatives hire.
Executives and legislatures may have a hard time accepting this complex mix of controllable (internal) and uncontrollable (external) factors. Many decision makers tend to erroneously consider calculating forecasts their responsibility – they may fail to distinguish between setting policy and establishing the facts needed to inform policy development and discussion.
The finance team must help everyone understand both the real options available to them with properly forecast revenues and the net effect of decisions on the government’s short and long-term financial health. Throughout this process, governments walk a narrow path between two dangers:
Being too Optimistic: Overestimating revenues and underestimating costs carry the most obvious risks. Finance and budget managers dread major mid-year budget adjustments to recognize revenue shortfalls or allocate new funding from reserves to cover expense overruns. Governments can be put in the difficult position of cutting into safe reserve levels or cutting services and staff if forecasts are too optimistic or if they miss major changes in the economy.
Being too Conservative: Underestimating revenues and overestimating expenses both have significant negative repercussions that professionals strive to avoid. Governments are expected to use coerced revenues (taxes) for citizens’ benefit, not to hoard cash in excess reserves. Rising or unreasonable reserve levels can trigger calls for tax cuts and even rebates. Unnecessarily restrictive budgets lead operating departments to reduce service levels and maintenance programs, degrading the community’s civic life and faith in its government.
So how do we solve this puzzle, preserve our sanity, and help our government succeed in its many responsibilities? Working transparently, using our historical records, conservative accounting, casting a wide net, and employing reiterative processes all contribute to a good forecast.
- Transparency during forecasting processes lets the entire finance team provide support, feedback, and fresh eyes on the numbers. Transparency also creates benefits beyond the finance team. It gives forecast users better insight into how the forecast.numbers were developed, their volatility and sensitivity. Better understanding can make it easier to accept hard facts.
- Historical detail is essential to understanding the current numbers and projecting trends into the future. Being able to drill deep into the data helps the analyst separate recurring from one-time events, and understand the specific cost elements that drive a complex cost curve.
- Conservatism (professional, not political) is a hallmark of accounting and provides a sound framework for prudent forecasting. Conservative forecasting takes the middle road in a range of outcomes, uses a straight trendline when the evidence does not demand a curve, and rejects unsupported hypotheses of economic calamity or prosperity.
- Casting a wide net, taking input from many sources, and following relevant news sources at local and national levels add perspective to the work. Considering alternative courses of action with what-if models and discussing findings with heterogeneous teams helps validate ideas and solutions.
- Finally, forecasting is an iterative process – it starts with the first set of numbers posted to the worksheet or modeling system and the full expectation that those numbers will change many times as fact finding, thinking, and dialog continues. No number is ever the final correct answer; in the end, the forecast is just an estimate, a best guess in a range of likely outcomes.
AI (Artificial Intelligence) and data analytics, the wisdom gained from better understanding big data, and industry-specific specialization will eventually lead to better tools that support the finance professional. A day when these tools supplant the human expert is harder to imagine.
In the final two posts, we will present some specific ideas for constructing solid and useful forecasts, then conclude by taking a look at some of the technical tools on the horizon and how they will influence this mission-critical process.
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 email@example.com.
Category: Government Finance