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MANAGING UNCERTAINTY: FORECASTING TECHNIQUES FOR FINANCE DIRECTORS

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Nottingham Business School

CIPFA: Central Government Finance Conference

Roger Latham – Visiting Fellow

Malcolm J Prowle - Professor

September 2013

The speakers Malcolm Prowle

• Professor at NBS • CIPFA member • Former senior finance manager • Former consultant with

KPMG/PWC • Background in finance and

operations research • Experienced business modeller

Roger Latham • Visiting Fellow at NBS • CIPFA member and former

President • Former FD and CEO of a large

county council • Qualified statistician and economist • Undertook forecasting analysis for

various organisations

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Co-authors of: • book on public services and austerity • research report on strategic financial leadership in the public sector • CIPFA publication on forecasting • many journal articles

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Themes

• Challenges facing public services

• Changing role of finance managers

• The role and importance of forecasting

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CHALLENGES FACING PUBLIC SERVICES

Managing uncertainty: forecasting techniques for finance directors

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Challenges facing public services

• Rising service demands – ageing populations

• Very low growth or decline in resources

• Austerity will be prolonged

• The importance of strategy

• Robust and sophisticated financial analysis will be needed

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Population ageing – the numbers % Elderly in (65+) in the population:

UK Sweden Japan China India

1995 15.5 17.3 14.1 6.1 4.6

2050 22.6 22.3 30.2 18.2 14.9

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Population ageing The very elderly in the UK population

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2013 2020 2030 2033 % % % % 65-70 31 27 27 26 70-80 43 45 40 40 80-90 21 21 25 24 90-100 5 6 8 9 100 & over 0 0 0 1 Elderly Total 100 100 100 100

% Very Elderly( 80+) in the UK population

Year % 1971 2.3 1991 3.5 2025 5.0 2033 7.2

The ageing of the elderly

Source: ONS

Population ageing Changing population structures

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Population ageing – the costs Relative health services expenditure by age group

Age Group Expenditure per head (£) StandardisedBirth 2655 5.0

under 5 794 1.5

5 to 15 185 0.3

16 to 44 328 0.6

45 to 64 459 0.9

65 to 74 949 1.8

75 to 84 1684 3.2

over 84 2639 5.0

Average 530 1.0

Source – Office for Health Economics 1990

Available data on social care (not much) suggests a similar profile

Population ageing – the consequences

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The economy is flat lining

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-6

-4

-2

0

2

4

6

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1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33

GDP annual growth %

Years 1980-2012

Series1

Source: IMF statistics

Austerity What they say now

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Austerity will last until 2020 (2013)

The public sector is only halfway through the reductions needed to achieve the deficit target (2012).

Austerity will continue until 2020 (2012)

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Voyage of Discovery

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McKinsey’s ‘Three Horizons’ of response to the recession (adapted to the public sector)

H1. Bridging

H2. Don’t Waste

a Good Crisis

H3. Paradigm

shift

• Coping strategies

• Trim fat, be flexible – sees us through

• Have contingency plans in case of worse

• Quick fix, rough justice, equality of pain

• ‘Reset’ costs at lower levels, take on sacred cows

• Be aggressive early

• Support top priorities and slash lowest

• “Wither on the vine” or “make it self-sufficient” alternatives

• “Use it or lose it” challenges

• Shift resources to strategic priorities - remove legacy services

• Schumpeterian technology shift

• Fundamental reorganisation (ending “command and control”)

• Shifting the public/private boundary

• Changing expectations and behaviour

From: Paul Jansen, McKinsey and Co, Forum on the Future of Higher Education, June 2009

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The Three Horizons

Horizon 1 is a current paradigm that works well until changes in the environment plus its own diminishing returns put it on a a curve of decline. Meanwhile Horizon 2 , aware of this in diverse ways is innovating more effective approaches which eventually overtake.

In the background, a completely new paradigm is emerging as Horizon 3. It appears for a long time to be marginal and ineffective but since it matches better the new environment it eventually takes over. The Horizon 2 innovations have served as enabling the transformation.

PREVALENCE

TIME

H3

H1

H2

“After the Downturn”- CIPFA/SOLACE Strategic Options

1. Big State/small State - Redefining the relationship

between the State and the individual

2. A significant de-layering of the public sector with

many more decisions taken locally with the minimal

oversight

3. A major initiative to maximise economies by much

more effective collaboration between public bodies

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Mapping to Strategic Options Big State/Small State Delayering &

Devolving Collaboration

H1 •Capital cuts •No reinvestment •Stop grant aid •Cut least favoured/defended services

•Tax/charging increase •Cash limit freeze •Pay freeze •Benefits freeze

•Cut partnership overheads •Axe Quangos •Common Purchasing

H2 •“Big Society” •Co-production •Service prioritisation •Pensions

•“Use it or lose it” •IT led investment •Seed corn funding

•Public/private partnerships •Shared Services

H3 •Reducing income/wealth inequalities •Self sufficiency for lower taxes •Sustainable communities

•Organisation change and takeovers •New technologies •Systems thinking

•Reorganisation •Community outcomes plans • Theory “U” Partnerships

• This is all very complex and there are huge financial implications in all cases

• Financial analysis and evaluation must inevitably become more complex and sophisticated

• This is what has happened in many parts of global business – why not in the public sector too

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CHANGING ROLES OF FINANCE MANAGERS

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Changing roles for finance managers

Source: The Hackett Group

Analytical Services

Transactional Services

Analytical Services

Transactional Services

Process and technology enablers

Managing the finances Managing the business

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Strategic financial leadership in public services

• Focus on sustainable and effective strategies

• Focus on robust strategic financial analysis

• Requires considerable up-skilling by many

• Strategic finance managers must also provide leadership

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Areas of increasing importance

• Cost and cost driver analysis

• Performance analysis and reporting

• Budget setting

• Forecasting

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Source: The Hackett Group

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Outside the Comfort Zone

Accounting –Budgeting

and Financial Planning

Statistics – Forecasting, Hypothesis testing, and prediction

H1 H2 H3

“Traditional Competencies” New Requirements

“Too Academic”

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I don’t need to know this because...........

You can’t ignore it because......

• It’s not practical...

• It’s too technical...

• It will take too long – I haven’t got time....

• I can’t use the results – too uncertain

• It’s a core strategic requirement

• You may not need to do it yourself, but you need to know what can/should be done.

• “He who does not learn from history will be condemned to repeat it”

• Managing uncertainty is the name of the game

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THE ROLE AND IMPORTANCE OF FORECASTING

Managing uncertainty: forecasting techniques for finance directors

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Key aspects

• Role and purpose of forecasting

• Structure

• Approaches

• Risk and uncertainty

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Role and purpose of forecasting

• Definition

“A planning tool that helps management in its attempts to cope with the uncertainty of the future, relying mainly on data from the past and present and analysis of trends.”

• Some Applications

– Policy analysis

– Demand forecasting

– Financial resource forecasting

– Strategy development

– Service reconfiguration

– Managing budgets

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Structure of forecasting

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FORECASTING PROJECT

e.g. future service demand,

future costs

Forecasting Process Forecasting guidelines of

good practice

Forecasting Stages Forecasting

Methods/Techniques

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Forecasting process and stages

Process

• Roles and Involvement

• Approach

• Responsibilities

• Consultation

• Reporting

Stages

• Determine the purpose

• Establish the time line

• Identify items to be forecast

• Select relevant forecasting methods

• Gather data

• Make forecasts

• Validate forecasts

• Decision making regarding results

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Forecasting Approaches

Qualitative

• Surveys

• Structured discussion

• World Cafe

• Dephi Methods

• Theory U

Quantitative

• ARIMA models

• Multivariate analysis

• Monte Carlo simulations

• Linear Programming

• Non-linear Programming

• Chaos Theory simulations

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Perspective on Approaches

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Method Chosen %

Qualitative Quantitive

Explanatory Model %

None Pre-determined Emergent

Source: Study of published research on public sector budgeting over 30 years Sample size =85!!!

Risk and uncertainty Risk • Is...a state of uncertainty where

some of the possibilities involve a loss, catastrophe, or other undesirable outcome

• Measured by....a set of possibilities each with quantified probabilities and quantified losses

• Relative Frequency hypothesis – R A Fisher

• Conventionally measured • Insurable, risk pooling, mitigated • “Known knowns” and “known

unknowns” • What the Banks thought they had

controlled!

Uncertainty • Is....the lack of complete

certainty, that is, the existence of more than one possibility. The "true" outcome/state/result/value is not known

• Measured by ... set of probabilities assigned to a set of possibilities

• Adaptive iterations – Bayes theorem

• Cannot be conventionally measured

• “Endured” rather than mitigated • “Unknown knowns”, and

“unknown unknowns” • What did for the Banks!

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