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Mike English
Mike English

Best Practices, Data Management, Forecasting

Financial Forecasting and the Issue of Diminishing Returns

Posted on Jan 20, 2016 12:00:00 AM

Every local government should invest the time and resources to develop a multi-year financial projection. This type of project can be time and resource intensive…but, it is completely necessary unless your organization is in the enviable position of having unlimited revenues. That is not the case for the vast majority of local governments across the country who are having to balance service delivery objectives against constrained or shrinking revenue resources.

Comprehensive long-term financial planning is increasing in importance and has become an essential on-going activity for local governments. A challenge in the process, though, is balancing the time invested to build the forecast versus the time needed to use and implement the output created from the projection. This blog post will start to examine this balancing act from a diminishing returns perspective.

Let’s start with two major points of value of a multi-year financial projection:

  1. The value in organizing information and strategic thoughts to form the foundation of a multi-year operating plan.
  2. The value in using the projection in the decision making process to actually align organizational resources and communicate strategic priorities.

Read "The Value of a Financial Projection: More Than Just A Spreadsheet"

If an inordinate amount of time is spent in the first area, then the value in the second area will be reduced. There is an inherent trade-off between the two value points given the constraint of time. A financial projection, no matter how accurate, has limited value to the organization if it is never delivered and implemented into the actual operating plans. So, at the outset of a project, it becomes important to establish a balance between the production of the forecast and its consumption.

Breaking Down a 5 Year Projection

The goal in a 5 year budget forecast is not to predict the exact ending cash balance for the enterprise at the end of the fifth year. Rather, think about breaking the results of a 5 year projection into three components:

  • Years 1 and 2 (Budgetary Level Accuracy) – the projected results within the first two years should be very accurate. With good data collection and intelligent assumptions, the projection output for the first two years should provide enough accuracy that the results will produce an executable budget template. For many local governments, many of the major revenue and expense variables are known or locked in for a one to two year period…thus, accuracy should be relatively high.
  • Year 3 (Early Warning) – the results in year three will be undoubtedly less accurate than the results of the first two years…and this is ok. If the final years of the projection indicate financial stress, then year-three may be an inflection point for decisions that can change the overall direction of the projection.
  • Years 4 and 5 (Directional) – the out-years in a financial projection should be used to evaluate the overall financial direction of the organization. The projected balances should not be interpreted as an actual prediction, but rather how the math will play out over time if no decisions are made that alter the financial direction of the organization.

You can use the model above to guide the data collection effort. Again, from a diminishing returns perspective, you should prioritize the effort towards the major components of revenue and expense (those line items that exceed 5-10% of totals), spending the most amount of time and effort on the accuracy of the assumptions and output within the first two years of the projection. For local governments, the revenue and expense items to focus on most closely might be:


  • Recent trends in local, state and federal revenues
  • Formulas and variables that directly impact local, state, and federal revenues such as inflation estimates, property values, tax/fee rates, etc.
  • The timing and cash flow implications of revenue collections


  • Staffing levels and projections for staffing based on service needs
  • Salary costs and projections, especially if multi-year labor contracts are in place
  • Benefits costs and related trends – particularly health insurance and pension costs
  • Operational costs and capital projects

    eBook Download - The Case for Investing in Decision Support Tools

As you begin to sift through the data and formulate assumptions, apply granular focus on the first two years of results. In many cases, these near-term revenues are tied to variables that are known and have been previously determined or calculated such as property values. On the expense side, local governments that have multi-year labor contracts should be able to use this information to accurately project staffing expense within a two year window.

Moving beyond the two year window of a projection, the assumptions may shift from “knowns” to “educated predictions”. And…the focus level on the results should move from a “line item” review to more of a “rolled-up” or aggregated review. The key focus point for the out-years is to confirm the existence of structural surpluses/deficits. From a diminishing returns perspective, the effort should be placed on confirming trends and imbalances at an aggregated level, not a line item level.

Now, this is not a suggestion that minimal thought, effort, and care should be placed on the assumptions and results of the out-years, because the recipients of the projection will be highly focused on those results. You should have confidence that the final years in a projection are reflective of the structural cash flow and all known operating plans/initiatives. The main point to communicate is that the 5th year in a projection is reflective of the direction that the organization is headed if no structural or operating changes are incurred or implemented within the 5 years. This idea is critical to communicate, especially for local governments with projected deficits…because most likely, the existence of a structural deficit will cause the organization to make course-correcting decisions – that will ultimately change the outcomes in year 5.

This may sound like a circular reference…because it is. And, this is the beauty of a 5 year forecast that is actually used to guide decisions. As previously suggested, the purpose of a 5 year forecast is not to predict the 5th year ending balance down to the penny. But rather, to use the projection to guide decisions that actually alter the initial projection…towards a preferential outcome desired by the organization.

In conclusion, and back to the concept of diminishing returns…

The best financial projection is one that is accurate and one that is actually used in the decision making process. In order to be useful for decision makers, the projection needs to be dynamic and easily updated. It may be valuable to incorporate sensitivity analysis into the projection so that a decision maker can evaluate outcomes across a range of assumptions. Of greatest importance, though, is that the process of producing a projection does not exceed the point of diminishing returns. Or, said another way, if the process is too complicated, and too much time is spent evaluating variables that will undoubtedly change over time, then the organization will miss the opportunity to effectively use the projection in its strategic and operational planning processes.

How have you used a 5 year forecast within your organization to drive operational and strategic plans…and how do you balance the issues of diminishing returns in your process?

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Mike English is a founder and the CEO/President of Forecast5 Analytics, Inc. – a technology company focused on software development and data analytics for the public sector. Mike has spent his entire career concentrating on the development of financial and strategic solutions for schools and municipalities. Forecast5 is headquartered in Naperville, Illinois – a suburb 30 miles west of Chicago.

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