A five-year financial model for municipal decision making and resource allocation
Mark W. Nottley
This article examines the reasons for the growing use of this budgeting technique in the public sector and the benefits that can be derived from a five-year future financial model. The City of Lincoln Park, a long-time advocate of financial modeling, is utilized as a case study.
Growing Popularity of Financial Modeling
Michigan’s municipal governments have been subjected to a series of fiscal challenges. Since 1978, local taxing ability has been limited by the Headlee Amendment to the state constitution, a statute which requires millage rollbacks when property value increases exceed the rate of inflation. Potentially more onerous, the recently enacted Proposal A, places an inflationary cap on the increase in individual property assessments; a restriction which may severely limit future revenue growth in many municipalities.
Additionally, federal assistance has been significantly curtailed and state-shared revenue has proven to be a volatile, less-than-predictable funding source. Coupled with rapidly rising costs, mandates and increasing service demand, the financial outlook dictates a prudent, planned approach to long-term resource management.
The short-range nature of traditional budgeting systems often renders them inadequate to meet the emerging fiscal challenge. Annual budgets typically consider only incremental changes to existing programs and services, and consequently do little to prepare a municipality for dramatic, unexpected events such as Proposal A. In the absence of a large fund equity, a municipality that is wholly dependent on short-term budgeting may be inviting financial crisis. In contrast, a five-year budget model, properly constructed, may provide the early warnings that are necessary to develop a long-term program which stresses service priorities and sound fiscal practices.
The City of Lincoln Park: A Case Study
The City of Lincoln Park, located in the “downriver” area of Southeastern Michigan, provides a classic example of the successful application and implementation of a financial modeling system. As an older, established municipality with a population of approximately 42,000, Lincoln Park has faced the ongoing challenge of balancing a limited resource base with the service requirements of the community. The city has been generally successful in this regard, largely as a result of belt-tightening and prudent financial practices.
Like many older Michigan cities, however, Lincoln Park entered the 1990s with a degree of financial uncertainty and apprehension; more specifically:
* some population loss was expected as a result of the 1990 census (with a corresponding decrease in state revenue sharing),
* property tax revenue could not be expected to increase dramatically during the 1990s,
* wages and benefits were consuming an inordinate amount of general fund budget,
* expenditures for items such as health care and solid waste disposal were far exceeding the rate of inflation, and
* infrastructure and rolling stock were aged and would require significant investment.
In light of these, and other financial considerations, the city required an overall game plan for assessing on-going financial conditions and determining spending priorities and cost containment strategies. This requirement was met through the development of a five-year financial model.
Developing the Lincoln Park Five-year Financial Model. The development of a five-year financial model for the City of Lincoln Park was a joint effort involving the mayor and city council, department heads and the city’s financial consultants. The process involved a line-item by line-item evaluation of general fund finances, including identification and analysis of all factors that would likely impact the city’s financial condition in each of five future fiscal years. Expert sources were consulted concerning particular revenue or expenditure trends, and capital requirements were meticulously documented.
The results of this evaluation were captured in a spreadsheet-based software program which closely resembled the city’s budgetary format. By virtue of its automated nature, the program could be easily manipulated to accept changes in assumptions and reflect the complexities inherent in city finances, such as fund interactions and transfers. Exhibit 1 illustrates the file configuration which comprises the five-year financial model; major elements of the spreadsheet organization are explained below.
* A master assumption file is incorporated into the model. Examples of master assumptions include the percentage of wage increase, inflation, health care cost increase and other significant variables. The master file allows these key assumptions to be modified easily on a year-to-year basis (i.e., “what-if analysis”).
* Master revenue and expenditure files provide a concise summary of the estimated year-to-year financial results, including fund balance. The level of detail is limited, with each major revenue source and city department or activity represented in the schedules.
* Support files generate the special financial data necessary for developing a concise and comprehensive financial estimation and model. These include
– an estimate of property tax revenue that incorporates the applicable tax limitation legislation;
– estimations of state-shared revenues by category;
– estimations of internal service funds or special revenue funds, which interact with the general fund through transfers and charges for service;
– an expenditure detail file that provides specific line-item information for each individual department or activity area; and
– a capital equipment file containing the specific capital items and related costs that have been developed for each individual department.
What the Model Revealed. The results of the financial analysis were decidedly negative. Based on the assumptions used, including current expenditure trends, it was estimated that the city’s expenditures would exceed revenue in each of the five future years, culminating in a virtual depletion of fund balance in fiscal year 1994, the final year of the forecast.
The mayor and city council had been actively involved in the development of the financial model. The completed model now provided them with a solid and rational basis for proactive decision making concerning the future direction of the city. Specifically, the model provided the following:
* the ability to concentrate on the total picture in determining current and future spending priorities;
* a basis for identifying problem areas and required actions at the earliest point-in-time;
* a rational method for defining labor negotiation objectives and supporting the city’s position in arbitration hearings; and
* as an automated model, the ability to quickly evaluate any number of “what-if” scenarios, such as, for example, the impact of a 2 percent versus a 3 percent pay increase or of an unanticipated increase or decrease in revenue sharing.
Lincoln Park’s Action Plan. In light of the negative results forecast within the financial model, the mayor and city council embarked on a long-range strategy for cost containment. The financial model provided the starting point for this strategy, which included
* implementation of a successful long-range collective bargaining strategy grounded in cost-benefit analysis,
* privatization of select services such as emergency dispatch and some motor pool functions,
* identification of departmental inefficiencies and institution of new methods for operation,
* initiation of early-out retirement incentives to reduce excess staffing in some service areas, and
* utilization of creative financing techniques for infrastructure and equipment replacement.
By systematically addressing these and other cost items, the city was able to eliminate many of the negative financial trends that were initially identified and incorporated in the financial model. As a result, the city has maintained financial integrity and, in the process, has identified and eliminated many inefficient and/or outmoded practices.
Lincoln Park’s experience with financial modeling and planning has resulted in a more informed, decision-making process – a situation in which public policy can proceed from a rational basis that is clearly aligned with long-range objectives and outcomes. This is particularly critical in an era in which resources are increasingly limited and municipalities are continually challenged to “do more with less.”
A version of this article was published initially in the March 1995 issue of the Michigan Municipal League’s magazine Michigan Municipal Review. The author has expanded it for Government Finance Review. MARK NOTTLEY joined the Michigan Municipal League staff in January 1995 as manager of municipal consulting services. Previously, be served in a similar capacity with the consulting firm, Plante and Moran, and as a senior governmental consultant with Coopers and Lybrand’s national practice. He has assisted numerous Michigan municipalities in developing and implementing strategies for improving cost effectiveness. For additional information concerning financial modeling, contact the author at 313/662-3246.
COPYRIGHT 1995 Government Finance Officers Association
COPYRIGHT 2008 Gale, Cengage Learning