Financial Forecasting

Forecasting is a key component in determining future operations, problems, and opportunities. Good financial forecasts benefit governments by enabling decision-makers to:

• Develop an understanding of available funding
• Evaluate financial risk
• Assess the likelihood that services can be sustained
• Assess the level at which capital investment can be made
• Identify future commitments and resource demands
• Identify the key variables that cause changes in the level of revenue and expenditures

Governments at all levels find forecasting beneficial in determining available resources and developing budgeted expenditure amounts. Most public entities use forecasts that extend three to five years beyond the current budget period, although some entities use 10-year forecasts. In any case, the forecast should be monitored and updated on a regular basis.
Quantitative or qualitative methods, or a combination of both, can be used to develop forecasts. Qualitative methods are more intuitive and are based on the following types of information:

• Judgmental
  Based on “good sense” or a decision made through discerning and evaluating. For example, a city auditor uses prior experience to project the impact of an increase in income tax revenue.
• Consensus
  Based on collective opinion or general accord. For example, a management discussion is used to determine the service level and corresponding cost impact of a policy to limit garbage collection.
• Expert
  Based on the advice of an expert. For example, a township clerk uses a State Employee Relations Board report on benefit costs to project future cost increases.

Quantitative methods include any of the following types of information:

• Trend Analysis
  Compares historical information to forecast percentage changes. For instance, in prior years, step and cost-of-living increases were about 4 percent for village employees. This percentage change is used to project future wage increases.
• Multiple Regression Analysis
  Uses chosen factors to determine the forecasted percentage change. For instance, a regression analysis is used to identify the health care cost reductions resulting from a wellness program instituted by a state agency.
• Time-Series Analysis
  Uses the average percentage change during specific time periods. For instance, over the past 10 years, police and fire department costs have increased at twice the rate of population growth. If the population is expected to increase at 3 percent annually, the costs for public safety may increase at 6 percent annually.

While entities may use either of these methods, research has shown that combining qualitative and quantitative methods improves forecasting accuracy.
Regardless of which method or combination of methods is used to develop a forecast, the following steps should always be followed:

1. Establish a base year.
2. Assess revenue and expenditure growth trends.
3. Clearly specify underlying assumptions.
4. Select a forecasting method.
5. Assess the reliability and validity of the data used to determine assumptions.
6. Monitor actual revenue and expenditure levels against the forecast and explain variances.
7. Update the forecast based on changes.

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