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Capability-focused Resource Management: Financial Decisions Dr Teri McConville Cranfield Defence and Security Some Basic Economics To understand debates about defence spending and its impact, we need some idea of what happens in an economy 5/23/2017 Capbility-focused mgt - 2 ‘The Economy’ is made by people Taxi driver Shoe maker Teacher Doctor The economy Carpet maker Farmer Miner Tailor 5/23/2017 3 Each contributes to the economy Taxi driver Shoe maker Teacher Doctor The economy And (in the cash economy) gets back cash Carpet maker Farmer Miner Tailor 5/23/2017 National Income = total of all incomes or total of all production for cash 4 Sudan 2010 Everything has a price supply price more demand less less 5/23/2017 product more 6 Trade = goods in & goods out Trade balance Taxi driver Shoe maker Teacher Doctor The economy Carpet maker Farmer Miner Tailor 7 Sudan 2010 Impact of Government Taxi driver Shoe maker Teacher Doctor Government The economy Carpet maker Farmer Miner Tailor 9 collects taxes and pays people to provide some services, including defence and security Inflation • Things cost more • money is worth less because • The supply or flow of money grows faster than the growth in the production of goods and services • The government spends more than receives; • Full employment raises cost of labour 5/23/2017 10 Sudan 2010 Impact of Defence Spending Advantages Provides security: which encourages investment Provides employment Stimulates technological advance that might be applied in civil sector Can train soldiers with skills that are useful in civil the sector But defence spending … x … takes government resources away from other priorities x … may lead to Government over-spending, causing excessive taxation and/or inflation x … absorbs good brains in non-productive activity x … can cause neighbours to spend more on defence Defence Spending: How Much is Enough? • Defence is like an umbrella • Defence sector can have power as a single customer, but – It has the capacity to absorb infinite resources • Defence industries might have a monopoly • Defence & security spending should not damage the society it is supposed to protect. • IMF and NATO – 2% of GDP is maximum/norm 14 Financial management & planning - Why? • To provide Commanders with a means of planning, resourcing and assessing the delivery of security outputs, in particular the delivery of Capability, in the most effective and efficient manner – i.e. financial management is central to effective overall security management Top levels of balance of investment Government revenues other Personnel Defence Infrastructure New equipment Equipment Modernisation In-service support Training disposal Basic terms Budget – a year’s envisaged income and expenditure – predicted flow of income and expenditure over the year – the predicted breakdown of spending over the year: labour, materials etc The bottom line of the defence budget, and the information about how it is derived, should tell the legislators and public about how much money is to be devoted to defence and security … and how much is spent. Basic terms • Budget • Plans – Multi-year anticipated/assumed income and expenditure – Enables affordability forecasts to be made – Countries vary in how they plan • UK rolling four year spending plan and 10 year equipment plan • France - five year spending plan including capital investment • Georgia? • Others? Basic terms • Budget • Plans • Current spending and capital spending (investment) Salaries Rations Current Training Ammunition Easy distinction in principle, hard in practice? Tanks Buildings Capital • • • • Basic Terms Budget Plans Current spending and capital spending Inputs – resources used to carry out particular tasks (money, people, equipment, time, information) Outputs – results of an individual’s or an organisation’s activities – pieces of equipment delivered – soldiers trained for a task – policy guidance agreed Output ______ = Productivity Input Basic principles of public expenditure management • • • • • • • Responsibility Accountability Transparency Oversight Comprehensiveness Predictability (Stability) Efficiency? • What am I responsible for producing (outputs)? • Am I managing the finances/other resources (inputs) involved in responsible manner? – efficiently and effectively? Basic principles of public expenditure management • • • • • • • Responsibility Accountability Transparency Oversight Comprehensiveness Predictability (Stability) Efficiency? • • • • • How well have I delivered the outputs for which I am responsible? Do I answer to someone if I haven’t? Are there penalties for me or my organisation? Are funds being used legitimately? – For purpose intended and in accordance with law/rules Need to combat fraud & corruption – control procedures and supervision of staff – separation of duties: those who decide what is to be bought should not actually buy Basic principles of public expenditure management • • • • • • • Responsibility Accountability Transparency Oversight Comprehensiveness Predictability (Stability) Efficiency? • • • Clarity of roles and responsibilities Openness in budget preparation, execution, reporting. Benefits – helps ensure accountability – reduces scope for abuse – allows society to question government – helps people to know what they are entitled to Basic principles of public expenditure management • • • • • • • Responsibility Accountability Transparency Oversight Comprehensiveness Predictability (Stability) Efficiency? • Set objectives • Set resources • Hold to account UK Oversight mechanisms External Parliament and specialist committees Defence & Public Accounts Comms. Auditor General/National Audit Office/ Finance Ministry Internal: Minister of Defence/ Defence Council Inspector General: Internal Audit & anti-Fraud Unit; (MOD) Police Basic principles of public expenditure management • • • • • • • Responsibility Accountability Transparency Oversight Comprehensiveness Predictability (Stability) Efficiency? • Include all payments and receipts • Allows prioritisation • Essential for effective accountability, transparency & oversight Basic principles of public expenditure management • • • • • • • Responsibility Accountability Transparency Oversight Comprehensiveness Predictability (Stability) Efficiency? • Resources being available in long term • Longer term strategic objectives • Essential for effectiveness BUT counter to control by the legislature Basic principles of public expenditure management • • • • • • • Responsibility Accountability Transparency Oversight Comprehensiveness Predictability Efficiency? • Economy • Efficiency (Doing things right!) • Effectiveness (Doing the right things!) Value for money Budget process Policy Review Strategic Planning Budget preparation Reporting & audit Accounting & Monitoring Budget execution Budget process Transparency Oversight, Accountability efficiency Policy Review Oversight, responsibility, predictability Strategic Planning Reporting & audit Budget preparation Accounting & Monitoring transparency efficiency Budget execution Transparency, comprehensiveness Delivering Value FINANCIAL DECISION MAKING 5/23/2017 30 Making Financial Decisions • Costs versus benefits • Notion of Relevant Costs – Future costs • How do we value intangible outcomes (e.g. morale, reputation)? Escalating Commitment 5/23/2017 31 Example of Relevance • A. B. C. D. 5/23/2017 A defence supplier invested £50 000 in equipment for a new project. The project has been cancelled. Should the company: Leave everything intact and look for a new contract? Scrap the equipment (save £1,500)? Use the equipment for spares (cost £500 but save £8 000)? Modify equipment for an existing project (cost £15,000, saving £35,000)? Extra cost Benefit Net Benefits A Nil Nil* Nil B Nil £1500 £1500 C £500 £8000 £7500 D £15000 £35000 £20000 32 Make or Buy • Motor transport spends £65 per day on hospital transport. • Two private bids: – £46 – £43 • Make or buy? • Other considerations 5/23/2017 Cost (£) Labour Fuel 19 6 Operating costs 40 Total 65 80% fixed Need to account for the fixed cost (£32) – real saving is 19+6+8 = 33 33 Return on Investment • Expected benefits • Minus initial cost • Divided by number of years • Timing may be a problem 5/23/2017 Initial cost (£000) benefit↓ Red 50 White 70 Blue 50 Year 1 10 10 10 2 20 10 20 3 20 10 10 4 20 20 13.5 5 10 30 3.5 6 5 30 3.5 7 2.2 30 3.5 Gross benefit 87.2 140 64 Nett benefit 37.8 70 14 Average return 5.4 10 2 As % 10.8 14.3 4 34 Pay Back (Rate of Return) • How long does it take for initial costs to be recovered? • If income is steady: = Initial outlay / number of years • If income varies we need to do some arithmetic! Red 50 White 70 Blue 50 10 10 10 2 20 10 20 3 20 10 10 4 20 20 13.5 5 10 30 3.5 6 5 30 3.5 7 2.2 30 3.5 Year 1 Gross 87.2 benefit 5/23/2017 140 64 35 Discounted Cash Flow • Considers what money will be worth in the future. • Discounting is the opposite of compounding – (There are tables to work this out!) • Example: • £1000 attracts 20% compound interest over 4 years = £2074 • £1000 with inflation at 20% will be worth £482.3 after 4 years. Expressed as ‘Nett Present Value’ 5/23/2017 36 For our three projects: Discount rate at 10% Initial Outlay Net benefit Net Present Value Red 50 37.8 14.466 White 70 70 19.486 Red 50 37.8 6.365 White 70 70 3.430 Discount rate at 15% Initial Outlay Net benefit Net Present Value 5/23/2017 37 The End Well done for persevering. Any questions? Let’s take a break! 5/23/2017 39