Capability-focused Resource Management: Financial Decisions

Dr Teri McConvilleCranfield Defence and Security

04/20/23Capbility-focused mgt - finance

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Some Basic Economics

To understand debates about defence spending and its impact, we need some idea of what happens in an economy

‘The Economy’ is made by people

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Farmer

Shoemaker

Taxi driver

Teacher

Carpetmaker

Miner

Doctor

Tailor

Theeconomy

Each contributes to the economy

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Farmer

Shoemaker

Taxi driver

Teacher

Carpetmaker

Miner

Doctor

Tailor

Theeconomy

And (in the cash economy)gets back cash

National Income = total of all incomes

or total of all production for cash

Sudan 2010

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Everything has a price

less moreproduct

pric

e

less

moresupply

demand

Trade = goods in & goods out

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Farmer

Shoemaker

Taxi driver

Teacher

Carpetmaker

Miner

Doctor

Tailor

Theeconomy

Trade balance

Sudan 2010

Impact of Government

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Farmer

Shoemaker

Taxi driver

Teacher

Carpetmaker

Miner

Doctor

Tailor

Theeconomy

Governmentcollects taxes

and payspeople to

provide someservices,

including defence and security

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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

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

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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 investmentGovernment

revenues

Personnel Training

Defence

EquipmentInfrastructure

other

Newequipment

Modernisation In-servicesupport

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)

TanksBuildings

SalariesRations

CapitalCurrent

AmmunitionTraining

Easy distinction

in principle, hard in

practice?

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 publicexpenditure 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 publicexpenditure 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 publicexpenditure 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 publicexpenditure management

• Responsibility• Accountability• Transparency • Oversight• Comprehensiveness• Predictability (Stability)• Efficiency?

• Set objectives• Set resources• Hold to account

UK Oversight mechanismsExternal Parliament and specialist committeesDefence & Public Accounts Comms.Auditor General/National Audit Office/Finance MinistryInternal:Minister of Defence/ Defence CouncilInspector General: Internal Audit & anti-Fraud Unit; (MOD) Police

Basic principles of publicexpenditure 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 publicexpenditure 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 publicexpenditure management

• Responsibility• Accountability• Transparency • Oversight• Comprehensiveness• Predictability• Efficiency?

• Economy • Efficiency (Doing things

right!)• Effectiveness (Doing the

right things!)

Value formoney

Budget process

Policy Review

StrategicPlanning

Budget preparation

Budget execution

Reporting & audit

Accounting & Monitoring

Budget process

Policy Review

StrategicPlanning

Budget preparation

Budget execution

Reporting & audit

Accounting & Monitoring

Transparency Oversight, responsibility, predictability

Transparency, comprehensivenessefficiencytransparency

Oversight,Accountability

efficiency

FINANCIAL DECISION MAKINGDelivering Value

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Making Financial Decisions

• Costs versus benefits• Notion of Relevant Costs

– Future costs

• How do we value intangible outcomes (e.g. morale, reputation)?

Escalating Commitment

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Example of Relevance• A defence supplier invested

£50 000 in equipment for a new project. The project has been cancelled. Should the company:

A. Leave everything intact and look for a new contract?

B. Scrap the equipment (save £1,500)?

C. Use the equipment for spares (cost £500 but save £8 000)?

D. 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

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Make or Buy

• Motor transport spends £65 per day on hospital transport.

• Two private bids:– £46– £43

• Make or buy?

• Other considerations

Cost (£)

Labour 19

Fuel 6

Operating costs

40 80% fixed

Total 65

Need to account for the fixed cost (£32) –real saving is 19+6+8 = 33

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Return on Investment

• Expected benefits

• Minus initial cost

• Divided by number of years

• Timing may be a problem

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

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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

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

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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’

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For our three projects:Discount rate at 10%

Red White

Initial Outlay 50 70

Net benefit 37.8 70

Net Present Value 14.466 19.486

Discount rate at 15%

Red White

Initial Outlay 50 70

Net benefit 37.8 70

Net Present Value 6.365 3.430

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The End

Well done for persevering.Any questions?

Let’s take a break!