Capability-focused Resource Management: Financial Decisions Dr Teri McConville Cranfield Defence and Security

11/12/2015 Capbility-focused mgt - finance 2 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 11/12/20153 Farmer Shoe maker Taxi driver Teacher Carpet maker Miner Doctor Tailor The economy

Each contributes to the economy 11/12/20154 Farmer Shoe maker Taxi driver Teacher Carpet maker Miner Doctor Tailor The economy And (in the cash economy) gets back cash National Income = total of all incomes or total of all production for cash

Sudan 2010

11/12/20156 Everything has a price less more product price less more supply demand

Trade = goods in & goods out 7 Farmer Shoe maker Taxi driver Teacher Carpet maker Miner Doctor Tailor The economy Trade balance

Sudan 2010

Impact of Government 9 Farmer Shoe maker Taxi driver Teacher Carpet maker Miner Doctor Tailor The economy Government collects taxes and pays people to provide some services, including defence and security

11/12/ 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 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 PersonnelTraining Defence EquipmentInfrastructure other New equipment ModernisationIn-service support 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) Tanks Buildings Salaries Rations 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 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 Budget execution Reporting & audit Accounting & Monitoring

Budget process Policy Review Strategic Planning Budget preparation Budget execution Reporting & audit Accounting & Monitoring Transparency Oversight, responsibility, predictability Transparency, comprehensiveness efficiency transparency Oversight, Accountability efficiency

FINANCIAL DECISION MAKING Delivering Value 11/12/201530

11/12/ Making Financial Decisions Costs versus benefits Notion of Relevant Costs – Future costs How do we value intangible outcomes (e.g. morale, reputation)? Escalating Commitment

11/12/ Example of Relevance A defence supplier invested £ 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 BenefitNet Benefits ANilNil*Nil B £1500 C£500£8000£7500 D£15000£35000£20000

11/12/ Make or Buy Motor transport spends £65 per day on hospital transport. Two private bids: – £46 – £43 Make or buy? Other considerations Cost (£) Labour19 Fuel 6 Operating costs 4080% fixed Total65 Need to account for the fixed cost (£32) – real saving is = 33

11/12/ 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 Gross benefit Nett benefit Average return As %

11/12/ 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 Gross benefit

11/12/ 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’

11/12/ For our three projects: Discount rate at 10% RedWhite Initial Outlay5070 Net benefit Net Present Value Discount rate at 15% RedWhite Initial Outlay5070 Net benefit Net Present Value

11/12/ Discount Rate: 15%RedWhite Discount Factor Cash Flow Present Value Cash Flow Present Value Initial CostYear Cash Inflows/ Profits Year Year Year Year Year Year Year Nett Profit Nett Present Value

11/12/ The End Well done for persevering. Any questions? Let’s take a break!