Evaluating forecasting methods for cash management in the Navy Working Capital Fund

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(1)Calhoun: The NPS Institutional Archive Theses and Dissertations. Thesis Collection. 1998-12. Evaluating forecasting methods for cash management in the Navy Working Capital Fund Bestercy, Robert J. Monterey, California. Naval Postgraduate School http://hdl.handle.net/10945/8323.

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(6) NAVAL POSTGRADUATE SCHOOL Monterey, California. THESIS EVALUATING FORECASTING METHODS FOR CASH MANAGEMENT IN THE NAVY WORKING CAPITAL FUND by Robert. J.. Bestercy. December 1998. Thesis Co-Advisors:. Shu. S.. Liao. John E. Mutty. Approved. for public release; distribution. is. unlimited..

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(8) REPORT DOCUMENTATION PAGE. Form Approved. OMB No.. 0704-0188. estimated to average 1 hour per response, including the time for reviewing instruction, searching existing data sources, gathering and maintaining the data needed, and completing and reviewing the collection of information. Send comments regarding this burden estimate or any other aspect of this collection of information, including suggestions for reducing this burden, to Washington headquarters Services, Directorate for Information Operations and Reports, 1215 Jefferson Davis Highway, Suite 1204, Arlington, VA 22202-4302, and to the Office of Management and Budget, Paperwork Reduction Project (0704-0188) Washington DC 20503. Public reporting burden. 1.. 4.. for this collection of information. AGENCY USE ONLY TITLE. REPORT DATE December 1998. (Leave blank). !. REPORT TYPE AND DATES COVERED. Master's Thesis. AND SUBTITLE Management. in the. Navy Working. Capital. FUNDING NUMBERS. 8.. PERFORMING. J.. PERFORMING ORGANIZATION NAME(S) AND ADDRESS(ES). ORGANIZATION REPORT. Naval Postgraduate School Monterey, CA 93943-5000 9.. 5.. Fund. AUTHOR(S). Bestercy, Robert 7.. 3.. 2.. Evaluating Forecasting Methods for Cash 6.. is. NUMBER. SPONSORING MONITORING AGENCY NAME(S) AND ADDRESS(ES). SPONSORING/ MONITORING 10.. /. AGENCY REPORT NUMBER 11.. SUPPLEMENTARY NOTES. The views expressed in this thesis Defense or the U.S. Government. 12a.. are those of the author. and do not. reflect the official policy or position. DISTRIBUTION / AVAILABILITY STATEMENT. Approved for public release; distribution. is. of the Department of. 12b.. DISTRIBUTION. CODE. unlimited.. ABSTRACT (maximum 200 words) This thesis researches business forecasting models and methodologies for application in the in the Navy Working Capital Fund (NWCF). The recent dissolution of the Defense Business Operations Fund (DBOF) and establishment of the service Working Capital Funds has resulted in an increased emphasis on effective cash 1. 3.. management of cash management. practices at the service level. Unpredicted outlays in an era of severely declining budgets have caused further. scrutiny of cash. management. practices in the. NWCF,. which generates nearly $20. billion annually in. revenues and expenditures.. NWCF and outside the Department of Defense were evaluated for potential application at the Assistant Secretary of the Navy (Financial Management & Comptroller) (ASN (FM&C) and Supply Management Activity Group Forecasting models within the. (NWCF-SM). level of the. NWCF.. possible implementation across. all. Specifically, the. NWCF-SM expenditures forecasting model was analyzed and evaluated for. NWCF business activities.. analyzed and recommendations were. made. Additionally, a developmental cash. management system was. and private sector benchmarks were discussed to illustrate techniques that may be applicable in NWCF cash management. Cash collection and disbursement data were collected at ASN (FM&C) and NWCF-SM and evaluated for forecasting possibilities aforementioned models and methodologies. A simple probabilistic model was presented for application in NWCF cash management. for improvement. Finally, several forecasting methodologies. forecasting. 14.. SUBJECT TERMS. Cash Management, Forecasting, Models, Financial Management, Budgeting, Navy Working Capital Fund. 17.. SECURITY CLASSIFICATION OF. REPORT Unclassified. NSN. 7540-01-280-5500. 18.. SECURITY CLASSIFICATION OF. THIS. PAGE. Unclassified. 19. SECURITY CLASSIFI- CATION OF ABSTRACT. Unclassified. 15.. in the. NUMBER OF. PAGES 164 16.. PRICE CODE. 20.. LIMITATION. OF ABSTRACT. UL Standard Form 298 (Rev. 2-89) Prescribed by ANSI Std. 39-18.

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(10) DUm. FY KNOX LIBRARY. NAVAL POSTGRADUATE SCHOOL MONTEREY, CA 93943-5101 Approved. for public release; distribution. is. unlimited. EVALUATING FORECASTING METHODS FOR CASH MANAGEMENT IN THE NAVY WORKING CAPITAL FUND Robert Lieutenant. J.. Bestercy. Commander, United. B.A., State University of. States. New York,. Navy 1985. Submitted in partial fulfillment of the. Requirements for the degree of. MASTER OF SCIENCE IN MANAGEMENT from the. NAVAL POSTGRADUATE SCHOOL December 1998.

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(12) ABSTRACT The recent. dissolution of the Defense Business Operations. Fund (DBOF) and. establishment of the service Working Capital Funds has resulted in an increased emphasis. on. effective cash. management. practices at the service level.. Unpredicted outlays in an. era of severely declining budgets have caused further scrutiny of cash. practices in the. expenditures.. NWCF,. which generates nearly $20. Forecasting models within the. (Financial. Management. &. Comptroller). Group (NWCF-SM). Activity. expenditures forecasting model. across. all. NWCF. at the Assistant Secretary. NWCF.. made. for. forecasting methodologies and private sector forecasting. illustrate. techniques that. may be. applicable in. and disbursement data were collected. at. model was presented. for possible implementation. management. improvement. Finally, several. benchmarks were discussed. NWCF cash management.. Cash. to. collection. ASN (FM&C) and NWCF-SM and evaluated for. forecasting possibilities in the aforementioned. probabilistic. NWCF-SM. the. Additionally, a developmental cash. system was analyzed and recommendations were. of the Navy. Supply Management. Specifically,. was analyzed and evaluated. business activities.. and. and outside the Department of. (ASN (FM&C) and. of the. levels. billion annually in revenues. NWCF. Defense were evaluated for potential application. management. models and methodologies.. for application in. v. NWCF cash management.. A. simple.

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(14) TABLE OF CONTENTS INTRODUCTION. I.. 1. A.. Background. 1. B.. Objective. 4. C.. Research Questions. 4. D.. Scope of Thesis. 5. E.. Methodology. 5. OVERVIEW OF THE NAVY WORKING CAPITAL FUND. II.. A.. Concepts and History of Working Capital Funds. B.. Budgeting. C.. Current Status of NWCF Cash Management. III.. in. the NWCF. 9. 9. 21. FINANCIAL FORECASTING AND MODELING. 30. 37. A.. Models and Simulation. 38. B.. Business Forecasting Models. 40. C.. Choosing the Appropriate Forecasting Method. 42. D.. Industry Practices. 53. IV.. A.. DATA COLLECTION AND MODEL REVIEW Understanding the Accounting Cycle. Vll. 65. 65.

(15) B.. Data Collection Methodology. 70. C.. NWCF Cash. 75. ANALYSIS. V.. Models and Forecasting. 89. .-.. A.. Quality of Data. 89. B.. Trend Analysis. 92. C.. Forecasting Applications. D.. Implementation Considerations. VI.. in. the NWCF. CONCLUSIONS AND RECOMMENDATIONS. 97 108. Ill. A.. Summary. Ill. B.. Research Questions. 1. C.. Suggestions for Further Research. 116. 12. APPENDIX A FORECASTING METHODS. 119. APPENDIX B TREND ILLUSTRATIONS. 121. APPENDIX C NWCF-SM BUDGET DATA. 125. APPENDIX D ASN (FM&C) CASH REPORTING SYSTEM. 127. APPENDIX E NWCF-SM FLT REGRESSION CHARTS. 129. APPENDIX F SIMULATION OUTPUT. 143. LIST OF REFERENCES. 149. VI 11.

(16) INITIAL DISTRIBUTION LIST. 153. IX.

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(18) I.. A.. INTRODUCTION. BACKGROUND The Navy Working. December 1996 when. the. Capital. Fund (NWCF),. a revolving fund,. established in. Under Secretary of Defense (Comptroller) separated. Defense Business Operations Fund (DBOF) into four working. Army, Air Force and Defense (1997)].. was. capital funds. the. Navy,. -. [Office of the Inspector General, Department of Defense. The term "revolving fund" describes. the. mechanism used. to finance the. business-like activities. Unlike an appropriated fund activity, which. is. Navy's. financed through. an annual appropriation of funds from congress, a revolving fund activity receives an. earned authority for the amount of every customer order accepted. accomplished, the revolving fund activity uses Working Capital Fund for the costs of. on stabilized. As work. (WCF). is. cash to pay. performing work or providing material. Customers are then billed based. rates. and. prices,. and the customers reimburse the. The fund "revolves" with an annual goal of a. WCF,. replacing the cash.. net operating result of zero. -. all. costs. covered and no profit retained [Department of Defense Publication (1996)].. The. DBOF. had been established. in 1991. by consolidating nine existing. industrial. and stock funds, in an attempt to foster a more business-like approach to Defense depot maintenance, transportation, supply management, and accounting operations. Regardless. of nomenclature, the intent of the revolving funds has been to focus management.

(19) attention. on. the total costs of essential Department of Defense business operations and to. provide quality goods and services. The working. at the. lowest cost [General Accounting Office (1997)].. capital funds are designed to operate. time, with service and material rates based. on a break-even basis over. on predicted costs and business. levels.. Administration of a working capital fund carries Antideficiency Act responsibility. U.S.C. Section 1517].. The Under Secretary of Defense (Comptroller). also requires that. the services maintain a 7-10 day balance of cash, plus investment cash.. Secretary of the. Navy. (Financial. Management. &. Comptroller). The Assistant. (ASN (FM &C)). maintains a balance between $400 and 700 million [10 U.S.C. Section 2208].. activities. fail. to. break even, due to. higher than. development of revenue, subsequent year maintain an adequate cash balance for. management of cash. at all levels. bill. rates. anticipated. must be raised. payments and. [3. currently. NWCF. If. expenses or slower to cover losses. capital investments.. and. Effective. provides for stable rates and prevents over obligation of. funds, or a failure to fully obligate funds authorized.. Historically, cash. revolving fund.. management. resided with the major claimant responsible for a. A major claimant is a bureau, office or headquarters, which is designated. as an administering office under the Operations and Maintenance appropriation. Comptroller Manual, Vol. 2,. Ch.. 2].. Prior to the establishment of the. claimants involved in cash management were the. (NAVSUP), which managed. (NAVSEA), which managed. the. the. DBOF,. [Navy. the. two. Navy Supply Systems Command. Navy Stock Fund, and Naval Sea Systems Command Navy. Industrial. Fund.. Through the creation of the.

(20) DBOF,. these responsibilities were transferred to the Office of the Secretary of Defense. Management. Defense. (OSD).. Review. (DMRD). Decision. 910. simultaneously. consolidated accounting and finance functions and personnel into the Defense Finance. and Accounting Service (DFAS). However, back. to the services.. services to. WCFs.. The. manage cash. -. in 1995,. OSD. capability for the. and resolve accounting problems. at all levels in the. Since the transfer of cash management and the creation of the. management has come under. management. was an eroded. net result of these events. to research. transferred cash. WCFs, cash. increasing congressional scrutiny and several General. Accounting Office (GAO) and Department of Defense Inspector General (DODIG) reports have. WCFs. made. specific. recommendations for improving cash management within the. [General Accounting Office (1997)].. Most. recommended develop. recently,. the. Defense. that each service. standards. to. enable. Working. The goal of this. in. thesis. all. is. Activity. common. model, or. budget development process.. if. Groups,. to assess existing. business practices to determine if Activity Groups (AG's) in the. effective. Congressional. Study. component develop a cash management model and. model employment. differences in business operations.. Fund. Capital. NWCF. models and. can. models can be developed to improve and. despite. utilize. an. facilitate the.

(21) B.. OBJECTIVE The research involved. investigating. improved cash management. Navy Working. forecasting techniques in the. Capital Fund.. capabilities. and. Specifically, forecasting. models were researched and assessed, and existing models were evaluated for possible application. the. in. identification. NWCF. NWCF,. and. model accuracy,. ASN (FM&C). existing cash. for. (3) evaluation. of data available. at. development of forecasting models or. management. research. thesis. and research of private-sector models,. results. included. for. (1). cash. (2) evaluation. NWCF. of. Activity Groups. tools, (4). comparison of. with forecasting results, (5) a summarization of. possible applications of forecasting tools in the. C.. The. methods and models currently being used. of forecasting. forecasting within the. forecasting. budgeting process.. NWCF.. RESEARCH QUESTIONS The following questions were addressed: 1.. Can 2.. Primary: forecasting. to. improve. NWCF cash forecasts?. Secondary: (1). Activity. models be used, or developed,. What models. Groups and (2). at. are currently used to forecast cash balances in the. NWCF. ASN (FM&C)?. Are private sector companies with similar business. effective cash forecasting techniques?. Can such models be applied. in the. activities using. NWCF?.

(22) (3). (4). (FM&C). How effective are existing models What requirements. exist for forecasting cash balances at the. and Activity Group levels of the. (5). Can. in forecasting cash balances?. ASN. NWCF?. forecasting tools be applied by. NWCF. AG's. to. more accurately. develop budget plans?. (6). statistical. Can. analyses. decomposition) or. D.. the data available to. (Statistical. Process. NWCF Control. AG's be used (SPC),. to. moving. develop other averages,. and. new forecasting models?. SCOPE OF THESIS Existing data were examined to assess model effectiveness and applicability to. NWCF budgeting.. Effectiveness. was measured by comparing. available historical figures. with forecasts. Data were evaluated for trends and seasonality to determine. if the. being evaluated could be modeled. Further, data were reviewed to determine. system. if sufficient. amounts were available for the types of models being considered.. E.. METHODOLOGY The methodology used included. instructions. and existing models,. the following:. (2) interviews. (1) literature. with budget analysts. review of reports, at. ASN (FM&C),. Navy Supply Systems Command (NAVSUP) and American Management Systems, (which developed models for. NAVSUP),. (3) collection. Inc.. of historical data concerning.

(23) disbursements, collections, liquidated/unliquidated obligations and planned and actual. NWCF budgetary figures,. (4) evaluation. of model in use. at. NAVSUP,. of non-DoD cash forecasting models and techniques for possible assessing model(s) or statistical analysis applicability in. of collected data. testing. actual budget figures. (1). in model(s),. (8) analysis. of. DoD. application, (6). cash management, (7). results. by comparison with. and variances.. Literature:. A. review of. government reports and. including. and. NWCF. benchmarking. (5). literature. instructions. on. models was completed,. existing. detailing. WCF. management. cash. procedures. Additionally, references were reviewed on forecasting models and statistical. techniques to determine the range of possible models and/or techniques that. NWCF. budgetary levels in the. collections, obligations. (2) Interviews:. NAVSUP.. NWCF in order to understand the forces that influence. and disbursements. in the different business areas.. Interviews were conducted with budget analysts at. Interviews focused on data sources,. how. forecasting or statistical analysis tools are utilized, if any.. determine. if forecasting is feasible. information. is. ASN (FM&C) used and what. Daily tasks were observed to. and beneficial from the viewpoint of the budget. Interviews were also held with the cash managers at each level to discuss. analyst.. historic. apply in. cash management. This review also included research into the business practices. at different. and. may. performance with respect to plans and goals.. financial. Attempts were made to interview. managers of firms with business practices similar. to the. NWCF..

(24) (3). Data Collection:. Historical. concerning. data. liquidated/unliquidated obligations and planned and actual. collected from resident databases at each interview. (4). disbursements,. collections,. NWCF budgetary figures were. site.. Model Evaluation: NAVSUP's cash model was evaluated. for effectiveness. by. reviewing historical performance data. Additionally, model documentation was reviewed. to. determine. (5). how the model. functions and. variables affect forecasts.. Benchmarking: Trade publications were reviewed to ascertain non-DoD. efforts at business forecasting.. Ingalls,. how. Companies with industrial/supply business practices. Newport News, Boeing) were contacted The. forecasting tools.. to determine if they. were. (e.g.. utilizing. review focused on government contractors and other. literature. manufacturing firms that use working capital to finance production and inventory. functions.. (6). determine. Model if the. forecasting in the. Application:. NAVSUP NWCF.. Collected cash. management data were reviewed. to. or other models identified could be used to improve cash. First,. the data were evaluated for use in a forecasting model.. Second, existing model effectiveness to accurately predict balances was assessed. Third, the candidate models were examined for applicability in the. statistical analysis tools. were reviewed. for application. NWCF. AG's.. by budget analysts or. Further,. activity. comptrollers in developing budget submissions.. (7) Tests:. Data collected. at the interview sites. comparing actual figures with forecasts. to determine. were tested in the model(s) by. "goodness of. fit".. Variances were.

(25) analyzed to determine model effectiveness. The model was also evaluated on the value of the forecasts to budget analysts. and cash managers..

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(27) OVERVIEW OF THE NAVY WORKING CAPITAL FUND. II.. CONCEPTS AND HISTORY OF WORKING CAPITAL FUNDS. A.. Working Capital Funds (WCFs) were. originally established in. DoD. by the 1949. National Security Act Amendments. The legislation authorized the Secretary of Defense. to utilize. WCFs. working. activities.. can be broadly separated into two categories, industrial operations and supply. operations.. The primary goal of WCFs. of carrying out. DoD. in revenue,. is. to focus. management. attention. on the. Focusing attention on costs. business functions.. especially considering that the current. WCFs. total cost. is. important,. are expected to generate about. $69 billion. while employing some 220,000 federal civilian employees and 24,000. military personnel [Department of the. $20. procurement and industrial. capital funds to fund inventory. billion in 1997, while. Navy. (1997)].. employing over 100,000. The Navy. civilian. WCF. alone generated. employees and 3,000 military. personnel.. In. most and. DoD, WCFs. service activities,. services,. are used to finance the operating costs of supply, industrial. by providing "up-front" funding. and subsequently recouping. that funding. for the costs of producing. to generate sufficient revenues over time to recover expenses. a break-even basis.. zero.. Pricing. is. goods. through customer reimbursement. throughout the operating year (hence the term "revolving fund").. supposed. and. The and. WCFs. to operate. are. on. negotiated each year to generate a net operating result of. However, the Under Secretary of Defense (Comptroller) mandates. 10. that the funds.

(28) must maintain 7-10 working days of cash, and funds. sufficient to. support capital. reinvestment programs [Department of Defense Office of the Under Secretary of Defense. (Comptroller) (1997)].. Regardless of the cash requirement, fund pricing. each year to cover expenses.. and. rates,. A. rates.. Defense Business Operations Fund (DBOF) 1991, the. Prior to. industrial funds.. DoD WCFs. In late 1991, a. were divided into four stock funds and. new fund was. established,. industrial funds, as well as several appropriated. was. on the. to focus leadership attention. combining. fund support. revolving fund called the Defense Business Operations. DBOF. services and defense. components continued. within the financial. all. DoD. five. stock and. activities into. a single. Fund (DBOF). The concept of. total costs. of DoD business functions,. and to promote active cost management in the revolving fund. activities. estimated. carry-over loss from the previous year will raise prices. while a profit will decrease prices and. 1.. the. is. activities.. The. military. to be responsible for operating the business. However, Defense Management Review. structure.. Decision 910 capitalized financial management and accounting functions into the. Defense Accounting and Finance Service (DFAS), realigning disbursing and accounting personnel from the services into the. new. activity [General. Accounting Office (1997),. Report AIMD-97-152]. The transfer of accounting functions occurred during a period of. significant. downsizing throughout DoD, and the net effect was the. finance and accounting personnel at the service level.. 11. loss. of experienced.

(29) The Office of the Secretary of Defense (Comptroller) balance of the. DBOF. through. management of. DBOF. cash to the services and. management. DoD. managed. DoD. 1995,. component. the cash. returned. level to align cash. accountability with those entities responsible for the business activities. DBOF. funded.. In February. year 1994.. fiscal. centrally. further evolved or devolved in. December 1996, when the Under. Secretary of Defense (Comptroller) cancelled the. DBOF. Army Working. Capital. Capital Fund, the. Working Capital Fund and. Navy Working. the Defense-wide. and established four funds, the. Fund (NWCF), the Air Force. Working Capital Fund,. collectively the. Defense Working Capital Funds [Office of the Inspector General, Department of Defense (1998)].. Navy Working Capital Fund. 2.. The activities,. NWCF. is. used. to finance. and account for costs. at. Navy. business-type. applying standard accounting principles as specified by the Federal Accounting. Standards Advisory Board and the Office of Management and Budget.. revolving funds, the. NWCF. is. Like most. designed to operate on a break-even basis over time,. recovering current year losses or returning gains through subsequent year rate changes.. In establishing the. activities in the. the fund.. NWCF in. NWCF,. 1. 996 the Navy included not only supply and industrial type. but also. made. several changes to the organization of activities in. The changes included merging. the Logistics Support Activity. Group. into the. Supply Management Activity Group and transferring the Defense Printing Service to the. Defense Logistics Agency [Department of the Navy (1997)].. 12.

(30) The organization now includes activities. grouped together. nearly fifty. as. shown. NWCF. primary activity groups, with like business. The. for financial reporting purposes.. activities. activity groups represent. with a revenue base of approximately $20 billion annually,. The. in Figure 2.1.. six. groups that closely align with. larger activity groups include several secondary activity. Navy. organizational structure.. There are currently a. total. of seventeen activity groups, including a corporate level holding area for pending financial transactions at the Assistant Secretary of the. Comptroller). (ASN (FM&C)).. Navy. (Financial. Management. &. [Department of the Navy (1997)]. 1998/1999 President's Budget Supply Management. $6.2B. Depot Maintenance. $4.. Research and Development. $6. OB. Transportation. $1. Information Services. $0.2B. Base Support. $1.8B. Figure 2.1. .. 1. 1. Navy Working Capital Fund Revenues. Supply Supply Management -. A. primary activity group consisting of two secondary activity. groups, Supply Management. - Navy, and Supply Management - Marine Corps. The area. encompasses inventory management. for shipboard, aviation. and consumable spare parts and commodities.. 13. and amphibious repairable.

(31) Industrial. Depot Maintenance -. A. primary activity group consisting of four secondary. Ordnance, Shipyards, Aviation and Marine Corps.. groups:. maintenance, repair, manufacture, overhaul,. refit. activity. The functions include. and engineering services.. Services. Research and Development activity groups: Air. Command, Facilities. A. primary activity group consisting of six secondary. Warfare Center, Surface Warfare Center, Undersea Warfare Center,. Control and. Ocean Surveillance Center, Naval Research Laboratory and. Engineering Service Center.. Functions include research, development,. test,. evaluation and engineering support functions.. Transportation. ships, Special. logistics. -. A. primary activity group that provides Naval Fleet Auxiliary Force. Mission ships and Afloat Prepositioning Force ships for sea transportation,. and special missions.. Information Services. groups. (DoN,. DoD. -. A. primary activity group consisting of three secondary. and. Federal. Agencies),. which. provide. regional. activity. automated. information services, and design, development and environmental support for information. technology systems.. Base Support -. A. primary activity group consisting of nine Public Works Centers that. support facilities maintenance, services and. facilities.. 14.

(32) Organizational Relationships. 3.. ASN (FM&C) the. maintains overall responsibility for the solvency of the. NWCF. Program/Budget Office for the. ASN (FM&C). develops budgets for the. NWCF,. as. [Department of Defense Publication (1996)].. NWCF. for. submission to the Secretary of. Defense by collecting and consolidating activity group budget estimates. Activity group submissions by collecting and consolidating submissions from. managers develop. their. their. Activities. activities.. prepare. budget. submissions. by. considering. performance, anticipated workload and numerous other factors that. business.. Correspondingly,. communication flows to ensure. up. to date. to. when budgets. budget information. is. activity. maintained.. budgetary chain closely mirrors the actual chain of shipyard) reports to an activity group. (e.g.. Naval Sea Systems Command),. (ASN (FM&C)).. Point). that. is. group managers and. Management. appear. in. the. command. also the major claimant. in turn will report to the. organization. information.. 15. for. this. as an activity (e.g.. command. Program/Budget office. ASN (FM&C),. Activity Group) and activities (e.g.. NWCF. activities. Communication through. Figure 2.2 provides a partial illustration of how. group(s) (e.g. Supply. Control. manager. who. affect future year. are being executed in the current year,. ASN (FM&C),. and from. may. historical. Navy. activity. Inventory. communicating budgetary.

(33) NWCF ORGANIZATION ASN (FM&C). 1. SUPPLY AG. NAVY INVENTORY CONTROL POINT. DEPOT MAIlsfT AG. NAVY SHIPYARD J. 1. R&D AG. TRANSPORT AG. \ I. B. Figure 2.2 Partial. Communication continues. NWCF Budgetary Organization. frequently throughout the planning, programming,. budgeting and execution phases of the Department of Defense budget cycle to. facilitate. budget estimate submissions, budget changes and the solution of execution problems. Figure 2.3 illustrates the data flow to and from the major entities in the. For example, in the case of the Fleet and. Industrial. NWCF. Supply Center (FISC) Pearl Harbor,. budget submissions are developed and forwarded to Naval Supply Systems. (NAVSUP). as the Supply Activity. Group manager.. budget.. NAVSUP. collects. Command. and consolidates. submissions from activities in the group and forwards the consolidated submission to. ASN (FM&C). for. inclusion in the. eventually the President's Budget.. execution occur,. ASN (FM&C). Secretary of Defense. Likewise,. when. deviations from expected budget. will contact activity group managers,. contact activities to determine the sources of deviation.. Accounting Service (DFAS). is. budget submission, and. who. in turn will. The Defense Finance and. the clearing house for financial data from activities,. 16.

(34) producing reports for. all entities. errors or delayed processing. and helping. to determine causes. [NAVCOMPTINST. ASN. ACTIVITY. (FM&C). GROUPS A. of deviations, posting. 7102.2 (1995)].. ACTIVITIES 1. DFAS. NWCF Budgetary Data. Figure 2.3 Flow of 4.. Definitions. The following. a). are. some of the more. frequently used terms in. NWCF budgeting.. Cash Management. Cash Management. is. the process. by which managers maintain a. sufficient. supply of cash to meet day-to-day business needs and future investment plans.. The. process includes developing cash plans and monitoring execution, researching and. reporting deviations from plan, and analyzing collections, disbursements and transfers. affecting the cash balance.. Effective cash. management. in the. NWCF means maintaining. 7-10 days of operating program disbursements plus six months of capital program disbursements.. The cash requirements. are levied. by the Under Secretary of Defense. (Comptroller) and are set to maintain solvency and prevent violations of the Anti-. Deficiency Act. [Department of the. Navy. (1997)]. 17.

(35) Outlays. b). Outlays in federal budgeting refer to the actual cash payments (including. checks paid, electronic fund transfers,. been spent. Outlays,. The term "outlay". is. etc.) that. occur in a. In. deficit,. NWCF. taxes and other sources are used to. or surplus, in a given fiscal year.. terms, outlays additionally refer to the difference between. disbursements and collections within the. positive outlay indicates that. cash balance in the. NWCF,. as reported to the U. S. Treasury.. more was disbursed than. NWCF. A. When. A. collected and results in a smaller. negative outlay indicates collections were greater than. disbursements and results in a larger cash balance in the. (1991)]. what has. congruous with "disbursement" and "expenditure".. when compared with revenues from. determine the federal. fiscal year, basically. outlays are discussed in this thesis, the. NWCF.. [Library of Congress. NWCF. definition of outlays. applies.. c). Collections. Collections in a. NWCF activity refer to revenues. services (transportation, industrial work, repair, design,. any. entity authorized to. be a. NWCF. agencies, other services or other. R&D).. from sales of material or Collections can be from. customer, including private agencies, other federal. NWCF. activities.. NWCF Navy customers.. 18. Most. collections are. made from non-.

(36) Planning, Programming, and Budgeting System (PPBS). d). implemented. Originally. in. DoD. in. the. PPBS. 1960s,. scheduled framework for planning, programming and budgeting in. PPBS. follows a. strict. multiple taskings required under. e). PPBS. is. The. Navy Program Information Center. (1994)]. cash balance becomes significant at the. as an aggregate 7-10 days cash. most closely monitored. at. is. determined by. from cumulative collections and adding the surplus month's cash balance brought forward.. (or subtracting the deficit) to the previous. is. net result of the. Cash Balance. subtracting cumulative disbursements. balance. programs.. a well thought out and defensible budget.. Calculated on a monthly basis, the cash balance. NWCF,. DoD. all. a. timeline and calls for simultaneous development of short and long-. term plans, while considering the effects of current execution.. [Department of the. establishes. ASN (FM&C). and activity group level of the. must be maintained on hand. ASN (FM&C). (as the. used to determine what action,. if. The. to. pay. bills.. Cash. is. Program/Budget Office), and the cash. any, should be taken in advance billing. customers (described below) to maintain solvency.. [Department of Defense Publication. (1996)]. Advance Billing. f). Advance or services agreed. billing does not. billing refers to the practice of. having customers pay for work. upon before the completion of work or delivery of. change the schedule of work to be accomplished, but. 19. service.. it. Advance. does increase the.

(37) short-term availability of cash.. began large-scale advance advance. billing liability. Advance. billings in 1993.. billings are a carry-over. When the. from. DBOF, which. NWCF was established in. 1996, an. of $2.2 billion was passed along, necessitating continued advance. billing to the current day, although at a greatly reduced rate.. Progress in reducing. advance billing has been achieved largely by price increases used. to generate additional. cash. [Office of the Inspector General, Department of Defense (1998)]. 5.. and Legal Requirements. in the. a). 10. Working Capital Funds. U. S. C. Section 2208:. The Secretary of Defense may funds. NWCF. Policy. require establishment of working capital. to:. (1). Finance inventories of supplies.. (2). Provide working capital for industrial and commercial type. activities that. provide. common. services for the. DoD.. WCFs. must be. reimbursed, and regulations for costing and pricing shall be prescribed by. the Secretary of Defense.. b). 10 U.. S. C.. Section 2216a: Defense Business Operations. Fund. Specifies that charges (prices, rates) are set to recover full costs, including. capital depreciation. and the cost of the Defense Accounting and Finance Service.. 20.

(38) c). 31 U. S. C. Section 151 7: Antideficiency Act Violations. Specifies prohibited obligations and expenditures, in that an officer of the. United States government. may. not. make. or authorize an expenditure or obligation. exceeding an apportionment or an amount permitted by regulations under U.. S. C.. Section 1514(a). Penalties for violations include specific provisions for fines and. imprisonment.. d). Defense A uthorization Act for 199 7:. Specifies amounts authorized for obligation and expenditure in fiscal year. 1998, limits. NWCF advance billing to. $1 billion (Section 371), and directs rate/surcharge. revision to generate an additional $5 billion in revenue.. B.. BUDGETING. THE NWCF. Cash Management. 1.. As. IN. discussed earlier, cash management. is. the process. by which financial managers. maintain a sufficient balance of cash on hand to meet day-to-day requirements and to support planned investment. The process includes, but. plans, that. is,. anticipating. month. to. month. is. not limited to, developing cash. collections and disbursements; monitoring. execution of the cash plans; and analyzing deviations from plan to determine causes.. Accurate estimates of collections and disbursements and hence, outlays, are. critical to. avoiding a negative balance cash position, or a violation of the Antideficiency Act. Since 1993, the working capital funds, in. all. forms (DBOF,. 21. NWCF),. have experienced a cash.

(39) shortage and have had to advance. cash managers have. bill. made headway. customers for work not yet performed. The. in reducing the. amount of the advance. NWCF. billing since. assuming cash management responsibility from the Office of the Secretary of Defense in 1995. However, advance billing continues to be necessary to maintain a positive balance. in the. fund [Office of the Inspector General, Department of Defense (1998)].. Cash Balances/Investment Capital. a). Cash generated from the which. WCFs. through. many. pay the. bills.. no. Cash balances. goods or services. is. the primary. means by. are determined at the beginning of each year. decisions and iterations during the budget process pertaining to workload. levels, estimated costs,. services.. sale of. Pricing. is. profit or loss will. and setting prices to recover the estimated. negotiated to result in a net operating result. full cost. of goods and. of zero, indicating. that. be made from the sale of goods or services.. During the execution of the budget, the. WCF. should operate like a. checking account, with collections having the effect of a deposit and disbursements. (salaries, cost. of operations, material purchases) the effect of a check issued.. estimates concerning collections and disbursements are accurate, the. should be sufficient to pay outstanding. b). A. bills. and. to. WCF. If. budget. cash balance. maintain capital investment programs.. Customer Surcharges surcharge. is. a "mark-up" to spare parts sold to customers, used to. finance the cost of operating supply and repair depots.. established for material furnished. by a. Customer surcharges. WCF activity on a unit cost basis. 22. are. Surcharges are.

(40) computed. for parts. and material provided from supply. activities. by estimating the cost of. goods sold for the following year and dividing by the estimated sales revenue. Surcharges are levied in the form of a mark-up percentage to the original cost of the. material. (FY 1997's. material surcharge. was 54. percent).. The computation. for surcharges. includes factors for losses or gains from the previous year's operations.. Customer Rates. c). Rates represent the prices. NWCF activities will charge customers for work. performed or services rendered. Customer rates are established for services furnished by a. WCF. activity. on a. unit cost basis.. Unit costs are. set for. non-supply (cost/units. produced or services rendered) and depot-type activities (cost/direct labor hour).. are set. Rates. by estimating next year's costs and dividing by next year's estimated workload. Rates. approved by the definite focus. buyers and. on. and surcharges are. activities'. major claimant.. cost drivers,. sellers.. first. negotiated. with customers and then. Setting rates and surcharges requires a. and the negotiation process requires active participation by. Cost consciousness on the part of both parties leads to more efficient. behavior, and customers can and often do seek cheaper alternatives [Office of the. Inspector General, Department of Defense (1998)].. When. rates. establish a composite rate,. are. and. negotiated. and forwarded, they are consolidated. officially "set" in the President's. are calculated at the activity/activity. Budget.. group level in the spring prior. 23. to. Detailed rates. to execution. and.

(41) approved by. ASN (FM&C).. Customer budgets are adjusted accordingly. changes from the previous year, and are stable throughout the. to reflect rate. fiscal year.. Predicting Outlays. d). Predicting outlays. is. a function of predicting collections (revenues) and. expenditures (expenses), as was stated. earlier, in the. Expenditures. Accurate outlay predictions are because they receive. visibility at. NWCF,. Outlays = Collections -. NWCF. financial. managers. every level of the budget process, particularly. at the top.. critical to the. In the Executive and Legislative branches of the federal government outlays directly. affect the aggregate federal. budget balance. [Library of Congress (1991)]. Predictions for future year collections and expenditures start at the lowest. levels in the. from the. NWCF,. activity. the activities.. In general, activities are provided control. group manager, authorizing an annual/quarterly. work within. rate. numbers. of obligational. that set level,. matching workload and. schedules to set a monthly phasing of anticipated obligations.. Likewise, the activities. authority.. will. Activities, in turn will. estimate their monthly. expenditures. anticipated events and factors.. based on workload, schedule and other. Phasing plans for obligations and expenditures are. negotiated with and approved by the activity group manager.. consolidate activity plans for submission to. various changes that. the. may. ASN (FM&C),. Activity group managers. and adjust according to the. occur during the budget development process. [Department of. Navy Program Information Center. (1994]. 24.

(42) Development of accurate budget plans. very. is. difficult,. as accounting. anomalies, unstable workload and other environmental fluctuations are. defense budgeting. Despite this. fact,. common. in. even minor deviations from plan must be explained,. as small deviations in the large ($20 billion annual) collections or expenditures plans can. lead to seemingly large deviations in the relatively small (millions of $) outlay plan.. ASN (FM&C). example, suppose that. billion. and disburse $20.5. collections. outlay. fall. short. billion, for a. by $200 million. would increase. example,. forecasts that in. to. ASN (FM&C). $700. FY. 1998 they will collect $20. planned outlay of $500 million.. (a. For. Should actual. one percent deviation from plan), the actual. million, or a. 40 percent increase from plan.. In the. had developed a very accurate (99 percent) budget estimate, yet. balanced budget watch dogs would be none too happy with the deviation from that estimate driving an additional $200 million in unplanned outlays.. accurately predicting the budget picture. is critical at all. As can be. levels for financial. surmised,. managers in. theNWCF. 1.. Budget Formulation and Execution Process. Major players. in the. congress, the Office of. NWCF. Management and Budget (OMB),. Defense (OSD) Comptroller, Budgetary timelines in the. Programming, complicating. ASN (FM&C),. NWCF. and Budgeting the. budget formulation and execution process are the. budget. activity. the Office of the Secretary of. group managers and. activities.. follow the cycle established in the Planning,. System. (PPBS). for. development. process. is. 25. all. DoD. parallel. programs.. sequencing. Further. of budget.

(43) formulation events with the Program Objectives. Memorandum (POM). development.. Whereas budget formulation focuses on the next two budget execution. POM. years,. provides a six year intermediate range plan within the Future Years Defense Plan. POM. (FYDP).. FYDP. and the. will not. be discussed in. more on. the program, and. Submission dates do not 2.4 below.. Note. revolving fund, the. the rates and surcharges involved. differ. that in. As a. May. NWCF. financial. focus. to execute the. earlier discussion that. FY. the. is less. illustrated in Figure. managers were preparing. 99 budget, which commenced. FY. 1. Oct 98.. POM. 98 budget. Recall from. each block shown in Figure 2.4 represents multiple steps of. submission, budget mark-up and reclama. [Department of the. Navy Program. Information. Center (1994)]. POM. SERVICES SUBMIT POMs TO SECDEF. DEFENSE PLANNING GUIDANCE. PDMs PRESIDENT'S. ISSUED. BUDGET. BY SECDEF. (00-05). SUBMISSION FY 00. (00-05). A_ JAN 98. MAR 98. MAY 98. JUL 98. TO. CLAIMANTS SUBMIT BUDGETS TO ASN (FM&C). CLAIMANTS. (00-01). FIELD. BUDGET. on. and the expected outlays.. submissions (FYs 00-05), budget submissions (FYs 00-01), executing the. and preparing. is. development and. NWCF. from appropriated programs and are 1998,. significance. POM. overlap of dates and deadlines with the budget formulation,. execution of the current year's budget.. Of. detail.. ACTYS SUBMIT BUDGETS. Sample. 98. FEB. SERVICES. SUBMIT BUDGETS TO SECDEF (00-01). (00-01). Figure 2.4. SEP. POM and Budget Submission Timelines. 26. 99.

(44) Activities. a). Activity budgets are submitted in the. NWCF. group managers.. activities. may be. multiple appropriations in addition to their. on. historical. performance and current. to. May. timeframe to activity. simultaneously submitting budgets for. WCF. data,. March. submission. The submissions are based. and on the best estimates of the. activities'. managers. As. stated. development of customer expenditures.. Each. the. earlier,. rates,. budgetary. focus. at. the. level. activity. is. the. followed by a predicted phasing of collections and. rate includes different costs that. applied to the service or material being provided.. can be either directly or indirectly. Rates are in turn approved by activity. group managers and subsequently used to develop the budget plan. In recent years, rates. have been. NWCF. difficult to stabilize. activities. and accurately predict due. have experienced. difficulties predicting. customer bases and the resultant overcapacity. The net. to infrastructure. workload from. downsizing.. their declining. result has frequently. been lower. than expected collections, which has resulted in higher rates in the next year to recover. less. than expected earnings. The so-called "death spiral" of demand has ensued. That. when. rates. go up, customers use. less,. driving business even lower in. many. areas.. negative effects of inaccurate budget forecasts have been nearly universal in the. and have caused problems level. [General. in maintaining adequate cash balances at the. Accounting Office (1997)]. 27. is,. The. NWCF. ASN (FM&C).

(45) Activity. b). Group Managers. ASN (FM&C). The. Budget Review schedule controls the budget process.. Figure 2.5 illustrates the event timeline.. •. APR-MAY. BUDGET GUIDANCE ISSUED. •. MAY-JUL. EXHIBITS PREPARED. AND SUBMITTED. •. JUL-AUG. EXHIBITS REVIEWED. AND ANALYZED. HEARINGS ARE CONDUCTED. MARKS (ADJUSTMENTS) ARE RECOMMENDED RECLAMAS (APPEALS) ARE SUBMITTED DECISIONS ARE. •SEP. DoN BUDGET SUBMITTED TO osd. Figure 2.5. ASN (FM&C). Activity group managers. to establish the baselines for pricing. set to achieve a. MADE. •AUG. Budget Review Schedule. work closely with. and. rate setting.. Net Operating Result (NOR) of zero. ASN (FM&C). budget analysts. Material surcharges and rates are. in a. budget year.. managers prepare an operating budget and a capital budget.. Activity group. The operating budget. represents the annual operating costs of the activities, including depreciation expense, and. identifies projected collections, expenditures, the. NOR,. and military requirements, unit costs and customer. rates.. well,. from simple consolidation of. predict collections. performance indicators, civilian. Methods of forecasting vary. activity inputs to running. as. mathematical models to. and expenditures. Collections and expenditures are formulated based. on projected workload and the expected costs effective manner.. capital assets or to. The. capital. to. accomplish that workload in a cost-. budget forecast represents the resources required to buy. improve existing assets to become more. 28. efficient.. In general, the.

(46) activity. group managers' inputs are accepted with few changes from. eventually. become. part of the President's Budget.. It. ASN (FM&C). and. should be noted that forecasted. budgets can be and often are changed just prior to the President's Budget submission in February, to reflect events and. submission [Department of the. c). new. information that developed subsequent to the. Navy Program Information Center. OSD. (1994)].. ASN (FM&C). ASN (FM&C),. in addition to. schedule, also participates in the. OSD/OMB. depicted in Figure 2.6.. 29. managing the DoN's budget submission Budget Review.. The event schedule. is.

(47) •. AUG. BUDGET GUIDANCE ISSUED. •. SEP. EXHIBITS PREPARED AND SUBMITTED. •. SEP-OCT. EXHIBITS REVIEWED AND ANALYZED. HEARINGS ARE CONDUCTED. PROGRAM BUDGET DECISIONS (PBDs) ARE ISSUED. •OCT-DEC. RECLAMAS ARE SUBMITTED AND REVIEWED •. NOV-DEC. DECISIONS ARE. MADE. MAJOR BUDGET ISSUES (MBI) MEETINGS ARE HELD TO RESOLVE OUTSTANDING ISSUES •. SECDEF DISCUSSION WITH PRESIDENT. DEC. PRESIDENT'S BUDGET SUBMITTED TO CONGRESS. •FEB. Figure 2.6. OSD Budget Review Schedule. In addition to the myriad budget reviews, submissions and responses,. (FM&C). is. also closely monitoring the current year's budget execution, each. receiving the previous month's performance data from. analyzing reports to determine performance in relation to. DFAS, and last year's. The flow of information concerning execution deviations mirrors above. C.. in the. budget development process. [NAVCOMPTLNST 7102.2. ASN month. preparing and. budget forecasts.. the flow described. (1995)].. CURRENT STATUS OF NWCF CASH MANAGEMENT The congress and. the General Accounting Office. development of the working. (GAO) have watched. capital funds with great interest.. In a period of steeply. declining budgets, the $20 billion in collections and disbursements in the. 30. the. NWCF. has.

(48) become an. object. of significant. scrutiny,. especially. when. unanticipated outlays that affect the balance of the federal budget.. piqued when the funds are not performing according. and. rate increases. involve. new. become necessary. to. to plan,. cover losses.. fund. the. can. cause. Additional interest. is. and when significant price. Although the. NWCF. does not. appropriation of funds by congress, the rate and price increases require that. the budgets of appropriated fund activities. (NWCF. customers) be "plussed up" so they. can afford the increases.. As. interest. has arisen, the. been frequently audited by the. management. to preparation. NWCF GAO. and other defense working. on various. capital funds. issues (see Figure 2.9),. of financial statements.. have. from cash. Additionally, the defense. WCFs. were directed by the congress (Section 363 of the National Defense Authorization Act. FY. for. 97) to develop and submit an improvement plan for revolving fund business. operations by September 30, 1997 [Department of Defense Office of the Under Secretary. of Defense (Comptroller) (1997)].. Specific. Accounting. Practices;. Policies,. Systems. and. areas. targeted for. improvement were. Cash Management,. Setting. Prices,. Surcharges and Agreements; and Stabilized Rates. This report requirement highlights the congress' major concerns with the. forecasts. is illustrated. in Figures 2.7. WCFs. Recent performance and. 2.8.. 31. in cash. management.

(49) FY 97 DoN Actual/FY NWCF99 Cash OSD Submit. FY 98 Pres Bud Plan. vs. DO. With Aug Advance Billing. S352M. Fro). AJv. Bill. Bal. S479M. Nov. Oct. Dec. Jan. Feb. Mar. May. Apr. ". Actuals. 1. Jun. Aug. Jul. Sep. Forecast. 'Budget Plan. '. Actuals w/o Advance Billing Forecast as of 02. Figure 2.7. FY. 1997. Oa 1997. NWCF Cash Track. DoN. FY 98 DoN NWCF Cash. S977M S938M. ^StMM. /. \—-— \. ^. S814M. S754M. s*. S75SM. S527M S455M___~. *W^ s::5M^H. S230M. a^^^^. S327X*". S2J2M _S1Q?M_. /. -S274M. N.. -S432M. -S505N?. SM1M Sep. Oct. Nov. ——Actuals. Dec. Jan. —•—Pres Bud. Plan. Feb. Apr. -^-Actuals w/o Advance. Preliminary June Actuals. Figure 2.8. Mar. May Billing. Jun. Jul Proj. Plan reflects Pres. FY. 1998. EOFY Cash. Bal. Bud Submission. DoN NWCF Cash Track. 32. Sep. Aug. for entire year.

(50) As position. fiscal. Figures 2.7 and 2.8. illustrate,. without advance billing, the. would have been negative from the inception of the fund. year 1998.. The fund has remained solvent by advance. billing. NWCF's. until the. cash. middle of. customers for work. not yet performed, a practice that the congress has directed to be terminated by the end of. fiscal. year 1998.. 1.. Audits and Reports. Figure 2.9. working. lists. reports. and audits issued concerning cash management. in the. capital funds.. General Accounting Office Report AIMD-98-039 Report AIMD-97-221 Report AIMD-97-152 Report AIMD-94-80. Cash Management in the Defense Working Capital Funds DoD Faces Continued Challenges in Eliminating Advance Billing Challenges Facing DoD in Managing Working Capital Funds Financial Management: Status of the Defense Business Operations Fund. Inspector General. Report No. 97-067. Defense Agencies Cash Management. in the. Defense Business Operations. Fund Report No. 96-178. Internal Controls. and Compliance with Laws and Regulations for. Defense Business Operations Fund Consolidated Financial Statements for. FY. 1995. Department of Defense Office of the Under Secretary of Defense (Comptroller) September 1997. A Plan to Improve. the. Management and Performance of the Defense. Working Capital Funds. Figure 2.9Audits. 2.. and Reports on Cash Management. Initiatives. The managers of the. NWCF. have taken steps. performance, efficiency and accuracy in reporting.. at. all. Consider the. to. improve. initiatives. taken to. levels. improve cash management, specifically in the area of budget forecasting.. 33.

(51) Since 1995, the. NWCF. has worked off nearly $2 billion in advance. The DBOF, then. achieving a positive balance in the fund in mid- 1998. carried advance billings to remain solvent since 1993.. the. billing,. NWCF. had. ASN (FM&C) continues efforts to. develop an automated cash model to improve activity reporting capabilities and cash. management. reporting.. ASN (FM&C). In a primarily "grass-roots" approach, the. personnel have identified requirements, scrubbed data inputs and developed a working prototype cash model in a one year time period.. produce reports and to allow. made. to actively convert. balances in a. activities to. raw. The model. is. already being used to. submit budgets electronically. Efforts are being. financial data into a usable format to determine cash. more accurate and timely fashion. [Office of the Inspector General,. Department of Defense (1998)]. Activity group managers have also. balance forecasting.. two major contracting. at. Control Point, Mechanicsburg,. PA. In addition,. model. to. NAVSUP. rate. Command. activities, the. and the Naval Inventory Control. has completed an extensive revision of. has developed. Naval Inventory. Point, Philadelphia,. its. cash forecasting. other efforts at promoting level loading workload, reducing contracting. lead-times and reporting financial data are underway at. at. improving accuracy in cash. provide better predictions of collections and expenditures.. Numerous. and. in. For example, the Naval Supply Systems. and implemented cash models. PA.. made headway. DFAS.. structures. A. Supply Management. that. may. affect. all. activity. group. NWCF. activity. 34. NWCF. tiger. activities, activity. groups. team has proposed changes. to. groups by reducing rates and.

(52) surcharges.. All efforts are focused on reducing costs and providing a clearer picture of. what the costs are and what they improvements. in. will be.. Within the scope of this. thesis, the focus is. on. cash management forecasting techniques, specifically, employing. modeling and other forecasting methods. to. enhance decision-making. ability.. The next. chapter will provide background concerning the development and utilization of financial. forecasting. methods and models.. 35.

(53) 36.

(54) FINANCIAL FORECASTING AND MODELING. III.. Forecasting and modeling have long been employed in organizations of. and commitment. to forecasting as. all. types,. an aid to decision making has increased steadily since. the early 1960s [Wheelwright, S. C. and Makridakis, S. (1985)].. Webster's dictionary. defines a model as "a description or analogy used to help visualize something that cannot. be directly observed", and " a system of postulates, data and inferences presented as a mathematical description of an entity or a. forecasting purposes, the. model. is. state. of. affairs.". a construct of the important features of the system. being modeled, simplifying the system and making. it. model can be. to. is. "to. said to simulate a system.. According. assume the appearance without the. model) can be changed. In the case of modeling for. to determine. reality".. what. more. easily manipulated.. Webster. 's. Such a. Dictionary, to simulate. Variables in a simulated system. effect, if any, the. (i.e.. change will cause in the. future.. A forecasting model. becomes a decision-making aid. create a simplified version of reality, including only the. excluding those which are not.. simplification, or "stripping. [Levenbach, H.. effects. &. Cleary,. away" J.. for managers:. most. P. (1984)].. on the. attempts to. critical factors,. The essence of model building to concentrate. it. is. this. while. process of. essential elements of a system. Models permit the forecaster. to predict the. of future events or trends, although the simplified version of the system cannot. account for. all. factors,. such as human behavior and unanticipated events or system. 37.

(55) changes. This. is. the trade. off- simplicity. for completeness.. No. forecast. model. will ever. be 100 percent accurate; rather the model becomes another useful tool in the decision. makers. kit.. A.. MODELS AND SIMULATION As. effects. discussed above, by simulating a system, an analyst can try to determine the. of decisions and environmental changes without actually dealing with "live". consequences. Simulation can be thought of as inexpensive, as opposed to experimenting with. reality,. which can be expensive. in terms. of resources and consequences.. This. economical feature has helped make simulation increasingly popular with managers when dealing with uncertainty in decision-making. Simulation permits the experimental testing. of hypothetical conditions that do not yet. With simulation, managers can. exist.. manipulate variables (the 'what-if question) to determine the effect those changes (or '. decisions) will have over a period of time. There are. will be discussed in this thesis, deterministic. The basis each variable. to. to simulation that. and probabilistic.. Deterministic Simulation. 1.. maker. two approaches. for this type. (e.g.. of simulation. collections will be. $19. is. that there. billion).. employ various mathematical methods. deterministic simulation,. anyone who follows the. 38. is. a single value estimate for. This approach enables the decision-. in. various. decision areas.. In. a. rules set forth in the simulation setup.

(56) should arrive at the given answer, although the answer. simulation. is. completed [Liao,. is. unknown. until. after the. S. S. (1998)].. Probabilistic Simulation. 2.. This approach applies a range of probable outcomes from simulation, based on input variables that have a range of possibilities.. range of values. value.. the. be $18. -. $20. billion), vice a single, or deterministic,. Likewise, the model will produce a range of outcomes, with associated levels of. confidence. $300. (e.g. collections will. Variables in this approach appear as a. (e.g. there is. million).. model. A. a 95 percent probability that outlays will be between $200 to. probabilistic simulation recognizes that the data used as the basis for. are less than precise.. Even the most sophisticated of models. data with varying degrees of reliability. 3.. - basically,. is. often based. on. uncertainty.. Building Probabilistic Variables in a Model. Various types of models and methods appropriate for business forecasting are discussed in detail in the sections that follow.. This section addresses the probabilistic. nature of variables that are used in constructing business forecasting models.. building probabilistic. involving uncertainty. and deterministic model are (i.e.. identical,. The. steps to. except that variables. a range of possible values) will require an assessment of their. possible outcomes and associated probabilities. For example, historically, collections for. January have been $230 million or lower 20 percent of the time and between $231 and. $250 million 80 percent of the time. This range, with associated. 39. probabilities, establishes.

(57) a distribution of possible values for the variable "collections".. Similar distributions can. be created for other uncertain variables, including growth or decline in interest rates.. BUSINESS FORECASTING MODELS. B.. Forecasting. involves. all. fields. marketing, production, budgeting and operations, to. can be broken. down. management,. of business. name a few.. from. finance. to. Business forecasting. into three distinct categories.. Judgmental Forecasting. 4.. Judgments are individual or group decisions and the vast majority of forecasting decisions. are. Makridakis,. This. is. addressed. S. (1985)].. through. judgmental. [Wheelwright,. In. many. cases,. mathematical function. generate outputs.. What. in the system, either. This. this. is. the basic premise of. make. may be more. approach. intuitive. most. the judgmental forecaster does. and. is try. a good short-term. reliable. than any. forecasts: inputs to a. system. and determine what happens. from personal knowledge about the system, or through a group. discussion and analysis of the system. In. in Figure 3.1,. C.. S.. Nearly every manager employs subjective forecasting every day.. the intuitive approach, the seat-of-the-pants effort to. response.. shown. methods. and the. reliability. all. cases, the system. of the forecast. is. is. kind of a "black box", as. based on the record of forecasts. versus actual occurrences over a period of time. [Nelson, C. R. (1973)]. 40.

(58) SYSTEM k, W. INPUT. 'BLACK BOX. 9. w W. Figure 3.1 Concept of Forecast. OUTPUTS. Models. Quantitative Forecasting. 2.. There are three sub-categories of quantitative forecasting:. a). Time-Series Methods. Time-series methods attempt to identify patterns in data using time as a. reference.. The. forecast. b). is. then based on the identified patterns through extrapolation.. Explanatory Methods. Explanatory methods seek to identify the causal relationships between. made by applying. those. Monitoring methods identify changes in patterns and relationships.. This. variables that led to the outcomes observed.. Forecasts are. relationships to the future.. c). method. is. Monitoring Methods. used when extrapolation of past patterns or relationships. 3.. not appropriate.. Technological Forecasting. Technological forecasting. economic or. is. political issues.. is. used to address long-term technological, societal,. There are two subcategories:.

(59) Extrapolative. a). Extrapolative forecasts use historical patterns and relationships as a basis. for predictions.. Normative. b). Normative forecasts use objectives, goals and desired outcomes as a basis for forecasting, thereby influencing future events. [Wheelwright, S. C.. and Makridakis,. S.. (1985)]. Appendix and techniques.. A. provides a comprehensive table of forecasting approaches, methods. As described above,. system being forecast. is critical.. selecting an approach that. is. appropriate for the. In addition, an intimate knowledge of the system's. functions and relationships, as well as extensive analysis of available data,. is. essential for. successful forecasting.. C.. CHOOSING THE APPROPRIATE FORECASTING METHOD. NWCF. cash. disbursements, outlays. equations for. management. and cash. budget. data. As. balances.. consist. of. primarily. discussed in Chapter. I,. collections,. the simplified. NWCF cash management are:. Collections. - Disbursements = Outlays. (+/-). (Equation. 1). and. Beginning cash balance + Outlays. (+/-). 42. = Ending cash balance. (Equation 2).

(60) A. further review of the historical data used to develop budget submissions. that the quantity. of collections and disbursements. is. relative to time; that. and disbursements accumulate over the course of the. Appendix A, consider the Quantitative approaches. as mentioned earlier, are appropriate for quantitative data.. further. Options can be narrowed. Appendix. budget. data.. [Wheelwright,. S. C.. (1985)]. time-series consists of chronologically ordered observations. The assumption. system.. NWCF. Time-Series Methods. 3.. A. S.. Consider the. methods may be appropriate, some forecasting methods are. better suited for different variables within the. and Makridakis,. in. Quantitative forecasts,. by considering the types of quantitative methods available.. possibility that, while several. collections. Using the table. fiscal year.. to forecasting.. is,. shows. A. provides a. that there exists. is. list. of. common. a pattern that. is. from a particular. a function of time.. time-series methods, with brief descriptions.. Time-series methods assume that history repeats itself and that the future will be. some. kind of continuation of the past. Forecasts are obtained on the basis of past values over a period of time.. Time-series analysis involves breaking. down (decomposing). sub-patterns that reflect the different forces that are at. patterns include the following:. 43. data patterns into. work within a system. The. sub-.

(61) Long term example. is. population. trends: Trends can be increasing, decreasing or unchanged.. the growth of population over time.. is. The. trend. is. a steady upward slope. An when. graphed as a function of time.. Long Term Trend!. 5:. 200. E.. 150. _o. c. o. ~. 100. 3. a.. o. 50. •. 1952. 1957. 1962. 1972. 1967. 1977. Year. Figure 3.2. Seasonal variation:. A. time-series exhibits a seasonal pattern if the variable. changes according to a seasonal pattern. in a. geographic location.. When. Long Term Trend. An example. temperature. is. of constant length, and. accounting or. many. the average monthly temperature. plotted against time, a seasonal pattern. revealed that repeats itself every twelve months.. fluctuations. is. The seasonal. may be due. to. m Seasonality!. 1. S. 9. 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69. Figure 3.3 Seasonal. 44. Trend. factor reflects periodic. weather,. other factors.. is. holidays,. quarterly.

(62) Cyclical variation:. In this case there. is. no obvious pattern as noted with. Cyclical factors often represent the ups and. seasonality.. interest rates.. downs of. the. economy. or. Cyclic patterns differ from seasonality in that cyclic fluctuations are not. necessarily of a constant length.. Cyclical Trend. yi.. 90 80 70. \ ^M -. y^"*^. ^V. rm. ^V. J*. \_. V^*****^. 60 E. 50. 40 30. 20 10. 1959. 1964. 1974. 1969. 1979. Year. Figure 3.4 Cyclical. Random the variable. is. deviation: In this case there. is. graphed over a period of time.. Trend. no discernable pattern whatsoever when. An. element of randomness or error. is. always present in a time-series, regardless of the presence or absence of the three aforementioned patterns. [Liao,. S. S.. (1998)]. Figure 3.5. Random. 45. Pattern.

(63) A. time-series can be. Appendix B, Figure. where. (see. and hence the expression. 5),. Y=T*. composed of any combination of the above patterns. S. *. C*R. (Equation 3). Y is the variable of interest and T = long term. trend. S = seasonality. C = cyclical pattern. R = randomness In this fashion,. when any. or. all. of the patterns are present in a time-series data. each can be expressed by some mathematical equation that patterns present.. When. patterns are present in a time-series,. it. representative of the. is. is. set,. necessary to break the. patterns out using decomposition.. Decomposition. a). Decomposition separates the patterns by removing patterns one thus enabling each pattern to be mathematically modeled separately.. random methods. effects are not readily susceptible to analysis. for analysis. and seasonality. To. isolate the trend pattern. a. 46. ratio to. a time,. Cyclical and. by decomposition.. by decomposition have been developed only. at. As. such,. for long-term trends. moving averages. is. used..

(64) Centered Moving Period. Average (M.). Value (Y). (T ). 1. 5. 2. 7. 7. 3. 9. 7. 4. 5. 7. 5. 7. 7. 6. 9. 7. 87. 7. 9. Figure 3.6 illustrates. periods.. variation. line is. By. how. Moving Averages Table. a centered. moving average removes the highs. In this time-series note that the period of seasonality. centering a. moving average on each of. completely removed, leaving only a trend. is. Y=. 7. 9. Figure 3.6 Centered. and lows by averaging.. 7. 5. 7.. Plotted on a graph. it. would be a. flat line. is. three. the three periods, the seasonal. line.. In this example, the trend. with a y-intercept of. 7.. Should a. trend line with a slope be revealed, a linear equation for that trend line can be derived. using simple regression, discussed in the next section.. The seasonal. pattern. is. represented by a seasonal index,. observation within a seasonal period.. observation. (i.e.. months. in a twelve. computed. for each. Computation of the seasonal index for each. month period). is. actual-to-moving average ratio for each observation.. 47. accomplished by. The mean. first. computing an. for these ratios is next.

(65) computed. for all. "matching" observations in the data. observations). This. mean. is. set (e.g.. average. all. the January. the seasonal index.. Subsequent to the modeling of the trend seasonal index, both elements are. combined. line. and development of the. in the original equation.. Y=T*S*C*R Thus the time-series the. examples provided. in. is. represented by a single mathematical equation.. Appendix B, the trend and seasonal. In. patterns can be isolated. (assuming away the random and cyclic patterns as insignificant) and a seasonal index for each month and an equation (model) representative of the trend line can be computed.. The variable of model. [Liao,. 4.. interest. can be forecasted for any period from the base period using the. S. S. (1998)]. Explanatory Methods. Explanatory methods are based on the premise that the future can be predicted by understanding the factors that explain. why. the variable of interest changes. Developing. an explanatory or causal model makes the system more understandable and allows the forecaster to experiment with different combinations of inputs to study their effects. forecasts.. Forecasts are based on relationships with other variables.. To narrow. the approach to a specific forecast method, a further review of the data. from the system being forecasted but which. the. NWCF. on the. method. is. will provide the. required.. Several explanatory methods. most accurate and. reliable forecasts?. may work,. In the case of. cash management budget system, the regression method becomes the logical. 48.

(66) choice, as variations in the variable to be forecasted can be explained. another variable (see equations. 1. and. in. 2).. Simple Regression Methods. a). As discussed above,. the regression. method of. functional interdependence of variables in a model.. function of a certain. number of. The. forecasting expresses the. forecast. factors or variables that determine. forecasts can be, but are not necessarily, time-dependent.. the. by variations. is. its. Regression. is. expressed as a. outcome.. Such. concerned with. problem of estimating the value of one variable, called the dependent variable, on the. basis of one or. more. b). variables, called the explanatory or independent variables.. The Simple Regression Model. In simple regression, the dependent variable. and a single independent variable by the. letter. X.. is. annotated by the. letter. Y,. Figure 3.7 illustrates the dependent. variable (Y) plotted against the independent variable (X), with the dots representing. actual observations. and the solid. line representing a linear equation. by regression.. 49. "model" developed.

(67) Regression. Y. Line. =a+bX °. .. Error. e=Ya -Y. =. Slope. b. y- intercept. Figure 3.7. The Simple Regression Model. Regression allows us to express the relationship between algebraically, with the. value of X.. 3.7,. Y. a. between. The. model describing. algebraic. model can be expressed. represents the actual. Y. c. (i.e.. the expected average value. Y. observed. the regression line) and. Y. a. (i.e.. is. is. c,. and. In Figure. the plotted points), and the difference. the error,. e,. as illustrated in Equation 5. In. represented by b.. Y when X = 0.. Additionally,. The objective of regression. determine the equation (Equation 4) that minimizes the error term (Equation. 5),. is to. thus best. describing the actual relationship in algebraic terms [Liao, S. S. (1998)].. Y e. c. =. = a + bX. Y. a. -Y. (Equation 4) (Equation 5). c. 50. X. given a specific. as Equation 4 (see below).. the Figure, a represents the Y-axis intercept, or the value of. the slope of the regression line. Y. Y.

(68) Least Squares Method and Software Regression Analysis. c). The. squares method. least. regression line that minimizes the. is. a. common method. sum of the squared. used to develop a. error terms e (equation 4),. more so. than any other straight line that could be fitted through the observations. For the purpose. of. this thesis, the least squares. statistical. method. will be discussed only as. Most spreadsheet-type software has. software.. The software automatically. perform regression.. it. is. applied using. the statistical capability to. calculates a regression line. employing. A sample output is provided in Figure 3.8.. the least squares method.. SUVMOftf OUTPUT Ftejession Statistics. MJtipleR. H5^S70S. RSquare. (X978100644. A^ustedR Square. 0.97734549*. Standard &ror. 0.729524553. Observations. 31. Cfceffloerts. Hanc&tftmor. ^1553181102. Intercept. X Variable 1. 0.527216719. O.O14649206. Figure 3.8. The output. FSS. 0.268524373 -2.0361 35.939. Hvalue. LoAer99Vo. Upper99y. 0.O48465 -1.10237541 -0.00393679. 128&-25 0.497255713. 0.55717772. is. the. R. Square. in Figure 3.8. statistic,. Ljtper950%. -1.102375409 -0.003986795. 0.497255713. 0.557177725. Sample Regression Output was produced using Microsoft Excel, based on a. dependent variable being regressed on one independent variable note. Lcwer95.(M. (in this case time).. Of. which represents the relationship between the two variables,. and the strength of that relationship. In. this case the relationship. seems strong. at nearly. 98 percent.. The. Intercept. is. the y-intercept a.. The. X. Variable represents the slope of. the regression line b.. The. the coefficient terms.. A general rule of thumb is that, unless the sample size is very. t-statistic. provides an indicator of the statistical significance of. 51. small.

(69) (i.e.. ten or less), a t-statistic should be at least. significant.. A. The equation. an. for the coefficient to. variable with an insignificant t-statistic can be. for the regression line. Y If. two. £. =. be considered. removed from. the model.. is:. + 0.527X. (-0.553). X value is inserted (time in months from the base period), the Y value can be. predicted at that point.. Figure 3.9 graphically illustrates the regression model, as plotted. against the actual observed data.. Sample Regression. ACTUAL AMT -. 13. 16. -. -. REGRESSION EQUATION. 19. MONTHS Figure 3.9. Sample Regression Graph. In Figure 3.9, the solid line represents the actual observations, and the broken line,. the regression line.. 3.. When. While the. fit is. not perfect,. it. is. 98 percent (R-Square) accurate.. Developing a Forecast the simplified. The model permits. model has been constructed, a forecast can be developed.. the forecaster to estimate the effects of future events or trends.. the above discussion of model building. and forecasting techniques, a. 52. real-life. From. system can.

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