Forecasting is very difficult, especially if it is about the future.
--Niels Bohr, Physicist, Nobel Prize winner, 1922
Financial forecasting, which defines a government's financial parameters, is one of the finance officer's most important tasks. Accurate forecasting also forewarns a government about financial imbalances, allowing it to take action before a potential imbalance becomes a crisis, and forecasts can promote discussion about the future and how the organization might develop long-term plans and strategies.
This article describes a step-by-step approach to conducting revenue forecasts in local governments. As Bohr said, forecasting is not easy--but a structured approach can help forecasters ask the right questions, given the environment and audience; use the most appropriate techniques; and apply the lessons from one round of forecasting to future rounds. Structuring the forecasting process provides the following potential advantages:
* Forecasting is easier to replicate each year, leading to greater organizational learning.
* The process is transparent and relatively easy to explain to others, which should make it easier to get others to accept the forecasts.
* Because a structured process encourages the forecaster to adhere to forecasting best practices more diligently than an unstructured method would, the results should be more accurate.
The GFOA has adapted the following forecasting approach from the advice of leading forecast scientists' and the experiences of public finance practitioners and academic researchers. It involves the following steps: (2)
1. Define the Problem. What issues affect the forecast and presentation?
2. Gather Information. Obtain statistical data, along with accumulated judgment and expertise, to support forecasting.
3. Conduct a Preliminary/Exploratory Analysis. Examine data to identify major drivers and important trends. This establishes basic familiarity with the revenue being forecast.
4. Select Methods. Determine the most appropriate quantitative and qualitative methods.
5. Implement Methods. Use the selected methods to make the long-range forecast.
STEP I: DEFINE THE PROBLEM
The first step in the forecasting process is to define the fundamental issues affecting the forecast, providing insight into which forecasting methods are most appropriate and how the forecast is analyzed, as well as providing a common understanding as to the goals of the forecasting process. It will also help the forecasters think about what their audience might be interested in. While each local government will have distinct issues to consider, there are three key questions that all governments should consider as part of Step 1.
What is the Time Horizon of the Forecast? The time horizon affects the techniques and approach the forecaster will use. For example, short- and medium-term forecasts demand higher levels of accuracy because they will be used for detailed budgeting decisions. Longer-term forecasts are used for more general planning, not detailed appropriations. Also, some forecasting techniques lend themselves better to shorter- than longer-term forecasting, and vice versa. Longer-term forecasts will benefit from presentation techniques that emphasize the degree of uncertainty inherent in the forecast and the choices decision makers face.
Is Our Forecasting Policy Conservative or Objective? An organization can adopt one of two basic policies on how forecasting will be conducted. A "conservative" approach systematically underestimates revenues to reduce the danger of budgeting more spending than actual revenues will be able to support. An "objective" approach estimates revenues as accurately as possible.
Some public officials prefer conservative forecasts, which reduce the risk of a revenue shortfall. But this kind of forecast can also cause unnecessary fiscal stress during the budget process as the organization closes a fictitious revenue gap. …