Page 5
2
Trends and Best Practices in Capital Budgeting
Trends and best practices in capital budgeting were discussed by three speakers: Carol O'Cleireacain, a visiting fellow at the Brookings Institution and a member of the President's Commission to Study Capital Budgeting; Paul Posner, managing director, federal budget issues, at the U.S. General Accounting Office, and Lauren Uher, from the Office of Federal Procurement Policy, a unit of the White House Office of Management and Budget.
PRESIDENT'S COMMISSION TO STUDY CAPITAL BUDGETING
Summary of a Presentation by Carol O'Cleireacain, Ph.D., Visiting Fellow, Brookings Institution
The 15-member President's Commission to Study Capital Budgeting was created by an Executive Order issued by President Clinton on March 3, 1997, as an outgrowth of Congressional debate over the proposed balanced budget amendment to the Constitution. The fact that the President and many members of Congress came out of state government where capital budgeting and borrowing is the norm also provided an impetus for the creation of the commission. The Executive Order directed the commission to prepare a report on various aspects of capital budgeting, including the budgeting of capital in other countries and in state and local governments; define capital and depreciation for capital budgeting purposes if possible; and determine the broader effects of a possible federal capital budget on budget discipline, public policy choices, and the state of the economy.
In its February 1999 report the commissioners concluded that there are aspects of federal budgeting that contribute to a suboptimal allocation of capital spending among projects. Overall, maintenance is short-changed in this process. The commission, however, declined to recommend that the federal government have a separate capital budget.
The commission found much of value in state and local government practices, for example, state and local governments audit their assets; have good capital reporting and planning; and have effective project management. These governments routinely budget for capital maintenance, and all of those could be goals and practices for the federal government.
Page 6
In its final report the commission made 11 recommendations aimed at achieving 4 objectives: (1) improved priority setting; (2) improved budget decision making; (3) improved reporting; and (4) evaluation of the results of those decisions.
Recommendations 1-2 deal with improving priority setting. Recommendation 1 calls for the creation of 5-year strategic plans tied to annual budgets. Recommendation 2 urges benefit cost assessments for both capital and operating items, so that they can be adjusted, refashioned, or eliminated, as appropriate. The commissioners were struck by testimony indicating that many federal agencies still do not know what they own. They have not customarily kept track of their capital assets and they do not tie the life cycle of these assets to their budget proposals.
Witnesses told the commission that, regardless of the level of planning in the Executive Branch, Congress often does not know of or use the information. The point of the first two recommendations was to ask that there be better operational capital plans and to encourage their integration into both the executive and legislative budget processes.
Improved budget decision making is the focus of Recommendations 3-8. Recommendation 3 is for the Congress and the Executive Branch to experiment with capital acquisition funds (CAFs) for one or more agencies. Budget authority would be lodged in the CAFs for federally owned capital assets. These funds would “rent out” their facilities to various programs in each agency, charging them the equivalent of debt service.
Originally suggested by Office of Management and Budget (OMB) staff, the CAFs are intended to help ensure that programs are assessed the cost of using capital assets and to smooth out the peaks and valleys in the appropriations process by spreading out the cost across an entire agency. If the experiment proves successful, the CAF approach should be adopted throughout the federal government.
Recommendation 4 is that all capital projects or usable segments thereof be fully funded before work begins. This recommendation is meant to bring an assessment of the life-cycle commitment into budget decisions at the beginning. In this way, Congress can fully evaluate likely costs and benefits before appropriating funds.
Recommendation 5 is that rules for the scoring of leases be strictly followed by both agencies and the Congress to reinforce an appropriate buy or lease decision. In theory the scoring rules require a net present-value calculation, but the commission heard countless evidence on the gaming of the system and the repeated use of short-term leases even though they were not cost effective over the long term. We really did not have the ability to figure out a new way of doing this, but we made the strongest recommendation that we could to at least go back to the rules you have in place and use them and bring back some long-run perspective into leasing.
Trust fund reform is the subject of Recommendation 6. The commission agreed that trust funds, such as those created for highways and airports, are useful for insulating certain types of infrastructure and other types of capital spending from the budgetary balancing process. But this purpose is fulfilled only if the funds going into them truly represent charges or fees for the use of services they support and the monies raised are actually spent on the dedicated uses. To ensure that this is done the commission recommended that the President's budget disclose the earmarked taxes or fees and spending of these various capital-related trust funds. This would allow policy makers to
Page 7
make informed decisions about whether to increase spending on the authorized activities or to reduce the assessed charges to finance those activities.
The commission's report also urged that state and local governments receiving federal grants for infrastructure be required to certify that they are maintaining the infrastructure as a condition to receiving additional federal aid. About two-thirds of publicly owned fixed capital is owned by state and local governments. About one-quarter of this has been directly financed by the federal government.
Recommendation 7 is for the Executive Branch and Congress to experiment with giving agencies incentives to manage their assets efficiently. This proposal was an attempt to reward better management and to encourage efficient experimentation at the micro level, even at the level below agencies. It was basically saying if an agency does something well and saves money it should be able to keep some of it rather than sending it back to the treasury.
The next three recommendations deal with improving reporting. Recommendation 8 is that the President's annual budget should contain a breakdown of proposed current and projected federal spending over the budget year and the subsequent four years for investment, operating expenditures, transfers to individuals, and interest. Such a breakdown would inform policy makers, Congress, and the public of the President's long-term vision for federal spending.
The commission felt that it would be helpful to the public debate if, short of a separate capital budget, the President's executive budget were to lay out proposed investment spending for the coming 5 years that would link to the 5-year planning and budget that we proposed in Recommendation 1 and the benefit cost analysis in Recommendation 2. There should be a link in presentation even if we could not call it a capital budget.
Recommendation 9 is that federal financial statement reporting be improved in 3 ways:
1. Federal agencies should be required to issue more detailed information about the composition and condition of federally owned or managed capital assets under their control, and OMB should consolidate these reports and summarize them in the annual budget.
2. There should be enough information in the consolidated reports to provide Congress and the public with accurate benchmarks for making comparisons both in the current year and over time.
3. The calculation of depreciation in various government reports should be standardized.
Private-sector members of the commission were unmovable on the need for improved financial reporting. Just as corporate decision makers have accurate accounting data to help them assess past performance and make decisions about the future, Congress and the public should have accurate accounting on federal assets and investments.
Recommendation 10 is a strong call for agencies and OMB to develop standardized methods for estimating deferred maintenance. The commission was surprised and distressed at the lack of information on the state of the government's existing assets, the inadequate sense of accountability that parts of the federal
Page 8
government have regarding the past investments that have been made with taxpayer money, and the absence of life-cycle and replacement planning.
The fourth objective is evaluating the impact of past budgetary decisions. Recommendation 11 calls for a “federal report card,” a new portion of the President's annual budget in which agencies under OMB guidance assess the extent to which major investment projects have produced expected results. This report is intended to be as quantitative as it can possibly be with projects being measured against an appropriate cost of capital. Where costs and benefits cannot be expressed in monetary terms the evaluations should identify project objectives and assess outcomes qualitatively.
If the recommendations help accomplish what was intended they will help to bring some of the ethos and tools of the private sector and the kinds of evaluations that people in the capital markets make every day to do what has been a fairly closed federal system of accounting and budgeting. As a citizen and an economist, I think that would be a step forward for everyone.
I cannot emphasize strongly enough that the Executive Branch cannot carry out these changes alone. Eventually, effective budgeting will require the Congress also to make changes in the way it does business.
BEST PRACTICES OF LEADING ORGANIZATIONS
Summary of a Presentation by Paul Posner, Ph.D., Managing Director, Federal Budget Issues, U.S. General Accounting Office
Innovative organizations in the private sector and state and local government continue to develop new asset management approaches applicable to federal agencies.
Of the $74.7 billion spent in fiscal year (FY) 1999 by the federal government on direct major physical capital projects, $53.9 billion was spent on defense-related projects and $20.8 billion on civilian projects. The President's budget estimates that $75.7 billion will be spent on direct physical capital projects in FY 2000 and $78.5 billion will be spent in FY 2001.
The General Accounting Office routinely finds that capital projects cost more than planned, fail to meet scheduled milestone dates, fail to meet missions and goals and ultimately contribute to the perception that the federal government does not deliver on the services that people want at an acceptable cost.
We are becoming increasingly aware that really good budgeting for capital rests on good planning and good management. All too often the federal government focuses on replacing existing assets and not performance. We also do not look at capital asset decision making in the broader context of what we are trying to do in federal government.
We need to start thinking about what we are in business to do, just like the businesses of this country did in the 1980s, and fundamentally develop high-quality strategic and performance plans, something that most agencies had not been doing before the 1990s. We have to develop reliable financial information and have that audited. Agencies then have to make sure that their capital decisions become grounded in this new framework.
Page 9
To help federal agencies implement needed changes GAO surveyed leaders in capital decision making in the private sector and in state and local government who have honed their skills by facing capital markets, shareholders, and voters. They have been doing this for many years. In some sense, the federal government is catching up. The GAO distilled the essence of what the leading organizations were doing and how they were successful into five principles detailed in the report, Executive Guide: Leading Practices in Capital Decision-Making, published in December of 1998.
Leading organizations have a number of practices in common.
1. They first establish the goals for the organization and figure out how capital can contribute to achieving these goals. In other words, they integrate organizational goals into the capital decision-making process and focus on outcomes, not inputs. Many states identify facilities they no longer need. Many states and private companies do not look at their asset condition and make plans on that basis. Rather, they begin with the challenge facing their organization and go from there.
2. Leading organizations take an inventory of assets and determine their current capabilities and condition. All the leading organizations had extensive inventories, not just lists but evaluations of the condition of those assets and the performance of those assets. Before new projects were authorized at one leading institution, managers were required to identify their existing asset base and say why current assets could not fill those needs either in their current state or in a modified state. Many communities and entities were calculating deferred maintenance. Some entities instituted a maintenance reserve fund, recognizing the implicit disincentives in dealing with maintenance issues that do not involve elaborate ribbon-cutting ceremonies. They had earmarked a fund for maintenance that was apparently very effective in addressing some of the outstanding backlog.
3. Leading organizations have a strong analytic tradition that is used as the basis for decisions. These organizations are awash in measurements for proposed asset acquisitions and plans. They have elaborate measures for customer satisfaction, various performance calculations, cost measures, life-cycle costs, and risk analysis. They do not stop here. Some have developed elaborate scoring approaches that presented groups of decisions in ways that were very compelling to decision makers. In one state the finance agency ranks all proposed projects on a score from 0 to 700. Projects that were mandatory or critical to life and safety or necessary to fulfill a federal mandate were scored 700. Others were ranked on 7 or 8 factors like risk, public safety, cost savings, and linkage to strategic plans. And in that state the list was available to the public. A project's success in gaining approval could not always be determined by how it was scored, but it meant that if there were a deviation, someone had to explain publicly or possibly face inquisitive reporters.
Page 10
4. A long-term perspective in planning and budgeting capital projects is another characteristic shared by leading organizations. We routinely found 5- to 10-year frameworks in place. It is the only way to fully capture what you are doing in the capital arena. And it is one that we at the federal level can learn from.
5. Leading organizations uniformly budget for their acquisitions on a full funding basis. In other words, they want to hold themselves fully accountable for the life-cycle costs and benefits and compare them in the only way they can, which is up front when they make their decision. This approach encourages accountability and development of accurate cost estimates. At the federal level we often do not observe this principle even though OMB has it in their guidance. An ongoing GAO study is finding that Congress is increasingly being asked to fund the acquisition of capital assets with less than full funding. The incremental funding of projects is partially due to budget processes that put caps on spending. In leading federal agencies, state and local governments, and the private sector, managers are breaking projects into useful segments that will stand alone, so that if you stop you will still have something of value. This helps reduce the peaks and valleys of spending in large projects and helps control risk.
Cost and schedule overruns are a constant problem in the capital projects arena. In its study GAO found that high-performing organizations partially solve this problem by publicly available milestones, which if missed trigger the need for a public explanation to a governing body. In these organizations there is a retrospective evaluation of both high-level employees and contractors responsible for managing these assets based on how well they do against their goals and milestones. Managers or projects often pay a price for failing to meet goals.
Also in these leading organizations, most of which have both capital and operating budgets, capital projects are expected to contribute budgetary savings on the operating side of the budget. This often creates pressure by operating components to bring capital projects online so that expected budget savings can be redirected to operations.
How do we encourage a longer-term focus both in the Executive Branch and the Congress so that decisions are grounded in an outlook beyond the current budget year, in which all discretionary appropriations are grounded? How can decision makers be prompted to pay attention to good information? Well-developed performance information often is well received by Congress. One area where performance information is needed is maintenance, which has no constituency in Congress. Federal audits may begin to focus attention on this subject.
GAO is receiving numerous requests from Congress to look at how the Internet can improve federal operations. This will lead to pressure in the new administration and Congress for fundamental change in the way agencies are structured. This means we need to look more boldly at the tradeoffs we face before we even decide what new capital we need. And more importantly, we need to look at the tradeoffs we face as we look at the old capital we have been living with for many years.
Page 11
Finally, the budgeting process has to reflect these processes. If we do not pay attention to good capital planning in the budget process, it will surely fall by the wayside. And that is going to be a significant issue. Most of us feel that process has to continue to be grounded in the up-front funding principle, but that agencies need to be given more flexibility in how they implement capital decisions in the budget process through revolving funds or the proposed capital acquisition fund that the Office of Management and Budget has put forward, for example.
OMB'S CAPITAL PROGRAMMING GUIDE
Summary of a Presentation by Lauren Uher, Deputy Associate Administrator for Acquisition Implementation, Office of Federal Procurement Policy, Office of Management and Budget
Lauren E. Uher reported on federal agency progress in implementing practices outlined in OMB's Capital Programming Guide, a supplement to OMB Circular A11, Part 3, for planning, budgeting, and acquisition of capital assets. To date, implementation of capital programming is uneven between departments and within departments and agencies.
The steps in capital programming are planning, budgeting, procurement, and management-in-use, which are translatable to the select, control, and evaluate phases often used in the information technology community. The information technology community is leading the way in implementing practices outlined in the Capital Programming Guide.
In the planning stage OMB is asking agencies to link proposed investments to strategic and program performance; analyze current asset performance; identify performance gaps; detail functional requirements; evaluate alternatives; select the best investment; analyze benefits, costs, and return on investment; conduct market research; assess risk; develop risk mitigation and management plans; and develop a sound acquisition strategy.
Agency return on investment or benefit cost analyses are still lacking at this stage. Although it is sometimes difficult to quantify the benefits of a project, this should not be used as an excuse for not attempting to measure or quantify benefits. Agencies are still struggling with the concept of useful segments because it is a new way of thinking and they are unsure how to do it.
Agencies that have adopted cost schedule and performance measure baselines are still having trouble with the concept of managing to cost, schedule and performance parameters. Project rebaselining occurs too frequently. Acquisition planning and procurement are still not fully integrated into capital programming or capital planning investment control processes in most agencies. For example, for capital projects submitted to OMB for FY 2000 some agencies analyzed all of the alternatives as a means of identifying what the performance gap was, completed return on investment and benefit cost analyses on all alternatives, assessed risks, developed risk management mitigation plans, and made a well informed decision about the investment they wanted to undertake; but when I got to the part of their capital asset plan that talked about their acquisition
Page 12
strategy, I found that what they were contemplating was a non-competitive cost-reimbursement fixed-fee contract. So all of the good work, all of the hard work, all of the good thinking that they had done to identify and to mitigate risk up front was being undone by something as simple as the selection of a procurement instrument or vehicle. After questioning staff in the agency I discovered that the people in contracts or in procurement did not know what the bigger objective was, what the bigger picture was, and therefore had not been consulted in making recommendations as to how to achieve the project's objectives by putting together a sound acquisition and contracting strategy.
One of the best practices we have seen over the past two budget cycles are significant improvements in capital programming and budget decision making in those agencies where, the senior officials—chief information officer, chief financial officer, chief procurement officer, and budget officer—are all participatory members in the agency's investment review board or executive review board and work with each other weekly or biweekly and are aware of each other's limitations and their considerations. I have noticed increasingly over the last couple of years that I am able to engage more and more people of a broader function spectrum in organizations about subjects like integrated project teams, the organization of an executive or investment review committee in their department or agency, and the integration of investment decision making with the budget process. I think that is a very positive sign.
What is next for the capital programming process? I would like to see steps taken to integrate the Capital Programming Guide back into OMB Circular A11, Part 3. The latest revision to OMB circular A130, which pertains to the management of information resources, could serve as a model.
I would also recommend emphasis on individual capital asset plans for projects be shifted to place emphasis on 5-year agency plans that take into consideration the agency's entire investment portfolio. Useful linkages should also be established between agencies' 5-year strategic plans and annual performance plans required by the Government Performance and Results Act of 1993.
I favor revising Part 34 of the Federal Acquisition Regulations dealing with major system acquisitions to address planning, budgeting, and acquisition of capital assets. This would force agency acquisition processes to be integrated into department level capital programming processes. Also, there is a great need to institutionalize a performance-based acquisition management system. Too many agencies are still measuring whether they are achieving their cost goals by measuring how much money they have spent so far, with no indication as to whether they are achieving what they had originally intended.
Finally, there is a federally developed software tool available called the Information Technology Investment Portfolio System. A few agencies have taken the tool and have modified it to manage their entire capital asset portfolio.
