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									South Gippsland Shire Council                                             1 October 2008
                                                      Outtrim Recreation Reserve, Outtrim


C.9 PROPOSED FINANCIAL STRATEGY - QUARANTINE FAVOURABLE
    FINANCIAL YEAR END VARIATIONS TO AN INTERNAL RESERVE

      Author: Tom Lovass

      Manager: Rohan Puls

      INTRODUCTION

      At its meeting on 5 March 2008, (item C5 refers), Council adopted all
      recommended long term financial strategies in the tabled report with the
      exception of the following strategy:-

         ‘That wherever possible, any material favourable budget variations
         realised in a given financial year be specifically quarantined and
         allocated to a ‘future funds’ reserve (unless required to finance projects
         deemed as ‘unavoidable’) that in future periods can be used as a
         funding source for either one off unexpected unavoidable cost or for a
         specific capital upgrade or extension project’.

      Council requested that it be provided with further information on this strategy
      proposal.

      RECOMMENDATION

      That the long term financial strategies are modified to include the
      following strategy:-

      That wherever possible, any material favourable budget variations over
      $100,000 realised in a given financial year be specifically quarantined
      and allocated to a ‘future funds’ reserve (unless required to finance
      projects deemed as ‘unavoidable’) that in future periods can be used as
      a funding source for either one off unexpected unavoidable cost or for a
      specific capital upgrade or extension project. Favourable variations up
      to $100,000 can be utilised as a funding source for either a one off
      capital renewal project or council initiative that did not receive funding
      in the annual budget setting process.




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South Gippsland Shire Council                                             1 October 2008
                                                      Outtrim Recreation Reserve, Outtrim


      BACKGROUND

      Financial strategies are very important. They provide prudent financial
      guidance and parameters for Councillors and officers to consider and abide
      by, when formulating annual and longer term business plans. The financial
      strategies influence the business planning process from both a strategic and
      operational planning perspectives. They are in effect the financial business
      rules for the organisation.

      The financial outcomes of the business planning process are translated into a
      series of budgeted financial statements commonly referred to as the 10 year
      Long Term Financial Plan (LTFP), which include key financial performance
      indicators. Both the LTFP’s and actual financial results over the years can
      and have been benchmarked and performance managed.

      The financial strategies are continually reviewed and refined on an annual
      basis, the objective being to improve financial efficiencies that then translate
      to stronger financial performance outcomes in current and future years.
      Some core financial strategies will never really change, however, others are
      expected to be refined and changed to reflect the growing financial maturity of
      the business.

      The strategic challenge

      Councillors would be familiar with the diagram below that depicts tiers in a
      financial pyramid which have been disclosed in the long term financial
      strategies and long term financial plan documents over the past 6 years.




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South Gippsland Shire Council                                             1 October 2008
                                                      Outtrim Recreation Reserve, Outtrim


      Financial strategies provide the mechanisms that enable the organisation to
      climb up the tiers in the ‘financial pyramid’ over a period of time. Long term
      business viability does not happen by chance. It has to be planned for.

      It requires adopting a strategic and structured approach to financial planning
      practices which in turn greatly increases the chances of achieving long term
      financial goals in a cost efficient manner. It stabilises the business planning
      process.

      This disciplined strategic approach to annual and longer term financial plans
      has served Council well over the past 5 years. The financial strategies have
      been reviewed and refined over the years to match the progressively growing
      financial maturity of this organisation.

      2003/04 to 2007/08 1st tier strategic focus:

      In 2003 Council acknowledged that it faced considerable financial challenges
      that required addressing as a matter of some urgency. The development and
      focus of the financial strategies in the earlier years was very much focussed
      on addressing Council’s 1st tier ‘critical short term sustainability’ challenges.

      There was a need to achieve consistent and progressively stronger operating
      surpluses in order to strengthen the working capital position and to address
      our high level of borrowings. Whilst the financial strategies were initially
      heavily geared to addressing the 1st tier challenges, it should also be noted
      that there was at the same time a number of strategies that focussed on 2nd
      tier challenges. Good financial strategies are not annual centric in nature.

      These financial strategies were in fact reviewed and endorsed by the
      Municipal Inspector of Local Government.

      2008/09 2nd tier strategic focus

      The 2008/09 budget which was developed within the 10 year LTFP
      framework represents a milestone where Council will have successfully
      addressed all its 1st tier critical short term sustainability issues. This means
      the strategies are now geared to addressing 2nd tier ‘long term financial
      sustainability’ issues.

      The proposed financial strategy that is the subject of this report is considered
      to be a very relevant and key strategy. It replaced a strategy that also dealt
      with favourable year end variations. Rather than direct funds to an interest
      only loan which has now been retired, it proposes that a similar process be
      initiated to quarantine funds to a new ‘futures reserve’. The financial logic or
      rationale for both strategies remained unaltered and that is to continue
      applying a disciplined approach to managing scarce financial resources.




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South Gippsland Shire Council                                             1 October 2008
                                                      Outtrim Recreation Reserve, Outtrim


      Looking further ahead 3rd tier strategic focus.

      It is also suggested that Council begin to give some serious consideration and
      plan to take advantage of its growing underlying financial strength at an
      appropriate point in time.

      It is suggested that potentially from 2010/11 when a position of financially
      sustainable performances looked likely to be actually achieved that Council
      could consider further supplementing its ‘internal reserve’ by allocating the
      equivalent to 1% of its rate revenue to the reserve on an annual basis.

      Rather than having hundreds and thousands of dollars it would more likely
      end up being some millions over a number of years.

      It is worth noting that the Federal Governments 2008/09 budget plan released
      in May 2008 to partition surpluses in capital investment funds (infrastructure,
      education and health) follows the exact same financial principles as this
      proposed financial strategy.

      It should be also noted that no one from either side of the political spectrum
      has discredited the financial or economic implications of the strategy. Rather,
      the debate has been more political in nature, focussing on what the most
      appropriate project priorities are that should be funded in future years from
      the fund.

      This strategic approach is somewhat a new approach in government strategic
      financial planning processes. Reason being that financial planning in
      governments have always had a tendency to be annual centric in nature.

      RATIONALE FOR REFINING AND RETAINING STRATEGY

      The financial strategy proposed to Council at its meeting on 5 March 2008
      was in fact a variation of an existing financial strategy that targeted end of
      financial year’s favourable budget variations. The original strategy that was
      applicable from 2003/04 up until 2007/08 was: -

         ‘That wherever possible any material favourable budget variations
         realised in a given financial year be specifically quarantined and
         allocated to a loan reserve (unless required to finance projects deemed
         as ‘unavoidable’) so as to be allocated against the interest only loan that
         is due to be refinanced in 2007/08’.

      At year end, any favourable capacity realised (the difference between actual
      net costs and projected year end budgets) was quarantined to an internal
      reserve that was to then be applied against long term debt. This enabled a
      further $1.4 million dollars of principal to be paid off which effectively saved
      Council over $0.7 million in finance costs.




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South Gippsland Shire Council                                              1 October 2008
                                                       Outtrim Recreation Reserve, Outtrim


      The focus of the original strategy was very much 1st tier centric. The strategic
      objective was fully realised in 2007/08. The refined ‘proposed strategy’
      merely proposes to shift the strategic focus to addressing 2nd and even 3rd tier
      objectives of the financial pyramid. The financial discipline remains unaltered,
      the financial intent shifted up the financial pyramid.

      Rather than apply the funding against long term debt, the strategy has been
      refined to direct favourable year end variations to be utilised for either
      unavoidable costs or alternatively as a source of funding for major works in
      future years. The potential financial opportunity cost benefits of employing
      such a financial strategy is considerable.

      Rationale for maintaining and continuing with disciplined approach

      It is worth noting that ever since Council adopted a strategic approach to
      financial planning that it has in fact been producing improving financial results
      in line with its adopted financial plans. Improving financial performances
      should however not be confused with good or strong financial outcomes.
      There is a big difference.

      It took some 5 years to address critical 1st tier short term sustainability
      challenges. Council in 2008/09 can now focus its strategic attention with 2nd
      tier long term financial sustainability challenges.

      It would be inappropriate to somehow assume that in 2008/09 has managed
      to get itself into a position of some financial strength and as a result can begin
      relaxing its financial discipline.

      Not all financial capacity is quarantined

      It is important to note that the proposed strategy does not advocate that all
      financial capacity be quarantined to an internal reserve.

      Financial capacity can invariably be identified / quantified:-

      1.    During the financial year,

      2.    Towards the end of a financial year and

      3.    At the end of the financial year

      The previous financial strategy (quarantine capacity funds for long term debt)
      and the ‘proposed strategy’ only dealt with favourable financial capacity
      realised at the end of the financial year.

      There are two other situations where potential capacity funding can be
      identified.




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South Gippsland Shire Council                                             1 October 2008
                                                      Outtrim Recreation Reserve, Outtrim


      The first process can occur mid way through the financial year if and when it
      is established that projected net expenditure is shown to be favourable to
      what was originally forecast. Council would be advised of this situation and
      as part of this process could then consider reallocating the funds to new
      projects and / or initiatives. The important criteria being that the alternate
      projects nominated need to be completed by financial year end.

      The second process occurs towards the end of the financial year (typically
      when the following year’s budgets are being developed) in which any net
      favourable expenditure outcomes identified in the current year is effectively
      released as an additional capacity funding for the following financial year’s
      budget.

      In both instances, Council being strategically focussed should be
      endeavouring to allocate the capacity funds towards much needed capital
      renewal works as opposed to either capital extension works. Another
      important consideration being that the additional projects do not compromise
      the existing planned programs being delivered.

      Financial risks associated with ‘proposed strategy’

      The only real financial risk associated with this approach of establishing
      internal cash reserves is that in future years that either an unavoidable event
      and / or a special project need will not eventuate. If this was the case it
      means that Council had accumulated funds into a reserve for no worthwhile
      purpose. This is highly unlikely to be the case.

      The risk of such strategy is somewhat greater trying to ensure that aside from
      having funding available for unavoidable and unforseen cost events that the
      most appropriate project with strategic benefits to the organisation is chosen
      to be funded from the reserve.

      This is particularly so if funding over a number of years was not required to be
      released for unavoidable expense requirements and as a result becomes a
      considerable sized financial reserve.         It is important that structured
      methodology processes are developed to ensure that the most appropriate
      project/s with important strategic benefits to the community is / are chosen
      that the internal reserve will fund.




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South Gippsland Shire Council                                             1 October 2008
                                                      Outtrim Recreation Reserve, Outtrim


      Operational performance benefits

      Aside from financial benefits gained by partitioning moneys from favourable
      year end results for likely future events (be they unavoidable and / or special
      projects) there are other operational performance benefits that would flow on
      from this strategy, including:-

      •     Reducing risk of capacity funding being diverted to capital expansion
            projects (when an opportunity presents itself to reduce the infrastructure
            renewal gaps) and

      •     Not compounding the existing challenge of Council officers
            endeavouring to complete a given level of capital and major projects in a
            given year by then adding some more work to be completed.

      This is where commercial and government approaches to business planning
      and operational performance management have tended to vary considerably.

      Commercial organisation core objective is to deliver planned outcomes and
      within specified budget. Any favourable outcomes recognised throughout the
      year are either returned to the shareholder as increased dividends or retained
      in internal reserves. The increased capacity is then factored into forward
      business plan considerations. Reactive management is minimised. The
      overall management process is more structured, disciplined and accountable.

      In local government the tendency is to be very reactive when it comes to
      dealing with capacity funds. Due to the service orientated nature of the
      business the tendency is to try and do more immediately with the available
      funds.

      The risks of inappropriate expenditure decisions being made and not
      completing planned outcomes increases materially. Local government is
      sometimes criticised for ad hoc decision making processes and for not
      delivering planned outcomes within specified timelines.        Our reactive
      management processes inadvertently contribute to this problem.

      A fair argument could be put that we should in fact in future years as our
      business maturity increases to seriously consider partitioning all favourable
      variations to internal reserves rather than make allocation decisions
      throughout the years. The objective should be to deliver planned outcomes
      and within budget during the financial year.

      The capacity funds can then be considered in a more strategic manner as
      part of the forward business planning process. The management process is
      therefore strategic in nature as opposed to being a reactive or ad hoc
      management approach.




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South Gippsland Shire Council                                            1 October 2008
                                                     Outtrim Recreation Reserve, Outtrim


      SCENARIO MODELLING

      Several models are presented below that show the financial impact of
      introducing a strategy that quarantines year end favourable financial
      variations to an internal reserve.

      Scenario 1: - There will be a need for $0.5 million additional fund
      requirements for an unavoidable cost event in five years time

      Scenario 2 - There will be a need for $2.0 million funds for a significant one
      off special project in five years time.

      The assumptions used in both models are as follows:

      •     The favourable year end variation achieved is modelled at 0.5%
            favourable variance in cash expenditure budgets Income statement over
            each financial year.

      •     Interest on investments is 8.5%.

      •     Term of borrowing is 10 years.

      •     Finance cost of borrowings are 9.5%.

      •     The services and infrastructure funding gaps (primary & secondary in
            nature) have been identified and a plan is being implemented to bridge
            over a defined period of time

      Scenario 1 ($0.5 million unavoidable cost event - no reserve funds)

      If there is an unavoidable cost event in 2011/12 that requires $0.5 million and
      no funds have been quarantined in a reserve, the required funding would
      have to be obtained by either:

      •     Reducing the capital works program in 2011/12 by $0.5 million which
            represents 6% of the capital works program in that financial year. If the
            cost reduction was in renewal works this would be undesirable

      •     Borrow $0.5 million and if repaid over 10 years the total funding impact
            would be in excess of $76,000 per annum (total repayment $785,000
            which includes a $285,000 loan financing costs)

      If the cost reduction in the capital works program was in renewal works this
      would be undesirable because it would prolong the time required to bridge the
      funding gap. Also the event would force reactive management practices to be
      adopted in revising the capital works program. This can of course lead to
      further cost inefficiencies.




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South Gippsland Shire Council                                             1 October 2008
                                                      Outtrim Recreation Reserve, Outtrim


      Similarly, if borrowing were utilised, from a cash flow management
      perspective this would have adverse impact on the following 10 years finance
      activities cash flows. This would have to be offset by increasing the cash
      flows from operating activities over the same years; otherwise this would
      translate into a gradually weakening of the Council’s working capital over the
      coming years.

      Scenario1a ($0.5 million unavoidable cost event - reserve funds)

      If there is an unavoidable cost event in 2011/12 that requires a $0.5 million
      and funds have been quarantined in a reserve, the required funding would be
      obtained by:

      •     Transferring $0.5 million funds out of the reserve (which would have
            accumulated $0.79 million over the five years)

      Also, whilst the funds have been quarantined and gradually accumulating in
      an internal reserve it would have generated $78,000 additional interest
      income over the five years in a tax effective manner (not subject to tax). This
      additional income stream would have the effect of further strengthening the
      underlying operating performance of Council.

      The difference between the two models is that rather than have to reschedule
      capital works programs or borrow funds, there are internal funds that can be
      accessed and the achieved in a financially efficient manner.

      The strategic approach to quarantine some spare capacity over the years
      serves to stabilise the forward business plan of Council and minimise ad-hoc
      reactive decision making processes. It is sometimes referred to as prudent
      financial management practices and is the norm in the commercial world.

      Scenario 2 ($2.0 million major project initiative - no reserve funds)

      If there is a major project initiative requiring $2 million and no funds have
      been quarantined in a reserve, the required funding would have to be
      obtained by:

      •     Borrowing $2.0 million and over 10 years paying back $3.14 million
            (principal $2.0 million, financing cost $1.14 million).

      Scenario 2a ($2.0 million major project initiative - reserve funds)

      If there is a major project initiative requiring $2 million and funds have been
      quarantined in a reserve, the required funding would be obtained by:

      •     Transferring $0.79 million funds out of the reserve; and

      •     Borrowing $1.21 million and over 10 years paying back $1.90 million
            (principal $1.21 million, financing cost $0.69 million).




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South Gippsland Shire Council                                              1 October 2008
                                                       Outtrim Recreation Reserve, Outtrim


      The difference between the two models is having to borrow an additional
      $0.79 million and incur an additional $0.45 million finance cost over the
      10 years.

      Again, this translates through as increased cash flow pressures and on
      operating results in the forward plans statements of cash flows and income
      statements.

      The opportunity cost difference between the two models no matter what the
      scenarios are, is considerable. The models simply demonstrate the fact that
      a disciplined approach to business management practices result in financial
      efficiency gains being realised.     A less disciplined approach has a
      considerable cost impact.

      OPTIONS

      Council would be aware through informal discussions that the financial
      management advice has been very much along the lines of continuing to
      maintain the financial discipline in regard to how it strategically deals with
      year end favourable financial outcomes.

      It is however also acknowledged that Councillors would like to be able to
      provide more to their communities wherever it is reasonably possible to do so.
      It would not be unreasonable to allow some latitude to release some surplus
      capacity whilst at the same time not compromise the overall financial strategic
      intent of Council.

      Options include:

      1.    Do nothing. The $30,000 variation is immaterial and if ‘left alone’ would
            marginally strengthen the working capital position of Council. Council
            has a specific financial strategy to strengthen the working capital
            position over the coming years. It is of no coincidence that the Auditor
            General’s assessment of Council financial sustainability has also
            earmarked that Council ought to strengthen its working capital.

      2.    Again do nothing but allocate the $30,000 to fund one or several of
            Council currently unfunded projects or initiatives. It is important that any
            project/s chosen are ‘one off’ in nature as opposed to being recurrent in
            nature (that require funding stream over a number of years). Ideally the
            project chosen should either be a capital renewal project or community
            initiative that did not receive funding in the 2008/09 budget setting
            process.

      3.    Adopt the ‘proposed financial strategy’ dealing with favourable
            variations, the financial impact then being that the $30,000 would be
            quarantined to an internal reserve. This is similar to but a more
            financially disciplined variation to the first option discussed above.




                                        Page 209
South Gippsland Shire Council                                               1 October 2008
                                                        Outtrim Recreation Reserve, Outtrim


      4.    Adopt a modified ‘proposed financial strategy’ dealing with favourable
            variations, the modification being that any material variation over
            $100,000 be quarantined into an internal reserve. This would enable
            Council to have a reasonable level of latitude to fund initiatives / projects
            without breaching the overall intent of financial strategies. This is a
            more financially disciplined variation to the second option discussed
            above proposal.

      Council should consider adopting a specific financial strategy on how it
      wishes to deal with material year end favourable variations.         It is
      recommended that either option 3 or 4 would be a reasonable and financially
      acceptable strategy that would complement the other suite of financial
      strategies.

      The recommendation for Option 4 is worded as:

      ‘That wherever possible, any material favourable budget variations over
      $100,000 realised in a given financial year be specifically quarantined and
      allocated to a ‘future funds’ reserve (unless required to finance projects
      deemed as ‘unavoidable’) that in future periods can be used as a funding
      source for either one off unexpected unavoidable cost or for a specific capital
      upgrade or extension project. Favourable variations up to $100,000 can be
      utilised as a funding source for either a one off capital renewal project or
      council initiative that missed out on funding in the annual budget setting
      process’.

      If Council wishes to maintain a more disciplined approach to its strategic
      financial management practices it should then choose option 3. The
      recommendation would be worded as:

      ‘That wherever possible, any material favourable budget variations realised in
      a given financial year be specifically quarantined and allocated to a ‘future
      funds’ reserve (unless required to finance projects deemed as ‘unavoidable’)
      that in future periods can be used as a funding source for either one off
      unexpected unavoidable cost or for a specific capital upgrade or extension
      project’.

      Taking into what we have accomplished over the past five years, Councillors
      desire to be able do more for the community and the financial challenges that
      lay ahead it is recommended that option 4 is a reasonable proposal that does
      not compromise the strategic financial intent of this organisation.

      IMPLICATIONS

      The short term pain of having to maintain financial discipline (expressed as
      financial strategies) is rarely seen to be a pleasurable experience. The
      benefits are invariably felt later on. It requires considerable discipline. There
      is now very clear documented financial evidence that Council over the past 5
      years has significantly improved its financial performances.




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South Gippsland Shire Council                                              1 October 2008
                                                       Outtrim Recreation Reserve, Outtrim


      There is also very credible strategic financial evidence that shows that this
      Council still needs to improve and strengthen is financial results over the
      coming years. This has been independently validated by the Auditor
      General’s independent assessment of what they have noted to be the
      financial sustainable challenges of this Council.

      The current and preceding Council can be both applauded for what they have
      achieved in both adopting a series of long term financial strategies and
      financial plans and actually keeping to it over the past 5 years.

      Council now has the opportunity to leave a strong strategic financial legacy
      for the ‘new’ Council to take on board and build on. Strategic financial
      decisions made now will have an important bearing as to whether this
      organisation in the future can and will be in a position to seriously target the
      3rd tier of the financial pyramid discussed in the ‘proposed financial strategy’
      paper.

      CONCLUSION

      Part 7 of the Local Government Act 1989, among other things requires
      Council to comply with the following principles of sound financial
      management:

      •     Prudently manage financial risks relating to debt, assets and liabilities.

      •     Consider the financial effects of Council decisions on future generations,
            and

      Council is in a position to begin consolidating its 2nd tier challenge of
      achieving long term financial sustainability and at the same time begin
      strategically targeting the 3rd tier challenge, that of adequate levels of funding
      for service provision including infrastructure asset management.

      The proposed strategy was in fact refining an existing strategy and reflecting
      the growing maturity of Council in regard to its financial planning practices.

      If Council has a conviction that in future years there is a reasonable chance
      that it envisages that its community would benefit by the undertaking of some
      major project that would most likely require considerable funds then
      strategically it should be planning and gearing up now to obtain the most
      efficient financial outcome in the long run.

      A secondary benefit of having such a strategy is having internal capacity
      funding on hand in the event of any material unavoidable cost event
      eventuating. As an example this Council has had a history of 2 calls for
      unavoidable unfunded superannuation commitments over the past 10 years.
      It would not be unrealistic to expect other unavoidable events to occur in
      coming years.




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South Gippsland Shire Council                                               1 October 2008
                                                        Outtrim Recreation Reserve, Outtrim


      Council, by choosing not to continue with its strategic disciplined approach to
      dealing with favourable year end variations as it has done over the past five
      years, would by default signal that the objective of achieving strong financial
      outcomes is now less important as an objective.

      From an overall long term financial perspective the outcome is not ‘mission
      critical’ that has dire financial ramifications. However, to get to the 3rd tier one
      has to do things differently to what is currently being done.




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