56. Labor-Intensive Businesses and the Learning Impact on Cost Estimation
Capital Budgeting, Planning and Forecasting, Performance Evaluation are just some cases when a different impact can be observed with reference to the human factor productivity affecting its output in a different way over time at different stages of a business process.
The same thing you can gather when you have to do with Make-or-Buy decisions as well as th Cost-Volume-Profit Analysis.
What are we talking about?
Here is a classic example applied to the Budget Process:
Budget Output: 1,200,000 units
Average Direct Labor Time per product unit (including the inefficiency rate): 5 minutes
Total Budget Working Hours: 1,200,000 x 5 = min 6,000,000 = hrs 100,000
considering a Learning Rate at 90% (see below the definition and the calculation of the Learning Rate) after 6 months and supposing a steady monthly production output.
Total Budget Working Hours: 600,000 x 5 min + 600,000 x 4 min = min 5,400,000 = hrs 90,000
This is a very short and "rough" example of the importance of the Learning consideration in the cost estimation processes of a labor-intensive firm.
Yes, we are considering the case when Labor is the main factor that characterizes the business processes and produces that product/service to deliver to the customer.
Furthermore, when the tasks performed are so repetitive that a productivity enhancement is a natural effect of their continuous execution over time, it's easily understandable how in the business estimation processes of all kinds you cannot neglect Learning and the best way to calculate its impact.
One may think that this concept applies only to the manufacturing industry but this assertion is belittling. I should say that it is good for any kind of a labor-intensive business, ranging from manufacturing to services and last but not least for the software companies where the developers are as faster in the programme unit (usually a given number of code lines; for more specifications Page Contacts) creation as "bigger" their work is.
First of all, it is important to see the formula usually accepted one makes use of for calculating how Learning impacts the time and the costs of the Labor resource.
It is the following:
Y = Cumulative Average Time per Unit at the Double Output
a = Time of the first Unit at the reference Output
Taking the numbers from our previous example with Learning:
Y = Total Time at the Double Output/ Double Output = 5,400,000 min/ 1,200,000 = 4.5 min
a = 5 min
Learning Rate = Y/a = 4.5/5 = 0,9 = 90%
Of course at a some point the Learning ends up and no further Unit Time reduction can be expected except for those cases when change in the business process happens such as a new technique, some change in the labor mix and so on.
One thing is certain: when all is unchanged, the productivity enhancement ends up and the Learning Curve becomes a straight line.
Another point to be highlighted is that the Learning impact measurement through the Learning Rate seen in the lines above, that define it as the percentage by which the Average Unit Time decreases as the Output doubles, relies on the assumption that the productivity the enhancement goes on constantly.
That is not always true since there can be cases that see enhancement in a different way; for instance you can have a decline in the Average Unit Time by a given percentage after some Output Units and a different percent decline after working a furher number of Output Units.
However the most suitable and realistic Learning model is not the focus of this article (if you want to dig deeper into this, you can ask info on page Contacts), but we prefer focusing on the need for the analysts and controllers to take it into account when they are estimating costs, their business is a labor-intensive one and the tasks performed are repetitive.
This need becomes more true and strategic when the company has a Cost Leadership Strategy and even more when the Pricing model is based on a Mark-up to the costs.
How can you disregard an appropriate Learning Curve Analysis!!?
55. Strategic Reporting Adherence: Lean, from the processes to the accounting
I wrote very often about the linkage between Strategy and kind of the cost management approach in order to give the managers the best decision-making support to achieve the business’ goals.
In this article I want to focus on another point that needs to be highlighted that is the relationship between cost management methodology and a suitable system of reporting and managerial accounting.
As a matter of fact without this it will be impossible to reap completely the benefits from the cost management approach we have chosen and as a result to see the success or not of the business strategy.
I think that the best possible example about this relationship we should make concerns the Lean philosophy, I have previously dealt with on n. 30 of this page but I want to write about again because it is very functional to the goal of this article.
We are going to see how the Lean Accounting derives directly from the principles of Lean Manufacturing and we do that by starting just from the Lean definition.
Lean (we call it this way and not Lean Manufacturing because its principles can apply to all the buisness transaction) aims at the identification and reduction of waste or non value–added activity within a process from the point o view of the customer.
Lean starts from the common concepts with TQM (total Quality Management) and utilizes the entire organization (each member) in order to focus on the customers, both internal and external ones, and meet and or exceed their expectations.
It is intended to enhance the process flow, increase the throughput, reduce Inventory Level, reduce Customer Lead Time, enhance quality and customization and as a result improving decision making and profitability.
In operational terms its successful implementation determines for instance on-time delivery, higher machine availability, machine setup time reduction; better utilization of labor; reduction of excess fixed assets.
Some of these results are not measurable in the short term and in order to gauge fully the benefits from the Lean adoption we need an appropriate accounting system.
FOR INSTANCE THE INCREASE IN PRODUCTIVITY WOULD DETERMINE AT ONCE IDLE CAPACITY THAT WOULDN'T BRING ANY IMMEDIATE FINANCIAL RESULTS UNLESS IN THE LONG TERM WHEN THE ELIMINATION OF THE EXCESS FIXED ASSETS WOULD TRANSLATE INTO COST SAVINGS.
At the same time when removing the EXCESS FIXED ASSETS the Decrease in Inventory would determine an immediate higher cost for the first period after the Lean implementation.
I will explain why.
As a matter of fact the elimination of fixed costs, that go into the evaluation of inventory according to the full-cost accounting technique, would lead to a lower related share by unit of product so that in period of decreasing inventory (a cost) the negative fluctuation compared to the prior period is higher than it should have been without reduction of the Fixed Assets and related costs.
These aspects, as we will see, need an appropriate tool to be understood and seen as they are, that is great financial benefits after the first period.
This tool is the Lean Accounting.
Thanks to the Income Statement according to the Lean Accounting Model one can highlight immediately the Cost of the above decrease in Inventory and consider it as an additonal profit to achieve in the long term.
The lack of this tool might cause employees and middle management to undervalue the benefits of Lean philosophy implementation and could bring about the backsliding to old concepts together with other factors.
The risk of this is greater than one could expect because of the consideration that the Pull policy about manufacturing is just one of the main points of Lean and as a result it produces important financial consequences.
I will be more clear.
The goal is of the Pull approach is not working on a Budget basis but when customer orders arrive, so that a high Inventory level would be useless and expensive.
Just a punctualization about Lean philosophy.
This aspect just deal with is typical of the manufacturing companies but as I underscored previously the Lean approach is suitable also for other kinds of businesses and industries.
It derives also from the consideration that the elimination of waste is fundamental for Lean and if we bring in our mind that the waste concept is very large.
It includes the activities that customers don’t want to pay for.
Here is a short list of this kind of waste activities that support this statement:
- The time the accounting department waits for completing the period-end close prevents other people from accessing the company’s network and getting their tasks done. In other terms it is waiting.
- When conveying information that does not add value to the product or service.
- Over-Processing: redundant steps added to a process; very often this happens when building a feature into the product/service not taken into consideration by the customers.
Do you want another passage from the Lean philosophy to the Lean Accounting?
I will do two other examples.
One tool of the Lean approach is the Value Stream Mapping that is the visualization of the activities and information concerning the production of a product or service for the customer and, as a result of the focus of Lean on the customer needs, those activities that create value for a product group (similar products or services) come into account.
These Value Streams that cross horizontally all the departments, should be “weighted in the financial aspect to enable the measurement of the continuos improvement of the processes.
At this point the Lean Accounting comes up as the most suitable accounting approach to highlight and measure improvements thanks to the adoption of Lean concepts.
The core is to take products or service that derive from similar processes that are financially measured by regrouping those products and services into the same Value Streams.
By doing this way the business efforts from the Lean Implementation are fast to be seen and assessed.
Why not to write about another cardinal point of Lean philosophy, one-piece flow?
It causes the firm to work on smaller quantities, producing just when the orders arrive.
If on one hand that gets the advantage to have greatest flexibilty in the customizazion of the product/ service, on the other hand the total sales in the short term may decrease whilst increasing in the long term because of the higher capacity to bring value to customers by meeting their requests.
Even this financial impact can be highlighted by the Lean Accounting Statement and correcly seen as a temporary profit decrease recoverable in the following periods.
Other elements can be deal with about this topics, that’s why you can interact on Page Contacts.
An exhibit of a Lean Accounting Income statement represents the summary and an example of the the Lean accounting intended for the correct evaluation of Lean approach implemantation.
It is an abstract from the article n 30 I invite you to read to complete the picture about the Lean Accounting.
Table 1 – Lean Income Statement, January 2018
Sales 620,000 750,000 1,370,000
Materials 145,000 140,000 285,000
Labor 152,000 168,000 320,000
Other costs 35,000 26,000 61,000
Total 332,000 334,000 666,000
Value-Stream Margin 288,000 416,000 704,000
Other Value-Stream Costs:
Manufacturing 152,000 175,000 327,000
Selling 25,000 33,000 58,000
Total 177,000 208,000 385,000
before decrease in Inven. 111,000 208,000 319,000
Decrease in Inventory (25,000) (36,000) (61,000)
Value-Stream Profit 86,000 172,000 258,000
Cost of the Unused Capacity (45,000)
Nontraceable Fixed Costs (75,000)
Operating Income 138,000
54. Zero-Based Budgeting and its Strategic Sides
How many times we come across some sort of resistance to the implementation of a new Cost Estimate Model within an organization to support the creation of a sound basis for the best possible decision making!
One way to give evidence of the great usefulness of this potential model could be focusing on the businesses discouraged by the great differences between Actual and Budget.
A lot of companies are facing many changes and will have to face many more obstacles due to new technologies and the customer preferences that impact not only the produc/service features but even the business organization.
As a result many managers bring into question the need for the traditional Budget since in their opinion the Actual will be so different from the "estimated" because of a great deal of factors.
Instead of putting aside a guide for pursuing the goals of the company why not to abandon the traditional incremental-decremental way of building the budget and to start from scratch!!??
The "start from scratch" relates to a new Cost Estimate Model embedded into the Budget process.
Let's take a step back.
What do I mean by "incremental-decremental"?
The most used way to estimate the General Expenditures is to take as a basis for increasing or decreasing the amount of the past period.
After that according to the projects and to the strategy of the business that basis is taken as a start point either to increase or to diminish the outlay for the purchase of the related resources.
In other terms the "bare bones" of the general expenses, usually the majority of the business expenditures, aren't brought into question and your spending won't be ever kept up with the pace of the new challenging needs from the customer both with reference to the output and the related services.
How to do during these dynamic times not to miss out on the market requirements when planning?
Starting from Zero is the first essential step.
What do we mean by that when talking about planning and first of all about Budgeting?
We mean what is known as Zero-Based Budgeting, that is technique providing the cancellation of the amount of the expenditures of the past fiscal period as a basis for adding or taking off money to be spent on the related resources over the next period.
Every single dollar to spend on the resources needed by the business to work must be explained and justified.
That involves the lack of need to take something "obsolete" as a basis on which the business managers, each of them with reference to their business unit, start to reason.
To be more clear I think that a short list of the steps Zero-Based Budgeting consists of may be usefull and I will do this by highlithing as much as possible a strategic approach.
Identifying once more the strategic goals of the business by declining them into cost cut objectives and/or revenue increase ones.
Quantifying these goals by assigning if possible (according to the business stage in its life cycle and its martket) a minimum reference target, firstly for the business as a whole, secondly for its Business Units.
Then it would be "mandatory" bringing all the managers within the organization up to date with those "measures".
Each BU manager must spot the decision activity packages that falls under their responsibilty and rank them according to their importance for the BU and the Value Added that those activities bring to the Customers (last but not least the internal customers, meaning by them the other BUs that give or take services to/from that BU).
The techniques used to rank these activities based one the costs and the benefites associated are different but the related dissertation goes beyond the goal of this article.
Identifying the cost drivers that explain the consumption of the resources for each BU to do their job.
Allocating the resources of the previous step to each BU so that one can forecast the respective amount.
Cutting the excess spending, if any, by taking into consideration the ranking of the third step with reference to the strategic goal of the first step.
In other terms one can proceed just in consideration of the mere goal to cut cost or also of the Value that the activities being examined bring to the customers and their contribution to generate revenues.
All the steps contemplated within an organization concerning the negotiation and approval process between Top Managment and BU managers.
After seeing these steps some considerations can be made about the benefits and disadvantages about ZBB.
The greatest advantage is the result of the total review of the business activities that enables the business to be responsive in a manner as timely as possible to new changes and advances in the technical as well as in other elements needed to be up to date with requirements from the customers.
The extent to which one can capitalize on this feature depends on the cost approach used to quantify the resources to be absorbed by the business activities.
This operating side of the approach used is determinant to succeed in the goal of the ZBB that in itself doesn't suffice in very dynamic markets if the most suitable cost technique is not used.
However, this may be the subject of a future article where an in-depth dissertation would be expanded on.
Another great aspect of ZBB implementation is that it enables the strategy to soak into all the Business Units because of the Top-Down method.
As a matter of fact the starting points, as we have seen in step 1 and 2, consist of the strategic goal decisions of the Top Managers and the following communication to the other managers.
It requires greater effort and is more time-consuming than the traditional Budget because all the activities are analyzed deeply and this can discourage the business managers.
I would add that an appropriate people training to ensure the budgeting is implemented correctly could be a smart move.
Some advocate that when the work is so great the implementation of ZBB could occur not every year but every scheduled period (for instance 3-5 years) especially in the large-sized companies where a further remedy provides the business divisions/departments could adopt it by taking turns.
I don't see the latter remedy very positively when the operations between one division and another are recurring.
Some argue that ZBB "prefers" the short term because it aims mainly at cutting cost but we can state that the ranking of the activities if well done according to their capacity to generate revenues and to match the customer needs will yield great fruits in the long term, too.
Of course an appropriate training is needed with reference also to this aspect.
Summing up, the ZBB is an evergreen approach that could help businesses have an useful guide to their activities without taking the risk to be late in matching the market trends and requirements.
Like any other business process should be enhanced in its operating aspects and in the way it is communicated within the organization environment that is an aspect not to be undervalued.
If you wish to debate even more on ZBB, you can resort to thestrategiccontroller.com with your questions, opinions and any other related feedback.
53. How Many Kinds of Overhead Variance Analysis!
How many finance people jump on board of a company with a standard cost accounting system well-established and never looked closely!?
The result is the analyses come out automatically without knowing how they are achieved.
That is the case of the Overhead Variance Analysis, one of the most complex issues to explain to a future smart management accountant.
Thestrategiccontroller.com will make an overview to make the mechanisms clear to anyone who may be interested.
Let's start out from the main formula of the Overhead Variance Analysis.
Total Overhead Cost Variance = Actual Overheads - Budgeted Overheads
You know that the Overheads are both variable and fixed, so the companies that have in place a cost system able to distinguish these two categories may carry out the variances in a separate way that spot 3 or 4 of them.
The business not able to make this distinction can use a two-variance model.
At this point you will have understood one of the factors that makes this topic not so easy to be absorbed.
Here is the first and most detaile model.
Total Overhead Cost Variance = (Actual Variable Overheads + Actual Fixed Overheads) - (Total Overhead Application Rate x Standard Driver Quantity)
Please note that the driver chosen as a basis for the overhead allocation to the products may be different and vary according also to the Volume-Based or Activity-Based Approach.
That is not the article for disserting about that and we prefer going on by a simple example.
That difference (Total Overhead Cost Variance) shows how far the related expenses went compared to the amount estimated in the Budget but what matters most is to evaluate the business performance considering the output achieved at the end of the period analysed in the best possible way and costing the products to the same degree and that's why we make use of the concept of Fllexible Budget by appling the unit cost of the driver chosen and the overhead rate (standard and actual) to the period's production.
We can see much better by starting from the following formula.
Total Overhead Cost Variance = Actual Overheads - Applied Overheads
At this point the previous formula becomes:
Overhead Cost Variance = Actual Overhead - Applied Overhead = (Variable Overhead + Fixed Overhead) - (Total Overhead application rate x Standard driver allowed for the production of the period).
Let's assume that the driver chosen for the imputation of the overheads to the products consists of the labour hour.
As a result the Standard driver allowed for the production of the period becomes Standard labour hours allowed for the production of the period.
As we are about to see the formulas for the Variable Overheads may look the same as those of the Direct Cost Variances but the interprepretation is different due to the subjective relationship between the driver chosen (in our case the Labour Hours) and tha varible overheads.
However this issues would require another article and that's why you can get in touch on page Contacts if you want dig deep
Let's turn to our topic and a table showing some numbers for an imaginary Manufacturing company with one product and with Labour Hours as the driver chosen will be very useful to understand that formula.
Table 1 - Standard Cost Sheet (Manufacturing Company A)
|Cost Category||Quantity per unit||
Unit Cost or Standard Overhead rate (for Overhead)
Cost Category Amount
|Direct Materials||6||$ 25||$ 150|
|Variable Factory Overhead||5 hours||14||70|
|Variable Manufacturing Cost||470|
|Fixed Manufactiring Cost||5 hours||26||130||130|
|Standard Cost per Unit||$ 600|
After adding these further data:
Actual Output: 1,000 Units
Budget Output:1,200 Units
Actual Variable Overhead Costs: $ 56,000
Actual Fixed Overhead Costs: $ 150,000
We turn that formula into numbers.
Total Overhead Cost Variance = Actual Overheads - Applied Overheads = (Variable Overheads + Fixed Overheads) - (Standard Total Overhead application rate x Standard driver allowed for the production of the period).
Total Overhead Cost Variance = (56,000 + 150,000) - ((Standard Variable Overh. Application Rate + Standard Fixed Overh. Application Rate) x (Standard Labor Hours per Unit x Actual Output)
Total Overhead Cost Variance = (56,000 + 150,000) - ((14+ 26) x (5 x 1000)) = (206,000 -200,000) = $ 6,000
In this case the actual is higher than the second member of the equation by $ 6,000 and that means that the overheads were underapplied to the production because each output unit has absorbed a higher overhead share than the expeced one.
In order to understand the causes we are going on to breakdown this Total Overhead Cost Variance.
Let's go on with the Total Variable Overhead Variance and see that it is equal to:
Total Variable Overhad Cost Variance = Actual Variable Overheads - Standard Variable Overheads Applied to Production = $ 56,000 (Standard Variable Overh. Application Rate X Standard Labor Hours per Unit x Actual Output) = 56,000 - (14 x 5 x 1000) = 56,000 - 70,000 = -14,000
That means that these Oveheads have been overapplied because each output unit has absorbed a lower variable overhead share than the expeced one
On the opposite side the Fixed Overhead Costs have been underapplied by 20,000 as a result of this equation:
Total Fixed Overhead Cost Variance = Actual Fixed Overheads - Standard Fixed Overheads Applied to Production = $ 150,000 - (Standard Fixed Overh. Application Rate X Standard Labor Hours per Unit x Actual Output) = 150,000 - (26 x 5 x 1000) = 150,000 - 130,000 = 20,000
Variable Overhead Cost Variance
When talking about a four variance model, we are going to see the first two variances that are those related to the Variable Overhead Costs.
First of all, let's show the full data table that will help us to break them down.
Actual Labour Hours per Unit = 5.6
Standard Labour Hours per Unit = 5
LA = Labour Hours applied to production: 5,000
AW = Actual Labour Hours worked: 5,600
APv = Actual Variable Overhead Application rate: $ 10
SPv = Standard Variable Overhead Application Rate: $ 14
Now we can analyse the first variance, the Spending one, that is the difference between the Actual Overhead Costs and the socalled Flexible Budget of the Variable Overheads based on period's inputs.
Variable Overhead Spending Variance = Actual Variable Overhead Costs - Flexible Budget of the Variable Overheads based on the period's inputs = (AW X APv) - (AW x SPv) = (5,600 X 10) - (5,600 X 14) = 56,000 - 78,400 = -22,400
In other terms: (APv - SPv) X AW = (10 - 14) X 5,600 = $ -22,400
It is Favourable since the company should have spent more by applying the Standard Variable Overhead Rate (14) at the Actual Labour Hours worked (5,600 Direct Labour Hours).
In some cases, for some cost categories, this variance could be further decomposed in Price and Efficiency variances needed to dig deep into the causes of it, but that will be explained on request (if interested) on page Contacts.
As to the Efficiency Variance we'll calculate the difference between the Flexible Budget of the Variable Overheads based on period's inputs and Flexible Budget of the Variable Overheads based on the period's outputs.
Variable Overhead Efficiency Variance = Flexible Budget of the Variable Overheads based on period's inputs - Flexible Budget of the Variable Overheads based on period's outputs = (AW x SPv) - (LA X SPv) = (5,600 X 14) - (5.000 X 14) = 8,400
In other terms: (AW - LA) X SPv = (5,600 - 5,000) X 14 = $ 8,400
Please note that in this Variance for Variable Overheads the Flexible Budget of the Variable Overheads based on period's outputs is equal to Standard Variable Overheads Applied to production ($ 70,000).
It is Unfavourable since the company should have spent less by working at the Standard Labour Hours per Unit for the period's output, 1,000, and applying the Standard Variable Overhead Application Rate.
What I feel like specifying about this Variance is that the inefficiency or efficiency one can derive from its analysis follows the same direction of the inefficiency or efficiency of the driver chosen (in our case the Direct Labour Hours) as a basis for the allocation of the Overheads to products/services to the extent of the validity of the relationship between Variable Overheads and the driver.
As a result the person in charge of the subject driver, taken for good that relationship, is also responsible the efficiency of Variable Overheads,
Furthermore, the correct relationship between the driver used to allocate this kind of Overheads makes the manager in charge of the driver (machine hours, labour hours,...) responsible for the same overheads.
As a result, if you make the wrong choice, that will cause problems of fairness and motivation that will translate into a bad effectiveness of the actions taken to decrease the same Overheads.
Fairness because a manager could be held responsible for something that is out of his control and remunerated, in case of compensation partially linked to the financial results of his Business Unit, less than deserved when the Variable Overheads increase.
Motivation because other managers, whose behaviour really impact the amount of the Variable Overheads, won't be pushed to act in the same interest of the Business as a whole and in the end they will make decisions that will cause that expenses to grow and grow.
At this point the debate could be shift to the most suitable approach to allocate the Overheads we are dealing with but this is not the article dedicated to this topic and let's go on to the other variance left.
Fixed Overhead Cost Variance
As we have seen above the Total Fixed Overhead Cost Variance adds up to $ 20,000 and that means that for product-costing purposes they were underapplied in the meaning we repeated many times in the previous lines.
Yet prior to starting the dissertation over these variances, I want to remember some basic concepts in the end that will help the reader to better interprete them.
The Application rate for the Fixed Overheads is not like that for the Variable ones an immutable amount per unit of the driver chosen (in our example the Direct Labour Hours) that makes the related Overhead Costs increase in direct proportion to the increase in the driver quantity (taken for granted the validity of the relantioship).
It is an amount per unit of driver that increases or decreases following the opposite direction of the increase in the driver quantity because the Fixed Overheads don't vary within a large interval of the driver quantity.
In other terms we are recalling the concept of the variable and fixed costs and their different impact on the product cost.
That said, let's go in-depth with the breakdown of the Fixed Overhead Cost Variance by saying that just like the Variable Overhead Variance it can be broken down into two categories.
They are called Production Volume Variance (PVV) and the Spending Variance.
PVV = Budgeted Fixed Overhead Costs - Standard Fixed Overhead Costs Applied to Production
In our example:
SPf: Standard Fixed Overhead Application Rate
LS: Standard Labour Hours
LA: Labours Hours Applied To Production
52. Project Control and some Risk Assessment Methodologies
This article wants to pay homage to the Project Control and the role the Risk assessment plays therein.
The uncertainty is a typical issue of any business decision to be made but it takes even more importance when the projects take time and the technical steps as well as the related resources may be impacted by the occurence of some events, both positive and negative ones.
That's why any firm operating on project must be well-shelled against the Risk of these events and its operating "way" is so peculiar.
The steps a company makes in analysing the risks related to a potential project are 4:
1. Risk Identification.
We are going to deal with the Assessment step, focusing on two ways that can be followed in order to weigh the consequences of some events if and when they occur.
The existing approches are generally categorized into qualitative and quantitative ones, each of them is broken down in different methodologies.
We want to pay attention to one method per approach.
Prior to getting started let's give a short definition of the quantitative and qualitative techniques.
The quantitative method weighs the risks by means of given measurement units and it is used for different purposes ranging from the financial consequence assessment to the determination of the success probability of the project without forgetting the determination of the effects of potential forced changes in the work schedule.
The qualitative approach is intended to rank the total risk of the project without resorting to any unit of measurement, by defining the criteria enabling the assessment of the consequences resulting from the occurrence of the risky events.
That said, let's start with a methodology of the qualitative approach.
Let's guess a matrix where the projects are classified and ranked according to their positioning with reference to the extent (the higher, the greater extent) of the consequencies of a particular event and the occurence probability of the same event (the more on the right, the less probable the risky event).
Matrix 1 - Risk Exposure Matrix
The projects d, e and f are positioned beyond an Attention Threshold that causes the project manager to pay more attention to these than to a, b and c.
The size of this Matrix depends on the levels (number of columns and rows) spotted as the appropriate in order to assess the projects according to the usual features of the company projects with reference to some criteria such as:
1. Internal features of the project: skills requested and available, technologies requested, characteristichs of the materials and timing of the supply,....).
2. Financial dimension of the project: presence of subcontracts and/or partners, entity of the investments to be made...).
3. Category of the project: importance of the client, impact on the whole business, contract clauses,...).
As you can notice the ranking of the project under the qualitative approach is subjective since it depends on the judjment of the project manager that relies on his ability and the experience of the business about similar projects that are never the same with reference to the features above exemplified.
On the opposite side the ranking is rather fast and easily comprehensible through that matrix.
If you want to be more detailed and professionally appropriate about the definition of the level of the risk, Exposure, for that event you are looking over, you have to spot some categories the risk level falls in and that depend on the combination of the degrees of each variable.
Here are the levels of the risk (Exposure) that we suppose are four:
At the same time, turning back to our example of the Matrix 1, the variables, whose classification convergengy determine the level of the risk (Absent, Moderate, High, Alarming) are weighed this way:
4. Very High
After that here is the Risk Exposure Matrix in its detailed configuration.
Matrix 2- Risk Exposure Matrix (Full Version)
Once you place your project into one of the Matrix cells its exposure will be immediately ranked and if it lies in the Alarming/Outstanding cells (above an imaginary Attention Threshold Line), it will need all the precautions and consideration of the project manager and his team with reference to that given event under "investigation".
If many risky event might occur, as many Risky Exposure Matrixes should be drawn and the classifification of the business projects with reference to the whole exposure comes out as a anatural consequence according to the number of the most risky placements of each project.
There is the chance of getting a most accurate classification but that means passing to an intermediate form between quantitative and qualitative approach; nonetheless that isn't the goal of this article and if you want to know more, you can reach out to thestrategiccontroller.com on page Contacts.
Having dealt with that specific qualitative technique, let's move on to one of the quantitative ones.
The Earnings Matrix is one of the application of the Decision Theory and is particularly useful when assigning a percent probability to a very unusual or even Unprecedented event to assess the Risk Exposure of a project/decision is hard.
As a matter of fact this is a very current recurring issue and it turns out to be a very useful way to estimate according to your strategy and your risk aversion.
When it comes to attributing a percentage to a given scenario/event the Bayes' Theory shows up as the best technique we know.
It has previously been "dealt with" in the article n. 18 of this page, "How to deal with the uncertainty in the estimation process", under the paragraph Scenario Analysis.
Now let's turn our attention to the Earnings Matrix and draw a matrix where Dx is a specific decision (comparable to a project) and Sy is the state (comparable to an event).
The combinations of Dx and Sy result in an amount that can be either a gain or a loss and we indicate as P (when negative - P)
An example will make the concept more clear.
D1 = Launch of a busines product into a single new country
D2 = Launch of a business product into two new countries
D3 = Increasing the sales of the existing products through a larger commercial network in the usual market.
S1 = Scenario with some Entry barriers into one country.
S2 = Scenario with some Entry barriers into two countries.
S3 = No Entry Barriers into the countries involved.
Matrix 3 - The Earnings Matrix
At this point you can apply your personal Risk Aversion by adopting one of these criteria:
Optimistic Criterion: you will choose the decision that realizes the highest potential earnings (in our case D2 with P (profit) of 280,000 under the Column "S3").
Minimax Criterion: you will choose the decision when the lowest earnigs are the highest possible (in our case D3).
Halfway Criterion: you will choose the decision when the average earnings are the highest possible (in our case D2 with the average that is worth 218,000).
See you on the n. 53.