34. Risk Management: some important metrics
The risk is the main factor taken into account by a skilled CFO and Project manager in the fulfilment of their tasks and that happens both when planning the future business activities/projects and over their execution.
This article focuses on some cases of the risk evaluation and its indices made use of concerning the project control and management.
The main quantitative technique used for undertaking a project also in comparison with other alternative project is without any doubt the Bayes’ Theorem.
It assigns to every project/investment decision the Weighted EMV (Expected Monetary Value), that is the sum of the expected monetary values of each scenario/risky event (that is each estimated profit/loss multiplied by its respective probability of occurring).
If you want to see better the above concept, you can look at the article n. 18 of this website under the paragraph “Scenario Analysis”
However, some other quantitative “factors” can be taken into account and not only about the decision whether to get a project going or not.
Why am I writing about quantitative approaches?
I am doing that because there are some other methods, called qualitative, that analyse the projects and the related risks without reference to any kind of metrics, that are more easy to be understood but at the same time with a strong degree of subjectivity.
In this article I will focus on the quantitative approaches that take into account the financial side and you will see both how these metrics are calculated and how they can be used.
Let’s start with the case when you want to know the exposure of the project/activity to the risk, meant by as a maximum effort to be faced if the risky event occurs.
It’s obvious, that there isn’t a one-size-fits-all value for all the projects or industries. A reference term must be identified which the maximum expected monetary value should be compared to.
This term is the BAC (Budget at Completion), that is the sum of all the project costs estimated at the initial stage of its life.
After this foreword, here is the Risk Exposure Level (REL)
REL = MAX EMV (Expected Monetary Value)/BAC
Let’s guess the maximum loss estimated for the project to be the increase in the procurement costs following the levy of customs duties on the raw materials being imported and fundamental to the execution of the project.
This loss is estimated $ 3,500,000 and the total value of the Project Costs is $10,000,000
REL = 3,500,000/10,000,000 = 0,35
This metric compared to that of other projects could give a preference order with reference to the risk degree if you are in a proposal stage.
Of course there are other factors complementary to that risk preference order made on the basis of the REL in the choice process of the projects.
I want to list just some of these concurrent strategic elements without going into further details in this dissertation:
- Financial standing of the firm and related funding matters important to facing the higher expenses following the potential realization of the risky event.
- Timing of the receipts from the customers.
- Kind of project pricing whether lump sum or mark-up one.
- Inclination to the risk of the top management.
- Compensation criteria (the higher the variable share linked to the project results the higher the number of little risky projects undertaken).
What if a given project has a high REL but at the same time its acceptance is fundamental to the strategy of the company and putting into practice counteractions is too expensive?
The project manager can try to transfer the risk with the MAX EMV to other entity, through for instance an insurance contract or giving that activity related to the risk in subcontract to third parties.
This practice is very advisable when the risky event isn’t under the control of the project manager, such as the macroeconomic elements (inflation trend is an example), but also when it can be contrasted by the responsible of the project and all the related financial assessments are negative.
The REL can be used also in the monitoring phase, that is when the project is being executed and the risk must be kept under control on the basis of new information.
Moreover, the project manager with the help of the project controller could measure the effectiveness of the actions put in place to reduce the risk degree by resorting to a new calculation of the REL for the ongoing projects.
Nonetheless, one thing needs to be specified.
In the latter use I highlight that the effectiveness of the corrective actions should be measured by taking into account the same risk cluster of the initial stage.
In fact, over the life of the project some other risks not considered previously can come up; then for seeing only whether the project manager is doing well, the MAX EMV must be calculated just for the old risky events.
If the ratio is lower than the previous one, the actions carried out are yielding positive effects.
It goes without saying the all the risk events, old and new, must be taken into account for a general attention to the future of the project.
What about the Contingency Funds?
When the risky events are identified by the people responsible for the project and the activities it is broken down, evaluated and taken “inside” the project, that is not transferred to other entities, then the following step is setting some appropriate funds intended for the necessary counteractions.
They are called Contingency Funds and must be included in the well-known Risk Plan.
It can happen at a given Check in Progress that the risk why a Contingency Fund was set vanishes, that is the probability of the realization of the related event doesn’t exist any longer.
In that case, that fund can be used either for setting new funds for unforeseen future risks (project allowances), or for increasing the contingencies against other risks previously considered, or for facing the expenses incurred for risks already realized and not foreseen during the intial stage of the project.
Another potential use of that fund could be the possibility of increasing the ratio that measures the expected project profitability, that is Project Revenues to Project Costs.
This ratio is called K coefficient and it is increased when the Contingency Funds (costs) are diminished.
K coefficient of the project = Project Revenues/Project Costs
A prudent project manager usually prefers the solutions listed before.
After describing the Contingency Funds and their potential utilization, the following step is showing the risk metrics that refer to them.
Risk Tendency Level , that is the ratio between the total of the Contingency Funds available and the Budget at Completion (BAC).
RTL = CFtot/BAC
It shows how much the company is open to spend because of the risk in comparison with the total costs of the project.
This metric goes a long way toward explaning the attention threshold that the company sets on a specific project together with the REL and RAL.
The latter (Risk Acceptance Level) results from the the total of the Contingency Funds available divided by the total of the EMV for a project.
RAL = CFtot/EMV tot
It expresses how much of the estimated risks of the project the company accepts to put on its charge.
33. Another useful "piece" of variance analysis for the BU
In the previous article n. 9 of this website we showed how the Market Share Variance is calculated and its potential use also for performance evaluation purposes of the Sales dpt, in particular when we are dealing with products/services going through their maturity stage.
Now we are going to show another very useful piece of the revenue (contribution margin) variance analyses for the BU.
Summing up, the Sales Variance is broken down into Price Variance and Volume Variance.
The latter is even more broken down into Mix Variance and Quantity Variance.
The last level of the analysis of the Revenue deviation, we also make the same way for the Contribution Margin Variance, causes the Quantity Variance to be divided Into Market Share Variance and Market Size Variance
One consideration must be made: fundamental to this calculation is the inclusion of the all the products of the company that are selling in the same market, making a category of products.
For instance if we manufacture three models of smartphones the reference numbers should be the total of all three products or the average value, depending upon what we are putting into the related “formula”.
In so doing, we’ll see how the Market Size Variance plus the Market Share Variance is the total of the single Quantity Variances of the 3 models.
To be more Clear here is a table with the reference Data:
Actual Unit Sales
Budgeted Unit Sales
Budget Market Share
Here is the magical equation:
Market Size Variance = (Actual Mkt Size in units – Budgeted Mkt Size in Units) X Budget Market Share X Budget Average Price
$ 218,280 = (30,000 – 35,000) X 21.4% X $ 204
In this example the variance of the Revenues traceable to the variation of the Market Size in comparison with its expected value is Unfavourable since the Actual Size is lower than the Budgeted one.
How can this value be used?
As said above the Market Share Variance, when it is calculated, could be used also as a metric to assess to the performance of the Sales dpt about products that are in a maturiy stage of their life cycle.
In fact, the value of the Revenue Variance traced to the Variation of the Market Share might reflect the ability of our salesmen to sell our products compared to that of the competitors when that product family has been selling long since.
As to the Market Size Deviation, it could serve as a quantifying tool of the trend of the market, since it measures the revenue variance due to the change in the appreciation of the reference customers towards that category our products are a part of.
This figure could be the basis or not (depending on favourable or unfavourable analysis) for some business decisions concerning that market, both investments on asset-related resources and variable resources such as salesmen “fleet”.
It goes without saying that these decisions require that past data analysis like the Market Size Variance should be combined with information concerning the future, for instance about new models to be marketed, also from the competitors, that are exclusive tasks of that Marketing Dpt..
In any case, the purpose of this article is, like the whole website, to highlight that the management control has at its disposal any kind of instruments suitable both to see whether the strategy is successful or not and to define it.
32. Budgeting process: not only a numerical issue
The budget and its process are without any doubt the main issues that keep awake many managers involved.
The main goal, as we know, consists of setting the “right” targets (financial and non financial) for the next fiscal period accordingly to the objectives of the multi-year planning and in consideration of the perspectives of the dynamic environment where the business operates.
In order to achieve that goal any kind of business “must” move its employees, from managers to the low-level employees in a way that is fair and at the same time motivating, to that direction.
In other terms, if the firm wants to attain the main goal, it cannot neglect the collaboration of its "people" because every entity is not an entity in itself but it works thanks to the commitment of those people involved.
If we want to make a sort of example breakdown of objectives that a budget should pursue with reference to its managers and employees here is a short list:
1. Creating the confidence in the attainability of the budget targets.
2. Creating a reason/incentive for achieving those targets.
3. Allowing a given degree of flexibility to the managers involved in the “daily” decision making.
4. Avoiding some arguable behavioural issues put in place to make the targets more easy and be compensated for their achievement.
5. Reducing the costs incurred for internal compliance control
The efforts of the top management in relation to these objectives depend, of course, on the kind of business, the industry and the last but not the least the skills of its employees.
There isn’t a “one-size-fits-all” list of rules and considerations to apply in any case, but some chances of choosing from methods and styles of proceeding that enable the firm to hit its goals exist instead.
I want to put on the table as a first issue the style in managing the budgeting process.
Do you prefer an authoritative approach or a participative one?
Some state that if the main objective is the setting of impartial targets in the full accomplishment of the general interest of the whole Business Unit without being affected by egoistic behaviours and manipulations of the managers, the authoritative budget is the favourite.
In order to be more clear, it’s necessary to shed light on what I mean by egoistic behaviours and manipulations of the managers.
This phenomenon, known also as budgetary slack, occurs when the targets in terms of revenues are put on a lower level than it is really expected and when the ones in terms of costs are set on a higher level than it is really expected.
That happens to make the task of the managers more easy and make them more easily rewarded if their compensation is also linked to the degree of the budget goal achievement.
By using this approach as a result the continuous improvement culture is also facilitated in consideration of the lack of a high degree of negotiations amongst the several levels of responsibility inside the company.
On the opposite side the participative approach, thanks to which the targets are set in full agreement with the all-level managers, allows the top management to be aware of the reality of the things, to motivate all the levels of the employees towards the achievement of the targets in a spontaneous way because they feel the firm as their own one.
The supporters of this approach maintain that in so doing the goal congruency, that is the alignment between business goals and manager interests, is more easy to be achieved.
Nonetheless, “very attainable” target risk looms large when the participative approach is so to say too participative.
The lever for the success of the budgeting process certainly is the goal congruency to get by trying to apply a right mix of the two methods.
In this regard another issue springs up: the linkage between compensation and degree of the achievement of the budget target.
Opinion of some professionals is that it is a hurdle when the level of the targets is high and it causes the managers to make controversial behaviours, some of which I want to indicate now:
1) Managers are discouraged and slow very much their commitment.
2) They may put in place some manipulations of the performance evaluation indices to make them earn their compensation.
3) Incentive for the budgetary slack discussed above.
In consideration of these potential factors, in the case of the fixed-performance contract, as this kind of reward is called, the objectives set into the budget should be balanced, that is motivating but not very hard, and the variable compensation not too high.
Another way not to cause these negative effects and/or make the budget unrealistic is to link the compensation to some external benchmarks or by setting trend of continuous improvement on some indicators, period after period regardless of the respective targets indicated on the budgeting process.
My personal opinion is to make use only of the Forecasts, just for performance evaluation purposes.
I will be more clear.
I should link the compensation to some percent differences of chosen indicators between the respective values highlighted in straight Forecasts.
As a guarantee of the reliability of the estimations some statistical techniques should be used, in particular when you deal with overhead expenses.
In so doing the budget validity should be saved and a forward-thinking culture should be facilitated in the daily management of the Business Units with all the following advantages.
For further info about this brand-new way, don't hesitate to get in touch.
31. The great implications of the true capacity costs (PART ONE)
Many of us are convinced to know what the cost of the unused capacity is, achieved by dividing the total fixed costs of a product/service line by the respective theoretical capacity and then multiplying the hourly rate by the unused capacity.
In case of mass production and when the customization is not so high so that the time spent on the activities is the main driver of the allocation of the costs, there is a much more precise way to calculate the cost of the unused capacity.
The original formula considers that all the staffed hours are worked and the share of the unused capacity consists of only the unstaffed ones.
In reality, we must take into account that also a share of the staffed work hours isn’t made and even if made some time it doesn't add value to the customers, becoming non-productive capacity that is different from the idle capacity that consists of the unstaffed work hours.
This distinction have a reflection over the costs that should be attributed to the non-productive capacity on one side and the costs that should be imputed to the idle capacity instead
In order to more clear, let’s make one step back, by defining two concepts that are very important to understanding the above categories.
It consists of all the resources that can be used 24-7, that is all the fixed assets purchased to meet the customer demand and setting the process needed for make it.
The time of reference for it is the theoretical capacity: 8,760 hrs a year.
These metrics are made with reference to each PRIMARY cost center and within each PRIMARY cost center according to the number of product/ service lines, so that if the lines are three the theeorectical capcity is 8,760 x 3.
The respective costs of the fixed assets define the cost of the Committed Capacity and the Committed Cost per hour is achieved by dividing the total cost of the fixed assets by 8,760 hrs (If one only product line)
Examples of the assets falling into Committed Capacity:
Of course, these costs are always incurred regardless of the output produced.
It concerns all the resources deployed to make the process, put in place and set by the resources linked to the Committed Capacity, work.
It refers to the staffed hours because these resources cannot be used, by nature or by other factors, 24 – 7.
Examples of resources falling onto Managed Capacity:
If we are obliged to give a volume-based definition of the respective costs, just few are variable because much of it varies at intervals of the volume so that we can define them stepped fixed cost for the most part.
The total cost of these resources define the cost of the Managed Capacity and the Managed Cost per hour is achieved by dividing it by the number of the staffed hrs.
Now we turn back to the Idle Capacity and Non productive Capacity concepts.
IDLE CAPACITY: THEORETICAL CAPACITY – STAFFED HOURS
IDLE CAPACITY COST: Committed Cost per hour x IDLE CAPACITY
Here we need to recall the value concept that “marks” the activity that brings the product/service to life or makes it valuable for the customers.
The Manufacturing time and the Development one make the Productive Capacity.
All the remaining activities are internal ones that, although carried out to set Manufacturing and the Development activities, don’t add value to the customers or are even a waste.
So we have:
NON-PRODUCTIVE CAPACITY: STAFFED HOURS – PRODUCTIVE CAPACITY
NON-PRODUCTIVE CAPACITY COST: NON-PRODUCTIVE CAPACITY X Available Cost per hour (Committed Cost per Hour + Managed Cost per Hour)
As we have just seen in the last cost calculation we consider also the Committed Cost per Hour because we make use also of the 24-7 assets to make the process work.
We can, of course, determine the PROODUCTIVE CAPACITY COST by multiplying the respective time by the Available Cost per hour:
PRODUCTIVE CAPACITY COST: PRODUCTIVE CAPACITY X Available cost per hour (Committed Cost per Hour + Managed Cost per Hour)
This approach that we call Capacity Cost Management (CCM) can be used not only for the manufacturing companies but also for the service ones wwhen the customization is not so high so that the process and the time spent on the activities are the main drivers that explain the resource consumption.
The strategic implications that leverage these concepts and costs are several and go from asset-investment decisions, product costing, competitiveness improvement to incremental business acceptance and profitability enhancement.
These matters will be treated in future separate dissertations on this website.
30. How does the Lean Accounting support the decision making?
The Lean Accounting is a costing method and a performance evaluation approach that has been developed to monitor the success in the Lean-Manufacturing system.
That means that in order to fully understand and put the dissertation on the Lean Accounting into the right frame we should recall those causes of the rising of the Lean Manufacturing and those principles directly linked to the adoption of the Lean Accounting itself.
The remaining technical considerations about the Lean manufacturing method fall beyond the goal of this articles and that’s why they aren’t shown.
The businesses operating in very dynamic environments, where the preferences of the customers change frequently and the actions of the competitors go fast, don’t need to adopt a push approach, that is producing on the basis of a production budget and as a result increasing the inventory level.
Furthermore, this inventory level in view of the changing and dynamic market could be very difficult to be disposed of in a profitable way.
At the same time the Lead Time (time needed to fulfil a customer order) must be short.
What can the firm do?
Increase the speed of the manufacturing process flow and the productivity ratios, ensuring contemporarily the quality of the product.
About the last aspect of the quality, the perspective adopted by the Lean approach is the value to the customer that means the quality is linked strictly to preferences of the product users.
As a result, the value stream concept arises.
It is a set of those activities carried out to manufacture a group of similar products (a product family).
The advantages of the Lean Accounting
The Lean Accounting makes use of these Value Streams in an appropriate Income Statement that helps managers achieve these kinds of benefits:
1) Better and realistic understanding of the profitability of those groups of similar products, Value Streams, interested by the Lean Manufacturing implementation.
Starting from the consideration that it’s not requested the calculation, in this context, of the cost of each product, the cost allocation process with its uncertainty related to the principles adopted is avoided.
The costs are allocated only to each Value Stream and this results in a higher precision of the calculation of the profitability of the groups of the related products.
Those costs that cannot be traced to the Value Streams in a clear and direct way, because not incurred for the manufacturing of the products considered, are put aside.
This fact marks a clear distinction between the full-cost accounting methods that need also the allocation of the indirect costs to each model/product and the Lean Accounting whose purpose is showing the progress of the Lean Manufacturing implementation, meaning that every cost not traceable to the Value Streams is charged to the whole Business Unit.
When the full-cost accounting method is used and the Lean Manufacturing is in progress, you can identify one of the causes (point a) of the following benefit out of the Lean Accounting.
2) Getting immediately the financial results from the adoption of the Lean Manufacturing, otherwise visible only in the long term.
Some of the reasons of this delayed visibility in the usual Financial Reports follow:
a) If a full-cost accounting method is used the Income Statement will include all the fixed manufacturing costs in the inventory until the selling/disposal of the products.
The decrease in the inventory resulting from the adoption of the Lean Manufacturing will cause the passage of those fixed manufacturing costs related to previous periods of increase in the inventory to the Income Statement related to the “Lean implementation period” characterized by a decrease.
In simpler terms, a cost in the inventory item will be reported.
The adoption of an appropriate Lean Income Statement will highlight this specific cost, that will be interpreted as a future positive financial result, to be added to the Operating Income shown in the same report (see table 1).
b) The focus on the Pull approach that enables the firm to manufacture only when the order is received by the customer causes the firm to reduce the size of the orders (at the same time trying to get the customers accustomed to this new policy).
In financial terms, this means in the first periods lower sales and revenues.
c) Of course, such a drastic change to a completely diverse way to manufacture requires a prior period of reorganization and learning, with the costs of training and advisory services hitting high levels in the first stages.
d) Over the Lean Manufacturing implementation period much of the capacity of the business unit will become unused and just after the disposal or the redeployment of the related asset/resources the costs savings will be highlighted.
As we have seen about at the previous point a about the cost of the decrease in the inventory, the cost of the unused capacity might be decided to be shown, through appropriate methods, in a Lean Income Statement and interpreted as a future positive financial result (see table 1)
The managers unaware of this “delayed visibility”, without Lean Accounting adoption, will see the financial improvements only some months after the start of the implementation and could make early negative judgements on the Lean Manufacturing and erroneous rushed decisions about the products included in the Value Streams.
Here is a realistic example of Lean Income Statement:
Alpha Inc. manufactures several models of TV sets and recently made the decision to implement the Lean Manufacturing method and adopting at the same time the Lean-Accounting Reporting.
As a result, the managers spotted two main Value Streams, each of them gathering similar products with similar features without further breakdown into LED and LCD models and different Sizes: Smart TVs and Tradition TVs
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
Further strategic implications
The main advantage of the Lean Accounting is, as we have seen, assessing in financial terms the progress of the Lean Manufacturing.
Nonetheless, some other considerations should be made.
First of all, this costing method isn’t needed in some companies even if the Lean Manufacturing is being applied.
In fact, those firms that work on commodity markets where the change in the customer needs/preferences is not frequent as well as the variety of the products is not high, there isn’t the need for the Value Stream creation and respective financial reports.
Another aspect concerns the lack of the cost allocation at product level that if on one side speeds up the highlighting of the financial results of the Lean Manufacturing, on the other side leads to an average cost for any product included in each Value Stream.
The former aspect enables short-term decisions about the Value-Stream Income and Inventory level; the latter one limits some decision making on the long term that needs accurate cost information at product level.
In this regard the traditional full-cost accounting method is most useful and it could be appropriate to add one of the existing approaches to the Lean-Accounting system.
What about the price?
When the policy of the company is to make the price, not to take it from the market, and this is more frequent when a differentiation strategy is adopted, the managers need an accurate calculation of the model/product costs in order to have a basis on which to set a mark-up and to be profitable.
That is not the case of the Lean Accounting that fits the price taker best.