Warning: define(): Argument #3 ($case_insensitive) is ignored since declaration of case-insensitive constants is no longer supported in /home/u742613510/domains/strategy-at-risk.com/public_html/wp-content/plugins/wpmathpub/wpmathpub.php on line 65
Contingency planning – Strategy @ Risk

Tag: Contingency planning

  • Big Issues Needs Big Tools

    Big Issues Needs Big Tools

    This entry is part 3 of 3 in the series What We Do

     

    You can always amend a big plan, but you can never expand a little one. I don’t believe in little plans. I believe in plans big enough to meet a situation which we can’t possibly foresee now. Harry S. Truman : American statesman (33rd US president: 1945-53)

    We believe you know your business best and will in your capacity implement the necessary resources, competence, tools and methods for running a successful and efficient organization.

    Still issues related to uncertainty, whether it is finance, stakeholders, production , purchase or sale, has in most cases increased due to more complex business operational environment. Excellent systems for a range of processes; consolidation, Customer relationship, accounting has kept up with increasingly complex environments, and so has your most important tool – people.

    But we believe you do not possess the best available method and tool for bringing people – competence, experience, economic/financial facts, assumptions and economic/financial tools together.

    You know your budgets, valuations, projections and estimates, scenario analysis all are made and presented with valuable information regarding uncertainty left out on the way. Whether this is because human experience related to risk, or analyzing, understanding and projection macro or micro risks is hard to capture, or tools not designed to capture risk is the cause. It is a fact that most complex big issues important for companies are based on insufficient information, a portion of luck, gut feeling and believes in market turns /stability/cycles or other comforting assumptions shared by peers.

    Or you are restricted to giving guidelines, min/max orders, specifications and trust to third party experts that one hope are better capable of capturing risk and potential in a narrow area of expertise. Regardless of this risk spreading or differentiation works – you need the best assistance for setting your guidelines and road-map both for your internal as well as external resources.

    Systems and methods (( A Skeptic’s Guide to Computer Models (Pdf, pp 25) , by John D. Sterman. This paper is reprinted from Sterman, J. D. (1991). A Skeptic’s Guide to Computer Models. In Barney, G. O. et al., Managing a Nation: The Microcomputer Software Catalog. Boulder, CO: Westview Press, 209-229.)) are never better than human experience, knowledge and excellence, but if you want to look closer at a method/tool that can capture the best of your existing decision making process and bringing it to a new level. You should look closer at a stochastic complete p/L/balance simulation model for those big issues and big decisions.

    If you are not familiar with stochastic simulations and probability distributions, take a look at a report for the most likely outcome (Pdf, pp 32) from the simulations – similar reports could have been made for the outcomes you would not have liked to see, giving a heads up for the sources of downside risk, OR for outcomes you would have loved you see – explaining the generators of up-side possibilities.

    Endnotes

  • Top Ten Concerns of CFO’s – May 2009

    Top Ten Concerns of CFO’s – May 2009

    A poll of more than 1200 senior finance executives by CFO Europe together with Tilburg and Duke University ranks the ten top external and internal concerns in Europe, Asia and America (Jason, 2009).

    cfo_europe_top_ten1

    High in all regions we find as external concerns; consumer demand, interest rates, currency volatility and competition.

    For the internal concerns the ability to forecast results together with working capital management and balance sheet weakness ranked highest. This is concerns that balance simulation addresses with the purpose of calculating the effects of different strategies. Adding the uncertainty of future currency and interest rates, demand and competition you have all the ingredients implying the necessity of a stochastic simulation model.

    The risk that “now” has surfaced should compel more managers to look into the risk inherent in their operations. Even if you can’t plan for an uncertain future you can prepare for what it might bring.

    References

    Karaian, Jason (2009, May). Top Ten Concerns of CFO’s. CFO Europe, 12(1), 10-11.

  • Budgeting

    Budgeting

    This entry is part 1 of 2 in the series Budgeting

     

    Budgeting is one area that is well suited for Monte Carlo Simulation. Budgeting involves personal judgments about future values of large number of variables like; sales, prices, wages, down- time, error rates, exchange rates etc. – variables that describes the nature of the business.

    Everyone that has been involved in a budgeting process knows that it is an exercise in uncertainty; however it is seldom described in this way and even more seldom is uncertainty actually calculated as an integrated part of the budget.

    Admittedly a number of large public building projects are calculated this way, but more often than not is the aim only to calculate some percentile (usually 85%) as expected budget cost.

    Most managers and their staff have, based on experience, a good grasp of the range in which the values of their variables will fall.  A manager’s subjective probability describes his personal judgement ebitabout how likely a particular event is to occur. It is not based on any precise computation but is a reasonable assessment by a knowledgeable person. Selecting the budget value however is more difficult. Should it be the “mean” or the “most likely value” or should the manager just delegate fixing of the values to the responsible departments?

    Now we know that the budget values might be biased by a number of reasons – simplest by bonus schemes etc. – and that budgets based on average assumptions are wrong on average ((Savage, Sam L. “The Flaw of Averages”, Harvard Business Review, November (2002): 20-21.))

    When judging probability, people can locate the source of the uncertainty either in their environment or in their own imperfect knowledge ((Kahneman D, Tversky A . ” On the psychology of prediction.” Psychological Review 80(1973): 237-251)). When assessing uncertainty, people tend to underestimate it – often called overconfidence and hindsight bias.

    Overconfidence bias concerns the fact that people overestimate how much they actually know: when they are p percent sure that they have predicted correctly, they are in fact right on average less than p percent of the time ((Keren G.  “Calibration and probability judgments: Conceptual and methodological issues”. Acta Psychologica 77(1991): 217-273.)).

    Hindsight bias concerns the fact that people overestimate how much they would have known had they not possessed the correct answer: events which are given an average probability of p percent before they have occurred, are given, in hindsight, probabilities higher than p percent ((Fischhoff B.  “Hindsight=foresight: The effect of outcome knowledge on judgment under uncertainty”. Journal of Experimental Psychology: Human Perception and Performance 1(1975) 288-299.)).

    We will however not endeavor to ask for the managers subjective probabilities only ask for the range of possible values (5-95%) and their best guess of the most likely value. We will then use this to generate an appropriate log-normal distribution for sales, prices etc. For investments we will use triangular distributions to avoid long tails. Where, most likely values are hard to guesstimate we will use rectangular distributions.

    We will then proceed as if the distributions where known (Keynes):

    [Under uncertainty] there is no scientific basis on which to form any calculable probability whatever. We simply do not know. Nevertheless, the necessity for action and for decision compels us as practical men to do our best to overlook this awkward fact and to behave exactly as we should if we had behind us a good Benthamite calculation of a series of prospective advantages and disadvantages, each multiplied by its appropriate probability waiting to be summed.  ((John Maynard Keynes. ” General Theory of Employment, Quarterly Journal of Economics (1937))

    budget_actual_expected

    The data collection can easily be embedded in the ordinary budget process, by asking the managers to set the lower and upper 5% values for all variables demining the budget, and assuming that the budget figures are the most likely values.

    This gives us the opportunity to simulate (Monte Carlo) a number of possible outcomes – usually 1000 – of net revenue, operating expenses and finally EBIT (DA).

    In this case the budget was optimistic with ca 84% probability of having an outcome below and only with 26% probability of having an outcome above. The accounts also proved it to be high (actual) with final EBIT falling closer to the expected value. In our experience expected value is a better estimator for final result than the budget  EBIT.

    However, the most important part of this exercise is the shape of the cumulative distribution curve for EBIT. The shape gives a good picture of the uncertainty the company faces in the year to come, a flat curve indicates more uncertainty both in the budget forecast and the final result than a steeper curve.

    Wisely used the curve (distribution) can be used both to inform stakeholders about risk being faced and to make contingency plans foreseeing adverse events.percieved-uncertainty-in-ne

    Having the probability distributions for net revenue and operating expenses we can calculate and plot the manager’s perceived uncertainty by using coefficients of variation.

    In our material we find on average twice as much uncertainty in the forecasts for net revenue than for operating expenses.

    As many often have budget values above expected value they are exposing a downward risk. We can measure this risk by the Upside Potential Ratio, which is the expected return above budget value per unit of downside risk. It can be found using the upper and lower moments calculated at budget value.

    References