Defining Risk Based Budget Distributions – Part 5
An effective application of risk management principles can enhance many processes within the context of managing a business and enabling business managers to make better and more informed decisions. One critical area where risk management thinking can add significant value is to enhance the planning and budgeting process. My inspiration for implementing risk based thinking and analysis into the budgeting process initially came from the increased importance that more boards and regulators have placed on defining a corporate risk appetite and ensuring its consistent implementation throughout the company. Risk appetite statements have been a staple in risk policies for years, however these statements have tended not to be effectively tied to a company’s financials, performance, or capital capacity. Utilizing a risk based budgeting approach directly links a company’s risk appetite to its core financials and economic performance.
At most companies budgets are established as single line items for revenues and expenses. Critical to achieving a comprehensive risk based budgeting approach is recognizing that risk impacts the achievement of these budget targets. It is imperative to understand and quantify the risks that may impact the realization of expected or desired outcomes defined in a budget. Once these risks are taken into account, a budget item can be expressed in terms of an expected amount, and a “worst case” or “at risk”
To quantify a budget distribution, I have utilized what I refer to as the triple “S” approach: stochastics, scenarios, and sensitivities. All these methods are very familiar to risk managers and are frequently used within regularly occurring risk management reporting. A stochastic approach should be used when certain criteria can be met. This requires the availability of sufficient and representative historical data, and this historical data provides sufficient ability to predict future outcomes.
Management defined scenarios can be used as a substitute for defining “at risk” case events when sufficient historical information does not exist, but there is confidence and expertise to define parameters of potential scenarios, and ability to estimate approximate likelihood of a scenario. Additionally, specific “at risk” case historic events that may have occurred within
the company or the industry in the past can also be used. For example, I have used historic events to quantify “at risk” costs for certain types of regulatory or environmental compliance.
These defined scenarios can serve as a proxy for a downside event at a particular confidence interval, e.g., 99%, which is typically the basis for defining economic capital for most investment grade companies. In the absence of sufficient historical data, or insight into worst case scenarios, the fall back can be a sensitivity analysis where judgment and experience of downside potential is estimated.
Critical to successfully define ranges within budgets is to ensure that all material risks are identified specific to each budgeted line item and its impact quantified. A consistent risk “taxonomy” must be defined, where all risks that can impact budgeted items have been identified. In most firms with an active ERM program, such a taxonomy has been defined, and should be used
for the purpose of quantifying risk distributions in budgets.
Figure 1 provides an illustrative cross reference between a risk taxonomy, an income statement, as well as stages within an asset life cycle. For capital budgeting purposes, it is important to understand risk impacts not just in the current budget cycle, but also over the life of the asset investment. During the risk budgeting process, risks that are not felt to be material should also be identified and the rational supporting why and how the risk has been mitigated or not relevant should be vetted.
Cross referencing a comprehensive understanding of risks with budget items and utilizing the triple S framework, enables a thorough quantification of risk, its impact on budgeted items, and ultimately stakeholder value. It should be noted that the budget distributions produced during this analysis can vary based on the risk assumptions and specific scenarios defined. These assumptions and scenarios should be highly transparent to decision makers and form the basis of an effective dialogue during the budgeting process regarding risk, return, associated value added, and trade-offs between competing budget demands, and risk mitigation and value optimization strategies.
One of the elements of a successful risk based budgeting approach described in an earlier article is to recognize that risk capacity is a finite resource. The exercise of defining risk and quantifying its impact on a line item basis will explicitly identify where risk is being consumed. This allows a company to make more informed decisions regarding its overall risk appetite and how risk can be allocated to achieve the most optimal value for the stakeholders.
As is always the case with risk, the off-setting or correlation effects between the risks, and how that translates allocated budgets needs to be understood and defined. For example, exceeding an expected amount on an expense item is not necessarily a bad thing if it correlates favorably with increased revenues and improved stakeholder value. This approach will enable a company to directly attribute specific business activities, revenues and expenses to a defined risk appetite and capacity. Overall, significant benefits will be realized by a company implementing a risk based budgeting approach whether it be for a basic operating budgeting or for capital budgeting and deployment.
Specifically, the approach will enable a company to:
• Quantify risk appetite in a way consistent with business operations and expectations,
• Identify where risk is being consumed and optimize the allocation of risk capacity through the budgeting process,
• Understand where risk capacity is producing the most value for stakeholders,
• Allocate risk as a scarce resource and directly link it back to a company’s risk appetite and capacity,
• Integrate risk management analysis directly into the budgeting process to support critical business decisions,
• Provide greater transparency of where risk based value is created,
• Increases linkage between corporate risk appetite, capital capacity and specific performance achievement.
It should not be specific to any particular business activity, but should be applicable across all business activities and risks. Finally, it should provide insight into what the range of outcome might be, and how performance against potential outcomes can be determined, allowing management to make more informed decisions.
Bob Young, Partner, TechCXO, New York
Bob Young is a New York-based partner at TechCXO, and leads TechCXO’s risk management practice. See his full bio here.