Add Certainty to Your Decision Making – March 2014

This topic of interest involves financial management.  One of the most important corporate decisions to involve a CFO is capital allocation.  This decision entails how a company invests its resources which, in turn, determines the value that accrues to the owners of the company.  While, in the end, the CEO is responsible for capital allocation decisions, the CFO plays an important role in providing the information utilized in the decision-making process.  This information is, in large part, shaped by assumptions about the future.

Although the past five years have shown modest economic growth, some executives are still haunted by the devastating “black swan” events that arose during the 2008 financial crisis.  As a result, many are examining this question in their sensitivity analysis to stress test risks in capital allocation matters.  We believe this is a useful exercise, if not overdone.  A review of business history shows there are always periodic downturns. Not all of these were expected and many began at times of near universal confidence about the future.

One exercise utilized in formulating a sensitivity analysis is called the pre-mortem.  It aims to identify potential problems so that a firm can improve a product, project, or strategy before deployment of resources.  Such an exercise presumably avoids lessons that are learned from an actual implosion.  If done properly, it provides an extra level of certainty to the decision-making process.  Many pre-mortem efforts flush out important issues, i.e. what would happen to an important business line if a key manager died unexpectedly.  However, organizations must avoid becoming overly risk averse and thus veto good growth opportunities.

A good post-mortem process should possess the following characteristics:

  • An objective facilitator.  Those with a bias or deep personal interest in the outcome of the capital allocation project can inhibit observations of more objective participants.
  • Encourage discussion.  Use the pre-mortem to drive project sponsors to defend their assertions.
  • Varied participants.  All levels of the organization should have representatives, including naysayers who may otherwise be marginalized.

One caveat – avoid too much debate lest the result be “paralysis by analysis” which can cause missed opportunities and thus will discourage the use of an otherwise effective tool.

For more information on this topic, please see the following link:

http://www.journalofaccountancy.com/Issues/2012/Oct/20126143

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