Variance Analysis: Whom To Blame At Southwest?

What a difference a half-year makes! As recently as July 2008, the mass market uber-tabloid USA Today was praising Southwest Airlines for achieving its 69th consecutive quarter of operating profit. That’s a remarkable continuing achievement, one that the USA Today attributed to Southwest’s foresight in using hedging contracts to lock in low fuel prices during an era of skyrocketing energy costs.

Today, though, the direction of fuel price trends has shifted dramatically. What seemed to be prescient foresight on the part of Southwest now appears, with 20/20 hindsight, to have been a strategic error. By hedging at a price level that is now well above the market cost of fuel, Southwest incurred financial costs that currently exceed its total operating profits. Their CFO recently, and perhaps somewhat ruefully, confirmed to analysts “We do not believe it is the time to be long on energy.

So what was considered a brilliant fiscal strategy last July is now perceived as a costly and unnecessary expenditure. How should Southwest determine whether any one should be blamed for its current difficulties?

Two Variables … Umm, Make That Three

The first important point to recognize in answering this question is that there are at least two variables that must be considered when managing fuel costs. One is the price spent on each barrel on fuel; the other is the quantity of fuel used.

That may be an obvious fact, but its implications are fairly subtle because decisions about price and quantity are intertwined in complex ways. For instance, let’s assume that holiday season congestion at major airports is expected to drive up the volume of fuel consumed on airplane taxiways. Well, if the members of an airline’s management team are certain that the consumption quantity of fuel will spike up next month, they might be willing to take more aggressive risks to keep the price per barrel low. Conversely, in times of declining fuel usage, the airline’s willingness to engage in aggressive price hedging activities might wane.

Furthermore, these two variables – price and quantity – often evolve into three variables when companies lock in guaranteed energy prices well in advance. Let’s assume, for instance, that an airline originally budgets $10 billion to buy 200 million barrels @ $50 per barrel. Let’s also assume that three different individuals, working independently of each other, make three different decisions: (a) the CFO hedges all oil purchases to lock in a rate of $45 per barrel, (b) the COO believes that fuel usage will likely spike upwards and authorizes the purchase of 250 million barrels, and (c) the Engineering Department finds a way to run jet engines at a highly fuel-efficient level during peak times, thereby holding fuel usage to 220 million barrels.

So what happens? Assuming the market price of fuel remains above $45 per barrel, the actual cost of purchasing 250 million barrels @ $45 will be $11.25 billion. Thus, the airline will overspend its $10 billion fuel budget by $1.25 billion, and three people – the CFO, COO, and Engineering Department Director – will share responsibility for this unfavorable variance.

So … Who’s To Blame?

An impatient Board of Directors might rush to judgment and hold all three individuals jointly responsible for overspending the cost budget by $1.25 billion. However, a “back of the envelope” set of variance calculations would caution them to take a more nuanced approach:

Based on this analysis, the CFO should actually be praised and not blamed for slashing a potential $2.5 billion budget shortfall in half by saving the firm $1.25 billion through effective hedging mechanisms. And what about the COO? (S)he should indeed be blamed for ordering 30 million barrels in excess of what was actually used, but not blamed for the full 50 million barrel difference between the volume originally budgeted and the volume eventually used.

So who gets the blame for the remaining 20 million barrel difference between the 200 million barrels in the original purchase budget and the 220 million barrels actually used? That’s hard to say; only an in-depth review of internal company records would be able to answer that question. Perhaps the COO’s analysts who prepared the original budget failed to reach out to the Engineering Department for a realistic estimate. Or perhaps the engineers neglected to provide the analysts with accurate information. Either way, it would be terribly misleading to rely on the overall $1.25 billion variance to make management decisions without considering its three core components separately.

A Failure To Communicate

Without knowing the situation that existed within Southwest during the past year, it would be unfair to blame the sudden and unexpected ineffectiveness of Southwest’s fuel cost management strategy on any single party. You can be sure, though, that any organization facing volatile price and volume factors will use variance analysis to track performance and address such issues.

To paraphrase Paul Newman’s nemesis in the 1967 film Cool Hand Luke, organizations that face huge budget variances often find that “what we have here is (a) failure to communicate.” Look again at the preceding hypothetical example. Had the COO and Engineering Department simply communicated with each other, the COO might have ordered 220 million barrels instead of 250 million barrels, and his $1.5 billion unfavorable variance might have shrunk to zero. Heck, the firm would thus have paid $9.9 billion for 220 million barrels @ $45, and therefore would have underspent its original budget of $10 billion!

That’s the power of variance analysis; in addition to identifying the sources of budget problems, it also suggests ways to fix ’em. Sometimes, sadly enough, we learn that multi-billion dollar variances could have been prevented by simple intra-firm communication techniques.

Hooray for Hollywood: Risk Management Faves

In the spirit of the upcoming Annual Academy Awards, and as a public service to the banking industry titans of Wall Street who presided over what Risk Management has called the colossal risk management failure of the financial sector, we at Enterprise Man are proud to unveil our AQ/PQ “picks” for the twenty best (or worst) examples of risk management in film history.

We welcome your comments, your suggestions, and even your heated arguments. Please feel free to prepare your letters to the editor as we proceed through our list in chronological order.

The Envelope, Please …

The Great Train Robbery (1903). The first modern story in film history, bankrolled by Thomas Edison himself, was a twelve minute video about an attack on a “money car.” Risk managers, take note of the brave attempts of the employees to comply with the railroad’s requirements for information and communication during times of crisis!

The Sheik (1921). The first great love story in film history also featured the first tragic business culture clash, as Rudolph Valentino’s Arab Sheik comes face-to-face with Western womanhood. Luckily, the French soon arrive to defuse the tension with tactful diplomacy. Merci beaucoup!

Safety Last (1923). The film title alone is sufficient to make a risk manager cringe! The same can be said for the iconic image of Harold Lloyd’s department store clerk dangling from a giant clock on the side of a Los Angeles skyscraper; who on earth forgot to engage the window locks?

King Kong (1933). Can some one please check those giant ankle cuffs (at least once) before the paparazzi swarm the giant, resentful man-killing creature with their blinding flash cameras? Is that too much for a risk manager to ask?

Swing Time (1936). Over 70 years before President Obama encourages Americans to “pick ourselves up (and) dust ourselves off” in his inaugural speech, dance instructor Ginger Rogers sings the same lines of encouragement to a seemingly inept new dance student named Fred Astaire. Clearly, the admissions department fails to detect his natural ability; why is he in a remedial class?

Modern Times (1936)
. Charlie Chaplin defies the risk managers of his own movie studio by making the world’s last great silent film in an era of musical comedy. This counter-programming tour-de-force is a non-stop parade of nightmarish business practices, including video security cameras in employee bathrooms and an Automatic Feeding Machine run amok.

Casablanca (1942). Humphrey Bogart and Ingrid Bergman prevent the impending Nazi theft of their inventory of fine French champagne by drinking it all as rapidly as possible. To make matters worse, they fail to record the appropriate asset write-offs before fleeing to Morocco.

Double Indemnity (1944). The greatest insurance scam in film history features the complicit involvement of Fred MacMurray’s lovestruck insurance agent. Unfortunately for the insurance company, claims investigator Edward G. Robinson is more interested in imbibing three olive martinis than in investigating employee fraud.

It’s A Wonderful Life (1946). Paying off depositors with honeymoon vacation money is an early red flag. Entrusting the most consistently inebriated man in town with large sums of cash is another no-no. Urban planners and macro-economists, though, enjoy noting that the rollicking town of sin in George Bailey’s nightmare would have likely been strongly positioned to survive the subsequent implosion of America’s industrial base.

Singin’ In The Rain (1952). Hollywood’s first film about the perils of lip synching presages the era of karaoke and Ashlee Simpson. Fortunately, Gene Kelly and Debbie Reynolds find a happer ending than fans of live music do today.

The Apartment (1960). Fred Macmurray, the only double honoree on our list, confronts Jack Lemmon with the most blatant case of employee harrassment in the history of film. And yet, in true Hollywood fashion, the little guy ends up with the beautiful girl.

Yellow Submarine (1968). The good citizens of Pepperland may not have been able to stop a hostile take-over by the Blue Meanies, but they demonstrate a helluva risk response capability by traveling to Liverpool and enlisting the aid of the Beatles …. and the little Nowhere Man as well!

2001: A Space Odyssey (1968). Two honorees in one year! 1968 was a terrible year in world history, but a great one for films with risk management themes. Here we find the first great Hollywood story of a computer virus from hell, one that creates a subtle public relations crisis for IBM.

The Godfather II (1974). “Keep your friends close, but your enemies closer.” This tale of organized crime provides the business world with a parable of an organization with a terribly dysfunctional corporate culture and a “tone at the top” that could use a fair amount of team building activity.

Network (1976). A media network executive decides to eliminate a character on a television show by staging his assassination … in front of a live studio audience … with real bullets. Somehow, the script item slips past the sensors.

The Secret Of My Success (1987). Michael J. Fox rises from mail room assistant to chief executive officer by flirting with the boss’s wife and acting, well, incredibly precocious. The most distressing aspect of the film, from a risk management perspective, is the obvious message that his character is far better prepared to lead the firm than any of the oblivious senior officers or board members.

Titanic (1997). Perhaps the greatest example of poor risk management in film history is tragically based on the true story of the White Star line’s decision to furnish an ocean liner with 1,178 lifeboat seats for 3,547 people. Amazingly, the corporation survives their horrendous blunder and remains in business for over twenty years until merging with a rival line during the Great Depression.

The Truman Show (1998). Jim Carrey appears in an unusual serio-comic role as an insurance salesman who finds his life at the center of a wildly successful television reality show. Once again, though, the network bureaucrats goof by failing to obtain a liability waiver signature from Carrey. Come to think of it, the bureaucrats commit a more fundamental error; they neglect to inform Carrey that he is on television at all!

Sideways (2004). A tale of love and misery in the Napa Valley wine country of northern California, this sleeper hit features an extremely colorful example of a customer relationship dispute in a wine tasting facility, as well as a classic line that depresses merlot aficionados everywhere.

There Will Be Blood (2007). Daniel Day-Lewis portrays a violently psychotic oil executive whose arch-nemesis waits far too long before finalizing a real estate transaction. The film also depicts, in fairly graphic terms, why children and others should not be allowed to tour production sites without wearing protective goggles and hard hats.

Super Bowl Ads: The Tail That Wags The Dog?

Congratulations to the Pittsburgh Steelers for defeating the Phoenix Cardinals and becoming the champions of the world of American football! With President Barack Obama proudly backing the Steelers, and with Senator John McCain of Arizona undoubtedly supporting his hometown Cardinals, one might be tempted to declare a “repeat” victory for the Democrats.

The real victors, though, might be the folks at the NBC television network for managing to sell “a large number” of its advertising spots for $3 million per ad. With longtime sponsors like General Motors declining to purchase air time in the current economic environment, NBC’s accomplishment might have been the most impressive one of the day.

The contest for Best Super Bowl Ad, of course, has long challenged the game itself for the attention of television viewers. From a business perspective, one might ask the following question: is the Super Bowl primarily a sporting event that happens to be televised … or is it primarily a sequence of advertisements that happens to surround a sporting event?

The Role of Flexible Budgeting

Every professional sports league, of course, has its own unique approach to generating and sharing marketing revenues. Some, like Major League Baseball, allow each team to form its own cable television network, thereby allowing organizations like the New York Yankees to become revenue powerhouses.

Others, like the National Football League, prohibit individual teams from signing their own television deals. Instead, the NFL signs league-wide contracts with national networks like NBC and ESPN. Teams in major media markets like New York and Chicago are thus unable to gain a disproportionate revenue advantage over their smaller market rivals.

There is an additional complicating factor as well; namely, teams never know in advance how far they will advance in their league’s postseason playoff series. In other words, they have no way of knowing how much of their product will be available for sale, thereby making it extremely difficult to anticipate how much of their total revenue might be generated by ticket sales and ancillary game-day purchases.

Teams must therefore adopt very flexible approaches to developing their fiscal operating budgets. Fortunately, flexible budgeting techniques can be very useful in ascertaining the impact of advertising revenue on a team’s overall financial structure.

A Minor League Example

Let’s consider an example of a minor league sports team that plays 16 regular season games. If it advances into the league’s playoff round but fails to advance to the championship series, it will play 4 additional games. And if it advances to the championship series, it will (once again) play 4 additional games.

What about game revenues and expenses? Well, let’s assume that the team averages $420,000 per game from ticket sales and another $420,000 per game in food and souvenir sales. It spends $5,000 per game on athletic supplies. And, on an annual basis, it receives $8.4 million from the league as its share of television contract revenues. In addition, on an annual basis, it spends $12 million on player salaries, $10 million on stadium or arena rent, and $4 million on league adminstration and support services.

Now let’s assume that the league permits its teams to sign their own local advertising deals as long as they do not infringe on the league’s national television contract. So let’s say that our team launches two radio and billboard advertising campaigns during the regular season in its local market, and adds two more sharply focused campaigns if it advances into the postseason. Each ad campaign costs $1 million for production and placement services, and each generates earnings of $2.1 million from local businessmen who contract for the product placement of their brand names and logos in the ads.

At the beginning of the year, before the team knows how far it will advance during the playoff series, it creates the following flexible budget ($s in thousands):

At first glance, it appears that the key to financial success is a successful run into the postseason. But what about the role of the radio and billboard advertising campaigns?

The Ad Campaign Is The Game

Stop for a moment. Take a deep breath … and think. You just read my previous sentence and instinctively glanced at the Ad Production Expense line, didn’t you?

That was a mistake. If you did that, then you’re still thinking “inside the box.” An “outside the box” thinker would realize that the ad campaign isn’t just a part of the game. From a business perspective, it is the game.

Let’s go back to the budget and divide it into two sections. Let’s call one section our Marketing Division, consisting of the ad production expense and the product placement revenue that is generated by it. And let’s call the other section the Games Division, consisting of everything else.

Using this approach to bifurcate our financial structure, we can collapse our flexible budget into the following ($s in thousands):

This gives you a completely different image of the team’s financial profile, doesn’t it? Apparently, the marketing activities earn millions of dollars in profits regardless of the team’s success on the field or court. And the games themselves generally lose money, even for playoff teams, unless a team is lucky enough to advance to the championship round. And yet, even for the championship teams, the marketing profits far exceed the profits that are earned by staging the games.

Thus, if you decide to purchase a professional sports franchise, how would you define your business investment? No team advances to the championship round each year; even perennial favorites like the Yankees go through extended droughts. Thus, your only pragmatic business decision would be to focus on generating marketing revenue, and to use the sporting events as a platform for selling ads.

Game Theory Dilemma: Too Much Is Not Enough

We’d like to offer our bittersweet congratulations to the late Heath Ledger for earning an Oscar nomination for his role as the Joker in Batman: The Dark Knight. As fans of the Cape Crusader well know, Ledger’s character is responsible for establishing the central plot twist of the film, a dilemma shared by ferry boats of ordinary civilians and incarcerated prisoners over whether to save themselves by cruelly slaughtering others.

Economists around the world have noted with some surprise, and a fair amount of pride, that this plot device accurately portrays a classic scenario of game theory known as the Prisoner’s Dilemma. In its original format, the scenario features a pair of prisoners who are each being pressured by police investigators to “squeal” on the other, and who must each decide whether they can trust the other to maintain silent fidelity.

Like many game theory scenarios, the Prisoner’s Dilemma focuses on choices that flawed human beings must make about whether to cooperate or to compete … to be faithful or to mistrust … to share with others or to grab for themselves. Interestingly, many seemingly incomprehensible macroeconomic conditions can often be understood by referring to these simple models of human behavior.

Rolling The Dice

Take the boom-and-bust cycle of the Las Vegas hotel market, for instance. Surely the developers of hotels and casinos must realize that there is a limit to their market’s demand for slot machines and table games! But if they realize this simple truth, then why are so many mega-projects still moving inexorably towards completion at a time of deep recession?

Wynn Resorts grabbed a head start on its rivals by opening its $2.3 billion Encore in December 2008; fast in pursuit for openings during 2009 and 2010 are the $9.1 billion CityCenter by MGM Mirage, the $3.9 billion Cosmopolitan, the $2.9 billion Fontainebleau, and a significant room expansion by the Hard Rock Hotel. One analyst noted grimly that it’s going to take years to digest the … capacity; in the meantime, room rates may drop well below the $100 level …

… hello, $25 a night stays!.

Urban planners may wonder how business developers could have signed off on all of these projects while failing to anticipate how their simultaneous expansions of room inventories would depress retail room rates. Not every one is falling into the same trap; because of such concerns, Caesars Palace by Harrah’s has partially cancelled its growth plans. Nevertheless, most of the major firms are blindly sailing ahead into the headwinds of a severe economic bust.

How Game Theory Works

Game theorists have a brief explanation for this example of mass myopia; they simply believe that business developers are fallible human beings. And fallible human beings, they explain, tend to look at the world from their own perspectives; in other words, they usually fail to remind themselves to look at situations from the perspectives of others before making decisions.

The key insight is that people should never make decisions about how to deal with their circumstances until they first consider how others are likely to respond as well. To phrase it a different way, game theorists believe that human beings are self-absorbed and self-focused individuals who aren’t very good at placing themselves in the shoes of others.

The Nobel prize winning economist John Nash developed a model known as the Nash Equilibrium; it can be helpful in illustrating this tendency. The model has been customized by countless thousands of business people and academics during the past few decades; here is yet another customized example..

Let’s assume that you are playing a gambling game in a casino with another player. You and your counterpart must each simultaneously raise one of your two hands. As soon as you do so, you jointly observe which hands are raised in the air – i.e. either (a) your left hand and his left hand, or (b) your left hand and his right hand, or (c) your right hand and his left hand, or (d) your right hand and his right hand – and then you use the following chart to identify the winners and losers.

At first glance, most people would recommend that you should begin by raising your left hand. After all, if you decide to raise your left hand, you are guaranteed to win $1. But if you decide to raise your right hand, you might either lose $2 or win $1. So why risk losing $2, with no prospect of winning more than $1, when you can lock in a guaranteed $1 gain?

In addition, considering that you have no idea what the other player might do, you might decide to assign him a 50% chance of raising his left hand and a 50% chance of raising his right hand. That means that, if you decide to raise your right hand, your overall “expected value” of a 50% chance of losing $2 and a 50% chance of winning $1 is actually a negative value. Thus, raising your left hand and winning the guaranteed $1 remains the better bet.

But what happens if your winning cash receipt is increased from $1 to $1.01 if both parties raise their right hands? Most people would still recommend that you should raise your left hand. After all, the potential loss of $2 remains far greater in absolute terms than the potential gain of $1.01. Why change your recommendation over a potential increase of a measly penny?

Sounds reasonable? I hope not! If you find yourself agreeing with this stream of logic, you have regrettably fallen into the mind trap of self-absorption.

The Mind Trap

To spot the trap, stop for a moment and look at the chart of winner and losers from the other player’s point of view. That’s right; take a minute and focus on his columns and not on your rows. Do you see why this stream of logic is wrong?

The insight is pretty simple. The other player should see that, if he raises his left hand, he is guaranteed to break even. If he raises his right hand, he is guaranteed to win $1. So why wouldn’t he decide to raise his right hand?

Of course, that’s exactly what he will always do. And once you notice that, you will undoubtedly realize that you are always better off raising your right hand – and not your left one – to lock in a guaranteed $1.01 win. Assuming that your winning cash receipt is $1.01 if both parties raise their right hands, of course.

Does this imply that the Las Vegas hotel and casino developers should have avoided making expansion plans in the Nevada market a few years ago, even though the market itself was strong and growing at the time? In a word … yes. Had they each taken into consideration the oversized expansion plans of their fellow hotel and casino developers, they would have undoubtedly realized that they were all building into a market that couldn’t possibly grow forever.

Joining a boom during a cycle of prosperity always seems like a good idea while the boom lasts, but the inevitable bust always follows. In retrospect, the better bet – in other words, the more prudent choice – is usually to invest in the growth opportunities that have not already been discovered by the rest of humanity.

Oil Firms: Lower Sales Producing Earnings?

Oil inventories are soaring! According to last week’s January 13th Short Term Energy Outlook, published by the U.S. Government’s Energy Information Administration, “commercial inventories are well above average historic levels, and EIA projects that they will remain there through the end of 2010.” And OPEC agrees; in its Monthly Oil Market Report for January 2009, it notes that “US commercial oil inventories increased a further 2 mb in December, resulting in a contra-seasonal build in the fourth quarter, with stocks at the highest level since September 2007. Inventories at the WTI delivery point of Cushing, Oklahoma, stood at a record level of 33 mb, approaching maximum storage capacity…”

But if oil is piling up — unwanted and unsold — at delivery points around the world, then how do oil companies remain profitable? Exxon’s most recent earnings were a record $14.8 billion, and Business Week noted that Exxon’s Production Falls As (Its) Profits Soar.

Let’s think about that for a second. Oil companies are producing less. And whatever they do produce is piling up in gigantic storage areas of unsold inventories. So … how can they still be profitable?

The key to answering that question lies in understanding how costs flow from: (a) the moment that money is committed to be spent, to (b) the moment that it is actually recorded as a business expense. Management accounting professors have developed very helpful theoretical explanations for this phenomenon; now let’s discuss an explanation that pragmatically addresses today’s oil industry.

A Simple Scenario

Let’s assume that an oil refinery buys crude oil from a source that pumps it out of the ground — like OPEC, for instance. When it receives deliveries by boat — from oil tankers, let’s say — it stores the crude oil in temporary stockpiles until the refining operations are ready to process it.

The stockpiles of crude oil are then fed into the refining process, which are designed to produce refined products like heating oil and gasoline. In the real world, of course, the process is somewhat more complicated — additives like ethanol might be added to the refined product, and byproducts like naphtha might be produced as well — but let’s keep things simple for now!

The refined products are then stored in their own temporary stockpiles until the customers — oil distributors, chains of gasoline stations, and others — pick up their orders and carry them away. Customers of floating refineries pick up their refined products by boat, while customers of land-based refineries use trucks and rail networks.

A refinery needs to spend money on equipment, of course, and on engineers to keep the machinery humming. It also needs to spend money on non-manufacturing activities to keep its businesses alive — customer relationship representatives, for instance, and accountants to crunch the numbers.

Words, Words, Words

Now let’s review some simple vocabulary words. From the refinery’s perspective, the stockpiles of crude oil are Direct Material (DM) inventories to be transformed into the refined product. The stockpiles of refined products are Finished Good (FG) inventories. And the volumes of oil that are literally coursing through the machinery, on their way from being crude oil to being refined products, are Work In Process (WIP) inventories.

The barrels of crude oil that are purchased and received are classified as Purchases (P). The engineers are classified as Direct Labor (DL), the machinery as Overhead (OH), and the non-manufacturing activities as General Expenditures (GE).

Whew! That’s a lot of terminology, isn’t it? But it’s really just semantics, just learning a handful of words from the language of management accounting. That’s really all you need in order to understand the equations that explain why an oil company’s earnings are so heavily dependent on inventory balances.

Five Simple Equations

The method that we use to explain how inventory affects earnings is called job order costing. There are many different ways to express this method; we prefer to use five simple equations, the type that any elementary school arithmetic student can grasp.

Equation #1:

DM @ Start of Day + P – DM @ End of Day = DM Used in Production

Equation #2:

DM Used in Production (from #1) + DL Used in Production + OH Used in Production = Total Manufacturing Costs (TMC)

Equation #3:

WIP @ Start of Day + TMC (from #2) – WIP @ End of Day = Cost of Goods Manufactured (CGM)

Equation #4:

FG @ Start of Day + CGM (from #3) – FG @ End of Day = Cost of Goods Sold (CGS)

Equation #5:

Revenue – CGS (from #4) – GA = Earnings

Sounds complicated? Relax! It’s a lot simpler than it appears. Let’s talk through these equations one by one.

I. How much crude oil do we use in production each day? We begin by refining whatever was stockpiled in storage at the start of the day. Then we refine whatever we purchase during the day, except for the portion of our purchases that we stockpile until tomorrow.

II. How much of our resources in total do we burn through in production each day? We burn through our crude oil usage (which is calculated in the first equation), our direct labor usage, and our overhead usage.

III. What is the cost of the resources that we burn through to produce the refined oil that enters our FG stockpile each day? This is admittedly a tricky calculation because some of the resources that were used to produce today’s ending FG stockpile were actually burned through yesterday; that is why we have WIP @ Start of Day! And some of the resources that were burned through today will actually remain in WIP @ End of Day, and will be a part of tomorrow’s FG stockpile.

IV. What is the cost of the resources that we sell each day? We begin by selling whatever was stockpiled in storage at the start of the day. Then we sell whatever enters our FG stockpile today, except for the portion that we continue to stockpile until tomorrow.

V. What do we earn each day? This one is easy; it’s the difference between all revenues and all costs.

That’s All You Need!

Believe it or not, that’s all you need to understand why rising inventories — unused and unsold — can result in higher earnings. Let’s review the formulas one more time.

Let’s assume that DM @ End of Day is a lot higher than DM @ Start of Day. Well, then, DM Used in Production would be a lot lower … as would TMC … as would CGM … as would CGS. And if CGS is a lot lower, then Earnings would be a lot higher.

Likewise, let’s assume that FG @ End of Day is a lot higher than FG @ Start of Day. Well then, CGS would again be a lot lower, and thus Earnings again would be a lot higher.

The key insight is that each formula must be calculated before the subsequent one is calculated, for the simple reason that each formula relies on a number that is calculated in the previous one. Thus, if all of the End of Day inventories are increasing rapidly, the effect cascades down to an increase in Earnings.

Risk Management: Is Rubin to Blame for Citi?

Have you read Robert Rubin’s retirement letter? Three days ago, he walked away from a Citigroup role that paid him $115 million since 1999. Rubin, of course, is a former co-chairman of Goldman Sachs and Secretary of the Treasury. Here is an excerpt from his statement:

“My great regret is that I and so many of us who have been involved in this industry for so long did not recognize the serious possibility of the extreme circumstances that the financial system faces today. Clearly, there is a great deal of work that needs to go into understanding exactly what led to this situation and what changes, regulatory and otherwise, must now be implemented to reduce systemic risk and protect consumers.”

Rubin previously told the Wall Street Journal that he was not to blame for Citi’s collapse; he asserted that “what came together was … a cyclical undervaluing of risk … a housing bubble and (mis-guided) triple-A ratings … there was virtually nobody who (fore)saw that low probability event …” Nevertheless, he did acknowledge his involvement in a board decision to increase risk in 2004 and 2005, and at least one major Citi investor believes that Rubin is “resigning in disgrace.”

Whether or not you blame Rubin personally for Citi’s collapse, isn’t it a bit disconcerting that he told the Journal “there is a great deal of work that needs to go into understanding … this situation”? Indeed, perhaps Rubin couldn’t foresee Citi’s challenges. But shouldn’t we expect him to understand them by now?

The Four Questions

What exactly do risk managers do, any way? How does risk management work?

The fundamentals are actually quite simple. A competent risk manager comes to work every day and asks himself four questions. If he can supply four reasonable answers, then he is likely doing all he can to manage risk. But if he can’t … watch out! Then he isn’t doing his job.

Let’s run through these four questions briefly:

1. What can go wrong?

This step is called event identification. Risk managers must keep laundry lists of every major potential problem that might occur in the foreseeable future. If a problem isn’t foreseeable, though, it cannot make any lists; then risk managers can’t be blamed for failing to address it.

2. How bad will things get?

Risk managers can’t possibly address every problem on their laundry lists, so they must prioritize and focus on the worst potential problems. This step is called risk assessment; it classifies a problem as high priority if it is relatively likely to occur and relatively costly if not prevented.

3. What’ll be done if it happens?

This step is called risk response. Risk managers focus on the highest priority problems and then work with operations managers to confirm that the organization’s responses will be effective if prevention fails.

4. What’ll we do to prevent it from happening?

This step is called internal control activity. Risk managers confirm that operations managers continually train their employees, test their systems, inspect their products and services, and audit their administrative processes in an attempt to avoid (or, if avoidance fails, to detect and address) the problem.

The COSO Cube

Did we simply conjure up these four questions out of thin air? Of course not! Five major accounting, auditing, and financial executive trade associations have sponsored the development of COSO, an organization that has created an integrated framework for enterprise risk management.

To explore the intellectual origins of our four questions, download COSO’s free Executive Summary (which is available in over a dozen languages — even Finnish and Thai!) and look for an image of a three dimensional cube. You can also find this cube on numerous risk management web sites, such as those maintained by the FDIC in Washington and UCal Berkeley in California.

Have you found one of the cubes? Great! It has eight boxes across its front, four across its top, and four along its right side. Now look at the middle four of the eight boxes across its front: they are labeled event identification, risk assessment, risk response, and control activities. Yes, they represent our four questions that lie at the very heart of risk management.

How About Rubin?

So what does this tell us about Robert Rubin’s level of responsibility at Citi? You are welcome to develop your own opinion, though we encourage you to assess the issue after considering our four questions.

Was this cataclysmic confluence of events foreseeable? If it was, then someone at Citi must be to blame for failing to identify it during their event identification activities. On the other hand, if it was identified but not highly prioritized, then someone must be to blame for misjudging the likelihood that Rubin’s perfect storm scenario would in fact occur.

If Rubin is responsible for these risk management tasks, then perhaps it is best that he has resigned. But if someone else is responsible, then perhaps Rubin’s departure is Citi’s loss. That would also be a loss for the American taxpayers who have placed billions of bailout dollars in Citi’s hands.

About This Blog

Would you like to earn an MBA degree from Yale University? You had better check your savings account; it’ll cost you over $140,000.

Is that too rich for your blood? Are you willing to settle for a respected state institution like the University of Connecticut? That’ll cost you over $80,000 if you’re a non-resident, and over $50,000 if you’re a state resident.

Heck, even Baruch College of the City University of New York will charge you almost $20,000 for four terms of tuition. And that doesn’t cover student fees, textbooks, living expenses, and the hours and hours of time that could otherwise be dedicated to earning money.

In an era of limited resources, why do so many men and women spend so much money on academic business degrees? And how do so many academic business programs manage to attract these men and women to their doors?

You may be a skeptic who believes that they only enroll in these programs because academic degrees look attractive on professional resumes. After all, it’s certainly true that degrees from prestigious institutions can lead to better employment opportunities.

And yet, even if you don’t believe that the educational content of their courses can help them become better managers in the real world, you must acknowledge that employers must think so. If they didn’t, then they wouldn’t hire any graduates of these programs!

Our Dedication

This blog is dedicated to business professionals who believe that the tools and techniques that are taught in academia are valuable to practitioners in the real world. Likewise, it is dedicated to academics who produce research that guide the application of these tools and techniques, and who labor in real and virtual classrooms to help their students learn these tasks.

In other words, this blog is positioned at the nexus of business practice and academic theory. Whenever we see a business problem that calls for a solution that is taught in academia, we’ll write about it. And whenever we encounter an academic theory that can be converted into a pragmatic solution, we’ll cover it too. Metaphorically speaking, we’ll do our best to explain how to use hammers when we see nails that need fixin’ … and we’ll also do our best to help those proverbial carpenters locate the loosest nails.

But why is our blog titled AQ/PQ? What meaning does that mysterious acronym convey? It is a euphemism that we are using to describe professionals who possess qualifications as both academics and practitioners. As a publication that transcends the boundaries of theory and practice, our blog focuses on integrating the work of such AQ and PQ individuals.

Who Are “We”?

But who, exactly, are “we”? Who are the writers and publisher of this blog? And why do we care about developing and applying academic solutions to “real world” business problems?

“We” are the professionals of Enterprise Management Corporation (EMC), a boutique management consulting practice that was founded by Michael and Maureen Kraten in 1995. At that time, Michael was employed at one of the eight largest accounting and consulting firms in the world, and Maureen worked at one of the world’s ten largest banking institutions. EMC has since evolved into a multi-faceted firm that includes management consulting and content production and distribution of business training and development materials.

EMC is still led by the two of us, Michael and Maureen Kraten; we are the writers of this blog. We teach accounting, finance, and business economics courses at a pair of AACSB accredited colleges of business in the northeastern United States as well. We now define ourselves as “academics first” in terms of where we spend most of our time, and we measure our success by the number of business practitioners whom we help to succeed in the classroom and in the boardroom.

What Comes Next?

So where do we go from here? Considering that 2008 — the year that just ended — in many ways posed the greatest challenges to society since the Great Depression, we certainly do not suffer from a scarcity of topics to cover!

Nevertheless, we will do our best to address the questions that our colleagues, students, and clients pose to us. Casual readers of this blog are welcome to use the contact information in the margin of this web site to send us their own questions, thoughts, suggestions, and opinions.

The general length of each blog posting (with some modest variation on rare occasions) will be approximately 800 to 850 words, i.e. the length of a typical New York Times column. We will generally publish each new posting every Monday morning at 12:01 am Eastern (USA), though we always reserve the right to issue brief mid-week postings as well.

If you’ve made it to the end of this posting, then you must indeed be interested in our work. We welcome you to join us in the weeks and years to come!

Contact Us!

Please feel free to contact us by clicking on the “Leave a comment” link (below) and then posting your message.

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