My last posting spoke to one of COSO’s two recently issued guidance reports on enterprise risk management. The first provides approaches for getting started on an ERM initiative, and while it’s based on good intentions and provides useful information, especially to smaller companies, in Olympic games terms with only two entrants, that report gets the silver. The second report, Developing Key Risk Indicators to Strengthen Enterprise Risk Management – How Key Risk Indicators Can Sharpen Focus on Emerging Risk wins the gold – by a good margin.
COSO’s ERM report Application Techniques volume touches on the topic of key risk indicators, use of which was not commonplace at the time. Since then, along with key performance indicators, which focus primarily on past performance, more organizations have incorporated forward looking key risk indicators into their ERM processes, further enhancing risk management effectiveness. This new report does a good job of explaining KRIs and how they can be of benefit. A couple of simple examples include:
- For customer credit, where a common KPI includes data about customer delinquencies and write-offs, KRIs are developed to help anticipate future collection issues, focusing for example on analysis of reported financial results of a company’s 25 largest customers or general collection challenges throughout the industry to see what trends might be emerging among customers that could potentially signal challenges related to collection efforts going forward.
- Management of a chain of family-style restaurants sought to avoid a negative earnings event that could arise with unexpected market conditions. Recognizing that restaurant traffic is directly affected by customers’ discretionary income – where as discretionary income levels fall off, customers are less likely to dine out – management establishes as a KRI average gasoline prices people pay at the pump. This is based on the premise that when gasoline prices rise, discretionary income for individuals and families representing their core customer base decreases, and customer traffic begins to drop.
As such, KRIs enable management to take quicker action in dealing with the risks. In the later example, management is positioned to adjust marketing and promotion events to reduce the impact of the risk.
The report explains how KRIs are most effective when closest to the ultimate root cause of the risk event, providing more time for management to act proactively. And multiple KRIs can provide still more relevant information, keeping in mind that a close relationship between the KRI and the risk, and accuracy of information used, are both critical. Another benefit is the ability to readily track trend lines with dash boards or exception reports, quickly and easily communicating where action may be needed.
With KRIs continuing to gain recognition as important elements of enterprise risk management, this COSO report provides readily usable information and is definitely worth the read.