Do your leaders see the big picture, or just pieces?
Let me share a story (based on a real event) that you are watching on multiple monitors.
On the first screen, management of the company’s largest oil refinery are planning a major capital project to build a new processing unit. One of the refinery’s existing units produces not only highly valuable jet fuel, diesel, and gasoline, but also a variety of medium and low value byproducts (“midstream”). The new unit will reprocess the low value midstream products and convert them to medium value midstream or even gasoline and diesel.
You can see the refinery’s risk officer consulting with the management team. He is helping them with safety, compliance, and a variety of other sources of risk to the project.
The second screen shows the trading floor, where management is monitoring both the prices they will have to pay for the crude oil that is the raw material for the refinery, and the prices that the different products of the refinery can obtain in the market. You can see the trading floor risk officer, monitoring futures and derivative trading and other risks.
In response to a question from refinery management, the traders share the projected prices for the range of products that the new unit will produce.
Using that information, refinery management designs the new unit to generate the optimal mix of products.
Screen three has the financial team preparing forecasts for the rest of the year. They get a projection from refinery management that includes when the new unit will come online, its operating costs, and projected revenue.
The fourth screen shows the Treasury department. They are managing short-term investments and cash flow, based at least in part on forecasts and projections from Finance. The Finance risk officer is tracking and reporting currency, interest, and other sources of risk.
Four months pass.
Turning your attention to the refinery, you see that excellent progress is being made. The new unit is close to 70% complete. It is on schedule and on budget. The refinery risk officer is reporting that all remaining risks are within acceptable limits.
The traders continue to monitor raw material and product prices. They decide to change their derivatives trading strategy, as they are seeing a significant shift in the market. Product prices are shifting. The low value midstream products are increasing in value, while prices for gasoline and the medium value byproducts are falling. But while they (with the help of their risk officer) report that to senior management, they are focused on their own operations. They optimistically project no change in revenues, although there is a significant possibility that total revenues will fall.
Finance and Treasury continue as before.
Another two months go by.
The traders raise the alarm that revenue is dropping. Product prices have fallen steeply and are not expected to come back in the near future. They apologize for not warning everybody earlier.
Finance hurries to update the forecast and the executives meet to decide whether to change the projections they have shared with analysts and others.
Management at the refinery are innocently continuing to work on completing the new unit, which is scheduled to start operations in thirty days. Everything is looking good.
Meanwhile, Finance has shared its updated forecast with Treasury. With the drop in projected revenue, Treasury alerts the CFO and top management that cash flow is drying up. They will have to cut back 100% on capital spending, at least for the next month or more.
You see the CFO meeting with the refinery manager, asking him to defer any capital spending for three months. Words are exchanged, and the CFO is told that the money has already been committed on the new unit. Canceling or deferring the remaining construction will delay opening by three to six months, increasing costs, and reducing revenue.
The CFO replies that there is no cash to spend, and he cannot obtain new funding quickly.
Reluctantly, the refinery manager calls in his team and they figure out how to cut back work on the new unit.
Three months later, the executive team meet to celebrate the opening of the new unit.
However, refinery management and Finance tell them that it will not generate the anticipated return on investment that had been expected due to the change in product prices.
The refinery manager informs the CEO and the rest of the executive team that had they known, months earlier, that the prices for the mix of products of the new unit were changing, they could have modified the design. They could have made some adjustments to increase the volume of what were now higher value products.
But they didn’t know. Nobody told them, and they didn’t ask.
The Lesson Learned
People talk about the problem created when risk is managed in silos. That problem is what enterprise risk management (ERM) is intended to address.
But while it is true that risk is interconnected and so on, I would express the problem differently.
In this tale (again, based on a true story from my time at the oil refining and marketing company), the company was being managed in silos.
I have seen this time and time again.
When management is managing just their piece of the puzzle, they may optimize that piece at the expense of the whole picture.
I have seen:
- Two divisions of one company competing against each other for the same contract
- The three business units of another company fighting against the CIO’s proposal for a company-wide ERM. As a result, each business unit purchased their own systems that were not connected or integrated in any way.
- A factory that made enclosures for the company’s products deciding to sell them to a third party instead of their sister factory. The enclosure factory generated more revenue but forced their sister to purchase their enclosures from a third party at much higher cost.
When we see this, we need to ensure top management and, if necessary, the board know what is happening.
Managing the company in silos, perhaps enabled by addressing risk in silos, is a serious inhibiter of success.
Is this something you see in your organization?
I welcome your comments.
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Norman Marks on Governance, Risk Management, and Internal Audit 
I have seen variants of this scenario in many companies. This type of concern requires internal audit to step back to focus on the less technical things and consider organization, structure, motives, personalities – all elements of culture and how things are done. Unfortunately, it is too easy for auditors to focus on the activities in each silo and conclude they operate as that silo’s management wants.
As an aside, another example where internal audit’s “customer” is not management of the activity being audited.
Norman, I think the problem goes right back to the board approval. Why didn’t the approval document contain various scenarios, including one where there is a shift in the market? The board could then decide how to anticipate each scenario, if necessary, and instruct the ‘silos’ to produce a joint report each month indicating how each scenario was playing out.
As pointed out in the first post, internal audit has a role to check that the approval process is sufficiently robust to ensure all reasonable scenarios have been anticipated. ‘Risk management’ should be supporting the process of identifying scenarios and assessing the risks involved in each.
David, there was a failure to communicate and know what was happening in the other parts of the business.
There was a failure to monitor what was happening, including changes in what had been assumed.
Norman, I realise there was a failure to communicate. My point was that the approval process should be aimed at ensuring proper communication. If a company is being managed in silos, then that is a fault of the board and they should be told by internal audit, since IA should be seeing the effects of this from their auditing work, if it is being based on a proper ERM process.
I get the impression in the above examples that board members are not talking to each other and/or are not receiving relevant information and that this is where the problem starts.
Yes I saw this clearly where wood chip was sold onto the market place by one division thus making it more expensive for a sister company manufacturing board to buy the raw material.
In this case the silos were literal.
Risk identification followed by group workshops helped to prioritise strategies.