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Paying Attention to Externalities in Managing Risks

written by: ciel s cantoria • edited by: Donna Cosmato • updated: 8/14/2011

In coming up with cash flow estimations, the extent of possible side-effects to be considered goes beyond the project but extends throughout the community and environment. Limiting the extent of cost projection doesn't necessarily mean limiting risk management to what has been financially projected

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    The Deciding Factors for a Project’s Feasibility


    The Net Cash Increment or Contribution

    Decision makers are more inclined to base their evaluation of a project on the net cash increment that the completed project will contribute to the business. Basically, the project’s net cash flow (inflows less the outflows) should create an incremental effect to the present net cash flow of the regular business operations. Hence, the need to create a budget that would ensure that an approved project will conform to the cash flow estimation on which the project’s approval was based.

    However, it should be perceived that budget and cash flow estimations are two different concepts requiring different financial considerations. Where the capital budget deals with controlling operational costs to ensure that reasonable profits will be realized, the cash flow estimation takes into account the projected cash inflows and the effective and efficient utilization of the budgeted funds. The former ensures net profit, while the latter ensures net cash increment.

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    Constraints and Potential Risks of the Business Organization

    Other important factors for evaluating the feasibility of the project aside from its net cash increment are constraints and possible risks that the organization faces, while the project is ongoing. They are factors that may be external to the organization or to the project.

    These are events or aftermath that transpire as a result of the new undertaking, thus their quantifiable impacts are taken into consideration. They are referred to as externalities or side-effects or incidental effects. Basically, these factors can ripple through a business venture and affect its financial performance particularly its ability to deliver the projected net cash increment.

    Inasmuch as externalities and incidental effects are possibilities or potentials, their quantification does not form part of the operational budget. They form part of the cash flow’s estimation either as an additional inflow or an additional reduction. This is determined by the positivity or the negativity of the effect created by the incidental effect or externality.

    Other constraints similar to externalities include opportunity costs and they are also estimations that are given weight because they can affect the potential net contributions that will be generated by a project.

    Opportunity costs are easier to identify because they represent the income foregone by the business to give way to the new project. They are oftentimes actual cash inflows that will no longer be received once the project goes underway.

    Therefore, our discussion focuses on the more complex form of constraints referred to as externalities and incidental or side effects by furnishing examples. The objective is to provide project managers with ideas on how they can impact the financial position of a business entity. Hence, for this purpose, they are classified as positive or negative in order to determine if their respective effects would pose threats to the continuity of a project.

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    640px-Positive externality.svg 

    The Positive External Side Effects

    Some projects have tendencies to create positive results that are favorable to the company’s present cash position. This could be in the form of additional cash inflow that will be generated or an indirect reduction of costs.

    There are no comprehensive studies on how to quantify all the total cost of positive effects before they actually take place. A forecast is only an estimation, for which positive incidental costs could lead to greater positive benefits; hence, the possibilities can be limitless. However, the principle of conservatism should still prevail.

    Study the example below:

    Automated machineries are capable of producing a greater number of outputs and with more accuracy. The persons handling a particular unit of production will have fewer manual workloads with which to contend, resulting in increased productivity leading to greater profits. However, the result is the primary objective of the capital venture.

    A possible externality to this scenario is the time afforded to the employees which can be devoted for undergoing training programs in other units of production. Quantifying its effect can be determined by running a simulation of the production activities using computer aided machineries, and then determining how much time has been saved during an eight-hour shift.

    The time saved will be devoted to training programs which, otherwise, would have been conducted during Saturdays. As a consequence, the entire training period of the HR training programs lined-up for the year will thus be shortened. In such cases, the positive externality is the elimination of the costs of longer training periods that are being conducted during Saturdays, i.e. transportation and meal allowance, utilities, as well as the wear and tear of the training facilities.

    Although positive side effects could extend beyond the confines of the business entity, as they affect the families of employees, the community and its dwellers as well as the environment, the matter of quantifying all these is not necessary, since they will not pose threats to the continuity or existence of the project.

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    640px-Negative externality.svg 

    The Negative External Incidental Costs

    It can be said that current related studies pertaining to the frameworks and methodologies for determining the costs of negative incidents have been more extensive. The recent year’s turn of events manifested that not all estimates for externalities had fully measured-up to the actual costs of failed projects and ventures. The inference that can be derived from this is that decisions were based on net increments, which did not explore the full scope of the risks involved.

    An example is the British Petroleum (BP) Oil Spill in the Gulf of Mexico in 2010, for which the petroleum company’s liabilities amounted to $90 billion against their $104 billion equity. The extent of damages the company had to pay included:

    • General liabilities
    • Property Liabilities
    • Workers’ compensation
    • Cost of clean-up materials, technology, transport, communication and other necessities.
    • Compensation for the clean-up workers including the treatment of possible effects to their health
    • Reimbursement for tainted food and crops including the marine products that could have provided livelihood to the community fishermen
    • Destruction of the ecosystem not only to the gulf, but also to the marshes, swamps and rivers whose bodies of water were tainted with oil spills
    • Environmental liability
    • U.S. Longshore and Harbor liability
    • Negligence and criminal wrongdoing
    • Willful violations of the Occupational Safety and Health Act (OSHA)

    page1-761px-BP OilSpill FisheryClosureMap 062110.pdf 

    Moreover, the externalities affected several insurance companies since they had to satisfy numerous insurance claims for individual damages.

    These examples had beset an oil company at far greater costs than its estimations. Environmental liability, for example, included the number of migratory birds that annually visited the shores after a long migratory travel. The liabilities likewise took into consideration the drop in the number of tourists that trekked to the region, and the lost income of the businesses that depended in the region’s tourism industry.

    Other examples of large-scale side effects include those that affect financial institutions, inasmuch as their failed ventures can ripple through a nation’s entire economic condition. Iceland, for example, declared a state of bankruptcy in 2008 after three of its major banking institutions collapsed.

    In recent years, financial institutions like Goldman Sachs, JP Morgan Chase, and Citibank have received government financial assistance since the extent of their failed investments could have driven a greater number of businesses into bankruptcy during the height of the 2008-2010 economic crisis.

    On a much smaller scale, incidental costs can be exemplified by the decrease in income generated by a branch or unit in the event that another branch is set-up as a strategic move for providing better customer service. A product innovation can also affect the sales performance of an existing product if the new item is regarded as more economical albeit inferior in quality.

    Perceive that the call for placing further emphasis on paying attention to externalities is not only for its significance in estimating the potential net increment of a project. If for purposes of risk assessment, the said concept will be confined to what was considered in the cash flow estimation, the management of possible threats or risks surrounding the project will therefore be limited.