Measuring and Mitigating Risk
By Stephen Johnson
Founded in 1975, Arc of Yates is a nonprofit organization for people with developmental disabilities. We provide a wide range of community-based services, including service coordination, residential living, clinical services, employment opportunities, and industrial and educational development throughout Yates County in upstate New York.
As a nonprofit organization, we primarily rely on funding from state and local governments. These funding streams are affected by state and local budget deficits, early retirements of knowledgeable government workers who are not being replaced, inconsistent rate-setting methodologies and heightened government audit protocols.
As a result, we feel the strain on our own year-to-year budgets. With the recent economic downturn, we were unsure of how to account for potential shortfalls in our annual budget planning. When planning the budget, we also had to consider a number of additional variables and uncertain factors, including Medicaid rate reductions, state contract reductions, county contribution, state audits and inflation.
We decided to use Monte Carlo simulation, an analytical
technique that evaluates and measures the risk associated with any given
venture or project, to manage and mitigate these risks, and we chose Palisade’s
@RISK software to do so. Monte Carlo simulation is a computerized mathematical
process that allows users to define uncertain variables in their models and
obtain a range of
possible outcomes, along with the
probabilities that they will occur. It
can show the extreme possibilities—outcomes for the both the most risky and the
most conservative, along with
everything in between.
The technique works by substituting ranges for values that apply to uncertain inputs in a model. These ranges are called probability distributions, where certain values are more likely to occur than others. The normal distribution, or is a common example.
In @RISK, these probability distributions are sampled over and over to record new outcomes each time. This is the simulation itself, and the result is a range or distribution of possible outcomes and associated probabilities.
Such simulations are highly flexible tools used extensively in risk management to gain insight into what could happen, so resources can be allocated more effectively, better strategies can be designed, mitigation plans can be developed and better decisions can be made. By exploring the full range of possible outcomes for a given situation, effective risk analysis such as this can both identify pitfalls and uncover new opportunities.
Developing a Strategic Plan
Using @RISK, we were able to develop more effective strategic contingency plans and communicate our challenges to board members and other stakeholders. We also were able to quantify the magnitude and probability of risks in our funding streams that could affect our financial planning. And we could update risks monthly or even weekly to keep up with our fast-paced environment. As a result, we were able to gain crucial insights that enabled us to develop our three-year strategic financial plan.
Due to the magnitude of uncertainties and lack of clear guidance from the state of New York, some of Arc of Yates’ uncertainties were initially modeled as uniform distributions, which show an equal probability of all values occurring. As more information became available, those distributions became more refined to beta general distributions.
Because we are usually given a range of funding cuts (e.g., zero to 10 percent), normal distributions were not used, since it’s impossible to determine the mean or standard deviation: parameters that are required to use the normal. Where there was uncertainty in funding methodology, we used a combination of binomial and beta general distributions.
When historical data was available, we used @RISK’s distribution-fitting feature to determine the best distribution to use from the data. We are not sophisticated statisticians, but we found the above distributions to be easily understood by our stakeholders.
The software has also been instrumental in communicating risks to our board of directors. The graphs and output reports generated by @RISK are concise and easy to understand, enabling us to convey the key challenges and strategies to senior leadership more effectively and in less time.
One of the greatest benefits of using risk analysis software has been reducing a number of significant uncertainties down to a single output that provides our senior leadership and board of directors with a realistic expected outcome. Comparing the two outlying years in our three-year strategic financial plan has also provided advance warning that the next two years will be financially challenging.
As a result, we have reprioritized capital projects for the next three years and will work more collaboratively with similar agencies to reduce overhead and administrative expenses.
Using @RISK has empowered our organization to foresee potential obstacles and shortfalls in our budgetary forecast. By understanding risks, we are able to both quantify and focus on other activities that may generate replacement revenue and produce contingency plans for cost reduction.
Stephen Johnson is Arc of Yates’ chief financial officer.