Limiting Factors/KPIs/Variance Analysis
In this series of potpourri topics, Aliyyah shares her experience to teach important concepts around production planning, KPIs and managing foreign currency risk.
Limiting Factors – Production Planning within Financial Operations
When it comes to a SINGLE limiting factor in relation to performance management, I was taught to follow the method below for determining the optimal production plan. Using this method, we:
1. Identify the scarce resource
2. Establish the units of the scarce resource used by each product
3. Calculate the contribution and contribution per limiting factor for each product
4. Establish the production priority based on contribution per limiting factor
5. Allocate the scarce resource according to the ranking.
Unfortunately, we all wish it was this easy to determine the production plan. In reality, there is uncertainty to consider and MULTIPLE limiting factors surrounding the decisions over what and how much we can produce.
These multiple limiting factors can include how much our existing machinery can make, shipping delays, labour constraints, and shortages in critical raw materials. In addition, organizations make decisions based on both qualitative and quantitative data.
So, how do we decide what to produce when we have multiple limiting factors?
We have to consider the following:
1. Inventory levels and inventory cover, as well as pre-existing customer orders/contracts, as this essentially drives how much we need to produce regardless.
2. Where our customers reside, our business plan, and how our market is segmented, especially if we have export markets
3. Forecasting methods and availability of raw materials.
4. Contribution per product/SKU as we’d like to maximize those with the highest contributions
5. Linear programming. Largely evolved due to data science.
What is your top tip regarding limiting factor analysis in performance measurement?
Key Performance Indicators (KPIs)
Regarding KPIs, in addition to a long list of poorly designed ones, I have learned:
1. KPIs should be linked to a firm’s purpose, and at times there are trade-offs between KPIs such as ESG goals and short-term earnings.
2. KPIs require accountability however this is not a license to blame another department.
3. KPIs are future-oriented and are required for strategic planning. At the same time, KPIs require follow-ups and the goal should not be to simply measure what matters. We need follow-ups and active monitoring.
What have you learned about KPIs in finance?
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Foreign Currency Risk
If you are an exporter or an importer or work with clients in other countries, chances are, you have faced the challenge of managing foreign currency risk.
From my experience here is a list of options to consider when it comes to managing foreign currency exposure.
1. Developing a company policy where the other party is responsible for accepting transaction costs might be beneficial as it would provide defense for your organization. If there is no policy in place, negotiations should occur early in a relationship to confirm who is responsible for transaction costs.
2. Engage in leading or lagging. This entails collating payments to one particular supplier, taking a ‘calculated risk,’ and remitting payment when the rate decreases. However, there is a chance that the client relationship might suffer due to collation, so discretion is required.
3. Netting. Once you have regular sales and purchases between your firm and another, then this method works well. This method involves striking off debts owed in one company against the debts to be received by that same company. This also works well in group settings when intercompany transactions are the norm.
4. Matching. Instead of buying currency every time you need to settle a payment, why not have a foreign currency bank account? This works well once you regularly work with clients in one particular country.
5. And finally, there are exchange contracts which are agreements to buy or sell currency at an agreed rate in the future. Works well when there are shortages or simply too much volatility in a currency.
In closing, there are 3 types of foreign currency risk
Transaction, translation, and then long-term translation risk exposure.
How else do you manage foreign currency risk? Where do you see finance business partners playing a role in improving foreign currency risk management?
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