MGMT 8605M Week 9 Tolerance Statement Example

The Overrun a Contractor Can Absorb Before Its Bank Steps In: A Tolerance Statement Reading Capacity From the Credit Agreement and Audited Balance Sheet, Arguing Appetite as a Fraction and Setting a Band on Cumulative Unrecovered Overrun

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Walden University

MGMT 8605M: Financial Risk Management and Decision Making for Organizations

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Month Day, Year

The Overrun a Contractor Can Absorb Before Its Bank Steps In: A Tolerance Statement Reading Capacity From the Credit Agreement and Audited Balance Sheet, Arguing Appetite as a Fraction and Setting a Band on Cumulative Unrecovered Overrun

Purpose

Delmont Builders, a composite general contractor in Kansas City with about $140 million in annual revenue, carries most of its work on fixed-price contracts, so cost overruns that cannot be recovered through change orders fall directly on its earnings. This statement sets, in writing, how much unrecovered overrun the company can absorb in one fiscal year before its bank covenant or its surety relationship would force it to change how it operates. The statement uses three nested figures, capacity, appetite and tolerance, defined as in the COSO enterprise risk framework (Committee of Sponsoring Organizations of the Treadway Commission, 2017), which describes capacity as the maximum amount of risk an entity can absorb, appetite as the amount it chooses to take on to create value, and tolerance as the acceptable variation in performance around its objectives.

Capacity, Read From Documents

Delmont's credit agreement with its bank requires minimum tangible net worth of $18.0 million, tested at each fiscal year end. The audited balance sheet for fiscal 2026 shows tangible net worth of $24.5 million. The gap, $6.5 million, is the amount by which net worth could fall before the covenant is breached. An unrecovered overrun reduces net worth after tax, and at Delmont's combined tax rate of about 25 percent, a pre-tax overrun of about $8.7 million would consume the gap. Capacity is therefore about $8.7 million of unrecovered overrun in one year, assuming the year's other earnings break even.

The surety relationship sets a second limit that is not written in a single covenant. Delmont's surety, which bonds its public projects, has told the company in its annual review that its bonding line depends on maintaining working capital above $15 million, which is currently $21 million. A fall of $6 million in working capital, which an overrun of a similar size would cause, would put the bonding line under review. The two limits are close, so the statement uses the lower covenant-based figure.

Appetite as an Argued Fraction

The statement sets appetite at 40 percent of capacity, about $3.5 million of unrecovered overrun in a year. The fraction is argued, not announced. First, capacity is measured at year end, but overruns arrive unevenly, and a bad quarter late in the year leaves no time to recover. Second, the capacity figure assumes the rest of the business breaks even, while Delmont's results over the past ten years include two loss years from causes other than overruns. Third, Stulz (1996) argued that the main purpose of corporate risk management is to avoid costly lower-tail outcomes, such as financial distress, rather than to reduce all variability. For a contractor whose bonding line underpins much of its work, a covenant breach is such an outcome, and a wide margin below it is justified. A fraction above 50 percent would leave less than one bad project's worth of room between appetite and capacity, based on Delmont's largest single overrun of the past decade, about $3.9 million.

Tolerance as a Monitored Band

Tolerance sets a band on a single monitored metric: cumulative unrecovered overrun across all open jobs, reported monthly by the project controls group. The band has three levels. Below $1.5 million is normal. From $1.5 million up to the $2.5 million line, the finance chief reviews each month every job adding more than $250,000. Above $2.5 million, the matter goes to the owners, who decide whether to slow bidding, raise contingencies on new bids or add equity. The trigger sits below appetite so that the owners act before appetite is used up.

Terms Taken From One Framework

The statement uses one framework's definitions throughout, quoted once above, so that capacity, appetite and tolerance carry the same meaning in every future report. Rittenberg and Martens (2012) noted that organizations often blur these terms, which makes risk appetite statements hard to apply; fixing the definitions in writing avoids that problem.

A Stated Gap

The statement leaves one exposure unaddressed: overruns on several jobs arriving together because they share a cause, such as a regional labor shortage or a steel price spike. The monthly metric would capture such a cluster as it developed, but the band assumes overruns arrive independently. A correlated cluster could move cumulative overrun from normal to beyond appetite in a single quarter. The owners should consider a separate stress test for shared causes.

References

Committee of Sponsoring Organizations of the Treadway Commission. (2017). Enterprise risk management: Integrating with strategy and performance. https://www.coso.org/

Rittenberg, L., & Martens, F. (2012). Understanding and communicating risk appetite. Committee of Sponsoring Organizations of the Treadway Commission. https://www.coso.org/

Stulz, R. M. (1996). Rethinking risk management. Journal of Applied Corporate Finance, 9(3), 8-25. https://doi.org/10.1111/j.1745-6622.1996.tb00295.x