 By Craig Ferri, Managing Director, Palisade Europe
The turbulence in the global economy has projected the word 'risk' into many everyday conversations, both commercial and personal: the unacceptable risks taken by fund managers which led to the collapse of major financial institutions; companies risking bankruptcy as a result of recession; the risk of people losing their jobs – and potentially their homes; and so on.
As a result, there is also increased talk of risk analysis, which in turn has brought disciplines known as 'quantitative risk management' (QRM) and 'decision making under uncertainty' (DMU) firmly into the business zeitgeist. But for many small to medium-sized companies, QRM and DMU are still regarded as something of a dark art – and one that is not relevant to their day-to-day activities.
However, in boom or recession, the truth is that businesses make decisions every day – and each one of these has an associated level of risk: – where to invest, what product to produce in what quantity, which vendor to use, what price to charge, what marketing activity to pursue – the list is endless. Much of this decision-making is undertaken by looking into the issues facing a business, putting some numbers on them to calculate their impact, and then mitigating or allowing sufficient contingency in the event that things go wrong.
Examining business decision-making in detail illustrates that most enterprises could benefit from making the link to risk analysis, and from there taking a more strategic approach to the discipline. Cost estimation, budgeting, cash flow forecasting, operational risk assessments, sales forecasting – in fact any part of a business where there is uncertainty – can all be made more robust and meaningful.
Recession therefore has perhaps brought the idea of QRM to the forefront of business owners' minds. Essentially it is a valuable aide to making better, more informed decisions, where the amount of uncertainty on which they are based is known - ie the accuracy of the information used to make the decision has been calculated and factored in to the final outcome.
Accessible to all
Not only are QRM and DMU being used more, they are also becoming increasingly accessible. Traditional systems tended to be expensive, enterprise-based applications targeted at large companies who were prepared to spend considerable time, money and human resources. The result was an all-singing and all-dancing product which often ended up underused due to confusion on the part of the very employees who were supposed to make it work.
However, steady increases in computer processing have given the desktops of today as much power as the high-end servers of a few years ago, meaning that risk analysis and management is now an achievable goal for companies of all sizes. Our @RISK and 'The DecisionTools Suite' software, for example, are such desktop risk and decision analysis tools, with a key factor being that they work in Microsoft Excel, a program found on virtually every workplace computer in the UK.
'Monte Carlo Simulation', a technique originally conceived by scientists working to develop the atomic bomb as part of the Manhattan Project, enables users to introduce uncertainty into their previously static spreadsheets, which lets them look at things in a probabilistic, rather than a deterministic, way. In layman’s terms, this means that rather than companies and individuals making decisions based on estimates or best guesses, they can see all of the potential outcomes to a venture – and also how likely these scenarios are to occur.
Better decision-making
For many companies this significantly improves the decision-making process, in two ways. Firstly, it requires a change in the methodology of employees responsible for assessing risks and opportunities – away from arbitrary, single-point estimates towards a more balanced and pragmatic view. It also means that, for the first time, employees have a tool which allows them to communicate their recommendations to management or colleagues in a transparent and standardised way. For anyone who has ever been sceptical about Net Present Value (NPV) projections, being able to identify that a specific project has a 75 percent probability that profits will exceed £500,000 and a 95 percent probability that they will exceed £300,000 represents a real improvement to the more traditional “the NPV of this project is £331,768.52p”. Equally, being able to look at scheduling risk in a probabilistic and quantitative sense allows for the allocation of labour and resources in a way which minimises slack and wastage whilst maximising the return on investment (ROI)
Adopting a healthy approach to risk
So it would seem that the new 'risk management' language that is starting to develop in the workplace and being taught to a new generation of managers on MBA courses should be welcomed. But language and qualifications are not enough. Organisations must do more than pay lip service to QRM and DMU if they are to reap the rewards. The following offer basic, best practice guidelines on how companies can maximise their programmes:
1. Get buy-in
Risk management is not an optional extra. It is a business critical tool that is an asset and an integral part of the project. The company culture must be developed to embrace QRM and DMU in order that everyone understands their benefits and therefore accepts the need for them.
2. Get budget
Business tools cost money, but managing risk is an investment - not an overhead – and must be regarded as such. Allocating resource and making it a formal business process should be seen as an insurance policy. Not only will it help organisations make better decisions that will save them money in the long term but, by identifying potential risks and adverse events, it can protect them against unexpected costs in the future.
3. Get words
As with any organisational change, it is essential that everyone is clear on the new processes. Therefore a common risk language – or 'glossary' – needs to be developed to avoid misunderstanding and to ensure a consistent approach to QRM and DMU.
4. Get numbers
Qualitative assessment is essential, but numbers are more powerful – for example the percentage chance of meeting a deadline or budget. Monte Carlo random sampling provides the margin of error for a venture and is a good way to illustrate the consequences of different courses of action. Risk managers must ensure everyone understands these figures, and accepts them.
5. Get structure
Managing risk in order to make better informed decisions requires an appropriate organisational structure. Individuals and groups need clearly defined roles, and must then each take responsibility for their own area of expertise.
6. Get lateral
Every organisation has risks that it deals with on a daily basis and which must therefore be factored in to the decision-making model. However, no enterprise operates in isolation, so other external variables must be included. For example, even a small rise in fuel costs could have a major effect on revenues if raw materials need transporting long distances.
7. Get perspective
Political, cultural and social risk factors can be explored by involving all stakeholders. Investing time and money in consultation and research ensures that businesses have a clear idea of the complete environment in which they operate, and therefore minimise the chances of products and services failing.
8. Get reporting
Risks, and the management of them, must be reviewed regularly – and the programme amended if necessary. This requires a regular reporting process, in which risks are clearly identified and prioritised.
9. Get with it
Being risk aware does not mean being risk averse. Businesses should guard against rigidly adhering to 'the way we've always done it' approach, instead keeping up-to-date, learning new tricks and not being afraid to be bold. Although risky on the surface, these tactics prevent being left behind – much of the potentially uncertainty can also be removed with QRM and DMU.
And finally…
10. Get it documented
Back up the commitment to a thorough QRM and DMU programme with documentation. This validates the budget and buy-in requested at the start. And it’s good for business – organisations this thorough are guaranteed a competitive edge.
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