In its simplest form, risk, from an operational perspective, is a mathematical equation that focuses on the simple concept of risk vs. reward.
When we analyze how risk mitigation and risk tolerance effect business decisions, we are asking the decision-makers within the organization how much risk (or chance) they are willing to take versus the perceived rewards that could be obtained through a positive outcome of the decision being made. These are simple formulas and in a perfect scenario these two factors (risk mitigation and risk tolerance) would provide all of the information necessary to make major operational decisions. Unfortunately, like everything in life, it just isn’t that simple.
When assessing risk, it is extremely dangerous to use a
simplified approach to decision making, because the fact is that risk must
always be analyzed on an individual basis.
While risk tolerance and risk mitigation are always factors in analyzing
risk within the decision making process; other major factors also need to be
considered; such as:
The
current position of the company – i.e. if this is an investment decision
management must assess the effects on internal capitalization if the
investment ends up becoming a failure.
The
rewards of the decision – Risk mitigation simply refers to minimizing the
risks associated with the decision; and risk tolerance simply refers to
the level of risk that the company is willing to deal with. Another major factor in the decision
must be the value of the rewards if the final decision ends up being a
positive one. As those rewards must
justify the decision made by management it is necessary that they be
positive enough to fully compensate the organization in a way that makes
counterbalances the risk associated with the failure of the project.
The
motivation for the decision – While a simple risk analysis may provide the
same results for two types of decisions, the motivation for the decision
is another factor that must be used in the decision making process. If for instance the decision is related
to an acquisition of a competitor; the decision may be different if the
competitor is a danger to your organization or if the competitor has a
product that you believe has substantial long-term potential.
The
macro-economic climate – While a risk formula utilizing only risk
tolerance and risk mitigation doesn’t take into account the overall
economic health of both the organization and the market, as a decision
maker YOU BETTER. It is much easier
to recover from a poor investment or from a product failure during a
positive economic climate than during a poor one. When things are going well from
macro-economic standpoint bad decisions may cost money, when things are
going bad poor decisions can cost everything.
Contingency
Options – Back-Up plans are the difference between companies succeeding
and failing. The ability of an
organization to properly develop and implement contingency plans is a
vital factor in any risk analysis.
What are we going to do if this decision turns out to be a poor
one? How will we recover? Can we recover?
These are all questions that should be included in a proper
contingency plan, and more importantly there should be answers for all of
these questions. Without properly
creating and implementing contingency planning into any risk analysis, the
risk can’t be fully known. The fact
is that without this type of contingency planning the decision-makers are
not being provided a full picture and making decisions while not being
fully educated about the ENTIRE process is a good way to make a
company-destroying decision.
Resource
Availability – If, for instance, the decision being made is for a capital
investment, an acquisition, or a new product line it is important to
remember that even if the results are spectacular you may not receive the
tangible benefits for years. While
the investment may show a positive annual yield, the reality of the
situation is that you will have to do without that capital for an extended
period of time. For this reason it
is necessary to not only confirm that you have suitable resources in the
present, but that it is reasonable to project that you will have suitable
resources during the course of the entire investment. Otherwise, even a good investment could
have detrimental consequences.
Projected
Consequences of Failure – The first question that should be asked when the
opportunity is brought up is; What is the Consequence of Failure? This seems to be a basic ideal;
obviously you should know the consequences of the actions that are about
to be taken. However, in many
instances decision-makers simply resign themselves to assessing the most
obvious consequences, and since many of them are eternal optimists those
consequences aren’t that troublesome.
The fact is that when any risk analysis is performed it should
include an in-depth disaster analysis.
This analysis should focus on multiple scenarios by which this
project could fail. For instance,
instead of simply focusing on failure from a “black and white” perspective
it is necessary to understand that there are multiple stages of both
success and failure. While the
current analysis may only assume the loss of the capital investment, it may
also need to include factors such as lawsuits, debt loss, loss of key
reserves, loss of human capital, etc.
When many decisions are made at the organizational or operational
level the potential success is examined on multiple layers, it is just as
important to apply the same ideology to failure.
Exit
Analysis – While most projects are originally analyzed with the assumption
that choosing to engage in the project means that the organization will
see it through to the end (whatever that end may be), in reality many
projects end early for numerous reasons, such as:
We
decided to cut our losses
We
were provided an alternative exit (i.e. acquisition, buy-out, sell-off,
etc.)
We
were able to mitigate risk by ending the project prior to full conclusion
but were able to obtain a reasonable return.
We
found another more lucrative project to invest in.
It is necessary to determine
exactly what the organization wants out of the project and create different
points of exit. This not only forces the
company to take a more in-depth look at the project, but also forces the
company to continuously (throughout the project) review and analyze the project
to determine progress.
In a perfect world the formula for determining risk and
using that determination to make decisions would be extremely simplistic. However, in the real world there are numerous
factors that must be included in the risk formula to determine what type of
decision should be made in different situations. It is vital that the decision makers within
an organization are aware that risk is ever-changing and looking at it from a
vacuum is in itself highly risky behavior.
By focusing on different factors in addition to risk mitigation and risk
tolerance decision-makers place them in a better position to gain information,
a better position to conceptualize the goals and the threats of a particular
decision, a better position to see the decision from multiple scenarios, and
most importantly a better position to make decisions. This will ALWAYS be in the best interest of
the organization; and that is what risk analysis is always about.
Vijay Mistri, MBA (Finance), FCMA, FCCA is a leading management and governance consultant, having been a board advisor for organisations from various industries ranging from Mining, Real Estate and Tourism, to Media and Research.
