Beyond Risky: Going Beyond Risk Mitigation and Risk Tolerance is a Risk Analysis
Oct 28, 2016
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.
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