How Well Do You Manage Your Risk?

Or, more important, do you even know your risk exposure?  After reading Michael Lewis' book, The Big Short, it's clear to me that relying on others to evaluate your risk as the bond rating companies did is a bad idea, especially if you're being asked to risk assess their offerings.  It's as if you were to go to the bank, ask for a loan telling them they have nothing to worry about because you're going to tell them how credit worthy you are and the unthinkable, that is you not being able to pay it back, could never happen.  Yet, this is the position many companies find themselves in when they try to assess their exposure to changing market conditions.  They generally have a Plan A, the budget, which is effectively their best guess at some point back in time.  So what happens when things change?  Is there a Plan B and, more important, how well will Plan B work?  Is anyone even asking the question, what is the worst that can happen and what do intend to do then (Plan C)?

The problem with most risk assessment is that it's based on history, which can be a poor indicator of future conditions, especially when they are as volatile as those we are experiencing today.  We've all read about the tragedy that continues to unfold in the Gulf of Mexico following the sinking of that BP oil rig.  I doubt anyone can really estimate the true impact this event will have because of the many variables in play and our ability to control them.  Coincidently, BP executives were visiting this particular rig to recognize its exemplary safety record.  Things were going so well that apparent warning signs were ignored.  Several unsuccessful fixes have been attempted, each promising a resolution to the issue so no backup plan was really needed. Now the government is stepping in.  Sound familiar?  How the mighty have fallen all because the unthinkable happened.  There are many people angry right now and rightly so.  Most are probably more upset by how BP handled the situation than they are about the fact that it happened in the first place.  You can never really afford to eliminate all risk, but if you know your exposure and its impact, you may be able to manage the situations better when they occur, possibly even picking up on early warning signs and preventing the worst case from happening altogether.

It all sounds pretty dire. But, there is hope.  I had the good fortune to meet with one of our long standing customers earlier this month and they had a rather creative strategy.  On the one hand they had implemented a process whereby they evaluated the profitability of any significant new or changing customer relationship before they were accepted.  It included an escalating approval workflow that was commensurate with the revenue associated with the relationship.  I found this fascinating for two reasons.  First, they had leveraged the drivers of profitability from profitability model to do Pro Forma profitability modeling of this customer's relationship to their company.  Second, they are a public company and they had a repeatable process for determining materiality which should serve as an excellent example for other public companies that face regulatory requirements around disclosure.

This customer was also using several rolling forecast (or should I say projection) models to predict future financial and operational outcomes using multiple horizons.  These were updated periodically.  I was equally impressed by the fact that they were not quite satisfied with either the frequency or the accuracy with which they were able to accomplish this, so they were always interested in exploring new ways to improve.  No wonder they have been so successful and more than doubled in size since we first started working with them.  Knowing your drivers of profitability is a critical enabler for this type of risk management and this company as a very deep understanding.  According to one Gartner analyst, companies with this type of measurement capability outperform their peers by more than 30%.

Risk can manifest itself in a variety of ways.  It's how well you're able to manage this risk that will set you apart from your competitors.  Recognizing your risk exposure and establishing the right plans are critical success factors for navigating your company through these situations.  Wouldn't it make sense to model these scenarios and your action plans before they occur so you can choose the path with the greatest chance of success when the unthinkable happens?  So, if Plan A doesn't work, how do you rate the likelihood that your Plan B and Plan C will succeed?  Are you comfortable with those odds?

It's worth thinking about because the rate of change is accelerating and it's survival of those who can adapt the fastest.  Let me know what you think by joining the conversation.