Making a Measurable Difference
An acquaintance recently asked me the following:
"Can you quantify how risk management actually makes a difference? I'm tired of struggling with this issue. Any ideas?"Indeed, I do have some. I take a slightly different approach to risk management than is commonly associated with the term and common practices. Risk management to me is really decision analysis and management. Of the several benefits that decision analysis affords, the two that address your question directly are those associated with the revealed value of information and control. The value of information (VOI) tells one how much maximally to spend in order to make an unambiguous decision. It is essentially the marginal utility of obtaining more precise information. The value of control (VOC) tells one how much maximally to spend in order to get a desired outcome by controlling what was otherwise a critical uncertainty*. It is the cost to turn critical uncertainties (which expose us to risk) into decisions under our control.
In three of my recent projects, here is how such analysis played out.
- A major exploration & production company wanted to reduce the capital cost of an ERP system rollout in order to justify the economic value, which was originally judged to be $0 on a spend of $100M. Critical uncertainty analysis show that the areas targeted for capital cost reduction would actually destroy the value of the system further. VOC analysis showed that spending additional capital in those same areas could provide an additional $300M of opportunity value.
- A start up company estimated they needed ~$500K of capital. Our decision analysis showed that this level of capitalization bought about a 30% chance of success, while ~$2.5M bought about a 90% chance of success. The company had underestimated their required capital by ~5X. Furthermore, VOC analysis showed that the means to maximize the long term value was related to getting good sales people on board as fast as possible and the level of sales staff that was needed.
- A biomedical device company believed they needed to control the cost of development R&D on all projects as a means to improve the value of the company through improvements in capital efficiency. For a new product under consideration, VOI analysis revealed that practically all the effort for improving the value of the company should be placed in understanding some essential market parameters (e.g., actual market size, potential market penetration, and time on max penetration). In other words, instead of spending resources on an immediately inwardly tangible but ineffective area of control, VOI analysis showed what the max budget should be for understanding the target market better and how much that better understanding was worth over the potential improvements in development R&D.