Risk and uncertainty management

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Business people operate and make decisions in a risky environment every day. The consequences of their decisions are generally not known when the decisions are made. Furthermore, the outcome may be better or worse than expected. Price fluctuations and unpredictable sales are the biggest sources of risk for most businesses. Additionally, technological changes, legal and social concerns and human factors contribute significantly to risk business people have to face. A business person is most concerned with availability of goods and services for sale and availability of consumers and customers for the goods and services at a reasonable price.

Risk is thus the imperfect knowledge where the probabilities are not known. Other people view uncertainity as imperfect knowledge and risk as uncertain consequences. Risk management can thus be viewed as choosing among alternatives to reduce the effects of risk. For this to be achieved there will have to be a tradeoff between changes in risk, expected returns and entrepreneurial freedom. It is critical that the focus be on risk that matters. For a business person risk management will involve finding the preferred combination of goods and services with uncertain outcomes and varying level of expected returns. Risk management is thus the act of choosing among alternatives for reducing the effects of risk in business which in turn effects the businesses welfare position. Risk management strategies can 1) reduce risk within the operation, such as product diversification, 2) transfer risk outside the operation, such as production contracting or 3) build the operation's capacity to bear risk, such as maintaining liquid assets.

Sources of uncertainties:

Costs

Contract Awarded

Open Market Demand

Variable Costs

Fixed Costs

Revenues

Sharp Tailors

In order for a business to meet its arising obligations, it must deal with the risk that is as a result of desired or planned results not being achieved. In a business due to the numerous factors at play, there will always be uncertainties. Some of the uncertainties that could plague a business will include; uncertainty about customer needs - created by shifts in the environment. Customers and consumers have dynamic needs and this keep changing depending on the factors currently having a major impact on the environment. An individual will be influenced by other people, society, values among other factors in determining their needs from time to time. Uncertainty about technological possibilities - is as a result of rapid shifts in technological discoveries. This is the current most critical factor that has a single major effect on uncertainties by business people. Business has to operate in a dynamic world where emerging technologies make yesterdays breakthroughs obsolete and outdated. The challenge that business people have to contend with on a daily basis is to balance between their forecast of long-term technology and that which is about to become obsolete.

Uncertainty about distribution channels - created by power shifts in the value chain. Daily businesses rise and others fall. Conversely, environmental factors sometimes can make some businesses to maintain operations while others fold. As such, a business person, worries on the strength and reliability of the distribution channel both as a transmitter of raw material and final product to the consumer. This uncertainty is in some instances guarded against by business people holding huge quantities of inventory. This is especially so in places where supply is haphazard and demand is relatively high.

Uncertainty about the viability of an existing business model - this is created by potential changes in regulation or industry standards. Changes in the way a business conducts business or the standards that guide a industry could result in instability of a business especially if the changes happen abruptly without prior warning and without giving business an opportunity to adjust and adopt to them. In the long run the instability they cause to a business is the source of uncertainty.

All in all, the uncertainty in business when harnessed and used constructively is the base from which innovation is launched from. The uncertainties create a market for new solutions. The use of tried and tested business strategies in an effort to avoid uncertainty stifles innovations and creativity.

Consider planning. In a high-certainty world, a good measure of the effectiveness of a manager is whether the numbers and commitments in the plan are what later happens. This makes absolutely no sense when you simply don't have enough knowledge to accurately predict what is going to happen. Instead, insisting that managers stick to plan can lead to dangerous escalation of commitment to a failing operation or unwarranted investment in the core business well beyond the returns a company is going to receive. Further, imposing the expectation that one will 'make one's numbers' or 'deliver the earnings' is unrealistic when the underlying business logic for an operation has shifted.

Calculate the effect of perfect control:

This is determined by considering the option that the decision model suggests should be preferred and determining how the probability distribution of the annual profit would change if the decision maker is able to exercise control over the events that the model assumed were uncertain. For example is the uncertainty facing a business is annual fixed costs, variable costs, whether a major contract to supply will be awarded and the level of open-market demand. The challenge in calculating the effect of perfect control is determining the effect of controlling one of the uncertain factors and experiencing the change on the other factors either positively or negatively. If the fixed costs would be determined conclusively what would be the effect of the probability of the other uncertain factors affecting the business.

By varying this uncertain factors, a business person is able to determine which has the greatest effect on the overall operations of the business. If by increasing the probability of keeping having the contract awarded, the profitability has a minimal increase this shows that the expected pay-off from this move will not be significant. This could be interpreted to mean this factor - whether the contract is awarded, has little effect on the profitability of the company and that though uncertain, the business is better of addressing other uncertain factors that will have a significant effect on the profitability of the business.

By carrying out similar analysis on other uncertain quantities, varying each in turn to its most favorable value, while assuming the other quantities can not be controlled, helps determine the effect of perfect control.

Estimated values for uncertain factors:

Location

Market corner Bond Street

Factors Lowest Most Highest Lowest Most Highest

Likely Likely

Annual fixed costs 8 9.5 11 4 6 8

Variable costs / unit 3.7 4.0 4.3 4.2 4.5 4.8

Annual demand 3 8 12 3 8 12

Contract awarded 0 0.7 1 0 0.7 1

Next best option:

If the manager could take the actions to ensure that the fixed costs of Market corner were at their lowest possible value of $2 million, additionally, if it was possible for the manager to ensure that opern market demand would be equivalent to the highest possible level of demand and that Market corner could cope with the additional demand generated,? Additionally what if the manager could ensure that the variable costs will be at their lowest possible level?

Action Increase in Expected Risk of a loss Lowest possible

profit profit

No action $0.0 8.0% -$3.8m

Contract signed $0.32m 2.9% -$2.4m

Fixed costs at lowest $1.98m 0.2% -$1.8%

Maximized demand $0.95m 0 $0.33m

Lowest variable costs $1.22m 1.8% -$2.0m

From the results it is clear that trying to reduce fixed and variable costs or increase demand has the greatest potential for increasing expected profit and reducing the chances of incurring a loss. Similarly, increasing the chances of the contract being accepted and efforts to reduce variable costs are likely to be less productive. These results are arrived at as a result of each action being evaluated in new simulation that has to consider a large number of uncertain quantities.

Using brainstorming to create actions:

Brainstorming with a group of people is a powerful technique. Brainstorming creates new ideas, solves problems, motivates and develops teams. Brainstorming motivates because it involves members of a team in bigger management issues, and it gets a team working together. However, brainstorming is not simply a random activity. Brainstorming needs to be structured and it follows brainstorming rules. Brainstorming places a significant burden on the facilitator to manage the process, people's involvement and sensitivities, and then to manage the follow up actions. Use Brainstorming well and you will see excellent results in improving the organization, performance, and developing the team.

The brainstorming process will be,

Define and agree the objective

Brainstorm ideas and suggestions having agreed a time limit.

Categorize/condense/combine/refine

Asses/analyze effects or results

Prioritise options/rank list as appropriate

Agree action and timescale

Control and monitor follow-up.

Simply put, in brainstorming,

Plan and agree the brainstorming aim

Ensure everyone participating in the brainstorm session understands and agrees the aim of the session (e.g., to formulate a new job description for a customer services clerk; to formulate a series of new promotional activities for the next trading year; to suggest ways of improving cooperation between the sales and service departments; to identify costs saving opportunities that will not reduce performance or morale, etc). Keep the brainstorming objective simple. Allocate a time limit. This will enable you to keep the random brainstorming activity under control and on track.

Manage the actual brainstorming activity

Brainstorming enables people to suggest ideas at random. Your job as facilitator is to encourage everyone to participate, to dismiss nothing, and to prevent others from pouring scorn on the wilder suggestions (some of the best ideas are initially the daftest ones - added to which people won't participate if their suggestions are criticized). During the random collection of ideas the facilitator must record every suggestion on the flip-chart. Use Blu-Tack or sticky tape to hang the sheets around the walls. At the end of the time limit or when ideas have been exhausted, use different colored pens to categories, group, connect and link the random ideas. Condense and refine the ideas by making new headings or lists. You can diplomatically combine or include the weaker ideas within other themes to avoid dismissing or rejecting contributions (remember brainstorming is about team building and motivation too - you don't want it to have the reverse effect on some people). With the group, assess, evaluate and analyze the effects and validity of the ideas or the list. Develop and priorities the ideas into a more finished list or set of actions or options.

Implement the actions agreed from the brainstorming

Agree what the next actions will be. Agree a timescale, who's responsible. After the session circulate notes, monitor and give feedback. It's crucial to develop a clear and positive outcome, so that people feel their effort and contribution was worthwhile. When people see that their efforts have resulted in action and change, they will be motivated and keen to help again.

It is important to remember that for a brainstorming session to be successful, there are basic rules that must be adhered to at all times. These include;

Do not criticize - the solution to the problem may turn out to lie in an idea that, initially, may seen to be crazy.

Encourage participants to put forward any ideal that they can think of - particularly unconventional or outlandish ideas.

Aim to generate large quantities of ideas - in that way there is a greater chance that one or more of the ideas will lead to a solution to the problem.

Encourage people to combine or modify ideas that have already been put forward

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