Get smart about big risks

Risk Management, Sept, 1998 by David Matheson, Jim Matheson

Today's companies excel at managing business-as-usual risks. This success is manifest in numerous examples: financial institutions use derivatives to cope with the uncertainties of securities markets, commodity prices and interest rates; risk managers make a science of statistical analysis; globally-situated manufacturers hedge currency and interest rate risks; and industrial facilities apply fault tree analysis to a wide range of mechanical systems, giving them a handle on the probability of systems failures.

By all accounts, the management of quantifiable risk seems well in hand, but there is another, more troublesome, form of risk that can slip through the statistical net. Strategic risk occurs infrequently, comes out of the fog and generally represents something fundamentally new. Deregulation, technological innovation, social change and the emergence of maverick competitors are some of its carriers. While business-as-usual risks can damage earnings, strategic risk can kill a company and turn an entire industry on its head. Consider, for example, how deregulation has blown the lid off the long-distance phone business. This was once one of the most predictable and static industries in the United States. Today, it crackles with a continuing stream of technical innovation and mind-boggling mergers.

Deregulation changed the telecommunications business in completely unforeseeable ways. In the new, competitive environment, long-distance volume has more than doubled and the per-minute cost to consumers has dropped like a stone. Powerful new competitors like Sprint and MCI have wrestled market share away from the once-protected AT&T empire. Paging systems, cellular phones and new forms of digital communications--including the Internet--have appeared, in most cases developed by companies that didn't even exist five or 10 years ago.

No amount of data analysis can prepare a company for this form of risk, because there are no facts about the future. The only way to deal with it is for managers to elevate their thinking about risk from the tactical to the strategic level, and to improve the quality of their decision-making skills.

Head Smarts

In thinking about business structure, we can use the simple analogy of the human body: decisions made by the brain direct the activities of all other parts. No matter how fit those other parts may be, they are unable to function well if the brain is weak, confused, indecisive or out of touch with its environment. Likewise, when the organizational brain in the executive suite fails to make sense of its environment or anticipate how the world is changing, it puts the operating units at risk.

Companies in virtually every industry have spent the past 20 years becoming more and more operationally fit. Statistical quality control, customer service, time-to-market, process reengineering and other initiatives have made them leaner and more flexible. Advances in risk management have helped them negotiate important obstacles. In business-as-usual terms, they are much more capable. Unfortunately, few quality improvements have been made above the neckline, at the level of the organizational brain. The recent and much-publicized woes of Motorola provide a timely example. Not long ago, the company practically owned the world of wireless telecommunication, but it now finds itself dangerously behind in the field. Either through hubris or inattention to signals of impending change, the company's leaders failed to redirect their operations from analog to digital phones. They missed a strategic turn in the road, and none of the company's prowess in manufacturing or "six-sigma quality" has saved it from dramatic market share and revenue losses. Such are the consequences of a few bad decisions. For more evidence that executive-level awareness of risk is--to a certain degree-lacking, consider:

* In Search of Excellence, the best-selling book that helped launch the quality movement in the United States, lauded 43 companies. Within just a few years of publication, one-third of those "excellent" companies were in serious trouble.

* A disturbing number of recipients of America's coveted Baldrige Award have experienced major business reversals. The quality principles embraced by Florida Power & Light, winner of Japan's Deming Prize, did not save it from a series of disastrous attempts at diversification.

More than a few operationally fit companies blunder and fail due to misdirection from the top. They are then acquired and dismembered, and their healthy parts are harvested for transplantation elsewhere. We observed this recently in the case of Compaq Computer's takeover of struggling Digital Equipment Corporation. The healthy parts of DEC are now being incorporated into Compaq while the rest, including the staff units that failed to give clear direction to this once-great technology company, are being discarded.

Smart Principles

When smart companies encounter major forks in the road, they determine their alternatives and sort out the risks and opportunities of each. If they are unsatisfied with their options, they encourage employees to find new ones. Their methods of evaluation and selection are apolitical and objective. Uncertainty is not swept under the rug, but confronted, measured and factored into each decision, improving the odds that decisions will benefit shareholders and employees.