Every decision a small business owner undertakes involves risk. Given that none of us has unlimited resources, each decision involves trade offs as we must select some options and pass on others. Even choices that don’t seem to be risky have an element of risk; by doing one activity we lose the option to pursue others (opportunity costs). Typically, risk management looks at the negative side of choices, but it’s more valuable to consider risk comprehensively.
To analyze risk, it is useful to have a methodology that can be followed consistently and utilizes as much data as possible. By having a repeatable process, decision-making can be done in an apples-to-apples method and your firm becomes accustomed to using data and a framework to drive resource allocation. It is also beneficial to have a relatively simple manner to evaluate risk that everybody can utilize and understand.
Another key factor in analyzing risk is to develop a simple and quick process to avoid getting lost in analysis. While we want to consider risk in decision-making, we don’t want it to slow the decision to the point that opportunities are lost or the process becomes a financial liability.
The standard method of risk is: risk=probability of event x impact of event. For example, if we are trying to evaluate risk for investing in a new location we could consider: risk ($) = probability of an unprofitable first year (50%) x profit anticipated ($100K) for a number of $50K for this option. When we stack a number of these options together, we can start to see where the best location might be to open a new location. Obviously, this example is simplified for clarity. In practice, you would consider the many factors involved in location selection and distill them into the above formula.
This example works well for straightforward comparisons with a number of alternatives and can be depicted nicely in a chart format. The columns will have a description of the event followed by the risk formula in the next cells. The individual rows will have the options under analysis and the totals column displays the options together. With all of the options displayed together, the input to decision-making is quite useful. This method also works nicely in project management, where the breakdown of risk into components can be tracked and reported upon.
When an option is more complex and has to be compared to other complex alternatives, a decision tree can support the risk evaluation. A decision tree takes advantage of statistical analysis (not very difficult) to compare more options and alternatives. While it’s beyond the scope of this article to describe decision trees fully, I’ll briefly review the highlights.
When building a decision tree, start with the high level options and then break each option into the appropriate high-level steps. At each step you determine what options you could follow and assign a percentage probability (likelihood) to each “branch” or alternative. When the alternatives have been developed, that last step is to assign a dollar value to the last step in the “branch.” Then you roll up each option into its value via statistics and the result is an estimated total for each option. There are a few tools available that will do a decision tree, but most are expensive and suitable for more robust analysis. Excel can be set up to create decision trees; it just takes a bit of work to create the format the first time.
To wrap this brief introduction to risk analysis and management, lets look at a number of areas where understanding risk is important.
Operations. When picking suppliers, channels, partners, etc. you can use risk analysis to compare options. How disruptive would it be to lose a segment of the chain, what impact would a channel interruption have, etc. Considering risk up front can help avoid costly breaks in the operational chain.
Compliance. Are you at risk for a compliance violation? How much effort should be put into this area versus the risk of a compliance issue? This can cover taxes, workplace liability, insurance, etc.
Project management. Many small businesses don’t embrace a project management methodology, which causes a host of problems from budgeting, performance measurement, reporting etc. Project management embraces risk analysis as a part of the process and helps track issues.
Mother Nature. If your business is impacted by environmental factors, you can plan for risk in a measured manner and smooth out any disruptions over time.
Other areas you can consider are strategic goals, building a workforce, opening a new geographical area, financial, technology, etc.
The key to managing risk is to acknowledge it, have a process to analyze it, and incorporate it into your decision-making and reporting efforts. By applying a consistent way of managing risk, your organization will begin to consider risk at all levels, but in a manageable manner that benefits your whole business. Risk will always be present; having an established means of dealing with it will give your business a competitive advantage.