Denice R. Preston
Do you want a risk-management strategy that boosts resilience and uncovers new opportunities? Switch your focus from predicting things to preparing for the impact.
Supply chain disruptions across the globe, labor shortages in international conflicts, and the escalating cost of inputs and abandoned business districts and shopping malls, among others, have brought renewed attention to corporate risk management. This trend has been particularly interesting since the 2008 financial crisis prompted business leaders and executives to think differently regarding how they can prepare for major disruptions, often referred to as black swan incidents.
Traditionally, businesses have focused their risk-management efforts on the most likely occurring events. A black swan-related event, by definition, is improbable, which is why it is potentially catastrophic. After a highly turbulent ten years and a half of volatility, modern risk managers know they require more solid strategies for contingency planning. Enter a scenario analysis.
A More Dynamic Way to Manage Risk
Traditional risk management models are not up to par with the changing economic landscape, which has more spread risk with a longer tail. This calls for “fresh thinking,” says Erik Stettler, the chief economist at Toptal. “The modeling required today should focus more on dynamic processes, inflection points, and even how to model an external event that has never previously occurred.”
The analysis of scenarios is now a popular method during the outbreak. It employs the same statistical analysis methods are used in traditional risk management; its focus shifts away from incidents to impact. Instead of focusing on historical data to forecast interruptions and create contingency plans, scenario analysis simulated the financial effects of a set of events. It then utilizes the results to determine the sensitivity of a company’s operating financial information against perceived dangers. It can, for instance, assist a company in understanding how changes in the demand for its goods or services can affect its cost. Risk management strategies typically respond to a pre-determined event, while scenario analysis focuses on the operational impact and opportunities.
The result is more thorough contingency planning, resulting in a more flexible and resilient response to unexpected events, says Stettler, a data scientist and founder of the venture company Firstrock Capital. It also helps companies be less focused on managing crises and more actively about ways to use disruptions for their benefit Stettler says.
Case Study: A Contingency Plan That Launched a New Product
Jason Goldstein, who joined the Toptal consultancy network in 2021, was employed to provide CFO support for a rapidly growing US soft drink company that was feeling the effects of COVID-19’s impact on its business. Even though Goldstein was not specifically recruited to manage risk, he assisted his client in developing the framework for disruption response that didn’t just ease the burden of the epidemic. However, it also aided in the growth of the business.
The client, who distributes beverages to stores that sell convenience products, could not keep its shelves filled with products with the help of supply chain issues and rising wholesale costs. Goldstein initially sought to understand the inventory management process by analyzing the sales data and generating scenarios where distributors could use alternative products while keeping the store’s sales in check.
Space on the shelves is a critical element in maximizing retail sales, and inventory shortages can hinder a company’s ability to retain the value of real space. A scenario analysis has helped a supplier discover a different mix of products, allowingit to hold onto shelves without compromising sales at the store.
After reviewing the company’s financials, Goldstein created an interactive electronic dashboard for salespeople to ensure stores could assess the impact of trying out different mixes of products. Goldstein then analyzed the flexibility a company could have to transfer increasing wholesale costs, analyzing sales data to devise strategies. He also developed an idea to cut costs by maximizing delivery drivers’ routes.
“Data-driven financial analyses helped the business make better decisions,” Goldstein says. Goldstein. “By upping the analytical capabilities with even more data, we were able to work more strategically.”
In the wake of this study, the distributor was able to not only retain its margins on gross sales and boost the bottom line of its business, but it is now forecasting an increase of 100% in sales for 2022. It is also moving forward with plans to launch its brand of soft drinks in collaboration with its suppliers worldwide.
Identifying the Building Blocks for a Risk Framework
To prepare for the analysis of scenarios, a company must articulate the assumptions that guide its operations, as understanding them can help identify possible weaknesses. For instance, the soft drink company had to look at the fundamental questions: In light of the rising cost of inputs, Should we take on increasing wholesale and shipping costs to keep relations with our customers? What flexibility do we need to pass on higher costs to consumers? What is the best mix of products for our biggest customers? Do we have the potential to increase efficiency by altering the distribution method we use to offer our products?
In addition, businesses need to be aware that these risks could exacerbate each other. For instance, an incident that results in identity theft could damage the company’s reputation.
After threats have been uncovered, the company can turn to calculate the potential cost.
Analyzing the Impacts
The next stage is where the analysis of scenarios differs most from conventional risk management, changing the focus from responding to predicted events instead of looking at opportunities and impacts. This may mean looking at a company’s financial structure to identify actions it can adopt to boost its cash balance or diversify the key suppliers. The latest method involves more excellent mathematical analyses than traditional risk management. It includes measures like these:
Examine the elements that could trigger a shock, possibly because of a geopolitical incident or natural catastrophe. Add probabilities to these factors whenever they are.
Examine these probabilities about relevant information from the company’s operations. Consider first-order and second-order impacts, like how a drop or surge in price could not just influence sales but may also flow into other areas such as research and development.
Use a spreadsheet or algorithmic software to find the mathematical connections between corporate risk data and risks. Utilize this information to determine how different elements of the company react to disruptions and identify the areas that need attention.
Based on this research, the company can create contingency plans to prepare to deal with the more critical situations, not only the most likely ones. This can help a business understand the various forces influencing its business, good and bad. It also can provide a solid and factual basis for making difficult choices.
