Risk optimisation

Release cash Reduce cost Manage risk Improve ROI

T: +44 (0)20 7605 1600 E: [email protected] W: www.4cassociates.com

Identifying OpportunitiesMany businesses misclassify risks and overly focus onthose which are either relatively low impact (such asemployment issues), or high impact, well documentedand likely to affect the entire market (e.g. theEurozone crisis). At 4C, we look at risk across two keydimensions:

· Cost: calculating how much a given eventcould end up costing a business

· Probability: how likely is it that the event willoccur (see Figure 1)

High probability/ high cost events need to bemitigated, through hedging, or building a modeldesigned to insulate the business. Often the moreinteresting opportunities are found in the areasrelating to either high or low cost, low probabilityevents. These scenarios were referred to as “BlackSwan” events, in Nassim Nicholas Taleb’s “The BlackSwan: The Impact of the Highly Improbable”. In manycases the most economical way of dealing with lowprobability/ high cost events is to simply communicatethe threat to investors and explicitly take the risk.

Risk plays an inherent role in the development of anyleading business. This is particularly true in the currenteconomic climate, where the most successfulcompanies are often those which effectively managerisk.

As the economy becomes increasingly globalised,companies are finding themselves exposed to morerisks. Tighter margins and lean, extended supplychains have further magnified the potential effects ofunforeseen events and significantly impactedcompany risk profiles. Leading businesses have reactedto these amplified threats by carefully analysing theirrisk profiles and applying new quantitativeapproaches to examining evolving hazards.

In times of austerity it is not possible to put in placecontingency plans for every potential scenario. Allbusinesses take risks and consequently expose theirinvestors (and other stakeholders) to potential losses.Recent examples include suppliers providing burgerswhich contained horsemeat and Boeing’s Dreamlinerfleet being grounded due to tech malfunctions. Bestpractice is to understand each individual risk andeither explicitly take the risk, or devise an approachaimed at mitigating it. Different industries and companies choose to manage

Risk Optimisation

risk in distinct ways. Investors are often better able toabsorb a particular risk than the company itself, aspart of their diversification. The airline industry, forexample, is made up of companies which frequentlyself-insure their own fleets. This means the investorsshoulder the potential cost of a major incident, ratherthan purchasing expensive insurance that may notprovide full compensation. British Airways is one ofthe companies which has adopted this approach.

Businesses should think hard before investing insolutions such as the hedging of commodity costs andinstead consider clearly communicating risk strategyto investors. By explicitly linking performance tocommodity pricing, investors can build a clearunderstanding of the overall risk vs. benefit analysis(this is an approach used by some food companies).

On the other side of the spectrum, some companiesare unwittingly exposing themselves to major risks.The financial crisis demonstrated the relatively smallamount of structural insurance which financialinstitutions had in place. Many companies wereeffectively self-insuring but not realising what theywere exposed to. The industry as wholeunderestimated the risks involved in their business.For example, there was a belief that the risk of defaulton mortgages in the USA should be determined on acase by case basis. In reality the probability of adefault on each mortgage was highly correlated tothe others.

Identifying RisksRisks can be identified, however, most companies failto look beyond ‘standard’ risks. Forward lookingcompanies are able to:

· Identify all of the potential threats which thebusiness is vulnerable to and theirconsequences

· Estimate the probability of each scenario

Determining the various threats facing a businessprovides a platform upon which an effective riskmanagement programme can be built. Figure 2

provides examples of some of the various types ofrisks that companies face. Many risks are interlinkedand often one event will act as a trigger for amultitude of scenarios. A case in point is the collapseof financial services firm Lehman Brothers in 2008,which set in motion a chain of events that continuesto affect companies today.

When looking to determine the probability of anygiven event taking place, we have found that astatistical approach, backed by the right data, isusually more accurate than expert predictions. NateSilver, author of ‘The Signal and the Noise’, accuratelypredicted the outcome of the 2012 USA election in all50 states. Whilst most experts were swayed bycomment and perspective on events, Silver’s statisticalapproach allowed him to foresee Barack Obama’scomfortable victory.

Generally speaking data relating to past events can, atthe very least, provide an estimate of the probabilityof an event occurring. Once the overall approach tomanaging and tracking risk is laid out, a monitoringprocess can be put in place to understand changes inthe probability of particular events occurring. On theother hand, when trying to predict the likelihood ofan event for which there is very little data, or, in thewords of Donald Rumsfeld a “known unknown”, it isbest to apply common sense coupled with statisticalanalysis.

Figure 1



Prioritising and ContingencyWhen deciphering potential risks, businesses must notonly focus on the most likely disruptions but alsothose which could have the most dramatic impact. Thenecessity of this approach is illustrated by the 2010Deepwater Horizon oil spill. In this case the NationalCommission on the BP Deepwater Horizon Oil Spilland Offshore Drilling found that; “The companiesinvolved in the Gulf of Mexico oil spill made decisionsto cut costs and save time that contributed to thedisaster”. Had these cost saving initiatives beensuccessful they would have delivered only a fraction ofthe damage caused.

When Comet went into administration late last year,their suppliers found themselves in a weak position.Many vendors were unable to recoup what they wereowed as they were low on the list of secured creditors.The probability of Comet going out of business washigh, and consequently so was the possibility thatsuppliers would make a loss. The combination of highrisk and limited potential benefits should have proveda red flag to many vendors.

Companies also make costly mistakes when overcompensating for risks. At 4C, we have seen manycases of clients over insuring. Although thesesituations typically receive less media attention, theycan significantly inhibit company growth. Workingwith a client, 4C was able to ensure significant savingsby using a less expensive solution to carry out theclient’s deliveries. Adopting the new approach meantrelinquishing a percentage of the insurance paid outfor lost deliveries. A thorough study demonstratedthat the cost benefit vs. loss analysis, justified the riskof lowering the insurance percentage.

Building a Sustainable ModelRather than purchasing insurance, adapting a businessmodel to mitigate threats is often the most effectiveway of managing risks. In 2012, dry weatherconditions in the UK severely affected crops, forcingWalkers to cease crisp production for a number ofweeks. For a company which prides itself on usingonly UK potatoes, the possibility of a more severedrought in the future represents a huge risk. Walkersresponded by investing heavily in innovative solutionsaimed at reducing dependence on water fromtraditional sources.

Projects include devising a way to harvest the watergiven off by potatoes during the cooking process andthe iCrop, a device which monitors soil moisture anduses weather forecasting data to set the amount ofwater needed to irrigate fields. These initiatives willnot only make factories less dependent on volatileweather conditions, but also provide an advantageover competitors.

Juggling Growth and Risk ManagementLeading companies are taking a new approach tomanaging threats and thinking about risk as part ofthe budgeting process. This best practice includes:

· Having a process that identifies and capturesall risks, including low probability but highcost scenarios

· Thinking about risk in a structured,probabilistic way

· Consciously deciding which risks to take andwhich to mitigate, whilst communicating toinvestors the risks that they are exposed to

By adopting this strategy, businesses are able toleverage their risk management capabilities in orderto increase efficiency and drive growth.

4C Associates has the insight, technology andexperience to drive rapid profit improvement.We offer specialist consulting, technology andmanaged services to transform your costs. Weapply industry and functional expertise to deliverexceptional benefits.

Our team works with leading organisations across arange of cost categories including Direct Materials,Services, Marketing, IT, HR, Logistics, SupplyChain, Property and FM. We apply deep practicalknowledge, combined with process and changeskills, to deliver reduced costs and increased profits.

To discuss how we can transform your costs pleasecontact us at:

Tel: 0207 605 1600Web: www.4cassociates.comEmail: [email protected]

External Risks

Natural disastersReputationaldamageTerrorism

Figure 2

Strategic Risks

New competitorMarket shrinksEconomic recessionNew regulations

Expense Risks

Loss of key supplierIncreased costsRising commoditypricesNew regulations

Financial Risks

Devalued assetsChanging interestratesSupply chainbreakdown

Some Examples of Risks

