The Harbour Pilot

I confess, last post I slid a little quickly over “You quantify the risks”. ‘Fraid I had to, because it is a significant subject in itself. Entrepreneurs rely on their instinct and experience to appraise risk - but this is qualitative, and sometimes a number estimate can be very helpful.

The financial markets cheat a bit – as discussed earlier, they simply use historical volatility, This may have some benefits, but also serious drawbacks from buried assumptions. In any event, it is neither available, nor useful to an independent business.

So how does an entrepreneur establish risk?

By Guess and by [your deity here]

There is the time honoured method – guess. This has some advantages – its quick, simple, and inexpensive. At least, it is inexpensive if you guess right, otherwise it may be very expensive. The problem is that there is usually little attempt to test the guess properly, by questioning the assumptions you operate under. There is also the reality that you have limited information, and have no analysis to figure out what information might be helpful, let alone where to get it.

Get Other People’s Guesses

Well, this might be an improvement, in that it might get you a different view. Of course, other people have handicaps similar to yours, and so on you have no certainty that their opinions are better than yours. On top of that, they don’t now your business as well as you, and so their opinion may not accommodate the features you bring to the table. Lastly, who are you gonna ask? Your brother, your banker, your spouse, a friend? What is the pool of expertise available to you

Ask a Consultant

I’ m probably biased, but frankly (having been one) they suffer most of the handicaps of “Other People”, and you get to pay for the pleasure. If you are at all like me, I work too hard for my profits to buy advice that doesn’t really help me.

Risk Analysis – Applied Guesswork

Here’s how I do it. Get an envelope – all right a piece of paper. Start with your revenue side, and list what product you will be selling, how much of it, and to whom. List the price point for the product. Identify your competition. Identify the date you expect to start selling. For each of these points, put down three columns. The first is very negative, what you might consider a failure. The middle column is what you consider to be your best guess. The last is the level at which you would feel things were going reasonably well – not ecstatic, just pleased.

Next take a red pen, and note for the negative column what things might cause results to be in that column. These will be your typical sources of revenue risk. Some examples are;

• one of my top three distributors won’t carry the product because of a competitor
• I have to discount my product to buy floor space, since the items are bulky
• I might be late hitting the seasonal market by two weeks, reducing the stocking demand
• 3 of ten items might not fit the market channels I have

Tackle materials in a similar way. What are you buying, from whom, at what price. Your three columns in this case are fiasco, damaging, and acceptable. The base assumption here is that supply is at least acceptable, if not better in some ways, such as cost reductions, feature enhancements, reduced inventory stress and so on. Using the red pen, make notes of what might cause things to enter your three columns. Examples might be;

• my supplier goes bankrupt
• my supplier fails to deliver on time
• my supplier sells more cheaply to my competitor
• the quality of the supplier’s product is sub-standard
• the supplier cannot or will not hold the price

Next we turn to investment in assets. What new assets do you need, where are they coming from, how much will the cost, and what is their productive rate. Once again, make three columns. This time the columns need to be fiasco, fix cost, and adequate. Odd choice, you say. Well, the middle column, “fix cost”, reflects the fact that a piece of equipment may not perform as expected, but is salvageable. Usually you will need to move it to the adequate column, and doing that typically costs money.
Once again, write down in the columns what things might cause this placement. Some examples here are;

• my new NC fabricator needs re-programming frequently, at a cost of $2,000
• I can’t get replacement parts for my chain manufacturing machine
• my pizza oven won’t hold temperature properly, ruins product
• my delivery truck is a lemon
• the ceramic kiln is using 20% more energy than manufacturer spec’d
• my overhead bridge crane continually blows fuses on the winch motor

For each of these pieces of paper, take a pencil, and give each source of risk a likelihood factor – yup, right out of your head. Next for the middle column, make another guess about how much it will cost you to fix the problem, or alternatively, how much it decreases profits in dollar terms.
Ready for the last step in part I? Add up all of the percentages in the fiasco columns – these are risks that cannot be mitigated or reduced. The catastrophic risk is the sum of this column. Next you can tackle column two – for each item multiply the likelihood of the problem and the associated cost or loss. Add them up.

You now have two numbers. The first is a percentage, the second is dollars. Multiply the fiasco risk times the total amount you expect to invest – the weighted risk loss. Add to it the risk mitigation costs/losses. The number you now have is the total weighted risk loss. Compare this to how much you expect to make from the project – the percentage is your first pass at establishing a risk level.

Application Case

I roughed out some of the items above based on the following scenario. An existing distributor of consumer items through chain stores is bringing in a seasonal line of ten items. Expected sales levels are 1,000 units at $50 each, on a cost of $20 per unit. Total revenue expected to be $50,000, gross profit of $30,000, and the investment is $4,000 for marketing collateral.

I have estimated that the risks are
Revenue

• 3 bad items : 20% with an impact of $15,000 revenue reduction – $3,000
• 1 chain store drops out: 5% with an impact of 20% loss of profit - $ 300
• late hitting the market: 10% likelihood loss of 20% of profit - $ 600
• floor Space discount of10% : 10% likely 10% profit fall - $ 500

Materials

• supplier bankrupt : 3% likely, wipes out investment, plus $10,000 cost - $14,000
• late delivery : 10% chance loss of 20% of volume - $ 600
• supplier can’t hold price : 10% likely $5 per unit increase - $ 500

Delivery truck

• truck unreliable : 15% likely rental costs of $5,000 - $ 750

This would give us a 3% catastrophic risk costing us $14,000, plus a weighted risk-cost of $6,250 in losses or mitigation. Relative to the potential profit, the combined risk-cost is some $7,000 or about 23% of the project gross return. This is the risk benchmark.

Refining Your Risk

Ahhh, but we are not finished. We now have a list of potential risks and their impact. Our job as entrepreneurs is to work that list, find ways to reduce the likelihoods, develop contingency plans to deal with those we cannot reduce directly, and so improve our picture.

Now take this list to someone who can provide insight into the specific source of risk, and you have a way to obtain valuable assistance. Note that each sector has its own unique risks, and experience with them. The hospitality sector has shrinkage, and lawsuits from over-serving clientele. The retail sector has inventory writedowns from changing fashions. Manufacturing operations have risks from multiple materials. Construction has the risks of strikes. Service companies have the risks of unreasonable and dissatisfied patrons. No one shoe fits all.

Elaborations

There are more advanced methods of doing these analyses, nor are they conceptually harder than this approach. The next step up is building a spreadsheet model of the proposal, using variables for things like price per unit, cost per unit, and sales levels. Adjusting the variables can demonstrate the impacts more clearly, including variables that work against each other. Further up the scale, simulations can provide more insight, but they are fairly complicated.

At the end of the day, it is the judgement of the entrepreneur in considering the likelihoods, and their creativeness that helps risks go away, that define success.