Risk managers often face a quandary when it comes to managing costs. Cutting costs can increase risk, such as can occur when choosing to rely upon a single vendor because they offer the lowest price. It may also be felt that inadequate resources are dedicated to risk mitigation, so any new solution which mitigates risk is desirable, irrespective of how much it costs. This leads some to conflate risk management with the active pursuit of increased spending, but that is a mistake.
- Eliminating all risk is impossible because resources are always finite. The sensible approach is to determine the best tolerance for risk. Tolerances can be determined by weighing the cost of a negative impact occurring versus the cost of any policy to avoid, reduce or transfer risk. This is why risk managers should also be willing to accept risk when alternative policies are shown to be too costly.
- Overspending on the mitigation of one kind of risk will starve the business of resources that may have been better deployed elsewhere. A better sense of risk priorities may have led some of the spending to be directed towards the mitigation of other risks, with better overall results. Even if there were no reallocation of spending to other forms of risk mitigation, an impoverished business is more susceptible to risk than a business which generates larger profits and more cash.
- Innovation need not be exclusive to the part of the business which develops new products for sale to customers. Risk managers can use innovation as a way to broaden the range of risk mitigation policies available to them. The goal should be to deliver a reduction in risk that is more cost-effective than those methods that have already been tried or which can currently be purchased.
I was thinking about the misunderstandings about the relationship between risk management and cost management as a consequence of reading a recent installment of the new personal blog of Atul Jain, CEO of TEOCO. Atul writes well, and persuasively, about cost management as an ideology, and I agreed with everything he wrote, not least because my upbringing taught me to despise waste. However, it may be thought that overzealousness in cost savings leads to increased risk. There are certainly dangers in becoming so cost-optimal that a business becomes inflexible. So how do we reconcile the drive to reduce risk with the drive to reduce waste?
The correct relationship between risk and cost is determined by tolerance. Few businesses take a scientific approach to risk tolerances, but even an unscientific tug-of-war between cost-cutters and risk-reducers eventually leads to the corporate culture finding the tolerance it wants to live with. Suppose there was no possibility of anything unpredictable happening. Then a plan which incurred the lowest possible cost is also the plan with the optimal cost in every scenario. Now imagine that circumstances in the real world can deviate from the expectations from the plan. This change in circumstances can lead to additional costs, with the result that the theoretical lowest possible cost is no longer attainable in practice. One plan was optimal in a perfect world, whilst the risk-adjusted plan is optimal for our real world, in as far as we can make evaluations about how often the real world deviates from the ideal.
Sometimes I use the metaphor of racing cars to distinguish what it means to be optimal across different circumstances. The engineers who build Formula 1 racing cars do a tremendous job of optimizing every variable, with the result that different teams will complete a 5km lap with only tenths of a second separating their best times. But all their optimization is done within the context of driving on a Formula 1 track. If you were to drive their car elsewhere, you would soon discover that the optimization of a Formula 1 car is far from optimal for a road that has bumps in it, never mind when tasked to race a tractor in a ploughing contest.
True optimization involves a design or a plan that gives the best overall result across all circumstances we can anticipate. A wider tolerance is not wasteful if it makes it possible to efficiently cope with changing circumstances. A narrower tolerance is wasteful if it leads to an investment being wasted, as can occur because demands have changed and the original plan cannot be adapted. Finding the right tolerance means keeping costs to minimum whilst making sufficient allowance to cope with the bumps that may lie ahead.