Thought leadership

Introduction

Enterprise Risk Management is a strategic level process aimed at facilitating informed decision making and alignment of business pursuit and value creation plans with stakeholder expectations.

Organizations make decisions all the time. More often than not, these decisions have underlying assumptions about future business performance, expected cash flows etc. These future assumptions are the sources of risk and uncertainty to business managers.

Some of the risky decisions organizations make include:

• Investment selection
• New product development
• Capital budgeting
• Expansion into new markets
• Mergers and acquisitions
• Business process outsourcing
• Strategic recruitment

These business decisions are always made based on an aggregated view of risk, i.e. based on a number of risk factors (strategic, financial, operational and compliance risks), how likely are we to achieve a specific strategic objective. A qualitative assessment of individual risks is usually not sufficient enough to ensure a rigorous assessment of risks to facilitate decision making under uncertainty.

Quantitative risk analysis however enables this kind of risk aggregation and therefore facilitates more objective decision making by estimating likelihood of success of risk taking activities based on a set of circumstances. Examples of outputs from a quantitative risk assessment include:

• There is a 65% chance that the building project will exceed costs by 30% thereby putting us at significant reputational risk with our financiers and other stakeholders.
• There is an 80% chance that the new company acquisition will increase sales by 40% against the targeted 60% increase in that market.
• There is a 30% chance that the expenditure estimates submitted to the budgets committee will not be fully funded.

Such kinds of outputs enable decision makers to put in interventions to maximize probability of success. The business and risk management functions should be able to facilitate this kind of risk assessment when important decisions are being made.

How can organizations perform quantitative risk analysis?

There are a number of methods that can be used to quantitatively assess the impact of risk on business objectives. The most commonly used include:

Regression modelling – This is a valuable business tool with numerous applications for risk managers including assessment of pricing risk, cost estimates etc. Regression modelling facilitate understanding of relationships between variables. It can therefore be used to estimate future performance of a business objective based on performance of other factors.

Forecasting techniques – Quantitative forecasting techniques include time series methods that attempt to forecast future performance based on historical data and causal methods of analysis, that are based on predefined cause and effect relationships between variables.

Expected monetary value – This is an estimation technique popularly used in project risk management to estimate project cost and time reserves based on best and worst case project scenarios.

Monte Carlo simulation – This is a risk analysis technique that provides the decision maker with a range of possible outcomes and the probabilities they will occur in given a set of circumstances. Advancements is computing capabilities allow for thousands of simulations to be conducted therefore increasing the objectivity of the process. Monte Carlo simulation has widespread application in all sectors and in all business areas.

Other techniques not discussed here include decision analysis, linear programming and simulation modelling, all with varying degree of complexity depending on the business need and application.

For more information and practical guidance on how you can build in more objectivity in your risk management process, contact us on info@sevenlevers.co.ke. 

Bernard Kiore, Director at Seven Levers LLP