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Knowledge Is Power: Embracing Risk Analysis

Knowledge Is Power: Embracing Risk Analysis

How do businesses eliminate risk? The simple answer is this: They can't. It is impossible. Understand the nature of risk factors, and plan strategies accordingly. Create an environment in which the reality of risk is communicated, and employ the latest technological advances to forecast risk in order to improve the company's "risk health."

By Randy Heffernan
07/14/12 5:00 AM PT

The ever-changing nature of technological consumption, combined with the economic instability experienced since 2007, has given rise to a heightened awareness of risk analysis in the technology sector. As organizations engage in across-the-board belt-tightening, decision makers realize that the potential failure of each decision carries a heavier burden than ever before.

In the past, a project that resulted in a moderate loss in the midst of a bullish economy wouldn't necessitate a shift in day-to-day operations.

That has changed. These days, every dollar is scrutinized. As a result, lackluster investments are magnified, with attention paid to every unforeseen change and every mistake. Tech mainstays and startups alike now require a clearer forecast of a project's probability of success or failure.

Clearly, the margin of error has drastically shrunk, and organizations are paying greater attention to analyzing the risks associated with each project, investment and acquisition.

Risk Health

For any organization, the specter of risk is omnipresent. Whether that risk is clearly identified or is posing as something less menacing, the potential for fiscal disruption is constant.

So how do businesses eliminate risk? The simple answer is this: They can't. It is impossible. As was often said of basketball star Michael Jordan: "You can't stop him; you can only hope to contain him." The same holds true with risk. Understand the nature of risk factors, and plan strategies accordingly. Create an environment in which the reality of risk is communicated, and employ the latest technological advances to forecast risk in order to improve the company's "risk health."

While risk is often described in negative terms, it is important to view risk management in a more positive light. The advantages of identifying potential risk and the impact and probability that those factors may occur are many. Organizations that proactively view risk as an asset to decision-making are empowered to map out the necessary steps required to ensure success= and put the organization in a stronger position to increase the bottom line.

Communicating and Identifying Risk

Risk is multi-faceted and often difficult to identify, which makes the task of analyzing and managing it seem rather daunting. However, technology now exists to assist organizations in almost every industry to forecast risk factors and the probability that such factors may come to fruition.

But before implementing such methods, it is critical to create an environment within an organization that allows such technological analysis to accurately reflect the factors that carry the greatest risk.

Open Communication

Many organizations avoid frank discussions about risk factors for any number of reasons. If an organization is thriving, those who discover potential risk can be classified as fear-mongers or worry warts. Perhaps, the person who uncovers a potential risk factor is a junior-level staffer and is hesitant to bring this information to the forefront. In many cases, discussing risk may uncover unsightly truths about the organization that executives may want to be left hidden. Whatever the reason, avoidance of risk communication cannot exist in today's business climate.

Organizations of all types and sizes benefit from embracing risk management. Not only that, information about risk factors should be discussed across all appropriate departments. Creating such dialog may reveal unconsidered risk factors that can be mitigated before they turn into a big problem.

Identify Internal and External Risk Factors

Once dialog has been established, it is critical for organizations to transparently pinpoint and assess internal risk factors. By identifying risks that exist inside the company's walls, decision makers may learn certain practices -- and positions -- are now an impediment to forward movement.

There are many identified and emerging external factors that are directly or peripherally relevant to an organization and its stakeholders. Such risks may be too numerous to calculate from the onset, so it is best to begin by considering economic, competitive, political and regulatory developments that impact productivity and continuity in the initial assessment. For the tech industry, those factors can sometimes impact the future of an organization instantaneously. Over time, other risk factors will become apparent.

It is important for every member of an organization to contribute to the identification process, as risk factors vary across departments. For example, emerging risks flagged by the sales department may not be as easily recognizable to those in research and development.

For a number of reasons, organizations fall into the habit of just ignoring certain risk factors, but avoidance of risk is no longer a viable option for successful businesses. Each critical risk factor must be accounted for to model an accurate and impactful analysis.

Keep Risk Factors Current

Technology continuously evolves, and the risks that impact operations evolve with it. Twenty-five years ago, a downed telephone line could immediately halt productivity for just about any organization. There were no cellphones or email. Today, companies have a number of ways to communicate.

The bottom line is, certain risk factors aren't as relevant as they once were, and preparing for such risk may not be the best use of resources. Forward-thinking organizations are frequently re-evaluating and reprioritizing the risks that could create widespread impact. A stagnant view of risk makes organizations more susceptible to unwelcome surprises.

Monte Carlo Simulation and Computing Risk

Creating an organizational environment that embraces open communication and proactive identification of current internal and external risk factors will lay the groundwork to culling quantifiable risk data. Monte Carlo simulation (MSC) is a technique that can be used to simulate a variety of situations and forecast identified and unidentified risk factors.

MCS was first developed in World War II by scientists developing the atomic bomb. MCS accounts for risk in quantitative analysis and decision making through a series of repeated simulations. Since its inception, MCS has been utilized across a variety of industries, such as finance, energy, transportation, insurance and healthcare. Though powerful and sophisticated, MCS is available at the desktop software level, even as an add-in to Excel spreadsheets.

The Monte Carlo simulation builds models of possible results by substituting a range of values -- a probability distribution -- for any factor that has inherent uncertainty. It then calculates results over and over, each time using a different set of random values from the probability functions. Depending upon the number of uncertainties and the ranges specified for them, a Monte Carlo simulation could involve thousands or tens of thousands of recalculations before it is complete. MCS produces distributions of possible outcome values, and features a number of advantages over other methods of determining risk:

  • Probabilistic Results: Offers not only potential results of a given decision, but the probability that each decision will occur.
  • Sensitivity Analysis: Computes which inputs had the greatest impact on each outcome.
  • Scenario Analysis: Shows which grouping of inputs causes certain output values. For instance, one might observe that when profits are high, the significant inputs in the model were low operating costs, very high sales prices, and high sales volumes.
  • Correlation of Inputs: Allows users to model interdependent relationships between input variables, which offer an accurate view of how factors impact one another.
  • Graphical Results: Because of the data a Monte Carlo simulation generates, it's easy to create graphs of different outcomes and their chances of occurrence. This is important for communicating findings to other stakeholders.

Benefits of Monte Carlo Simulation

Because of the sensitivity of information Monte Carlo simulation can produce, an organization that employs this method will have a much greater understanding of how it is impacted by risk, specific to its unique business model. For example, risk analysis can reveal risk factors that would have otherwise taken stakeholders by surprise. Additionally, opportunities that may have never been considered are now discovered.

Ultimately, the use of Monte Carlo simulation can place an organization in position to favorably affect the overall bottom line. Risk analysis gives clear insight into which decisions should be acted upon or avoided, where resources may be wasted, what external risks need to be defended against, and what streams of income may not be available.

The presentation of information culled from MCS can be constructed in a manner that is easy for members across the organization to understand. Furthermore, having statistical proof of risk factors lends credibility to reports presented to decision-makers, and facilitates a more likely buy-in from team members.

Tech companies on the forefront are taking the initiative to proactively invest in risk analysis strategies. While doing so requires an initial investment, the cost of ignoring risk is far too great in today's competitive climate. Like all industries, the technology industry exists in an environment in which every decision must be made with cautious certainty, and the margin for error can be razor thin. Being equipped with accurate risk analysis will allow organizations to pursue a direction with the highest probability of success, and limited probability of failure.


Randy Heffernan is vice president of Palisade Corporation.


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