Managing Uncertainty for Market Advantage

Modeling Uncertainty to Gain Better Insight and Create Value

Gary Lynch, founder and CEO of The Risk Management Project, proposes that uncertainty is the new normal and that firms that espouse risk management can create and preserve value. In this article, Lynch describes how his firm used quantitative models to assist a manufacturer assess how it should respond to a competitor’s price-reduction strategy and how the strategy would impact the supply chain. The analysis enabled the manufacturer to share the insight with suppliers that challenged the sustainability of the competitor’s strategy.

Business executives often ask me: “What do I get in return if I do a good job managing risk?”  Translation: What is the measurable and tangible value of an investment for a specific risk initiative?   (i.e., an investment in time, management attention, capital, and/or resources)  Will the investment lower the cost of goods sold? Improve profitability?  Will it accelerate growth?  Will the implementation of risk programs, assessments, monitoring systems, and broader capabilities provide greater market advantage?

Professionals  that have dabbled in the risk profession know how difficult it is to quantify the measurable value of a risk program.  Many times the risk manager will resort to quantifying the “what if” of not managing risk.  In these instances, the risk manager asks, “What if we do not diversify our supply base?”  On a personal level, we justify investments in risk transfer products, such as insurance, simply because it’s either mandated or because it’s been generally accepted as a smart thing to do.   Although we might complain about excessive premiums, we rationalize the return on investment and purchase auto insurance to protect our financial well-being in the event of an accident.  Our goal is to mitigate a potential loss to a third party or limit our liability.  In the case of auto insurance, we buy the policy to minimize the out-of-pocket expense in the event of a major event and to get our automobile back in service as quickly as possible.  We refer to this mindset and associated decisions as value preservation, and it represents the majority of today’s risk activities, attention, and expense.

However, hyper-competitive market conditions, geo-political volatility, and continuous technological change create greater uncertainty.   Managing the uncertainty can be perceived as a nuisance or worse, disruptive and costly.  However, the effort can become an asset if the organization can gain a thorough, measured understanding of uncertainty as part of their value- creation process (i.e., innovation or business change initiative).  As Mario Andretti, the famous racecar driver once stated, “Whenever you’re aggressive, you’re at the edge of mistakes.”  Those mistakes must be minimized.

Uncertainty and risk are non-negotiable; they will always be present, so how does the organization leverage this capability and gain market advantage? Back to the original question, “What do I get if I manage risk better?”  What is my return if I favor caution over aggressiveness?  The answer, or benefit, is derived from gaining a more precise, measured understanding of how uncertainty can affect your desired outcome or expected return, early in the value creation process.  More importantly, it begins with a change in attitude and context, or having a better crystal ball than your competitors.  This is evident in the response to the question, why do we have brakes on automobiles?  Most would say to stop or slow down (preserve our value).  However, I will once again reference Mario.  As someone who pushed the limits, his context and attitude reflects the way business is managed today; his response, we have brakes on cars “to go faster.”

The following example demonstrates how the CEO of a mid-size industrial manufacturing company gained market advantage by aggressively managing uncertainty as part of the value- creation process.   His customer was a global distributor of a broad range of industrial products.  This customer managed its supplier risk by diversifying its sourcing between two main providers of this specialized product.   After many years of being content with a nearly even split, a competitor decided it was time to gain greater market advantage by reducing the price of their products by an average of 20 percent.  This was a somewhat risky strategy since there was no turning back; once the lower-priced product was offered, the buyer would have the expectation that this price level could be sustained.   The competitor assumed it could achieve a 30 percent reduction in cost of goods sold by migrating manufacturing of the product to Mexico.  Further, the competitor assumed that the majority of that savings could be returned to their customer and that it could capture another 5-15 percent market share.  Now, typically what happens in this situation is that the competing company matches the price move and the consumer savings. When that happens, the product becomes commoditized, and in the process, the response potentially leads to a lowering of the barrier to entry for their competitors.

In this situation, the CEO responded differently. This CEO took a different approach by incorporating the value of managing uncertainty in the decision to gain market share and protect already thin margins.

Sustainable Market Advantage

The CEO of the subject company decided that he needed to thoroughly understand and quantify the potential opportunity and performance impact of uncertainty over a three- to five-year time horizon.  First, the investment needed to migrate capacity to Mexico was quantified and the performance expectation was established.   Next, uncertainty was introduced into the model and analyzed over the same three- to five-year period.   Finally, data was collected, and the risk of the uncertainty for each scenario was modeled to restate what the anticipated performance expectation.

The result of analyzing uncertainty early in the value-creation process revealed that the competitor’s reduction in price was not sustainable by either his company or other competitors in the market.   The analysis suggested that over a very short period of time, the market advantage would evaporate, and it would create a bigger pricing/margin issue.  Significant and rapidly increasing expense would be incurred in order to manage risk in a newly configured supply chain.  For example, additional overhead would be incurred throughout the product life cycle in order to manage a variety of regulatory, environmental, asset, security, and safety risk.   Another concern arose as a result of stress testing the new supply chain.   Here, the analysis revealed a significant increase in the probability for a business disruption (the analysis could not determine exactly when but almost certainly that it would happen). It was concluded that the savings would evaporate in eight months and that either the buyer, or worse, the CEO’s organization—if his company matched the competitor’s strategy—would have to absorb the extra expense (or exit the business).  The CEO shared the results of the analysis with the buyer and used this information as leverage to protect the advantage it had. Specifically, he requested that the buyer challenge the competitor on how they would sustain their business with this extra expense.  The other question that arose was whether quality would be spared.

Conclusion

Uncertainty exists at the intersection of any opportunity and an expected return.  Adopting a practice to address and price uncertainty as part of value creation, i.e., when a significant business or operational change occurs, will potentially offer the organization a market advantage.

Gary Lynch is founder and CEO of The Risk Project, LLC, a Mendham, New Jersey, global risk advisory and research firm. He is the author of two books, At Your Own Risk (Wiley 2008), Single Point of Failure: 10 Essential Laws of Supply Chain Risk Management (Wiley 2009), and was a contributor to Supply Chain Disruptions: Theory and Practice of Managing Risk. In 2012, Mr. Lynch was appointed a senior research fellow for the Supply Chain Management Center at the University of Maryland’s Robert H. Smith School of Business. In 2012, he was also named as a Top 25 Information Manager by Information Management. Mr. Lynch can be contacted by e-mail at Gary.Lynch@theriskproject.com or by calling (862) 812-2176.

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