Risk Management Playbookon Black Swans and the Rise of Scenario Analysis

Supply chain failures across the globe and international conflicts, shortages of labor and rising input costs as well as abandoned business districts and shopping malls, and many more have rekindled interest in the management of risk for corporations. This is a trend that has been of particular interest ever since 2008’s financial turmoil compelled managers and business owners to reconsider how to plan for disruptive disruptions, often referred to as black swan incidents.

Traditionally, businesses have concentrated the efforts of risk-management around the most likely disruptions to happen. A black swan-related event however, is very unlikely. That’s why it so catastrophic. After a wildly volatile 10 years and half of volatility, current risk managers realize the need for more robust methods of contingency planning. Enter: scenario analysis.

A More Dynamic Way to Manage Risk

Traditional risk-planning models aren’t up to par with the current economic environment that presents more dispersed risk, with a longer tail. This requires “fresh thinking,” says Erik Stettler, Toptal’s chief economist. “The modeling required today should focus more on dynamic processes, inflection points, and even how to model an external event that has never previously occurred.”

Scenario analysis is now an increasingly popular framework during the pandemic. Although it employs the same statistical techniques that are used in traditional risk management, this approach shifts focus away from incidents to the impact. Instead of focusing solely on the historical data in order to predict the possibility of disruptions and devise contingency plans, the use of scenario analyses simulate the economic effects of a sequence of events. It then analyzes the results to assess the sensitivity of a company’s operating financial information against the perceived risks. For instance, it could aid a business in understanding the way that a change in the demand for its products or services might affect its cost. Risk management strategies typically are based on the response to events that are predicted while scenario analysis concentrates on the impact of operations and potential opportunities.

The result is more thorough contingency plans that result in more flexible and flexible response to unexpected events says Stettler who is a data scientist and founder of the venture company Firstrock Capital. It also encourages businesses to put less emphasis on crisis management and to think actively about ways to utilize disruptions to their advantage according to him.

Case Study on A Contingency Plan That Launched a New Product

Jason Goldstein, who joined the Toptal’s consulting platform in 2021. He was hired to assist the CFO of an expanding US soft drink manufacturer which was experiencing the effects of COVID-19 on their business. While Goldstein was not specifically hired to manage risk but he did help his client develop an approach to disruption that didn’t just ease the impact of the disease but also assisted in helping the company expand.

The client, which supplies soft drinks for convenience store struggled to ensure shelves filled with customers’ products due to supply chain issues and rising wholesale costs. Goldstein first set out to understand inventory controlby studying the sales data and generating scenarios where the distributor could replace other products and making sure that the store’s sales are not affected.

A young man sporting mask made of cloth and gray shirt, is in a store for groceries carrying a shopping basket in his right forearm. He’s looking through shelves filled with soft drinks.

Space on the shelves is an essential element in maximizing sales at retail as inventory shortages can affect a retailer’s ability keep hold of the value of real space. The analysis of scenarios helped one vendor discover a different mix of products which would allow it to hold onto shelves without compromising sales at the store. (Credit: Atoms)

After studying the financial data of the business, Goldstein created an interactive digital dashboard for salespeople, so that stores could assess the impact of experimenting with different mix of products. He also studied the potential flexibility the company could be able to use to spread out the rising wholesale costs, analysing sales data to devise strategies. He also developed an idea to cut costs by optimizing the routes of delivery drivers.

The use of financial data to make informed decisions aiding the company in making smarter decisions” claims Goldstein. “By expanding our analytical capabilities by adding more information we were able to be more strategic.

Based on this study The distributor keep its gross margins intact and improve their bottom line but but it is now anticipating a 100 percent sales growth for 2022. It is working on a plan to launch its own brand of soft drink in conjunction in conjunction with its suppliers in the world.

Identifying the Building Blocks for a Risk Framework

In order to prepare to conduct a scenario analysis, a business should be able to define the assumptions that drive its operations, as understanding the assumptions will allow you to identify potential weak points. For instance the soft drink distributor required to consider fundamental questions for example in the light of increasing input costs, do we need to take on the burden of rising wholesale and shipping costs to keep relations with our customers? What flexibility can we afford to pass on higher costs to consumers? What are the best mix of products for our biggest customers? Do we have the potential to increase efficiency by changing how we market our products?

To answer issues like these companies must be aware of the range of risks that could impede its achievement of its objectives, such as:

Cash flow and other issues with liquidity that affect your ability to fulfill obligations, get credit and many more.

Operational risk: external and internal risks that could impact day-to-day business operations

Risks to the economy: factors such as changes in stock market prices or monetary policy, which could impact a company

Risk of fraud and security: cyberattacks, data breaches, embezzlement, identity theft and theft of intellectual property such as

Reputational risk: frequently ambiguous but definitely quantifiable when evaluating the ways that negative publicity could affect credibility

Risks of compliance: changes to the law or policy that impact the way a business operates or the costs of conducting business

In addition, businesses need to realize the fact that these risks may exacerbate with each other. For instance an incident which results in identity theft could harm the company’s reputation.

Once threats are discovered, the company will be able to determine the potential cost.

Analyzing the Impacts

The next step is when scenario analysis differs the most away from conventional risk management, shifting away from reacting to anticipated events instead, focussing on opportunities and risks. This may mean looking at the financial structure of a company to determine what actions it could consider to boost its cash flow or to diversify the key suppliers. This new approach also involves more mathematical analysis than traditional risk management. It includes actions like the following:

Define the variables that could cause an interruption, such as a price shock, for instance caused by a geopolitical issue or natural disaster. Include probabilities for those events whenever they are.

Compare these probabilities with relevant data from an organization’s operations. Consider first-order and second-order impacts, like the ways that a rise or drop in prices could not only influence sales, but may also flow into other areas such as the research and development.

Find the mathematical connections between corporate risks and risk information using a spreadsheet or an algorithmic software. Make use of this data to discover how different elements of the company react to disruptions, and what areas are that need attention.

Based on this research it is possible for a business to develop contingency plans that can prepare for the most critical scenarios, not only the most likely ones. This allows a company to understand the various forces that affect the business, positive and negative, and can provide a solid and independent basis for making difficult choices.

Case Study on Powering Negotiations With Data

Michael Yarmo, a turnaround consultant in distress circumstances, conducted an analysis of a scenario for a farm that packs and distributes freshly harvested herbs to major US chain stores. In the wake of the outbreak the farm was struggling to manage increasing input costs and increasing demands from retailers including regular deliveries.

In order to survive the farm’s existence, it was necessary to figure out ways to absorb or transfer the more expensive costs. Because it was in financial trouble and in need of cash, the decision to absorb costs could affect its ability to remain in the business. However, passing the costs on was also risky since the farm wasn’t aware of the amount consumers would be willing to pay or how receptive retailers would be to increasing prices. Thus, Yarmo employed a scenario-planning approach to analyze the demand elasticity for his clients’ products which showed how much prices could go before consumers are able to resist. He also helped the farm come up with a compelling argument that it could offer to its customers, so it could present an appealing case to pass the majority price increases of its products to customers.

A close-up of a man wearing gray shirt, holding an empty plastic bucket that holds an herb garden. In front of him are the rows of other plants, that are surrounded by wires made of chicken.

The rising costs of farming and the growing demand meant that an herb seller required convincing retailers to pass the costs to the consumers. Through the use of scenario analysis this farm could be able find evidence that backed its position. (Credit: Rasa Kasparaviciene )

“[The stakeholders] were nervous about having the price increase discussion, but they had to have that conversation,” says Yarmo that was a part of to the Toptal network in the year. The information provided by the network allowed the farm to create an appealing narrative that it could then present to the shoppers at grocery stores with greater confidence.

Shaking Up the Bureaucracy

The ability to plan for the most important scenarios rather than more likely scenarios can boost the process for managing risk in a business, which for larger firms is often implemented through multidepartment committees that represent various corporate functions, according to Paul Ainsworth, a former finance executive at General Electric. “The danger with the functional approach is you tend to focus on the risk you know about,” says Ainsworth which was a part of Toptal in the year 2018. Toptal network in the year 2018 and is a specialist in interim CFO. You’re an expert in things such as commercial and safety terms and are at ease with what risks that you’re taking care of, while failing tobe aware of the things that could be blinding you.

Instead of tackling risk in isolation, businesses should conduct scenario analysis by collecting data together and creating scenarios that draw on the experiences of all employees within the organization, from front-line workers to middle managers to senior executives. It could also mean reaching out to experts or consultants like white-hat hackers who are able to test the security of your company.

Looking Beyond Crisis Management

The aim of analysis of scenarios is to provide greater flexibility and freedom within the business’s processes. For instance the analysis may reveal ways to replace fixed labour costs with variable ones making use of digital platforms such as Toptal to find skilled contingent workers or leasing desks to employees working in co-working areas instead of leasing an entire office suite or moving enterprise information technology from on-premises facilities to cloud, which is hosted by the data center of a third party.

The flexibility you’re weaving into the structure of your company,” says Jeffrey Fidelman an expert in management consulting who is focused on growth, go-to market strategy and fundraising strategies for companies in the early and mid-stage which he joined in Toptal in 2016. Toptal network in the year 2016. “This is the best method that you can manage risk.

In the end, scenario analysis will allow a business to think beyond the impact and comprehend how to use its most important capabilities, technology and alliances to not only resist disruptions, but also make use of it to create new possibilities and breakthroughs. The hinge capabilities are strengths which a business might not have thought it was lacking, or could not had the ability to fully understand prior to.

A global internship firm which Stettler advised found these hinge capabilities in the early stages of the epidemic, when travel across the globe was shut down. Should the firm followed traditional risk management methods and reacted to the shock by focusing how to reduce expenditure and staff, or how to shift its operations to a different location. Instead, a scenario analysis guided them to encourage virtual internships and collaborating with universities to create workshops for employers to adapt to a distributed global workforce.

One of the most prominent examples from the epidemic was when several distilleries of liquor in the US began to produce hand sanitizers containing alcohol due to the escalating demand caused by COVID-19.

Using Scenario Analysis to Build Resilience and Opportunity

Financial crisis of 2008 as well as the COVID-19 pandemic have made evident that a fresh method of managing risk is required. A thorough knowledge of the kinds of black swan incidents that can shake a business and a commitment to data analysis can aid businesses in coping with these interruptions, while also identifying higher efficiency.

Making the use of scenario analysis a central part of the ongoing process also helps to create an effective method of managing risk, by bringing new voices into the process that would otherwise be blocked by internal bureaucracy and politics. Additionally, by involving employees, this approach will help to elevate the thoughts and suggestions provided by the directors. This provides an outsider, more skeptical view of executives, according to Ainsworth.

This results in an approach to risk management that helps an organization become more resilient to sudden circumstances and better equipped to seize new opportunities. A business that utilizes scenario analysis won’t need to be concerned with anticipating the next disaster however, it will be better prepared to face it.

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