Operational Risk Management: A New Performance Management Imperative
Most companies still rely on planning, budgeting, and reporting techniques that have not changed since Alfred P. Sloan revolutionized the profession of management in the '30s and '40s. The pace, volatility, and technological sophistication of today's business environment has made such processes obsolete.
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As exhibit 2 indicates, the average executive team bases decisions on information that is overwhelmingly financial, historical, and internal in nature -- the exact opposite of what they need for effective management of operational risk. Nowhere is the problem more apparent than in the budgeting process. Budgeting is typically a time-consuming ordeal, the result of which is largely obsolete the day it is finalized. Moreover, organizations spend the next 12 months explaining variances by pointing to flawed assumptions made at the budget's creation. All in all, given the effort expended on it, most organizations' bud-get delivers marginal -- if not negative -- value. In many companies, the first step toward better decision-making should be to dismantle the budgeting process and replace it with a more dynamic planning system that considers both operational and financial drivers of performance while explicitly addressing risk and variability.
Some mechanisms for measuring operational risk factors are already in use today. These include quality-management standards, such as ISO 9000 and the Malcolm Baldrige award process; process benchmarks from organizations like The Hackett Group; Fortune magazine's annual Best Companies To Work For list; and SocialFunds.com's tracking of corporations' social responsibility. What is missing is a systematic, objective, and comprehensive framework that assesses all of the nonfinancial variables contributing to an organization's risk profile.
A Framework for Measurement and Management
It is no coincidence that many of the companies which have established leadership positions in their markets are those that have most effectively harnessed the power of technology to turn operational information into insight. Wal-Mart tracks the flow of product through its stores to ensure that shelves are never empty, and successful airlines monitor advance bookings and adjust pricing accordingly. Still, corporate leaders' techniques for measuring operational risk are typically developed ad hoc; there is no universally agreed-upon process.
In the future, perhaps we will have a standard measure of operational risk not unlike a Moody's or Standard & Poor's rating that provides all interested parties with an objective and credible assessment tool. Such a system might offer business managers both an aggregate corporate score and a series of more specific predictive measures, which together could form a comprehensive early-warning mechanism for trends in operational risk factors. To be effective, the framework would need several key attributes: The measurement basis would have to be objective, fact-based, and consistent to ensure credibility. The model would have to acknowledge the unique characteristics of every organization and be able to adapt to changing situations. And, above all, it would need to deliver insights that are easy to understand and actionable.
The result of such a rating system would be that business managers would make better decisions because they would understand the implications of different operational risk factors on future performance. An impossible goal? Challenging -- but not impossible. The magnitude of the challenge should indicate the potential value of the journey.
As a starting point for discussing how such a mechanism might work, consider the following approach: Building on work initially completed by Greg Hackett, I have developed a simple framework encompassing three major variables that help organizations see the level of operational risk -- and, hence, the future financial risk -- they are carrying. This framework is not designed to be exhaustive but simply to illustrate one approach that could be developed in order to gain a better understanding of the operational risk profile of an organization. The variables are:
Market structure. An organization incurs certain operational risks simply by choosing which markets it will participate in. Business complexity and revenue volatility are directly impacted by the structure of the market. Recent events in the telecommunications and utility industries offer graphic examples of how companies' operational risks can increase exponentially in a very short period of time when their market changes rapidly. Within a decade, telecom companies and utilities were transformed from staid and predictable organizations into volatile, high-risk businesses; in 1985, Enron was still a sleepy manager of gas pipelines. Similar shifts took place in the brokerage and airline industries during the '70s and '80s. The transformation was devastating for some established players (e.g., Eastern, Pan Am, TWA), but it allowed innovative new competitors to emerge (e.g., Southwest, Schwab, Fidelity).
Today, changes in market structure are being driven by several factors, including technology, the regulatory environment, and consumer behaviors. Technology is altering fundamental, long-established characteristics of industries from telecommunications to retail to publishing. Because of their ubiquity and low cost, Internet-based services have demolished barriers to entry in many markets. Assessing the impact of changing market dynamics must be a key element of any effective business planning process.
