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Business is run by making decisions.
That’s a fact.
Success depends on good decisions (or luck). Hasty decisions based on incomplete or unreliable information usually lead to poor results (even with luck).
Those are facts.
When you make decisions, whether in business or in your personal life, is a risk appetite statement relevant?
Do you have a risk appetite statement in your personal life? If you don’t have or need one in your personal life, why do you need one in your business life?
Someone commented on LinkedIn that because people have different risk appetites you need a corporate risk appetite statement. I can sort of see that. People in different positions have a different attitude towards taking risks. For example, I would hope the CFO and General Counsel are more risk averse than the head of Sales.
But does a corporate risk appetite amount or statement drive your decision-making?
Weighing Your Options
Let’s take a relatively simple business decision. (The only simple ones are where the correct decision is obvious. Even then, the obvious choice may be the wrong one when all the information is obtained and studied.)
The company is considering raising the price of its flagship product. After all, it has been two years since it changed the price, and annual inflation is now above 4%.
We need to understand the context, including:
- The market is price sensitive. Customers see this product as a commodity and changes in its price will result in noticeable changes in demand.
- Three companies compete with us for market share. They have tended to change their prices in line with us, but that is not certain.
- Our manufacturing and related costs have been increasing. Since our last price increase, our costs are up 5%.
- There is pressure from analysts and the board to increase revenue by at least 5%.
The CRO (one of the best in the opinion of the CEO) has facilitated a cross-functional meeting to discuss the options and present their analysis to the CEO for his final decision. The meeting is chaired by the CFO and attended by the heads of Sales, Marketing, Strategy, Investor Relations and Manufacturing in addition to the COO, Corporate Controller and the Treasurer.
They identify three options:
- Make no change at this time and wait to see what the competitors will do. If one or more of them raise their prices, the group will reconvene to consider their options.
- Raise prices by 5%.
- Raise prices by 10% (after all, it has been two years since the last price increase).
While this may at first glance seem to be a simple example, in fact there is a lot to consider for each option including:
- How likely is it that our competitors will follow our lead and raise their prices by the same as us, more or less? There’s a range of possibilities and their effects on our revenue, and each point in the range has its own likelihood.
- If we lead the way, how will our customers react? Will it affect their loyalty to us? How soon will we start to see the effects of a price change on orders? Again, there’s a range of possibilities and associated likelihoods.
- If we start to see a negative reaction from the market, what will our board say? What options will we have to change our strategies?
- Can we afford a reduction in cash flow? What can we do with improved cash flow? Again, there’s a range of negative and positive effects on the business.
- What can we do to minimize negative effects and improve positive ones?
You're Making Business Decisions, Not Risk Decisions
This is why I talk about an “informed and intelligent decision.”
- Informed about the current situation, what we want, and what might happen (i.e., risks and opportunities).
- Intelligent because the process of making a decision is of high quality.
Now where does risk appetite affect the decision? Not in the slightest!
There are multiple risks and opportunities for each option, and they need careful consideration and analysis.
But they are valuable information in making a business decision. The decision is not whether or not to take risk.
Also, how do you aggregate all these disparate and unconnected (in many cases) sources of risk to come up with an amount you can compare to a risk appetite?
No.
A corporate risk appetite statement is not relevant in most business decisions.
Instead, the CRO or other math whiz can calculate the expected value of each option. That can help guide the CEO in making their business decision.
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What do you think?
If you think I am wrong, please explain how you use your personal risk appetite statement in deciding whether to buy this or that house, car, washing machine, etc. Did you use your risk appetite statement in deciding whether and who to marry, or which vacation to take?
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