How to handle risk

Drucker found that though risk cannot always be avoided or even reduced, it can be managed. This is important because potential success is frequently dependent on the amount of risk. At times, the higher the risk, the greater the payoff and chance of success. Moreover, the risk may be so obvious that a potential action may seem unlikely and be ignored by an adversary or competitor, making the strategy work because of the risk.

Two examples of risk takers

Geoffrey de Havilland’s “Mosquito” aircraft

During World War II aircraft designer Geoffrey de Havilland struggled because aluminum and steel were in high demand. In response, he designed and built a combat bomber using a plentiful but highly unlikely material, wood.

This had not been done since World War I and some thought this was impossible in modern air warfare. De Havilland eliminated all armor and defensive armament and developed a two-engine bomber that was very light, with a crew of only two. Its bomb capacity and range was of a heavy but well-armed four-engine bomber.

He named it the “Mosquito”. Capable of 400 mph it was one of the fastest planes of the war and operated effectively at both high and low levels which made it extremely versatile. Nearly 8,000 wooden bombers were built. Due to the aircraft’s speed, losses were not excessive and De Havilland’s risk paid off. Risk acceptance is as important a factor in business as in war.

Gillette’s safety razor

K. C. Gillette developed a razor consisting of a thin double-edged steel blade mounted between two protective plates to limit potential hazard and make self-shaving safer.

To eliminate the need for sharpening, the blade was thrown away when it became dull for a new blade to be used, however, this was more expensive to produce than a straight razor. In fact, Gillette had to practically give away the razors and make money only by selling blades, which was a significant risk.

The first sale was for only 51 razors and 168 blades, although a year later the company had to produce 90,000 razors and almost 13,000,000 blades to meet the demand. The risk had been significant but the product created a profitable industry.

Focusing on decreased risk can be wrong

Drucker saw that when focusing on decreasing risk, professionals in many professions frequently assumed that existing trends would continue but this was almost never true. A competitor’s action or something in nature or human affairs including a pandemic, war or the weather could change everything.

Even Drucker erred as a journalist when he predicted a continuation of the rising trend of the stock market in a newspaper article he wrote just before the Great Depression of 1929. After this experience Drucker advised managers not only to expect change but, even better, to initiate it with planned innovations and to carefully analyze and accept the right risks.

Drucker believed it not only important to take the right risks, but also to establish controls over the risks taken. He cautioned that risk control was difficult, however, due to three important characteristics:

1. A lack of objectivity
2. Results are not always controllable even if a company is focused on them
3. Measurements cannot always be exactly calculated even if they are measurable

The objectivity challenge: The “Hawthorne Effect”

The control selected at the Hawthorne Works, a factory outside of Chicago, was lighting conditions. One experiment examined the effect of increased lighting on work productivity. It was assumed that the latter would increase as wattage was increased and lighting got increasingly better and it did at first.

However, one week the wrong bulbs were used by mistake and wattage was decreased. Productivity should have declined but it improved. It was not a miracle nor an error in measurement, nor were these unique bulbs. What had happened was that workers expected the lighting intensity to increase weekly and this motivated them to work harder to achieve the expected results.

Today this is called the "Hawthorne Effect". It demonstrates that the novelty of having research conducted with an increased attention to measured results can have an impact on results. Drucker said: “Controls are not applied to a falling stone but to a social situation with living, breathing human beings who can be influenced by the controls themselves.”

Focusing on the real results

It may be relatively easy to measure effort or efficiency, but much more difficult to measure real results with the control. Drucker pointed out that it was of no value to have the most efficient design department if it was efficiently designing the wrong products.

Controls are also difficult because some results, while important to the risk, are not noted or even measurable. Even if you can predict that eventually an earthquake or a pandemic is inevitable, precise knowledge regarding the date, size and resulting damage is unknown.

Changes were anticipated with the introduction of the pocket size battery calculator. It caused the almost complete disappearance of the ubiquitous slide rule, carried by engineers and manufactured as the sole product of several established companies.

The seven risk control requirements

Drucker determined that controls must satisfy seven basic requirements.

Firstly, they had to be economical, or the cost of employing the control itself could create problems.

Secondly, they had to be meaningful in important ways.

Thirdly, they must be appropriate to what they are measuring. Absenteeism of a yearly average of 10 days per employee sounds acceptable, but if out of two employees one is never absent, the average of absences is created solely on the other one.

Fourthly, they must be congruent to the phenomenon measured. Victor Kiam, an entrepreneur, bought the failing Remington Electric Razor Company in the 1980s, which he made profitable. He wrote a book explaining his success which he promoted on television along with the razor.

His TV promotions were successful and the book sold well, but some said it offered few useful insights explaining Kiam’s success at Remington. Yet it sold more than 200,000 copies, surpassing many books on entrepreneurship published at the same time.

Later it was speculated that the author had spent almost $2mn on his TV ads. The net to the publisher was roughly 50 percent of the $30 sales price. Royalties for non-fiction books to the author at the time were about 15 percent of the net amount received by the publisher from the bookseller.

Therefore, the author had earned $450,000 in royalties, which was $1.5mn less than cost of the cost of Kiam’s advertising. He may have been willing to take this loss for bragging rights and possibly for promoting the company’s razors, but book sales contributed little to their sales. While sales numbers were typically used to represent the value of the book to the reader, it was questionable in this instance.

Fifthly, they need to be timely. Results are an expensive waste of time if the information received arrives too late to be of use.

Sixthly, they need to be simple, as complicated controls can cause confusion and lead to other errors.

Lastly, they need to be oriented toward action, because controls are not for academic interest, they are for implementing strategy and action with the appropriate risk.

The organization as the final limitation

On top of the seven requirements, the final control is the organization itself which operates with rules, policies, rewards, punishments, incentives, resources and capital equipment. Its success, however, comes from people and their daily, sometimes unquantifiable actions, such as the impact of customer interaction, morale and company policies.

While the expressions of actions, including compensation, may be quantifiable, feelings, drive, ambitions, leadership, vacations and the health of employees may be less so. As an operational system the organization cannot be accurately quantified except by results or progress toward defined goals.

Consideration of risk is essential. It is, however, important to pick the right risks and to control these while considering all factors that can affect them. Knowledge is power, or at least stored power.

Selecting the right risks and monitoring the seven important aspects of controls as identified by Drucker mean effective risk management. A manager cannot do more, nor should any manager consider doing less.

Has your business taken steps to manage organizational risk? Let us know in the comments below.

*Adapted and syndicated internationally from Consulting Drucker and Peter Drucker on Consulting: How to Apply Drucker’s Principles for Business Success.