Drucker looks at risk

Risk in management is unavoidable, in fact, according to Drucker it may even be desirable and is the basic function of enterprise. With this in mind, how do you positively address inevitable risks while minimizing adverse affects on your business?

Drucker reasoned that economic activity, of necessity, is the commitment of present resources to an unknowable and uncertain future – a commitment to expectations, assumptions, and predictions, but not to facts.

 

The future is impossible to see, but coming nonethesless.

However future facts are essential, yet they cannot be known with certainty. Risks are not taken only by the one at the top, but by everyone in the organization who contributes knowledge to the enterprise. That is, by every manager and every professional specialist at every level.

In attempting to lower risk, managers and professionals of all types sometimes make assumptions which are certain to lead to disaster. They assume stability in the current situation or that the current trend, whatever it is, will continue unabated. The fallacy of either assumption can be seen almost every day as stock market investors make one of these two assumptions with predictably unwanted results.

Drucker made one of these erroneous assumptions himself, learning the hard way how dangerous such an assumption can be. As a young journalist for the Frankfurter General-Anzeiger in 1929, Drucker predicted a rosy future and a bull market in his newspaper column. He had to eat crow a few weeks later with an article entitled "Panic on the New York Stock Exchange." The panic he wrote about, needless to say, was the onset of the worldwide Great Depression which last for over a decade. That’s a lot better than some of our journalists today who, in print or on television, attempt to put a positive spin to make it appear that what occurred was exactly what they had predicted, even though it certainly was not.

Drucker never made the same mistake again. But he knew that risks in business and in life could not be avoided. He concluded that "While it is futile to try to eliminate risk, and questionable to try to minimize it, it is essential that the risks taken be the right risks." He learned to analyze the situation to take the right risks. Moreover he discovered a critical factor: after deciding on the right risk: one had to institute controls in ones actions in taking the risk. Otherwise, even though it might well be right risk to take, the actions might be mismanaged such that objectives are not reached and failure results.

The Characteristics of Controls

Drucker found that all controls have three basic characteristics that make them difficult to manage:

1. They won’t be objective and they won’t be neutral
2. They need to focus on the real results, but that "real" results aren’t always possible to control
3. They are needed for both measurable and nonmeasurable events

Objectivity and Neutrality

This characteristic is a cautionary note. From 1924–1932 a study of lighting conditions was done at the Hawthorne Works, a Western Electric factory outside Chicago.

One experiment was to examine the effect on productivity of better lighting. It sounds simple enough. The control was to increase wattage of the light bulbs weekly and note the results. It sounds simple enough. It was expected that productivity would increase as lighting got better, and it did.

However, some time later, some joker decreased instead of increasing the lighting intensity. Guess what? Productivity continued to improve. What had happened is that workers expected the lighting intensity to increase and this motivated them to work harder and more productively.

This is known today as the "Hawthorne effect." It demonstrated that the novelty alone of having research conducted, along with the increased attention to the measurement, could cause at least a temporary increase in productivity. And it means that as Drucker said, "Controls are not applied to a falling stone, but to a social situation with living, breathing, human beings who can and will be influenced by the controls themselves.

Focusing on the Real Results

It is easy to measure effort or efficiency, but much more difficult to measure real results with a control. Drucker said that it was of no value to have the most efficient engineering department if it was designing the wrong product.

Drucker also differentiated leadership from management, and others have adopted his formula: that management was doing things right (read efficiently) while leadership was doing the right things. However, how do we know what "the right things" are? This is much harder to know when so many factors and multiple humans are involved.

Since leadership is an art, in observation, its quality may be in the eyes of the beholder. That’s not a very objective measurement, so one usually doesn’t measure leadership by efficiency, but by absolute results. The failure or success of a leader, is determined not so much by how hard a leader tries or how efficiently he or she works but by success or failure of the event or endeavor. It’s a crude measurement when we consider that so many uncontrollable factors (resources, quality of personnel, outside influences etc) are involved. But that’s all we have!

Nonmeasurable Events, Too

Controls are also difficult because some events in an organization, important to risk, simply aren’t measurable, whether results are available or not.

We already noted that you don’t have absolute facts about the future. You don’t know what may suddenly happen. The ubiquitous slide rule, once on the person of every engineer worthy of the name disappeared almost overnight when the pocket electronic calculator hit the market.

The 7 Control Specifications

Drucker also maintained that all controls must satisfy certain specific specifications, of which there were seven:

• They had to be economical – the less effort required to gain control, the better.
• They had to be meaningful – in other words they had to be intrinsically significant or symptoms of significant developments.
• They must be appropriate to the nature of what you are measuring – absenteeism of a yearly average of 10 days per employee sounds acceptable, but what if you have only two employees and one was never absent?
• Measurements must be congruent to the phenomenon measured. As a writer I’m always interested in book sales. I once read a book by a famous entrepreneur who had written a best seller. He had bought a well-known company and promoted the company’s product frequently on television stating that "he liked the product so much, that he had bought the company." His advertising promotions were great. However, when I read the book, I found it was at best fair. Yet it became a bestseller and sold 2,000,000 copies, surpassing many better books on entrepreneurship in sales, including Drucker’s Innovation and Entrepreneurship which came out at about the same time. One day it was revealed that the author had spent almost $2,000,000 of his own money promoting the book. Now book royalties are a lot less than you might think, frequently about 15% of the net amount received by the publisher, which is roughly 50% of the price of the book. Since this entrepreneur was not the publisher, I estimated that he had earned about $1,000,000 in royalties for his total book sales. So he personally lost a million dollars. He may have been willing to pay a million dollars to have a best seller just for bragging rights. But as a control measurement, book sales alone, the most frequent tool used to measure public demand for a particular book by readers is probably an incongruent tool.
• The final three are much easier and intuitive. They need to be timely. They are an expensive waste of time if the information received arrives too late to be of use. They need to be simple. As Drucker noted, complicated controls just don’t work. Finally they need to be oriented to action. Controls are not something instituted for academic interest. They are for implementing strategy once actions with the right risks are chosen

The Final Limitation

The final limitation on controls is the organization itself. An organization operates with rules, policies, rewards, punishments, incentives and resources, capital equipment, etc. but its success comes from people and their daily, frequently unquantifiable, actions. The expressions of their actions, such as an increase in salary, may be quantifiable. However, their feelings, motivations, illnesses, drive, ambitions, etc. are not. As an operational system the organization cannot be quantified.

What It All Means?

Risk is essential. They key is to pick the right risk and then to control this risk considering the many factors which make this control difficult.