A good friend recently came into some money and wanted to invest it all in his life-long dream – Mr Whimsy’s Ice Cream Emporium!
He asked for my advice, since the seller had suggested he would make £20,000 over a 100 days of summer by selling 100 ice creams a day at £2 each, and believed he could make almost double that if everything went well.
Being a friend I pointed out that there are a number of risks and uncertainties he needs to consider, including risk ‘events’ such as the van being stolen or vandalised, or the volume of sales varying due to location. I proposed we model the parameters associated with his decision. With coffee, croissants, and a spare 30 minutes we made a start…
The first thing we did was note the important parameters to be modelled including the risks and uncertainties associated with this particular investment decision. Being our first-pass at this analysis we kept it simple, knowing we could dive deeper into areas of interest later if warranted.
Along with the length of the summer season (100 days), our list of parameters were:
Weather – Ice cream.. Weather.. Sales.. Obvs. For Mr Whimsy, good weather would result in sales up by a quarter; poor weather would lead to sales falling by half.
Supplies – Ice cream is perishable and supplies could be hit by events such as manufacturer disruption, transport and warehousing issues. Any disruption will immediately impact on sales.
Ice cream dispenser – The dispenser is unreliable and if a part that is out-of-stock fails it could take up to a week for a replacement to be available. The van is more reliable, but if it were to breakdown, be stolen or vandalised, it would take at least a week to repair and up to a month to replace.
Price – Ice creams usually sells for £2 each, while securing a good pitch at a popular tourist site would mean Mr Whimsy could raise prices 10%. However in the wrong spot he would have to cut prices by a quarter.
The above covered the primary risks and uncertainties; we didn’t include the likes of accountant fraud or terrorism, accepting these risks did not require probabilistic treatment on this occasion.
Next we went through a process of identifying simple scenarios – pessimistic and optimistic – for each of the parameters listed, capturing a credible estimate of the impact and likelihood associated with each. This was done using plain and simple measures such as cost, percentage change and days lost, measures for which my friend felt comfortable providing an estimate.
So far, so easy. Mr Whimsy said this was quite different from his previous experience assessing operational risks at work, where he would be asked to associate poorly expressed events with a number between 1 and 5 in order to produce a score which frankly meant nothing to him nor anyone else. Heat maps. As risk professionals we must stop their use; they are bad – worse, they are dangerous. They are not credible and they damage risk’s reputation as a discipline. No more heat maps. Stop using them today.
I explained to my friend we now had all the information we needed to calculate how many sales he could expect over a summer, along with an order of magnitude range of upper and lower limits.
I explained that given the uncertainty factors he should expect sales to be around £16,000, however they could be as low as £3,000 or as high as £27,000 and he should invest accordingly.
Mr Whimsy was delighted with the output; he recognised this as a crude but credible estimate of the expected revenue, along with plausible upper and lower limits. This was information with which he could make a decision. He recognised the transparency of the approach since the numbers presented were based directly on his input, and parameters could be explored and revised to consider alternative scenarios.
Mr Whimsy bought his ice cream emporium! In order to mitigate the risks identified he bought a second fridge for stock, serviced the dispenser, bought comprehensive insurance and secured himself a pitch at a weekly antique fair!
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