An Engineering Approach to Risk Analysis

Instead of reflecting on the unlikelihood of rare catastrophes after the fact, Elisabeth Paté-Cornell, a Stanford professor of management science and engineering and risk analysis expert , prescribes an engineering approach to anticipate them when possible, and to manage them when not.

Kelly Servick is a science-writing intern at the Stanford University School of Engineering.  In a recent article, she reviews the work of Elisabeth Paté-Cornell in this subject area. Click here for Ms. Servick's article.  Click here   for the link to Elisabeth Paté-Cornell's paper on the subject.

Ms. Paté-Cornell argues that a true 'black swan' - an event that is impossible to imagine because we've known nothing like it in the past - is extremely rare. (Reference "The Black Swan" by Nassim Nicholas Taleb.) The terms "black swan" and "perfect storm" have become part of the public vocabulary for describing disasters ranging from the 2008 meltdown in the financial sector to the terrorist attacks of Sept. 11, 2001. But using these terms too liberally in the aftermath of a disaster is really just an excuse for poor planning.

Her research on risk analysis was published in the November issue of the journal Risk Analysis.  Here she suggests that other fields could borrow risk analysis strategies from engineering to make better management decisions, even in the case of once-in-a-blue-moon events where statistics are scant, unreliable or even non-existent.

A true "black swan" – an event that is impossible to imagine because we've known nothing like it in the past – is extremely rare. The AIDS virus is an example. More often, there are important clues and warning signs of emerging hazards (e.g., a new flu virus) that can be monitored to guide quick risk management responses.

The 9/11 attack was not a black swan as the FBI knew that questionable people were taking flying lessons on large aircraft. 

Similarly, she argues that the risk of a "perfect storm," where multiple forces join to create a disaster greater than the sum of its parts, can be assessed in a systematic way before the event because even though their conjunctions are rare, the events that compose them – and all the myriad events that are dependent on them – have been observed in the past.

An engineering risk analysis is based upon systems, their functional components and their dependencies. For instance, many plants require cooling, generators, turbines, water pumps, safety valves and more all contributing to making the system work. Therefore, the risk analyst must first understand the ways in which the system works as a whole in order to identify how it could fail. The same methods can be applied to medical, financial or ecological systems.

Paté-Cornell says that a systematic approach is also relevant to human aspects of risk analysis.

"Some argue that in engineering you have hard data about hard systems and hard architectures, but as soon as you involve human beings, you cannot apply the same methods due to the uncertainties of human error. I do not believe this is true," she said.

In fact, she and her colleagues have long been incorporating "soft" elements into their systems analysis to calculate the probability of human error. They look at all the people with access to the system and factor in any available information about past behaviors, training and skills. by doing this, she has found that human errors, far from being unpredictable, are often rooted in the way an organization is managed. "We look at how the management has trained, informed and given incentives to people to do what they do and assign risk based on those assessments." 

Paté-Cornell has successfully applied this approach to the field of finance, where she has estimated the probability that an insurance company would fail given its age and its size. She has found that companies need forward-looking models that their financial analysts generally did not provide. Traditional financial analysis is based on evaluating existing statistical data about past events - like trying to drive by only looking in the rear view mirror.

In her view, analysts can better anticipate market failures – like the financial crisis that began in 2008 – by recognizing precursors and warning signs, and factoring them into a systemic probabilistic analysis.

Medical specialists must also make decisions in the face of limited statistical data, and Paté-Cornell says the same approach is useful for calculating patient risk. She used systems analysis to assess data about anesthesia accidents. Based on her results, she suggested retraining and recertification procedures for anesthesiologists to make their system safer.

"Lots of people don't like probability because they don't understand it," she said, "and they think if they don't have hard statistics, they cannot do a risk analysis." In fact, we generally do a system-based risk analysis because we do not have reliable statistics about the performance of the whole system.

 

Economic Outlook

TEC Midwest relies on the economic forecasting of Brian Beaulieu with ITR Economics.  Why?  Because he has been so often right.  On September 25, 2012, he spoke to a group of TEC Chairs, TEC members and others at the annual Baird – TEC Luncheon in Milwaukee.

Here are my notes from that presentation.

Summary

1.   If there is a new market for your company, go for it.
2.    Be very cautious about hiring except to support your new market initiative.
3.    Look at China as a potential market, but seek competent advice before entering.
4.    The election will not impact the 2014 recession – the stage is already set.
5.   Obama will most likely win so “deal with it”.
6.   Your imagination and personal energy are the only things holding you back, not the government or the economy.  

Details

US Economy as a percent of the World’s GDP (~$70 trillion) is still the largest though down to 21.7% from 25% a few years ago.

US employment is on the rise as companies have finished “right sizing”.  However, there is a 6% structural unemployment as a result of people not possessing the right skills to fill open jobs. 

We will have a mild recession in 2014 beginning 4 quarters after mid 2012 regardless of who wins the election.  Our election will not be an economic game changer regardless of who wins

Housing is doing better than Brian's forecast of a year ago.  He expects it will be flat to up slightly during the 2014 recession.  First time buyers are being held back by student loan debt.

Leading indicators are up suggesting 2 to 4 more quarters of growth.

Liquidity is not a real issue with $2 trillion on corporate balance sheets.  The will contribute to a solid recovery in 2015 through 2017.  China is also building liquidity so the 2014 recession should be soft.

Brian sees a substantial downturn after 2017.

QE3 will continue to keep interest rates low and bond prices up – but beware, a bond bubble is being built.

Banks lending is up strongly but only to clients with good credit.

Retail sales are up 25% year over year and the Christmas buying season is expected to be good assuming retailers don’t skimp on inventory.

Deficit spending continues as sequestration of funds merely slows the rate of growth in government – no true cuts.

Bush tax issue will be pushed off until April to let the next Congress deal with it.

Taxes will go up but question remains “on whom?”

Oil in 2013 will reach $120 per barrel if Iran should turn into an open conflict.

Food prices will continue to go up.  Meat prices are currently low as farmers send their life stock to slaughter because of high fed prices.  They will go up once this herd culling is concluded.

Energy and food prices won’t impact Fed policy.

Health care has become a social right regardless of who is elected our next President.  The issue that 80% of a person’s life time health care cost is incurred in the last two years of life will have to be dealt with. 

The deficit as a % of GDP is a “train wreck” coming and will be exacerbated by the growth is health care costs.

The stock market will have a significant downturn in 2014.

The EU will find a way to survive.

Our dependence on foreign oil continues to decline even without a clear energy policy.  And about half of the 45% we now import comes from Canada.

Energy distribution is a growth area – getting energy from its source to population centers.

US productivity continues to improve due to capital investment, which remains cheap due to low interest rates.

Manufacturing as a percent of GDP is now 12.2% up from 11% in 2009 and is expected to continue to grow.

Interest rates will remain low through the 2014 recession.  Then rates will go up and the bond bubble will burst.

Is Trust Important to Organizational Success?

In a recent posting in Working Knowledge published by the Harvard Business School, James Heskett, HBS Professor Emeritus raises some interesting questions about the impact of trust on organizational performance.

Well known thought-leaders such as Chris Argyris and the late W. Edwards Deming argued years ago that trust is an essential condition for good performance. Most of us intuitively believe that there are economic benefits that trust may impart to an organization. These include` higher morale, increased loyalty to the organization, more delegation of authority, and greater assurance in transacting business faster and cheaper. Professor Heskett states that while this may be true "there is surprisingly little hard evidence to support these assumptions".

He goes on to point out that 30 percent to 69 percent of employees in the organizations he studied, agreed with the statement, "In my office, management is trusted,"  a wide range to say the least. Coincidentally, these numbers coincided with the financial performance of each organization, but he cautioned that his data base was not sufficiently large to be statistically significant.

Based upon comments from the readers of Working Knowledge, I conclude what I already believed - that trust is difficult to gain and easily lost. Professor Heskett goes on to suggest that trust is engendered by the process of setting and meeting expectations. Conversely, it is lost by setting and then not meeting expectations.

"Knowledge sharing would seem to foster trust as well. Other research suggests that trust may be associated with managers who hire, recognize, and fire the right people. At an organizational level, an aversion to letting people go in bad times may be associated with higher levels of trust."  This suggests that a "no surprises" approach to management would be beneficial in gaining and preserving trust. Again Professor Heskett cautions again that "there is not much good data on which to base a conclusion".

These thoughts regarding trust in organizations suggest that building trust should not be difficult. " It should be pretty simple, in fact. Don't create expectations that can't be met; share knowledge; hire, recognize, and fire the right people; be consistent and predictable; and avoid large-scale layoffs as much as possible."

Click here to read the entire article.

OSHA Inspections: Protecting Employees or Killing Jobs?

OSHA, the federal agency responsible for enforcing workplace safety, has been a center of controversy for many years. The old joke is that OSHA is not a small town in Wisconsin. 

Some new research by Harvard Business School Associate Professor Michael W. Toffel and his colleague David I. Levine suggest that OSHA may in fact have a positive influence on business. They analyzed data from California OSHA after Cal-OSHA decided to conduct randomized inspections of workplaces in addition to normal investigations of accidents and complaints.  Toffel and Levine found some interesting findings. They include:
•    Companies subject to random OSHA inspections showed a 9.4 percent decrease in injury rates compared with firms that were not inspected.
•    There was no evidence of any cost increase to inspected companies for complying with regulations. Rather, the decrease in injuries led to a 26 percent reduction in costs from medical expenses and lost wages along with a commensurate lowering of workman’s comp insurance premiums.
•     The findings strongly indicate that OSHA regulations can actually save businesses money.

I would tend to agree.  A safe workplace is good for business.  The human side is less accidents.  The financial side is less lost time and lower workman's comp premiums.  However, government tactics of fear and intimidation were never something I favored during my career as a business operator.

The authors observed that until now, there has been little solid evidence to support arguments for or against OSHA.  The effectiveness of government regulation on business in general has become a political football this election year. Advocates hold that regulations are necessary to protect public health and safety, while critics see them as arbitrary and costly to business.  The authors chose to take a closer look at the Occupational Safety and Health Administration because they had data from California OSHA that had not been available until now.

OSHA typically inspects those companies most likely to have problems, often following accidents and complaints, thus creating statistics from companies that are worse than average.

At the same time, when problems are resolved, there's no way of telling whether the inspections themselves helped fix them because a company with a bad safety experience in one year usually improves the following year even without an inspection.

Then California OSHA decided to conduct randomized inspections of workplaces, and Toffel and Levine realized they had the perfect real world experiment to settle the debate over workplace inspections.

Their most surprising finding is that inspections worked. Compared with firms that did not get a random inspection, the companies subject to random inspection showed a 9.4 percent decrease in injury rates. Just as important are the findings about the costs to companies of complying with regulations. The researchers found no evidence (within the margin of error) of any additional cost to businesses that had been inspected. In fact, quite the contrary: the decrease in injuries led to a 26 percent reduction in costs from medical expenses and lost wages. And those costs were felt immediately by the reduction of the firm's workman's comp insurance premiums.

In other words, according to Toffel and Levine, those who charge that OSHA regulations cost business money have it completely wrong. In fact, the regulations save money. The magnitude of the results surprised even Toffel and Levine, who expected perhaps a small savings if any. But the strength of the findings, they say, should persuade even skeptical critics.

The authors note, as they should, that a single study cannot settle the debate over all government regulation, or even the debate over OSHA. This study is limited to one regulatory agency in one state; other states and other agencies could show different results. One thing the research does show, though, is the value of randomized inspections as a way to help gauge regulations' effectiveness.

To review the complete article, which was written by Michael Blanding and appeared in the May 21, 2012 issue of Working Knowledge, click here.

A Parable of American Competitiveness

In the February 6, 2012 edition of Working Knowledge, Dina Gerdeman interviews Harvard Business School Professor Willy Shih and former President of Eastman Kodak's digital imaging business for several years.  Professor Shih makes the following observations:

• Outsourcing has chipped away at America's what he calls “industrial commons”.  I prefer the more descriptive term “tribal knowledge”.  In either case, it means the collective R&D, engineering, and manufacturing capabilities that are crucial to product innovation and new product development.

• Unless the US Government increases its support of scientific research and collaborates with the business and academic world, United States will continue slipping further in its ability to compete on the industrial stage. 

My concern is twofold.  We should not rely on the Government to fix this.  This is principally a free market issue, although the Government can certainly help. 

Secondly, we have seen that there is a difficult balance between the Government picking winners (and unfortunately losers) and letting free markets work.  The Government should invest in the research and let the markets through business people and entrepreneurs pick the winners.

From his experience at Kodak, Professor Shih saw that when American companies move pieces of their operations overseas to achieve cheaper manufacturing and labor costs, they often risk moving the expertise, innovation, and new growth opportunities as well.

Disastrous fallout

Outsourcing manufacturing operations has been occurring for decades, based on the assumption that moving grunt work overseas wouldn't affect US companies' competitive edge in the global marketplace. But Shih says that this assumption is wrong, and the fallout has been disastrous.

In reality, developing and executing a manufacturing process often sparks ideas that lead to creation of innovative new products. So when American companies allow the production of high-tech products to disappear from the local landscape, they also inadvertently risk losing expertise to produce the next generation of cutting-edge products.

Executives who defend outsourcing argue that there aren't enough American workers with the right skills or American factories with the same speed of production found in other countries. And besides, by moving work outside the United States, they contend that enough profits can be generated to stoke innovation at home.

I would add that if these two issues are in fact the problem, it begs the simple question “why is this?” The problem for US policymakers and companies competing in a global marketplace is this: How do we get enough American workers with the needed skills?  Once that issue is solved, the speed of production question becomes a simple matter of investment. 

 

Heading upstream

Shih says letting go of the design work is dangerous because it could block American companies' chances of designing the newest high-tech products and learning from those experiences. 

The United States didn't always allow technological innovation to run adrift. In the 1960s through the '80s many high-tech products could only be found in the United States. These successes were due in large part to government investment in basic science research and mass production.  The US Space Program, which is now being significantly reduced, is a prime example.

Government's role

Shih continues that if the United States wants to keep from slipping further in its ability to compete on the industrial stage, the government must increase support of scientific research and collaborate with the business and academic world. In addition, government officials and business leaders need to map out a long-term plan focused on efforts to keep important capabilities in the United States with the idea that they might bear future innovative fruit.  I would add that collaboration in the area of education to assure that American workers with the skills needed for today’s and tomorrow’s needs are available. 

Outsourcing by itself is not evil, Shih says. In many cases it makes perfect sense, but "we need to be more thoughtful and take a more sensible approach."

Shih concludes that US companies need to continue making long-term investments in R&D, and at the same time, management needs to stop "exaggerating the payoff and discounting the danger" of outsourcing production and cutting R&D.

"The United States is still the world's richest and largest economy. But at some point we need to have a discussion on the national agenda about what kinds of capabilities are important for the United States in the twenty-first century, and we need to invest in them.”

Click here for Gerdeman’s complete article less my insightful comments.

The Most Common Strategic Mistakes

In her new book, "Understanding Michael Porter: The Essential Guide to Competition and Strategy", Joan Magretta, Senior Associate at the Institute for Strategy and Competitiveness at Harvard Business School, distills Porter's core concepts and frameworks into a concise guide for us who run businesses.

In an interview with Professor Porter, Ms. Magretta asked him what he sees as the common strategic mistakes that companies make.  Here is a summary of his response:

1.  Trying to compete to be the best by going down the same path as everybody else and thinking that somehow you can achieve better results. This is caused by confusing operational effectiveness with strategy.
2. Confusing marketing with strategy by building strategy around the demand side of the equation and focusing on the value proposition. A robust strategy requires a tailored value chain or supply side element as well. Strategy links choices on the demand side with the unique choices about the value chain or supply side. You can't have competitive advantage without both.
3. Overestimating your strengths. This creates an inward-looking bias. For example, you might perceive customer service as a strong area. So that becomes the "strength" on which you attempt to build a strategy. But today, everyone has good customer service or they parish.  The same can be said for quality.  So a real strength for strategy purposes has to be something you can do better than your rivals. And ‘better’ because you are performing different activities than they perform because you've chosen a different model than they have.
4. Getting the definition of the business wrong, or getting the geographic scope wrong.
5. The worst mistake—and the most common one—is not having a strategy at all. Most executives think they have a strategy when they really don’t, at least not a strategy that meets any kind of rigorous, economically grounded definition.

Click here to read the full article.

Workplace Motivation

In motivating your workforce, social comparisons can be more important than financial incentives. Research by Assistant Professor Ian Larkin of the Harvard Business School, suggests that the most powerful workplace motivator is not financial reward. Key findings of his work include:

• The most powerful workplace motivator is our natural tendency to measure our own performance against the performance of others.
• In the age of social networking, employees are more likely than ever to share salary information with each other. Employers need to keep this fact in mind when designing compensation plans.

"Traditionally, [the field of] economics has held a very rational view of people, and there's a gigantic amount of literature focusing on financial incentives and the idea that simply having financial incentives causes people to work harder," Professor Larkin says. "But my research suggests that in deciding how hard we work and how well we think we're performing, social comparisons matter just as much."

Salaries are getting less and less secret because of social networking. So when it comes to compensation, employers should assume there are no secrets. Larkin points out that "people get upset quickly when they realize that there are large variances in how much other people are paid. Companies need to realize that with the overflow of information these days, paying peers differently is going to affect not only how those people feel but how their colleagues feel as well."

Larkin goes on to argue that paying each employee solely according to his or her performance is actually an inefficient strategy; and it can lead to resentment or even sabotage on the part of employees who believe they are underpaid compared with their colleagues. Thus, a standardized salary scale, combined with non financial incentive programs, may be the best way to motivate employees. "When deciding how much effort to exude, workers not only respond to their own compensation, but also respond to pay relative to their peers as they socially compare." 

Click here for the complete article as published in "Working Knowledge"