I enjoy
investing!! I enjoy as it allows you to apply frameworks from a diverse set of
fields.
One of my favorite
source of these models is Operational Excellence (OE) and the reason why I like
these is that they force you to list and quantify all assumptions in a systematic
manner. Also they are fairly simple to execute.
A new
process! A new launch!! As soon as on OE practitioner hears this they would do
this. They will try to identify break points. They will quantify impact of
these breaks. And finally and the end of doing this in a systematic manner they
would be able to see what are the biggest risks you need to worry about.
The blogpost discusses one of the common tools for
this called FMEA.( Failure Model Effects Analysis)
Any FMEA analysis has following inputs.
1.
Failures across Processes
2.
Modes/Reasons of Failure
3.
Effect of Failure
a. Impact of Failure (10 being catastrophic and 1
being negligible)- This will require you think business in terms of systems
with one part of business impacting other with lag
b. Probability of occurrence (10 being highest and
1 being lowest). You can use Baynesian thinking here to put probability basis a
baseline and then change if things change.
c.
Detection Number: Your ability to detect this
failure (10 being worst ability and 1 being best)
4.
Net Score
Now
simply multiply for each risk the probability and impact to get to a net score.
Higher Score means Higher Risk.
Example: Let’s
look at Aashiana Housing. Any stock you own is a business which has multiple
processes running. Using FMEA we want to identify failure modes associated with
each of these processes. Here I have listed few business failure modes for
Aashiana Housing
And now you
can see the big failure modes you need to track. Example I had ignored the risk
of softening of demand. I had assumed that the probability of slowdown is low
and company should be able to handle it. But if I had understood the impact and
my limited ability to detect this I would have been more prudent in understating
this failure mode.
However, this analysis
is not a static analysis. In OE world you keep reviewing the process and refreshing
the risks. Similarly, you need to keep revisiting the probabilities, impacts and
ability to detect on regular basis and if required adjust them to new information.
PS- The
probability, impact are my assessment of these. The detection ability is my
ability to detect in advance this failure reason with limited information.
