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Date Posted: 5/11/16
By Kevin Carpenter, contact:

How many times have you heard "that's just the way it is, and there's not a darn thing you can do about it", or as often stated in business "that's outside of our control”?   Well, it turns out that for many of the things we generally consider outside of our control, we're simply focusing in the wrong issue and should instead consider the impact of the event which we oftentimes can control (or at least mitigate).

Take these three classic uncertainties about which people frequently complain as outside their control.

  • The weather
  • The stock market (or oil price)
  • The traffic

We complain that we can't control these things and are subject to their random changes to interrupt our day, harm our business, or generally put us in bad moods.  However, when we instead focus on the impact of the weather, commodity prices and traffic, we find there are many things we can indeed control to add value ControlSystemto our projects and make our days a little brighter.  There's even a mathematical exercise you can easily go through to find the Value of Control and estimate what it's worth to you to control or influence the impact of each of these events. Control can come in two forms – Perfect and Imperfect. Imperfect is the easiest to accomplish as it’s not absolute control over a situation, but can mitigate some uncertainty.

The weather is actually an easy one and if you think about it, you'll realize you probably do this already.  Let's say you're going to an event tomorrow evening and there's a 50% chance of rain.  If it rains, driving will be a mess and it will take 45 minutes longer to get across town.  You would normally leave at 8:00 to attend the gala, but if you want to get there on time you would plan to leave early and adjust your prep and travel time accordingly.  This additional adjustment and prep time is the "cost" of "controlling" your travel time to ensure you're there at the start of the event.  If you're making the keynote toast and have to be there at the start, the "Value of Control" is high.  The "cost" is relatively low, so you adjust to make sure you make it in time.  Alternatively, if you're really not interested in the speeches and just want to get to the cocktails and mingling, then being a bit late has no impact.  The Value of Control is zero and you probably won't bother adjusting your schedule to get there right at the start.  However, if your spouse wants to get there on time, and you don't care one way or the other, recognize who the true decision maker is for this example and value the control correctly!

Stocks or commodity prices are a little more difficult to offset their impacts, but the math actually becomes easier.  Let's say you're buying a tech stock based on the general public opinion that they are going to get a huge contract and will enjoy many years of financial success.  The stock is trading at $100 per share.  If they don't get the contract, they could suffer so much they go bankrupt (to a value of $0).  You certainly don't want that to happen, but you think there's a 20% chance it could.  While you can't guarantee they get the contract, you can buy $70 put options (the right to sell at a set price) for only 50 cents.  Now, the risked Value of Control of preventing a negative event is the $100 (current price) minus $70 (the price if things go badly) times the probability of that happening (20%) or $6.  Buying the put options for 50 cents is a good deal.  If they don't get the contract and the stock heads to zero, you can sell your stock at $70 and lessen your losses.  If a great outcome happens and the stock goes to $150, the 50 cents you “wasted” in buying the options won’t have much of an impact on your return.

Oil prices work the same way.  With volatile prices, companies are often seen at the mercy of the large market swings or major downturns.  But many companies manage this downside risk by hedging their prices through various instvolatileruments.  They might sell futures several months out to “lock in” their prices of future production or buy and sell options to guard against wide swings from the current market view.  There are some energy companies that intentionally choose to not manage this risk.  They consider the swings of the market as part of the inherent risk of being in the energy business.  This strategy works fine when the market is somewhat stable or increasing, however when it crashes hard, they are left scrambling to cut costs and sell assets.  Those that have protected the downside can ride the down market a little longer and survive or even thrive when other companies are rationalizing assets.  If their timing is right and the risk is sufficiently managed, they are the ones that bounce back the fastest.

Finally, let’s look at the traffic issue from the city planner viewpoint.  In our last blog, we discussed a better approach to creating scenarios with the example of city planners forecasting the demand for highway expansion projects from a growing satellite region into the city. We noted that the demand for expansion was influenced by the growth in population, the degree of local amenities, the location of businesses and the changes in the workforce. Rather than be at the mercy of these factors, the planners can consider their impact on highway expansion costs and calculate a Value of Control.  They can then consider what things they might be able to do to impact outcomes and therefore the cost of the project.

For example, if the planners can defer a $50MM expansion project for 5 years, they would save about $11.5MM in the present value cost (using 10% cost of capital and 3% annual cost inflation).  So the Value of Control (controlling the demand for cars on the road to be able to wait 5 years) is $11.5MM.  For this amount of money, they could instead offer 10 years of tax abatements for up to $50MM in new business investment in the local community.  New businesses drive local amenities and reduce the number of commuters coming into the city.  A five-year delay also potentially allows for new technologies (rail, autonomous ride-sharing services, etc) to develop and further reduce the need for added capacity.

Some analysts think Value of Control is limited to a conceptual exercise to be performed simply to complete a step in a process framework.  However, by extending the calculation to create actionable plans, Value of Control becomes a tool to create stronger strategies with more robust and value adding features.

So the next time someone says “there’s nothing we can do about that”, dig a little deeper to examine the effects of the event.  You might find that not only can you do something, but that you can do something that adds tremendous value!

Next blog – how to budget your costs and projects in times of great uncertainty.




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