In Chapter 1 we developed the link between strategy and risk management in guiding the decision-making to formulate the business plan. Now, let us consider how to bring the plan to life, in other words, explore the relationship of positioning on value chain management. This is a fundamental choice facing all organizations. Think of how Apple, Nike, Walmart, and other high-performing organizations manage their value-adding activities to focus on their unique capabilities.

In our case, should the partners create (manufacture) their own deserts or should they outsource to a well-known local pastry chef? It is important to recognize that pastry baking is a different specialized skill set from cooking. In the early days of the venture there are advantages to outsourcing. First, the use of a well-known outsider may create halo effects that enhance the perceived quality of the new restaurant. It will probably be less expensive than hiring a pastry chef full-time and should reduce complexity in the kitchen. In addition to these benefits, it may make it possible to expand other offerings on the menu. We can view this decision as a risk transfer decision driven by the positioning theme. Most of the upside in terms of reputation goes to the outside supplier, who will get most of the credit for success, and any failures will likely accrue to the restaurant. Transferring operational risk here does not make the risk go away; it simply changes the shape. You now have inventory risk. There is also an element of vendor and financial risk depending on how the supplier contract is structured.¹ If the outside supplier is the more powerful player in this relationship, that person may impose contractual conditions on unsold goods that will create cash flow problems. Although the decision may appear to change the fixed cost of a captive chef into a variable cost, the structure of the contract could actually be creating fixed cash flow obligations similar to fixed costs. The manner in which operational leverage affects the capacity to take risk is an issue for all organizations, and this is where decisions concerning cash flows at risk (CFaR) become important.

Ultimately the decision is a strategic one linking positioning to value chain management. Which decision better accomplishes fulfilling the value proposition of the positioning theme? It should also be noted that the decision is a dynamic one that may change over time. For reputation reasons, the partners may start with a famous outside supplier but supplement those choices with internally prepared choices as the reputation of the restaurant gains greater recognition. We should also consider how learning affects risk management.² Over time the restaurant manager should learn more about the preferences of customers and be able both to enhance customer satisfaction by providing the desired offering while reducing waste. A clear win-win. The extent of the win, however, may be tempered by what competitors are learning from the restaurant's success and developing new tactics to limit the success.

In this scenario we have primarily focused on the inter-relationships among positioning, pricing, and risk. The positioning is the key risk management activity, and the pricing decisions drive risk/return. We have also tried to emphasize the relationship between organizational governance and market governance. The organization has a clear governance responsibility in identifying and managing the risks associated with its strategy and in a sustainable strategy it accomplishes this through pricing for expected losses (ELs). Yet, it must be recognized that there is a ceiling on the price that can be charged that is essentially a function of the market.³ This relationship makes it incumbent on organizations to have explicit risk management strategies. However, let us return to our two partners. Let us assume for a moment that they chose a scenic riverside location and took out the appropriate insurance policies related to weather and so forth. Let us go even further and say that they anticipated business continuity issues arising from floods and insured that. What risks remain?

We need to return to the previous discussion of how to determine the level of risks transferred. If all the risks of the location are transferred, then presumably all the gains associated with taking this locational risk would also be transferred. Consequently, the more likely real-world scenario is that the partners decide to accept (retain) and manage a certain level of risk. Either implicitly or explicitly they have determined their risk appetite. To make economic profits an organization must take risk and to have a sustainable position, those risks must be managed, and that demands an understanding of risk capacity and the development of a risk appetite statement.

All of the previous decisions that we have discussed affect the risk capacity of the organization. The degree of capital reserves, operational leverage, understanding of the risk drivers, and transparency of the risk decisions and the appropriate culture all affect the ability to take any risks, not just new risks. For example, the decision to hold wine inventory reduces our capital buffer.⁴ So, too, do the decisions on how we manage our value chain in the context of operational leverage. Fixed contracts and other devices increase our operating leverage by turning variable costs into fixed ones. However, they also have the advantage of securing strategic assets. Careful thought must always be given to the relationship between strategic assets and risk drivers.

Although before we were in the realm of ELs and flows, we are now in a different realm: the realm of the balance sheet, or stocks. Organizations must hold resources or access to resources to weather the unexpected. The questions are how much and what kind. To return to our previous discussion of the wine cellar, it is important to recognize this as a capital asset—albeit with market and liquidity risk. The wine or portions of the inventory can be sold; the issue is how easily and at what price as we see the interaction of liquidity and asset prices.⁵ But this takes us back to the demands of investors versus the comfort of having surplus resources. The partners may believe that the restaurant business is cyclical and accept that each venture has a limited life span. If this is the thinking, then the strategic decision would be to go very light in holding resources for contingencies because this will limit current returns.⁶ The point is that reducing idle resources limits organizational resilience. Take the opposite time horizon: the partners are building a business for their children to take over. Rather than managing to maximize return on investment (ROI) they would be more likely to focus on creating the needed cash flow to support family needs and doing the best to build up a cushion to get them through the “bad times.”⁷ It is also possible that in developing their positioning theme the two partners realize that they lack sufficient resources. Do they cut back on their dream—or at least develop a staged plan—or seek external investors? If they seek external investors, to what degree are they willing to accept the loss of control imposed by the demands of the investors?

It is not our purpose to say which is correct but rather to note that the process of resource allocation fundamental to strategy requires a specific understanding of the degree of control needed and a statement of risk appetite and tolerances if the manner of achieving strategic goals is to be understood. It is also worth considering risk migration and how risk changes shape. The consequence of this is that there must be a clear focus on the entire risk spectrum. If the specific risks are treated by individual specialists, the net effect may be to transfer the risk to another silo, not to effectively manage it.⁸

This discussion is somewhat static because it sees everything from the point of view of our two partners, but although they can influence how competitors respond, they can't control it. This forces our partners to consider how much of a buffer—cash in the bank, line of credit, and so on—they need before they can count on their venture to at least break even. In making this decision they need to consider not only how long it will take to build up their clientele but also how the response of other restaurants will affect the growth of their clientele and positioning. This aspect highlights the importance of the future for strategy and risk management. Later we will discuss how scenario planning is an important tool for dealing with this dynamic situation, but for the moment we simply want to highlight how the future orientation forces us to deal with uncertainty.

When you enter or alter your position in a competitive situation you have changed the dynamic, so to think that everything else will stay the same is fundamentally mistaken. Your actions, whether anticipated or not, will most likely change how others respond. So, it is imperative for your strategy that you anticipate what the likely reactions will be. But unlike the more “scientific” aspects of risk management, you need to be cognizant that the unexpected can happen. You will not have a historical database on rival responses. In some situations, if your positioning is quite distinct, your arrival may be welcomed as helping to bring new customers into the area. Or, you may be viewed as rivals for a fixed market—in which case, response may be swift and harsh if the rivals have the resources to do so. In this context, it is very similar to how you need to vet your assumptions about any frameworks or models you are using.⁹

Previously we noted that the partners were assessing cost drivers, capacity use, and the competitive landscape. They were implicitly building a model to help them make key business decisions. The model itself is a representation of reality using historical data and simplifying assumptions to predict future possible outcomes. In assessing the risks in this model, the partners need to be clear on the stability of the underlying inputs and assumptions—specifically, how often and to what extent do they vary over time? It is also imperative to understand the sensitivity of the decisions to be made to any given input or assumption. Clearly, the less stable an input or assumption and the more sensitive the model results are to any input or assumption, the more those must be tested through different model scenarios. Also, all assumptions should have a certainty factor—how much confidence can be placed on the assumption being correct?

These efforts to manage risks may create a new type of risk—in this case, model risk. Let us elaborate. The identification of risk and the assignment of accountability points to a planning process—perhaps an informal understanding or a more explicit business plan. The business plan can be seen as developing a model for the organization and, hence, the assumptions that are untested in the plan create something akin to model risk. We need a model to guide our actions and to simplify a complex reality, but confidence in the reality of the model may lead us to underestimate the complexities created in reality.¹⁰ This can be extremely dangerous because our confidence in the reality of the model leads us to see events in a specific way. These preconceptions can guide us to have dangerously slow responses to what is happening.¹¹ The more complex the model, the greater the opportunity for failure. In making decisions using models, the partners must establish an understanding of where and when the model is most vulnerable and how they can fail. This enables them to establish feedback mechanisms to monitor how well the assumptions in the models meet conditions as time moves forward, into the uncertain future.

Our belief in the past as a guide to the future may blind us to significant changes—think inflection points and discontinuity. In the case of our restaurant partners the emergence of molecular cooking or plant-based foods may challenge some of their long-held beliefs and skills.¹² Watching niche or fad trends become mainstream is why attention to emerging risks is necessary.¹³ Paying attention to changing consumer tastes is essential to creating customer value. To revisit a point we made with the wine inventory, it is not just the inventory that loses value, it is often the skills that created the inventory. The skill in cooking traditional meat may not be the same as preparing plant-based meals. Organizational slack may be necessary to prepare for the future—even if it reduces current returns.

THE ASSUMPTION OF GOAL CONGRUENCE AND THE IMPORTANCE OF CULTURE

If we go back to the notion of partnership, it was assumed that the partners would agree, but is that a good assumption? Maybe yes, maybe no. But it is worthwhile to explore how their different forms of expertise could lead to a clash. Given the positioning, the chef probably sees herself as an artist who will only use the finest materials to create what she wants. A celebrity chef a la Anne-Sophie Pic; Ferran Adria; Eric Ripert; Marco Pierre White; Clare Smyth; or the late Paul Bocuse, who trained under the first female chef to earn three Michelin stars, Eugenie Brazier¹⁴; and Joel Robichon will aspire to three Michelin stars.¹⁵ Now if this will bring in the customers, all is well and good. But what if the dishes create a very limited market?¹⁶ How will the manager with his planning and budgeting skills convince the chef of the need to adjust or go bankrupt? Although food may be an art, running a restaurant is also a business. One can see how problems lead to conflict that leads to broken partnerships.

Second, we haven't really focused explicitly on operational risk, which dramatically affects the positioning. The chef will have to find qualified suppliers and help. Although she is an artist, she is not the solo creator but rather an artist running an atelier that requires installing the appropriate procedures and supervision. It is not just about getting the right result—the chef can't reject too many dishes because this would frustrate waiting customers and create longer waits for everybody, as well as drive up the costs as the food is thrown out. The chef is not only key to the product part of the value proposition but also to the execution. This means managing the operational risks. And managing the operational risk means designing the appropriate processes and checks to produce the desired results. For the organization to succeed, masterpieces must be produced as close to every time as possible. The chef must accomplish the Herculean task of combining excellence with consistency. This is the challenge of managing operational risk to achieve an acceptable standard of masterpiece—as judged by the customer.

This is not just a challenge for the chef because the manager too must hire and train the appropriate waitstaff. Because this is a fine dining establishment, the waitstaff must not only be knowledgeable but their interactions with customers must be appropriate. This requires the waitstaff to be knowledgeable about the food, the wine,¹⁷ and the customer. The waitstaff is critical in matching the expectations of the customer to the capabilities of the kitchen. If asked for an opinion, it is essential that the waitstaff provide an honest one.¹⁸ If they don't, they become shills, not the trusted, knowledgeable advisors that good salespeople are. This role becomes especially important with repeat customers. Here, again, there is the source of a potential conflict between artistry and market demands. When the menu changes, a customer favorite may disappear. Now if this is an issue of seasonality, the customers will understand it is a quality issue, but if it is simply the chef being an “artist,” it is unlikely the customer will understand. We are sure that many artists get tired of repeating their hits, but it is the price of maintaining steady customers.

Now it should be acknowledged that some may accept erratic quality but what will be the impact on pricing and market demand?¹⁹ And some may accept a lower level of artistry for consistency, as the fast food industry demonstrates.²⁰ There are many possible positions, and of those some will succeed and some will fail. Our focus is not so much on evaluating the quality of the positioning as recognizing the impact of operational risk on all elements of delivery and on the promise of the value proposition.

Let us return to our example of the two restaurant owners to explore the relationship between goals and risk. Consider the decisions facing the two owners over short-term versus long-term profitability. Previously we noted that the partners would not seek external financing, but they came to realize that to maximize the value of their equity, they could use as much debt financing as possible. But this may expose the operation to near-term issues in generating the cash flow to cover the interest costs.²¹ This decision increases liquidity, or cash flow, risk and consequently reduces capacity for other risks. Assuming that there are no covenants on the loans that restrict management decision-making and their cash burn rate of reserves, this puts a specific time horizon on when the operation must start generating positive cash flows. This is a decision involving uncertainty. Certainly, the owners can study the statistics concerning similar operations or have heuristics based on their experience, but there is no certainty that these numbers will apply to their specific situation.

The decision must be made as to how to prepare for this contingency. Assuming their resources are exhausted, they can follow one of the three following choices:

• Accept the risk
• Consider taking in another investor
• Change the menu/promotion/pricing to increase the likelihood of generating early customers

What merits consideration is that to manage the situation, the partners must explicitly consider ex ante the probability of success. Some will say, what will be will be and if things don't work out we will deal with it then. But that is very problematic because in that situation you are approaching potential providers of resources in a weaker position. The weaker your position the more likely it is that investors or suppliers of credit will seek higher returns and the reduction of downside risk. The reduction of downside may affect the positioning of the restaurant by imposing new controls on the discretion of the two partners. Proper risk management is about not only managing the downside risk, but also capturing as much of the upside as possible. The distinction is an important one. Accounting profits do not recognize fully the importance of risk return. Consequently a firm can be profitable in accounting terms but destroying value because the return is not compensating investors for the risks they are taking.

This scenario is not a simple situation. It is possible, for example, that the two partners have determined that if their concept is to be successful, it will be in a specific time horizon. Although in some instances the calculation of economic capital, which enables you to survive the unexpected, is as much an art as a science as applying generalizations, even statistical ones, to specific situations, it is itself uncertain. But, the partners may have a gut feel from their experience in the industry that if the restaurant doesn't pass the market test in six months, it never will.²² If they are confident in this decision and have built it into their plan, then they will match resources to the opportunity and accept the judgment of the marketplace.

It is worthwhile to consider the links between the second and third options. The provider of external resources may say the menu is too exotic for this locale, that the restaurant needs to offer some more basic options. Depending on the chef's artistic inclinations, this may pose a problem and imperil the long-term positioning of the restaurant. After all, it is generally easier to move down market than up market.²³ The importance of managing ex ante is to maintain control of the vision. It is also worth considering how this situation could drive a wedge between the two partners. The chef may hold to the importance of the creative vision, while the manager may be more inclined to bend to business realities. At issue is the degree of goal congruence between the two owners. In larger organizations this can be seen as a governance issue: the degree of goal congruence between board and management and/or within the executive management ranks. In this situation, the agreement is under stress because the intensity that each holds to different goals of artistry versus survival may imperil the partnership.

There are other dimensions to the interaction of risk and artistry and that is in the acceptance of the menu by the patrons. Let us assume that the menu is posted online and in front of the restaurant for passersby. This leads to the following choice:

• The menu attracts diners with its novelty.
• Diners pass on the menu as being too exotic.

Consider why diners might pass first. Again, we want to simplify to make some fundamental points. Imagine a couple, in which one is a very traditional meat and potatoes person and the other is a vegan. Does the menu include options for both? For those who are thinking you can always add options, you need to remember the impact of options on positioning from the chef's point of view and the addition of complexity and increased likelihood of waste from the business point of view. You can't be everything to everybody for these reasons.

On a different tangent, the partners must decide on how family friendly to be. Encouraging younger people to develop taste is a worthwhile goal. Should there be the option of smaller servings for younger diners? If so, should those options be available for lighter eaters? Whatever the decision it will affect branding from the early customers and hence word of mouth and also the complexity of operations. Capacity to manage this complexity must be a preopening decision, or the restaurant risks losing the vision it started with.

In addition to positioning risk, we also need to consider how the goals interact with execution, or operational risk. Diners could be enchanted by the promise of the menu, which has created expectations of how the food will taste and even be presented. There are multiple dimensions to how this will play out. Let us explore the most important ones:

1. The diners love the meal and discuss it with friends leading to new customers.
2. The diners are disappointed because their preferred dish is sold out.
3. The server notices there is an issue and asks if the diners would like a change.
4. The diners send it back and request changes or a different meal.
5. The diners are disappointed but don't say anything to the server but vow never to come back and to warn their friends.
6. The meal is average and the diners' decision to return has more to do with convenience or some other factor not influenced by the superior quality of the food.

Obviously the first choice is the desired outcome. The second choice may or may not be problematic depending on what happens with the alternative dish. If it is available and exceeds expectation the result is not far behind the first in terms of desirability. If the second option doesn't meet expectations, then we are thrown into the world of the following four outcomes.

Although not optimal, possibility three demonstrates the importance of the staff beyond the owners. The server should act as the customer representative, even be the customer's advocate to ensure expectations are met. This may mean explaining what the chef was trying to achieve but accepting that the customer's needs must be met. In a sense, your frontline staff have the opportunity to turn a potential disaster into a win or to make the disaster much worse. The fourth possibility takes us into the realm of risk appetite and risk tolerances. The owners have decided what to offer and outcome four shows their offering is not meeting expectations. But the questions are, what is creating the gap between expectations and how large is the gap? Let's focus on the expectations first. Is the entree fully described on the menu? If it isn't, are the servers able to fully explain each dish in order to set the appropriate expectations? We have all had the experience of something looking fantastic on paper, only to change our minds when we learn more about the item under discussion. The role of the server is to narrow gaps between expectations and reality.

In terms of risk tolerances, there are two different metrics. The first is how often the item is ordered. If it is never ordered, what is the problem? Should it be offered as a special and have the server explain the dish in order to invite trial? If that doesn't work, it has failed the market test and needs to be taken off the menu because it is driving up waste. But there is a different way a menu item can fail and that is that it keeps being sent back. How many times can this happen before you change the dish to meet the complaints? You can persist in your vision and, given your business, you won't become a starving artist, but you will become a bankrupt artist. Yet, commitment to your vision demands that you establish parameters as to what is an acceptable return rate. To phrase it differently, what is an acceptable level of loss on each item? Can the losses on one item be offset by gains on other items, or does market pressure demand all items have a similar loss profile? And over what time frame? Managing a menu is the same as managing a portfolio of business lines or financial assets.

But we have ignored a very important dimension so far: organizational culture. Not only will our restaurant have its culture that includes awareness of all the risks we have discussed, it will be affected by the culture of the industry, which has shaped the attitudes of our staff—from kitchen workers to frontline. Later we will discuss issues relating to tipping and how incentives affect goal congruence and performance, but for the moment we want to focus on the culture of the industry, which is often problematic. We run the risk of providing a caricature, but we do it to make a point. As a customer, we love the chef as artist, but reading the biographies of many “artists,” or even entrepreneurs such as Steve Jobs, these are difficult people for whom to work. Reflecting on the well-known food writer and TV personality Anthony Bourdain's²⁴ suicide an article in The Wall Street Journal makes the following comment:

When John Hinman, owner of Hinman's Bakery in Denver, became a pastry chef in the mid-1990s, he learned through a tradition of apprenticeship. Many restaurant kitchens are run in a strict hierarchy where rising within a pyramid structure confers the right to dominate those beneath. “It's brutal, the berating that goes on. You had to be tough. You had to be able to take it,” Mr. Hinman says.

The food industry often draws non-conformist, Type-A perfectionists attracted to the unusual hours and the camaraderie of a kitchen crew he says. However, that spirit can lead to an unhealthy partying life stye. Mr. Hinman, a recovering alcoholic, in May co-founded a group called Culinary Hospitality Outreach & Wellness—CHOW, for short.²⁵

This is not a healthy culture in any era but may be especially destructive in the era of #MeToo—especially as sexism has been rampant in the industry.²⁶ Although a generally negative attitude toward an industry can lead to better organizations having a competitive advantage because they differentially attract the best people, the overall attitude to the industry will lessen the size of the overall pool. How can you expect your people to be advocates when they can't advocate for themselves? How can you attract the best people who always have options if you treat them badly? Although the answer is obvious, it isn't so obvious how you break out of the way in which you were socialized yourself. Changing tastes and preferences affect your ability to attract employees just as much as the value of your wine cellar. And excellent employees are the sine qua non of great customer experience.²⁷ Just as operational risk affects all other categories, so too does organizational culture and the recognition that what is acceptable can and will change—sometimes to your gain, sometimes to your detriment.

CONCLUSION

In a very real sense, you can see that managing a menu is similar to managing a portfolio of business lines. And how this portfolio is managed can force underlying tensions over what counts as success to surface. This conflict can exacerbate different views of what success means. Consider the extreme where the chef aspires to three Michelin stars and the manager is a recent MBA who is convinced of the role of big data and analysis in a successful operation.²⁸

The key concepts that we have explored here are the challenges of creating a value proposition and delivering on it. This ties together strategy formulation and implementation as well as managing different risks that arise from the positioning. Management of the challenges will go a long way toward establishing the reputation of the organization. At the heart of establishing and maintaining a reputation is the decision of which risks to keep and which to transfer. Strategy and risk management are about making choices. That is the subject of Chapter 3.