The Economics of Preparedness

By Guy Higgins

I’ve been listening to some of Thomas Sowell’s work lately.  Dr. Sowell is an economist and the Milton and Rose Friedman Senior Fellow at the Hoover Institute.  He proposed a definition of economics that I like very much.  According to Dr. Sowell, economics is the study of the allocation of scarce resources that have alternative uses.  Essentially, he is saying that economics is not about what to do with the one rubber hose gasket that you have – it has a single practical use (even if it were rare, which is the case only when your hose coupling is leaking and the hardware store is closed).  Economics is, however, about whether or not to buy a rubber hose gasket with your money when you have several other pressing needs for which the money could be spent.  Obviously, this simplistic example is for a single person, but much of economics (macro-economics) is about the sum of individual resources, needs and decisions.

I started with that short definition, because I want to talk about the allocation of resources within a company – those resources, whether they are people, time, capital equipment or money, are limited, and the needs frequently seem to be unlimited.  Company leaders need to be able to allocate those resources (all of which have multiple alternate uses) to achieve the company’s goals.

Without getting into a strategy formulation discussion, the company must have an overarching goal and a strategy to achieve that goal.  With those fundamentals in place, company leadership is in a position to make good decisions about resource allocation.  One of the big problems, as I see it, is that companies have a strong tendency to focus, exclusively, on things like sales volume, margins, and growth.  There’s nothing wrong with paying lots of attention to those, but there are other things that company leadership should be considering, and those things are frequently not included in the resource allocation considerations.

I’ll assert that the number one goal for any company should be to “Stay in Business.”  With that goal, the company leadership should ask, “What will put us out of business?”  The answers to that question will fall into two categories:

  • Failure to make an acceptable profit
  • Failure to prepare to recover quickly and efficiently from events that stop or significantly reduce operations

Company leadership, as I noted above, spends time on addressing the first of these two categories – failure to make a profit.  That leads to the sales volume, margins and growth focus.  It is relatively straightforward to figure out returns on resources allocated to these areas – not easy, but the methods are well known, and business schools make tons of money and provide their faculties with very nice life styles teaching those methods.

The vast majority of company leadership with whom I’ve spoken acknowledges the importance of preparedness, and many are allocating resources to be prepared.  The problem they face in allocating those resources is balancing the cost/benefit of preparedness activities against the cost/benefit of allocating those same scare resources to increasing sales and growth.  Identifying the cost of developing and exercising a preparedness program is just as straightforward as identifying the cost of other investments.  The benefit is the hard part.

In a post like this, it is not possible to provide approaches for calculating the monetized benefit of preparedness, but I will say that leaders need to consider four potential losses (any of which can result in a loss of income – in addition to the cost of the actual loss):

  • Loss of workforce – what would it cost and how long would it take to replace a significant portion of the workforce on either a temporary basis or a permanent basis?
  • Loss of facilities – what would it cost and how long would it take to repair or replace production facilities in all or in part?
  • Loss of data – what would be the impact of losing temporary or permanent access to critical company data?
  • Loss of knowledge – What critical knowledge is not captured in company data and what would it take to replace that knowledge if it were unexpectedly lost?  How long would it take?  Examples of such a loss of knowledge would be the sudden loss of a key sales person who has close relationships with a large number of customers and potential customers, one who knows all the regulators, and one who deeply understands how the market behaves.  Those are extremely difficult bodies of knowledge to capture – in fact, it’s impossible to capture them in their entirety.

With answers to those questions in hand, company leadership can begin to understand the impact of suspending operations for a day, a week, or a month.  These calculations are not rocket science, but they do require an extraordinary attention to detail and meticulousness in including all the “gozinta’s” and “gozoutta’s.”  A company whose operations have been suspended loses income almost immediately, but costs continue to accrue.

Company leadership needs to focus on “staying in business” whether the world behaves well (and all they have to deal with is the competition, the fickle customers, government regulation, ad infinitum) or behaves badly and revenue-generating operations have to be suspended.  The company that stays in business after a disruption makes more money than the one that does not.

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