Debt: You can’t live with it, and you can’t live without it!
Who likes writing checks for home mortgage, car payments, student loans, etc.? But without debt, most of us can’t afford the home we live in, the car that we need to get around, or the education that presumably gets us a good paying job to pay the relentless bills.
The debt principle is commonsense but uncommonly remembered. It consists of principal and interest. The higher the principal amount and the longer the payoff time, the more interest you pay. Whereas debt can create opportunities you may not otherwise enjoy, it can get you into trouble too, especially if you don’t manage it wisely. It can even bankrupt you! The same principle plays out on projects in our organizations in the form of what I call “risk debt.”
What is risk debt?
Risk debt is a metaphor, not unlike Ward Cunningham’s idea of “technical debt” in software development. It’s equivalent to the total cost of responding to risks—both proactively and reactively. The principal part of risk debt is what it may cost you to mitigate them proactively—presumably the minimum cost of managing your risks. If you instead respond reactively after they have materialized, it’s virtually certain to cost you more than this minimum. The additional cost is the interest. The longer you take to respond, the more the interest you pay.
Not every risk you conceive of is likely to happen. Nor is it likely that none of them will. Furthermore, the impact of each risk on project cost is not only different but uncertain. Therefore, it’s not prudent to either waste money up front to mitigate every single conceived risk or ignore them altogether to save costs.
You should aim to have enough in your project budget to pay for what will become risk debt. This equals the cost of proactive measures you decide to take plus the contingency reserves you set aside to respond to risks that will ultimately materialize in the future.
Why consider risk debt?
If you know the amount of risk debt a project carries, you can assess the project’s financial viability more objectively and make better go/no-go decisions. It also gives you better insight into the strategic options you can explore in managing the debt.
If risk debt is included as part of your project budget, you have a higher chance of completing the project within the authorized budget. If not, that chance drops to less than 10%. The reason is that some risks are bound to materialize to create debt, which you’ll have to pay as a cost overrun.
As a reactive measure, you’ll likely pay a lot more—possibly so much more that your ROI may even become negative thereby making the project financially non-viable. Even worse, it could tarnish your brand reputation and bankrupt your company.
Perhaps, most important, as a metaphor risk debt helps executives understand more easily its significance and provides them better insights into project investment and risk management decisions. They must recognize that there are three types of risk debt, namely good, bad, and ugly and strive hard to be on the good side. The slope from good to bad to ugly is dangerously slippery.
Good debt
Steve Jobs, the legendary cofounder of Apple, famously returned to the company as its CEO in 1997 after getting fired from the same job in 1985. His first major project was to develop and launch iMacs (remember those translucent, colorful, and cute desk top computers?) for the 1998 Christmas season.
One of the major risks his team identified was supply chain delays, especially considering the holiday season. In those days every computer manufacturer used to ship their products from China to the US by sea. To avoid sea shipping risks altogether, Jobs proactively spent $50 million to buy up all the available holiday air freight space between the two countries.
Come Christmas, Apple delighted their customers with short delivery times and prompt deliveries, thanks to air shipments. But its rivals like Compaq and HP found themselves up the creek when they wanted to expedite their shipments via air upon facing the usual sea shipping delays. They were aghast to find out their nemesis had hogged all the air space.
The risk debt Jobs paid proactively pales in comparison with the cost of fixing sea shipping bottlenecks and loss of revenues Apple would invariably have faced. Their ultimate bonus was a great product with gangbuster sales. Indeed, a good risk debt leading to an exceptional ROI!
Good debt is tied to effective risk management, timely decision making, positive ROI, and project success. A bad debt, on the other hand, is basically the opposite of all that. It is exemplified in Boeing’s development of the 787 Dreamliner.
Bad debt
Boeing executives decided to outsource most of the development process including their core engineering and manufacturing functions, notwithstanding the warnings from their own engineers. Its supply chain involved about 50 major suppliers and 150 sites across the globe. The executives hoped to shift the financial risk to the suppliers to minimize development costs and accelerate the schedule. But the results flew in their face—just as their engineers warned!
Supplier delays, bankruptcies, and quality issues ultimately caused Boeing billions of dollars in cost overruns and loss of revenue due to cancelled orders, not to mention the obliteration of massive shareholder value. What Boeing hoped to be good debt slowly became bad. Poor risk management, irresponsible decision making, and arrogance at the highest levels of the organization, among other reasons, are blamed.
By the way, the Dreamliner saga is not over yet. New production problems that could possibly cost more billions have been identified in 2021. Boeing’s bad risk debt can get worse, time will tell. Which brings us to ugly debt.
Ugly debt
Ugly debt is bad debt that has got worse. If you don’t address it in a timely fashion, bad can become ugly. The line between the two debts is thin.
General Motors (GM) ended up paying a colossal ugly debt of $900 million to the United States and more than $1.2 billion to the victims as part of various settlements for their notorious faulty ignition switch debacle that caused 124 fatalities and numerous injuries. GM had recognized but ignored the defect for over 10 years. It would have cost GM just a few dollars to fix each faulty switch, had they taken care of the risk early on. But over time, the interest part of the risk debt ballooned by several orders of magnitude to billions of dollars. A truly bad case of bad debt gone ugly!
The good, the bad, and the ugly risk debt is a continuum with a slippery slope. The slope is intrinsically built into the landscape of every project. To avoid falling down the slope, project sponsors and teams must understand the nature of risk debt and manage it proactively.
Risk debt: You can live with the good but not with the bad and the ugly.
Sherry S Remington says
Great Article Dr. Kodukula,
It is easy to see the past. What could project managers do to identify and remove the bad and ugly risk proactively.
Thanks!
Sherry
Dr. Prasad S. Kodukula, PMP, PgMP, DASM, DASSM says
Great question, Sherry! Please refer to my previous blogs that talk about specific proactive strategies for the four key types of risks we typically face on our projects. One most important thing project teams can do is to create a risk register where they identify risks that could happen, analyze and prioritize them based on their likelihood of occurrence and potential impact on project objectives, define various proactive response actions they can take (to avoid, mitigate, or transfer the risk), evaluate each action for its pros and cons, and implement the best option. By being proactive, you’re minimizing your overall risk debt.
As an example: Say, the proactive risk response measures you build into the project in its “planning” phase are going to cost you $10,000. This is the minimum (the “principal” of your risk debt) it takes to manage your risks. If you did not take any up-front action, some risks are likely to materialize during the project’s “execution” phase, and your response actions then may cost you $100,000. It’s $90,000 more now, compared to the initial $10,000. (This additional cost is what I refer to as the interest part of your risk debt.) But, going beyond the execution phase, if the risks manifested themselves in the “production” phase after the project has been completed, it may cost you one million dollars at that time. (The risk debt is now gargantuan, since the interest has ballooned up by one order of magnitude.) This is a simple illustration of how your risk debt can go from good to bad to ugly, as you take longer and longer to pay it.
Hope that helps.