HOW TO IDENTIFY POTENTIAL RISKS IN BUSINESS AND CALCULATING THE PROBABILITY THAT A RISK WILL OCCUR
Risk is a fact of business life, and a company’s exposure to risk increases as the venture grows. Understanding where the risk lies allows the enterprise to respond effectively through process improvement strategies and buffer strategies.
Process improvement strategies involve reducing the probability that the risk will occur by forming strategic alliances with strong partners or developing backup supplies and better communication with suppliers. However, even with process improvement strategies in place, it is impossible to eliminate risks completely.
Buffer strategies are used to protect the company against potential risk that can’t be prevented. Maintaining sufficient inventory and alternative sources of supply are two types of buffer strategies.
Supply Chain Risks
The common practice of outsourcing the upstream activities of a company – raw materials, manufacturing, assembly, inventory – presents advantages and risks to an entrepreneur. The advantages of outsourcing include the sharing of risk, expertise and resources. The risks are many and significant, however. The financial health of a supplier is critical to the stability of an entrepreneur’s business.
When a supplier faces financial hardships and cannot provide supplies, raw materials, and so forth in a timely manner and the entrepreneur has no backup, the result can be loss of customers and, in some cases, the failure of the entrepreneur’s business. Supplier capacity constraints are another source of risk for the entrepreneur. When demand fluctuates or increases precipitously, suppliers may not be able to ramp up quickly enough to meet the demand.
Quality-related risks and the inability of suppliers to keep up with technological change can have ramifications throughout the entire value chain, including raising the cost of producing a product. Changes in customer needs can affect the product design and, by extension, the types and quantities of supply needed. When suppliers are unable to make changes in product design that are required, entrepreneurs incur a risk. Finally, risks in the form of disaster – floods, fire, earthquakes – can disrupt supply chains and affect the entrepreneur’s ability to manufacture products.
Calculating The Probability That a Risk Will Occur
It is extremely difficult to calculate the probability that a given risk will occur with any degree of accuracy. Consequently, any risk/benefit analysis conducted will probably have flaws and even cause the company to decide that the cost of protecting itself is not worth it for the return on investment.
Nonetheless, it is important to gauge, based on industry and customer knowledge, the chance that a particular risk will occur.
Assigning a Level Of Significance To The Losses
Assigning a level of significance is again an arbitrary exercise, because the weight given to any impact of risk is based on the company’s goals, core competences, and focus. The importance of assigning a significance level lies in the need to distribute limited resources effectively. Most entrepreneurs don’t do contingency planning because they have neither the time nor the resources to devote to it. Therefore if probable risks are identified and rank-ordered, it is easier to choose where to allocate whatever resources are available.
Calculating the Overall Risks of Loss
The overall risk of loss is simply the sum of the risks times its probability of occurring times the cost of the impact to the business times the level of significance. For example, suppose an entrepreneur determines that there is a 40 percent chance that she will lose a key manager to a competitor.
The financial cost of that loss is the cost of doing a search for a new manager, which she estimates at N1 million ( this does not include the non-financial costs, such as loss of tactic knowledge). She assigns a weight of 80 percent, on a scale of 1 percent to 100 percent to reflect the importance of this risk. Thus the overall risk of loss is approximately is approximately N320,000 [(N1,000,000 x 0.40) x0.80]. If the entrepreneur does this for all the identified risks, it will be easier to decide on which risks to concentrate efforts and focus resources.