Risk Management

Learning How to Manage Risk

Most business activity takes place under conditions of risk. So, it is important for managers to understand the risk their business faces, assess that risk in terms of its potential consequences and benefits, and take appropriate steps to manage that risk to minimize its potential impact.

Risk management is an important function for most businesses. Floods, fire, and similar disasters are just a few of the many risks managers face today.

It is important to understand the distinction between risk and the potential consequences of risky future events. No one knows what the price of oil will be in ten years, so all consumers of oil products face the same risk regarding future oil prices. However, astute managers can position themselves to be better prepared for different eventualities.

For instance, suppose two competing businesses have been offered the opportunity to buy exclusive distribution rights to a new product for a fee of $500,000.

• One of the businesses has high debt, weak cash flow, and low cash reserves. If the firm buys the distribution rights and the product fails, the firm will have to declare bankruptcy.
• The other firm, has low debt, strong cash flow, and high cash reserves. While a product failure would be disappointing, this firm would be better positioned to absorb the loss.

Assuming both firms are equally equipped to promote and distribute the new product, they face the same risk. However, the consequences of a product failure are quite different for the two businesses.

There are several options that managers can pursue to manage risk. These include the following:

1. Understand one’s own risk propensity.

A manager with a high risk propensity, for example, might be expected to experiment with new ideas and gamble on new products. He or she might also lead the organization in new and different direction and/or be a catalyst for innovation.

On the other hand, the same individual might jeopardize the continued well-being of the organization if the risky decisions prove to be bad ones. A manager with low risk propensity might lead to a stagnant and overly conservative organization or help the organization successfully weather turbulent and unpredictable times by maintaining stability and calm.

Thus, the potential consequences of risk propensity to an organization are heavily dependent on that organization’s environmentOpens in new window.

2. Understand the potential costs and benefits of potential outcomes.

Managers and businesses that never take risks are unlikely to succeed. Consequently, it is important to understand the array of possible consequences that might result from a course of action and the costs and benefits associated with each.

3. Reduce Risk.

It is possible to reduce the consequences of risk. For instance, the riskiest approach is to never buy insurance because of the expense of monthly premiums. As long as nothing goes wrong, you come out ahead. But if problems do arise, the results can be catastrophic because of the losses incurred.

At the other extreme, it is also possible to fully insure against just about any conceivable loss, thus minimizing risk. In this case, though, the monthly premiums will be extremely expensive. So, most decision makers opt for a position in which they insure against major losses but also accept some of the risk themselves (in the form of deductibles and so forth). Balancing insurance coverage with premiums and deductibles is a form of risk management.

4. Share risk.

Another option is to share risk, often by working with strategic partners. For instance, ShellOpens in new window and BPOpens in new window have worked together to explore for oil in remote areas of South America and Africa. If no significant oil fields are found, each firm will only lose about half of the total cost of exploration.

Managers should take special note of risk when they are making decisions. From a decision-making perspective, risk centers around the availability of information about and an understanding of the probability estimates for payoffs and costs for each outcome.

Suppose, for example, that a labor contract negotiator for a company receives a “final” offer from the union right before a strike deadline.

The risk centers on whether the union representatives are bluffing. If the company negotiator accepts the offer, s/he avoids a strike but commits to a costlier labor contract. If s/he rejects the offer, s/he may get a more favorable contract if the union is bluffing, but s/he may provoke a strike if it is not.

Based on past experiences, relevant information, the advice of others, and her or his own judgment, s/he may conclude that there is about a 75 percent chance that union representatives are bluffing and about a 25 percent chance that they will back up their threats.

Thus s/he can base a calculated decision on the two alternatives (accept or reject the contract demands) and the probable consequences of each.

When faced with risk, managers must reasonably estimate the probabilities associated with each alternative. For example, if the union negotiators are committed to a strike if their demands are not met, and the company negotiator rejects their demands because s/he predicts they will not strike, his or her miscalculation will prove costly.

Much of what managers do— and most of the decisions they make—center around risk. Introducing a new product, adopting a new advertising campaign, agreeing to a new joint venture, signing a new contract, opening a new factory, or hiring a new assistant are each accompanied by some degree of risk. Indeed, if managers don’t take risks, in all likelihood their firms will stagnate and fall behind those who do. But the astute manager can manage risk and can usually keep it within acceptable limits.