In today’s economic climate both private and public sector are looking to cut costs. Essential items are scrutinized and “nice to have” items no longer included on the shopping list. When times are hard, available funds for unexpected items often decrease. Financial and strategic risk management becomes ever more critical for continuous success.
Increasing insurance cover is one way of ensuring any mishaps will not rock the boat too much. Another strategy is to tighten risk management procedures, leading to tangible, immediate cost reductions, such as fewer work induced illnesses, less injuries or spills and potential reductions in insurance costs.
Risk is not always limited to the owner of the hazard –major accident hazards carry risk potentials that can reach staggering amounts. For example, the cost of the fertilizer plant accident in Toulouse a few years ago has been estimated to have reached over 150 billion Euros – much paid for by society. Another example where societal costs can be hefty is water as several cases of drinking water contamination in Finland and abroad illustrates. Here the risk is taken by consumers drinking the water, but the risks of water contamination are largely managed by water companies, some of which have a very rudimentary idea of risk management.
To spend or not to spend?
Investments and increased expenditure in the somewhat abstract area of risk reduction can be hard to justify at first glance. Nevertheless, effective risk recognition, prioritization and management often not only protect you from losses but have the added benefit of actually reducing operational costs. Each saved euro will add directly to the company bottom line – in contrast, with a 10% net profit margin, you would have to increase sales by 10 euros to achieve the same increase in profitability. The cost of risk can be calculated through a simple equation:
Cost of risk = Risk management internal administrative costs + outside services and supplies + insurance premiums + losses
A reduction in any of these factors will decrease the cost and thereby increase profitability. In one case, a risk reduction program focused on worker ergonomics cost over 100 000 US$ to execute and another 70 000 US$ annually but saved the company some 700 000 US$ annually, thereby being equivalent to several millions of increased sales – not a bad return on investment.
The “cost of risk” factors are interrelated – for example, if you decrease investments in risk management, you are likely to occur higher losses. There is also a ceiling to what can be gained – the point when the predicted reduction of losses becomes less than the required investment. Finding the optimum balance may require application of traditional financial tools such as sensitivity analysis or cost-at-risk analysis in combination with assessment of the benefits to be had. Benefits often include not only cost reductions but also as intangible income: an increase in worker satisfaction, reputation, trust or image.
Denial or recognition?
To manage risk, you first have to recognize there is a risk that needs managing. Often risk management is regarded as a technical subject with ethical connotations, done because it is “the right thing” and cost is either not analysed or analysed in a superfluous manner. Far too often the company culture is still in a denial stage: “we do not have any risks that need managing” or “we have already identified and eliminated all our risks”. As long as this is the management view, there is little hope of using this potentially very effective management tool to increase return on investment.
When risk potential is recognized, it can be managed and from a risk management perspective, the old saying of “to manage it, you have to be able to measure it” has more than a grain of truth in it. Optimal risk management covers several aspects, allows prioritization and comparison of different types of risk – from a business point of view, prudent risk management is simply a way of ensuring your chosen business strategy will continue to allow you to be profitable. Successful companies encourage “what if” thinking and evaluate risk management investments based on potential for both monetary and intangible return. Risk management is seen not as a potential drain on cash flow but as a means of increasing profitability.
Identifying, measuring, prioritising and actively striving towards reducing the cost of risk will, in the long run, save you money, time, effort and heartache.
Gaia Consulting Oy