Costs of Business Risks - Essay Example

?Academia research Costs of Business Risk Management Accounting Maribel P. Jabido 5/16 The process of risk management involves risk identification, analysis, risk response planning, and risk monitoring and control. The costs of risk can include direct, indirect, and legal costs. Management of risks can be achieved through strategic management and enterprise risk management in market-based economies and use of non-market strategies. Management accounting must be able to measure costs and benefits of risk-response. It also entails strategic decision making that weighs the risk involved in all areas of business. Costs of Business Risk 1 Costs of Business Risk All projects in business involve risks and uncertainties. Risk identification determines what risks in the projects will affect the business. After identifying what these risks are, they are measured by means of using two types of risk analysis: qualitative risk analysis and quantitative risk assessment. According to Project Management Guide (2011), qualitative risk analysis is the relative measure based on the degree of quality or separating in categories such as high or low risk, less or more important risk, or a scale of 1-10. Quantitative risk assessment uses measurable and empirical data such as probability charts and percentages to determine associated risks. Responding to risks and ability to control these risks must be effected in the risk management process. Risk-response planning is essential in considering the most appropriate response that produces the greatest positive net benefit that which exceeds associated costs. Risk monitoring and control can be accomplished by using effective management strategies. Based on Johnson, K. and Swanson, Z. (2007) definition, enterprise risk management (ERM) is a strategy applied throughout the company and one of the key factors that directs the business where it Costs of Business Risk 2 intends to go. This strategy involves determining all activities and drivers that affect these activities through analysis. It gives the company the ability to control its risk so that it may focus on the things that are necessary in operating a business. Strategies used in market-based economies have an impact on economic growth. Globalization has flourished and is affected by the success and challenges of strategic management that are direct influence of strategists that play a role in society. Strategic management is defined as “an ongoing process that evaluates and controls the business and the industries in which the company is involved; assesses its competitors and sets goals and strategies to meet all existing and potential competitors; and then reassesses each strategy regularly to determine how it has been implemented and whether it has succeeded or needs replacement by a new strategy to meet changed circumstances, new technology, new competitors, a new economic environment., or a new social, financial, or political environment.” (Lamb, 1984:ix, Strategic Management, 2011). Firms emphasize on objectives that are “competitor-oriented” and focus on profitability. Cultures that have convergence characteristics such as China and India have developed rapidly. Corporations have used outsourcing to create “cost-savings strategy.” (Juras, 2007). At the same time, relations between financial regulatory agency and companies regulated with presence of Financial Accounting Standards Board (FASB) adapted ‘non-market strategies’ that involve social and political issues. Corporations are using this strategy to have innovative advantage in the market. For instance, according to Wu, B. (2010), Novartis AG, the fourth largest pharmaceutical company in the world faced with the challenge over denial of patents for a drug that treats cancer, conducted campaigns of giving away drugs for tuberculosis, malaria, Costs of Business Risks 3 and leprosy at little to no cost. Likewise, Toyota with assistance from environmentalist earned the right for owners of Prius hybrid cars to use carpool lanes in California even for drivers with no passengers. Market or non-market strategies involve some degree of risk. Firms need to measure the incremental costs (direct and indirect) associated with risk-response. According to Ballou, B., Heitger, D., et al. (2009), direct costs include costs of insurance, often referred to as business interruption insurance, costs of hedging that helps minimize risks, costs of strategic alliance or use of third parties so that it can reduce risk exposure, and costs of control activities. An example of indirect cost is negative impact on the organization’s reputation or reputation cost that is the result of specific risk response. A firm needs to find effective ways in reducing costs and controlling risks. It is the reason why organizations have delegated responsibilities that use enterprise risk management (ERM) to different positions such as managers, accountants, and internal auditors. ERM uses the key steps in incorporating the costs of risk-response. Measuring the cost and benefit of risk response can help estimate its effectiveness. The net benefit can be measured as follows: Net Benefit = inherent risk – residual risk Net Benefit – Cost of Response A positive net benefit represent a benefit that exceeds associated costs while a negative net benefit, as described by Ballou, B. et al. (2009) “should not be considered because its benefit is not sufficient enough to exceed associated costs” (p. 3). In addition, there are legal costs that can be incurred in litigation that can range from 3% to 10% of a firm’s annual revenues. Costs of Business Risks 4 To summarize Johnson, K. and Swanson, Z. (2007) description, Enterprise Risk Management (ERM) is an ongoing process that must be reinforced by decision makers and be part of the corporate culture and effected by these decision makers (e.g. board of directors, managers, and other personnel) just as making a profit. It is rather a strategy and not a tactic. It is designed to determine what potential events may affect the firm. It manages or controls its risk within its risk appetite. And lastly, it provides reasonable assurance to meet its goals and objectives. Risk and performance is measured when making top decisions that could affect business. Empirical analysis, according to Dai, Z. (2005) show that” risk has more significant impact on CEO turnover than a firm’s past accounting or stock-price performance and firm-specific risk affects these turnover decisions and not market or industry risk” (p.12). And, in these studies, shows that “risk dominates performance” (p. 37) from both stock returns and accounting earnings. Change in risk measures have marginal probability of 8% while performance measures have 5%. Conclusion It is critical that risk must be taken into account in all areas of business because it plays an important role in decision making. Higher management level (such as managers, controller or internal auditor) or decision makers (such as board of directors) must implement planning and control based on risk treatment such as using enterprise risk management (ERM). Risk-response strategies must be commensurate to company goals and objectives that will help in risk and cost reduction and produce positive net benefit. Costs of Business Risk 5 References Ballou, B., Heitger, D., Schultz, T. (2009). Measuring the Costs of Responding to Business Risks. Management Accounting Quarterly. p. 1-11. Dai, Z. (2005). What Matters More for CEO Turn-over: Performance or Risk. p. 9-43. Grant, John H. (2007). Advances and Challenges in Strategic Management. International Journal of Business. p. 11-24. Johnson, K., Swanson, Z. (2007). Quantifying Legal Risk: A Method for Managing Legal Risk. Management Accounting Quarterly. p. 22, 8 pgs. Juras, P. (2007). A Risk-Based Approach to Identifying the Total Cost of Outsourcing. Management Accounting Quarterly. p. 43, 8 pgs. Wu, B. (2010). CEOs Adapting to New Non-Market Strategies. UES Marketplace. Retrieved from http://uesmarketplace.com/2010/05/24/ceos-adapting-to-new-non-market- strategies “Strategic Management.” (2011). Retrieved from http://www.scribd.com/doc/46544265/Strategic-Management “Qualitative Risk Analysis.” (2011). Retrieved from http://www.pmvista.com/qualitative-risk- analysis/ Read More