Operating Risk

What is Operating Risk?

Operating risk refers to the likelihood that a company's profits or losses will be lowered owing to variables relating to its operations. 

Technical failures, operational faults, supply chain interruptions, legal and regulatory compliance challenges, and human error are all potential drivers of these risks. Operating risk can significantly impact a company's financial performance, reputation, and overall success.

Examples of operating risks include

• IT system failures that result in data loss or security breaches
• Production or manufacturing failures that result in defective products or delays in delivery
• Supply chain disruptions include shortages of raw materials or delays in shipping
• Compliance issues related to regulatory requirements, such as safety or environmental regulations
• Human errors, such as mistakes in data entry or processing

Operating risks can be challenging to anticipate and manage, particularly for businesses with complex operations or extensive supply chains.

Implementing effective risk management strategies, such as comprehensive frameworks and contingency plans, can assist businesses in mitigating the potential impacts of operational risks.

These strategies may include implementing comprehensive risk management frameworks, developing contingency plans for potential disruptions, and regularly assessing and monitoring risks to identify potential issues before they occur.

Impact of Operating Risks on Businesses

Operating risks can have significant implications for businesses, impacting their financial performance, reputation, and competitive position in the market. Here are some of the key impacts of operating risks:

1. Financial losses

Operating risks can result in business financial losses, including revenue losses, increased costs, and legal liabilities. 

For instance, a product defect leading to injuries may result in costly legal proceedings and settlements. Reputation damage can long-term affect customer retention, investor confidence, and business sustainability. In addition, financial setbacks can negatively knock on a business's operations, resulting in decreased profitability, less R&D spending, and other long-term effects.

2. Reputation damage

Operating risks can damage a company's reputation, affecting its brand value and customer loyalty. 

For example, a data breach that exposes customer information can lead to a loss of trust and credibility, causing customers to switch to competitors. 

3. Disruption of business operations

Operating risks can disrupt business operations, hampering a company's capacity to fulfill customer orders or deliver services.

For example, a natural disaster can disrupt supply chains, leading to delayed deliveries and lost sales. In addition, business continuity risks can significantly impact a company's revenue, market position, and ability to meet customer expectations.

4. Regulatory compliance issues

Operating risks can also result in regulatory non-compliance, leading to fines, penalties, and other legal liabilities. 

For example, companies failing to comply with environmental regulations may face fines, legal proceedings, and damage to their reputation. Regulatory compliance risks can also affect a company's ability to operate in certain markets, limiting growth opportunities.

5. Legal Liability

Certain operating risks can lead to legal liabilities for businesses. For example, if a company's products cause harm to customers, the company may be sued for damages. 

Legal fees and compensation payments can be significant and have long-term financial impacts on the business.

Strategies to Mitigate Operating Risk

Here are some strategies businesses can use to mitigate operating risk

1. Invest in technology and infrastructure

Investing in technology and infrastructure, such as predictive maintenance systems, can enhance operational efficiency and reduce the risk of equipment failure. 

For example, using predictive maintenance technology can help companies identify potential issues with the equipment before they lead to a breakdown, reducing the risk of production delays.

2. Diversify suppliers

Dependence on a single supplier increases supply chain risk, as disruptions to that supplier can lead to production delays. Diversifying suppliers can help companies mitigate this risk by turning to alternative suppliers if one supplier experiences disruptions.

3. Implement safety and quality control measures

Implementing safety and quality control measures can help companies reduce the risk of safety incidents, product recalls, or other quality issues. 

4. Develop contingency plans

Establishing contingency plans enables companies to prepare for unforeseen events and minimize the impact of operational risks. For example, companies can develop backup production plans, identify alternative suppliers, or establish emergency response procedures.

5. Conduct regular risk assessments

Regular risk assessments enable companies to identify and address new or emerging risks effectively. In addition, companies can use risk management software or other tools to conduct risk assessments and identify areas of vulnerability.

6. Develop strong relationships with stakeholders

Fostering strong relationships with stakeholders, including suppliers, customers, and employees, aids in more effective management of operating risks.

Measuring Operating Risks

Calculating operating risk can be challenging due to the need to estimate potential losses stemming from internal processes, people, and systems. As a result, several methods are used to measure operating risk, including:

1. Loss Data Analysis

This method involves analyzing historical data on operational losses to identify trends and patterns used to estimate the potential for future losses.

2. Scenario Analysis

This method involves identifying potential scenarios that could lead to operational losses and estimating each scenario's likelihood and potential impact.

3. Key Risk Indicators (KRIs)

Key Risk Indicators (KRIs) are metrics used to gauge the level of risk associated with particular operational processes or activities, providing insights into potential problems or emerging threats.

Some examples of KRIs that may be used to measure operating risk include:

• Number of customer complaints
• Percentage of incomplete or inaccurate transactions
• Employee turnover rates
• Number of system downtime incidents
• Compliance violations
• Average time to resolve customer complaints

4. Risk and Control Self-Assessments (RCSAs)

Risk and Control Self-Assessments (RCSAs) entail self-assessment by business units or process owners to identify risks and evaluate the efficacy of existing controls in managing those risks.

These are typically conducted periodically, such as annually or quarterly, and involve a standardized process for identifying and assessing operating risks.

5. Quantitative Modeling

This method involves creating mathematical models to estimate operating risks affecting a company's financial performance.

Operating Risk Case Studies

Let us analyze a few case studies of businesses that have suffered due to failure to manage operating risks. We will also discuss the lessons learned from each case and take a few practical learnings.

Case Study 1: Boeing's 737 MAX Crisis

In 2019, Boeing faced a crisis when two of its 737 MAX aircraft crashed, killing all passengers and crew onboard. The crashes were linked to a software issue with the plane's automated system, which caused the planes to nose dive. 

As a result of the incident, Boeing faced huge financial losses, legal liabilities, and reputational damage.

The lessons learned are:

• Effective risk management requires continuous monitoring and testing of systems and processes
• Companies should prioritize safety over profitability, even if it means delaying the launch of new products
• Strong corporate governance and communication are essential for managing risk and responding to crises

The practical takeaways are:

• Companies should implement comprehensive risk management frameworks, including regular testing and monitoring of systems and processes
• Companies should prioritize safety and ethics in all decision-making processes
• Companies should have effective crisis management plans in place, including clear communication protocols and strong leadership

Case Study 2: Target's Data Breach

In 2013, Target experienced a data breach that compromised the personal and financial information of approximately 70 million consumers. As a result, target faced legal liability, reputational damage, and lost sales due to the breach.

The lessons learned are:

• Cybersecurity risks pose an increasing threat to businesses, necessitating the implementation of robust risk management strategies
• Companies should prioritize protecting customer data by implementing rigorous cybersecurity measures
• Effective communication and transparency are vital for preserving customer trust and mitigating the consequences of data breaches

The practical takeaways are:

• Companies should regularly assess their cybersecurity risks and implement suitable security measures, such as encryption and two-factor authentication
• Companies should establish clear communication protocols to promptly respond to data breaches, including notifying affected customers and regulatory authorities
• Companies should prioritize transparency and honesty in all communications regarding data breaches

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Accepting Risk
• Activity Ratios
• Budget Variance
• Excess Reserves
• Net Debt-to-EBITDA Ratio