This article looks into what Risk Analysis is, its types, how it’s performed, qualitative vs. quantitative risk analysis, and its advantages and disadvantages.
What is Risk Analysis?
Risk analysis involves evaluating the likelihood of potential adverse events that could harm both organisations and the environment. It is a process commonly carried out by corporations (such as banks, construction companies, and healthcare providers), governments, and nonprofits.
Performing a risk analysis assists organisations in deciding whether to proceed with a project or endorse a financial request, as well as determining necessary measures to safeguard their interests. This analytical approach aims to strike a balance between risks and strategies for risk mitigation. Risk analysts frequently collaborate with forecasters to diminish negative impacts in the future.
Types of Risk Analysis
Risk analysis can take on different forms based on the focus and level of detail.
Cost-Benefit
Cost-benefit analysis (CBA), also known as benefit-cost analysis, involves a method for evaluating the merits and drawbacks of various choices. Its purpose is to identify the most effective alternatives that generate advantages while maintaining cost efficiencies in transactions, activities, and operational business needs.
CBA serves as a tool to compare existing or potential actions, assess their worth against the expenses incurred, and gauge the value of a decision, project, or policy. Widely applied in appraising business strategies, policy-making (especially in the public sector), commercial dealings, and project funding, CBA serves as a pivotal tool for decision-making.
Assessment of Needs
Assessing-needs analysis focuses on identifying and evaluating the specific requirements of a project, system, or initiative. It involves a comprehensive examination of the resources and capabilities necessary for achieving desired outcomes. By systematically assessing these needs, businesses can better understand their operational requirements, allocate resources effectively, and lower the risks from resource scarcity or misalignment.
Impact on Business
Business-impact analysis involves assessing the potential effects that various risks may have on different facets of a business. It encompasses a detailed examination of how specific risks could impact operations, revenue, customer relationships, reputation, and other critical aspects. As such, organisations gain insights into the potential consequences of risks, allowing for the development of effective solutions.
Root Cause
Root-cause analysis delves into the underlying causes of risks or problems within an organisation. Instead of focusing solely on the visible symptoms, this method seeks to identify the fundamental reasons behind issues. In discovering the root causes, businesses can address problems at the source, preventing recurring issues and enhancing overall risk management strategies.
How Risk Analysis is Performed
While various forms of risk analysis exist, several share similar steps and goals. Each company might opt to modify the following steps, yet these six stages generally delineate the common procedure for conducting a risk analysis.
1. Risk Identification
The initial phase in various risk analyses involves compiling a catalogue of potential risks, encompassing both internal threats stemming from within a company and predominantly external risks originating from outside influences. Ensuring the involvement of diverse company members in this brainstorming session is crucial, as different departments offer varied perspectives and insights.
A company might have already tackled major risks through a SWOT analysis. Although a SWOT analysis could serve as a starting point for further deliberation, risk analysis typically focuses on addressing specific questions, while SWOT analyses tend to be more overarching. While some risks might overlap, a risk analysis aims for greater specificity when targeting a particular issue.
2. Uncertainty Identification
The primary objective of risk analysis is to pinpoint problematic areas within a company. Often, the riskiest aspects coincide with undefined or ambiguous territories. Hence, a pivotal facet of risk analysis involves understanding the uncertainty associated with each potential risk and quantifying the range of risk that uncertainty entails.
Consider the instance of a product recall due to defective units shipped. A company might not possess precise data on the number of defective units, prompting the creation of various scenarios involving partial or complete product recalls. Additionally, the company might devise multiple scenarios for resolving the issue with customers, presenting low, medium, or high engagement solutions.
3. Assessing Impact
Typically, the aim of risk analysis is to comprehend how risks will financially impact a company. This is usually computed as the risk value, derived from multiplying the probability of an event occurring by the cost associated with it.
For example, in the scenario mentioned earlier, the company might evaluate a 1% likelihood of product defection, resulting in a $100 million cost if the event occurs. Thus, the risk value assigned to the defective product would be $1 million.
It’s crucial to prioritise averting potentially catastrophic outcomes. For instance, even if the risk value is $1 million, a single defective product could severely damage brand image and customer trust, potentially leading to the company going out of business, particularly if its annual sales only amount to $40 million.
4. Constructing Analysis Models
The inputs gathered are often generated into an analysis model. This model processes all available data, attempting to generate diverse outcomes, probabilities, and financial forecasts. In more sophisticated scenarios, scenario analysis or simulations can determine an average outcome value, quantifying the expected occurrence of an event.
5. Analysing the Results
After running the model and obtaining the data for review, it’s time to analyse the results. Management evaluates the information, comparing risk likelihood, projected financial impact, and model simulations to determine the optimal course of action. They might also request different scenarios for various risks based on differing variables or inputs.
6. Implementation of Solutions
Post-analysis, it’s time for management to act on the information gathered. Sometimes, the plan might involve maintaining the status quo; in risk acceptance strategies, a company decides not to alter its course as it makes more financial sense to deal with the risk if it occurs. Alternatively, management may opt to mitigate or eradicate the risk.
Qualitative vs. Quantitative Risk Analysis
Qualitative Risk Analysis
Qualitative risk analysis is based on expert judgement and subjective assessments. It doesn’t involve numerical values but rather uses descriptors like “low,” “medium,” and “high” to rank risks. This approach is suitable for a quick assessment of risks and is often used when detailed data is lacking. It is subjective in nature and relies heavily on the experience and expertise of the individuals involved.
Some examples of qualitative risk tools are SWOT analysis, cause-and-effect diagrams, decision matrices, game theory, among others.
Quantitative Risk Analysis
Quantitative risk analysis, on the other hand, involves numerical data and mathematical models to assess risks. It assigns specific probabilities and monetary values to risks, allowing for a more precise and data-driven evaluation. This approach is useful when you have access to historical data, statistical information, or when the risk’s potential impact can be quantified.
Advantages and Disadvantages of Risk Analysis
Risk analysis is often a double-edged sword and it pays to look at the advantages and disadvantages of doing it.
Advantages
Risk analysis allows companies to make informed decisions and strategise for unforeseen circumstances before they occur. Not all identified risks may come to fruition, yet it is crucial for a company to comprehend potential occurrences, enabling proactive planning to mitigate potential losses.
Furthermore, risk analysis aids in quantifying potential risks, allowing management to gauge the financial implications of potential events. This information can steer companies away from unviable ventures and prompt actions that diminish the probability of adverse financial impacts.
Moreover, risk analysis serves as an early warning system for potential catastrophic events. For instance, it may flag inadequate security measures for customer information. In such cases, conducting risk analysis can prompt the implementation of enhanced processes, meticulous documentation, fortified internal controls, and risk mitigation strategies.
Disadvantages
Risk, being a measure based on probability, cannot definitively specify one’s precise risk exposure at any given moment. It solely indicates the potential range of losses that might arise when incidents occur. There exists no standardised approach for computing and evaluating risk; even Value at Risk (VaR) can be approached in various ways. Typically, risk is presumed to adhere to normal distribution probabilities, which seldom align with reality and fail to accommodate extreme or unforeseen events known as “black swan” occurrences.
The 2008 financial crisis exemplifies these issues. Benign VaR calculations inadequately portrayed the actual risk exposure posed by portfolios holding subprime mortgages. The estimations of occurrence and risk magnitude were undervalued, leading to excessively high leverage ratios in subprime portfolios. Consequently, these miscalculations left financial institutions incapable of covering losses amounting to billions of dollars when the value of subprime mortgages collapsed.
Ultimately, businesses perform risk analysis to make informed decisions, allocate resources effectively, and protect themselves from potential disruptions or losses. It’s a crucial part of strategic planning and management, helping organisations navigate uncertainties and maintain resilience in a dynamic business environment.
DISCLAIMER: This article is for informational purposes only and is not meant as official business advice. AVANTE PARTNERS does not condone, endorse, or disparage risk analysis as a business practice and has no working relationships with any risk analyst.