Project Management - Managing Risk
What is a Risk?
Risk means uncertainty or chances of bad consequences. In other words, risk is possibility of loss, injury or destruction. It is always in negative sense. Its opposite is certainty, surety and safety.
In all businesses, risk is inevitable. In project management, there is a risk even before implementation, more risk while project is being implemented and still more when the project goes on steam such as no demand for the products or bad debts or bad-employees passing information to the competitors.
If one is certain about the outcome, there is no risk. This is known as zero risk. In our daily life, we go on doing our normal activity without an apprehension of risk like eating home prepared rice-curry. There may be one in million chances that there is food poisoning. Similarly, we have faith in national savings schemes and take no risk while purchasing Government’s DSCs (Defense Savings Certificates). If it says that the annualized return would be 18%, there would be no doubt in its creditability and hence no risk of default or lesser returns. This cannot be in case of a corporate bond, much less in corporate shares floating in the market.
Please remember that where ever there is no-risk, there would be minimum profit. For high profit, one should assume high risk. This is called Risk and Return Trade off.
What is Risk Management?
While risk is un-avoidable, it is manageable. We can manage the risk in a way that either it is passed on to others or considerably reduced. Let us say that we are building a house and are afraid that the steel-bars price may rise. If we want to eliminate this risk, we can purchase the bars and hold it in stock. (Though one risk is eliminated, other risks may crop up like risk of stealing, risk of obsolescence or risk of damages.)
Risk Management is the identification, assessment and management of risk at most economical cost. One can eliminate risk of theft by putting the goods in fortified stores posting gun-touting guards but the cost maybe more than value of the goods stored. The cost would considerably reduced if one is willing to assume a moderate risk like 5% probability of loss. That means a normal storage and a normal system of watch and ward.
A case study for Risk Assessment
The above data is based on a real-life box-making unit. Its cost-price structure had been very stable in the past. Both costs and prices have moved within a narrow band. Therefore, the assumed price is 30±1. Same pattern is reflected in cost. Fixed cost represents “fixed manufacturing costs”. Likewise, interest represents mark-up and bank charges. These costs are incurred on annual basis whether the unit is closed or is in full production.
BEST CASE & WORST CASE SCENARIO
From this simple model, we want to ascertain as to what could be the maximum profit if all factors were in our favor. It means, we get the maximum price but the minimum cost. In worst case scenario, it would be reverse: minimum price and maximum cost. Best & Worst Case Scenario calls for a decision – to go ahead or not.
Suppose one person wants to ride a rail which is about to leave. One is tempted to jump in without a ticket but one would think that if caught, what would be the maximum penalty. If it is Rs.500 and that person has more than it, he would take the risk. But if it is two-month imprisonment, no one would dare to enter the train without ticket.
We observe that if worst come to worst, we would incur a loss of Rs.17,600. Can we survive if we have to bear such a loss. It depends on our financial strength. If we are a large company such a loss is a peanut. If small, such loss may wipeout our business.
In the best case, we earn Rs.34,800. Higher the return, more the temptation. But if at best, one gets a small amount, one wouldn’t be interested to go for it in any case.
Business Risk & Financial Risk
Stated in another way, there are two types of risks: Business Risk and Financial Risk. Business Risk comes with the industry one enters. It is due to presence of fixed costs, the higher such costs, higher the risk. It is inherent and unavoidable. For example, one who runs a hotel knows well that the annual cost of running a hotel is fixed in nature like maintenance, depreciation, insurance, salaries and interest. It means that the hotel had to maintain a high occupancy rate to survive and a slight drop would take it into the red.
There are other types of industry like Edible Oil Plants. These plants have rather small fixed production costs but huge variable costs. If sales drop, so would be the variable costs. As such, an edible oil plant may easily survive in slump conditions whereas the hotel may have to go into bankruptcy.
Business Risk is measured by the degree of Operating Leverage (DOL) while measure of Financial Risk is degree of Financial Leverage (DFL), multiplying the two we get Degree of Total Leverage (DTL). The word Leverage means a force or pull, higher the leverage, higher the influence on profitability. Simply put, a DOL of 4 means that if earning increase by 1%, the Operating Profit would increase by 4% and vice versa.
Likewise, DFL would indicate changes in Net Profit as a result of changes in Operating Profit. TFL would reflect changes in Net Profit as a consequence of change in Sales.
Like in any business venture, project implementation is fraught with a variety of risks. One should not undertake a project without understanding the risks involved. Risks should be identified along with degree of threat. Once this is done, assessment process begins. Here the risk would be quantified through various tools and techniques as given in the chart.
At this point, one can categorize the risks involved. First is “Avoid” or do not go for it, leave it to others else it would be devastating for you. Second is ‘Pass it On” to others through contracts, insurance and guarantees. For example, the shopkeeper who extends credit to its customers through credit cards passes on the risk of default to the bank for a 2.5% commission. Third is “Assume” or go for it. This calls for provisioning or funding. While provisioning is a book entry, funding means physically keeping cash out of business for rainy days. One can have a contingent plan like cash limits, or stand-by arrangements like power generator etc.
But the best way is to reduce the risk. This could be by training of staff which comes under “Feedforward Control”. It could be phasing out like backward integration. A cloth merchant in Pakistan pursed this strategy and built an empire. First, he installed looms for making the cloth he was already selling. Second, he added yarn spinning for its looms. Third, he plans to go for a PTA Plant to manufacture raw material for yarn. Since, he had a captive market all the times, he reduced the risk of marketing.
There is certainly a tradeoff between capital costs and Operating Costs. If capacity is the problem, one can go for ‘cheap’ machinery and may later modernize it. Think of buying a printer for your own use. If you buy a cheap printer worth Rs.2,500, your printing cost would be Rs.5 per page. But due to small investment, your risk would be equally small. Next think of purchasing an expensive printer from Cannon for Rs.40,000. It would certainly reduce you copying cost to half-rupee per page but what if you do not have much to print?
Finally, one can reduce overall risk by having diversified portfolio of projects. I know of a soft-drink maker who went through slumps in winter. When he added a biscuit plant, he remained busy throughout the year as biscuits go with tea which is in high demand in winter.