Everything we do has some risk. Walking down the street you could get hit by a car, or an asteroid for that matter; when eating an ice cream cone you could choke on the cone or get sick from bacteria in the ice cream. There are risks in investing in a new feed mill — the technology may change, sales may drop such that your payback period lengthens, or the crane installing new bins for the feed mill could fall over and destroy some of your existing grain storage — but some risks can have a bigger impact on your business, and the prudent feed and grain manager analyzes risk appropriately and manages accordingly.
Risks don’t have to be all bad. For example, what is the risk of significantly increased demand for a newly developed horse feed you are selling (which is a good problem to have) but are these risks lost sales or erosion of goodwill if you can’t meet demand, and how would this affect your business? Probabilities come into play here also: In other words what are the chances “so and so” will happen? Do you have historical data which can help you determine how often a certain event or occurrence happens in your business? Do you need to check with your insurance agent to help you assess risk? In fact, that is exactly why actuarial tables were developed historically — to give businesses the chance to better understand what might happen in given situations and the probability associated with certain events.
Methods to reduce, mitigate risk
Our purpose in covering risk in this column is not to make you an expert on everything involving risk and how to handle it, but rather to ask some important questions and provide some management ideas on a topic we don’t often dwell on. Risk makes most people uncomfortable, and the uncertainty associated with it causes people to worry. As such, the (mostly) rational nature of the general population and business managers generally leads them to do something to mitigate and minimize risks (though we do have to be careful about making broad generalizations as there are always the thrill-seeking adrenaline junkies that thrive on risky activities such as skydiving or bull riding).
Basically, people deal with risk in five basic ways: avoiding risk, retaining risk, transferring risk, sharing risk and reducing risk.
As an individual or as a manager, you can avoid some risks altogether by refusing to accept a particular risk, though this may not be possible for all choices. Risk avoidance can be accomplished simply by not engaging in the action that gives rise to the risk. If you want to avoid the risks associated with the ownership of property or a piece of equipment, do not purchase the asset, but lease or rent it instead; however, it is generally well understood in economics that the greater the risk taken, the greater the potential for return — thus if total risk avoidance were utilized extensively, both individuals and society would suffer.
Risk retention may be the most common method of dealing with risk. As we mentioned at the beginning of this column, individuals and businesses face an almost unlimited array of risks, and in most cases nothing is done about them because we may see the probability of an event occurring to be very small. Thus, when an individual or firm does not take a positive action to avoid, reduce or transfer a risk, then that risk is retained. This risk retention may also be conscious or unconscious. Conscious risk retention takes place when the risk is recognized but not transferred or reduced. When the risk is not recognized, it is unconsciously retained. The result in both cases is the same: The risk is retained. Risk retention is a reasonable strategy — firms must decide which risks to retain and which to avoid or transfer based on their margin for contingencies and ability to bear loss.