Importance of Risk Analysis and Evaluation in Business

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Introduction

There are various definitions of risk (Kelman 2003; Thywissen 2006). A definition by Lowrance (1976) state that risk is a possible measure of probability and severity of adverse effects. A clear understanding that risk is a function for the performance of the states of the system is required and in return practicing the risk event. Combination of the consequences of an event also measures risk.

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Risk analysis involves identifying the possible threats that are likely to occur in an organization and analyzing the related ability of an organization to manipulate these threats (Geoffrey H.Wold &Robert F. Shriver, 1987).

Risk analysis involves understanding and identification which is a step that is emphasized in the risk management process and it provides a formation for the decisions on risk reduction that may be based on. Analysis of risk allows priority areas to be targeted for risk reduction and in the allocation of enough resources and hence this therefore plays an important role in cost benefit studies which provides a comparison for the costs of a particular action or project against its potential benefits. (Society of risk analysis, 2009)

One of the component for forming context is the development of a set of risk evaluation criteria against which risk level and the effectiveness of suggested treatment strategies can be measured, The first step of risk management process (ASINZ 4360 2004). Decisions have to be made In developing risk criteria. Risks to be evaluated may be based on any number of criteria like humanitarian, social, environmental, operational and financial.

Risk analysis has to match with risk evaluation method that is established. Risk analysis focuses primarily on biophysical vulnerability which is experienced by the element at risk as a result of an encounter with a hazard (Adger et al 2004). Biophysical vulnerability model aims at determining the impact of a hazard on the elements at risk such as people, buildings, infrastructure and the economy.

Environmental factors that cause risk

Pearce &Robinson (2002) discuss four external environmental factors economic, political, social and technological. Each external factors influence corporate strategy. While these descriptions are generally accurate, they may give false impression that the components and factors are easily identified, mutually exclusive applicable in all situations. (Pearce & Robinson, 1985) forces in external environment are so dynamic and interactive that the impact of any single element cannot be wholly disassociated from the impact of other elements.

Sullivan Arthur &Steven M.Sheffrin (2003) discusses economic factor as one of the environmental factors that cause risk which include economic policy, influences of the supply and cost of money reflected by the level of interest rates caused by the dissemination of government agencies and central banks. It also includes economic conditions generally revealed through economic reports and other economic indicators. For instance, trade deficits may have a negative impact on a nations currency, market usually reacts negatively to widening government budget deficits and in a high level of inflation in the country, a currency will lose value.

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According to (Stephen J.Kobrin, 1979), political factors cause a risk to an environment; this comes as a result of the forces from the national governance which causes interference or prevention from the normal operation of the business or change in the terms of agreements or cause complete or partial destruction of the business property that is owned by foreigners.

Stephen R.Toney (1998), also explains technology as another factor that causes risk to the projects whereby unlike most others they have the potential of failure to meet their goals. The six factors that influence the risk of failure are the failure to meet expectations, the activity for which the technology system is targeted is a factor in the probability of success, resources and commitment, organizational setting which describes the extent to which the proposed project requires cooperation and interrelationship between organizational units, whether the technology is new, old or current, the experience in the use of the technology has an effect, for instance if there is low experience in the use of technology there are high chances for high risk.

Paul B.D. (1955) explains culture as a factor which causes risk, it is composed of the set of beliefs, moral values, traditions language and laws (or rules of behavior) held in common by a nation, a community or other defined group of people. further still, customs including marriage that accompany religious and other beliefs, acceptable gender roles and occupations, dietary practices, intellectual, artistic and leisure time pursuits and other aspects of behavior. For instance in the United States and other nations with large immigrant populations there is a wide range of cultural diversity, religious beliefs, customs and values reflecting the scattered origins of the people.

Physical activities of different types of communities, home and work places differ and this can influence peoples health decisions and their way of doing things or performing duties and hence this is one of the elements environmental factors that cause risk in industries. Due to this factor, it is important to create environments in these locations that make are favorable in the engagement of the physical activity and in eating healthy diet. (National Centre for chronic disease prevention and health promotion, 2009).

Types of decisions that expose companies to risk

S.C.Young, (1993) Clarifies that the objective of analyzing a company’s risk exposure is to gain an understanding of the risks that the company faces. It’s from these that a company may be able to estimate the level of future losses and decisions of how best to manage these risks. Decisions typically depend upon many factors; utility theory can be used to summarize the advantage that a company will obtain from each alternative in a given situation. Decisions can be applied to determine the best course of action using the company’s utility function and its estimation for the future. Decisions depend upon the ability of a company to sustain a loss from retained risks and regulatory requirements relating to the risks

Risk perception influence behavior, unintended interpretations of the risk disclosure could adversely affect investor and analyst judgments and decision making (e.g., valuation judgments; buy/sell/hold decisions). (Slovic et al 1980; Viscusi et al 1986)

The types of decisions that expose companies to risk comprise of; Strategic decisions involve overall strategy which is the decisions which require considerable and careful use of judgment considerably for a person responsible for making decisions. Important pieces may be frequently missing hence these decisions will require a needed amount of analysis. These decisions may require production and improvement of a new product and investment in new plant or the development of new marketing strategy. (David Needham & Robert Dransfield, 1990).

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Capital Investment decisions as discussed by R.J.Bull (1980) is a future expectation of earnings of income over a specified period of time and in any investment makes it necessary for the commitment of funds show. Allocation of resources to fixed assets in a way to produce a lot of capital returns is important in this decision. It is important because it can influence the fortunes of the business for years to come. Investments normally generate future cash flows into the business, but it is also important to keep in mind that some investments are designed to affect cash savings by reducing the scale of costs associated with a particular activity. (R.J.Bull, 1980).

Enterprise risk management. formalisation of decision making and risk management has taken place in most companies. However the two processes cannot be integrated and aggregated to enterprise level. As a result, since business managers must make decisions on value enhancing opportunities without integrated information on risk exposure similarly, risk managers are making decisions on risk mitigation without integrated information on the value impact. In addition, risk management is often performed in silos where each risk type is managed independently without integrated information on how multiple risks interact, which often causes a firm’s failure (Watson Wyatt Company).

Risks and uncertainty in the sphere of investment decisions the problems of risks and uncertainty refers to the same thing. Risk arises by virtue of incomplete knowledge of a specific course of action. Uncertainity refers to the factors which influence the problem but on a general wide scale such as the general economic climate or the effect of political action whereas risk is used in discussion on outcomes of particular projects, fortune of a particular class of investor or determination of the market response which gives rise to the risk. (Wilfred Hingley&Frank Osborn 1978).

Techniques that deal with risk and uncertainty

Courtney, Kirkland and Viguerie (1997) suggest that different risk analytical techniques should be employed by managers for the different levels of uncertainty. They further explain that more qualitative tools should be used as uncertainty increases.

For over the last thirty years the concept of risk and uncertainty has undergone a substantial improvement. Industries like nuclear and oil have used widely quantitative and this has resulted to greater performance in efforts and the quality control on industrial production lines and to minimize losses due to accidents. Attention has been given recently to certain non quantitative techniques which consider human issues to do with management control and the safety culture. (IPCC, second assessment report, 1996).

Disaster risk reduction is one of the techniques used to focus on the prevention and reduction of the effects of disasters. For example, there may be development of restriction or building codes which may be implemented in certain areas of a city that have a high chance of being affected by flood. They offer protection incase of earthquakes or a specified level of shaking. United Nations has an international strategy on promotion of risk reduction. (Eric Schwartz, 2006).

Operation risk management is another technique which is used in dealing with risk and uncertainty. This process includes risk assessment, risk decision making and implementation of risk controls which result in acceptance, reduction or avoidance of risk. It also involves the regulation of operational risk including the risk of loss resulting from insufficient or failed internal process and systems, human factors or from external events. (Committee draft of ISO 31000).

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Conclusion

Design of hazard control system technique involves classification of the action changes and the disruption of the action chains. This method is designed inorder to reproduce actions among the elements of the system. (Sato Y.Henley & E.j.Inoue K, 1990)

Because of implementation problems which arise from lack of data and high uncertainty, Miller and Waller (2003) propose the use of a qualitative technique as an option together with the scenario planning inorder to develop a corporate integrated risk management tool.

Attention has been given to the literature such as Kahneman and Tversky (1979,2000), March and Shapira (1987), Benartzi and Thaler Wiseman (1999) and Leggio and lien (2002).This authors argue that when faced with risky decisions, decision makers fail to act according to the principles of rationality. The presence of risk and uncertainty appears to affect the decision making process as well as partly problems in gathering and processing information (Maritan 2001; Sharfman and Dean 1997)

Specific decision tools are more appropriate and important for some levels of uncertainty (Courtney et al, 1997)

Alessandri (2003) shows that risk and uncertainty are different and the two have different influences both jointly and individually on the process of decision making. When managers face risk, they tend to use more analytical, quantitative approaches and focus on finding the best decision.

List of references

Alessandri.T. (2003).The impact and uncertainty on rationality; Evidence from capital investment decision processes working paper presented at the academy of management conference.Seattle. WA

Carliss.Y.Baldwin, Donald V.Fites and Jeffrey.H.Dyer (1999-2007), Harvard Business Review on managing the value chain.

Committee Draft of ISO 31000, Risk management International organization for standardization.

Courtney.H.Kirkland, J, and Vigueria.P. (1997) Strategy under uncertainty.Havard Business Review, 75 (6), 66-79

Dave Needham, Dransfield, Rod Harris and Martin Coles (1995), Business for higher awards, Heinemann,

David Needham & Robert Dransfield (1990), Business studies. UK. Mc Graw-Hill International.

Eric Schwartz (2006), A needless toll of natural disasters, op-Ed, Boston.

Geoffrey H.Wold &Robert F.Shriver (1987), ’Risk analysis techniques,’ Disaster recovery journal.

March. J.G and Shapira. Z. (1987).Managerial perspective on risk and risk taking management Science.33 (11)

March. J.G and Simon. H.A (1958). Cognitive limits on rationality in organizations.Newyork.John Wiley &Sons (pp 137-172)

Paul, B.D.ed (1955), Health, culture and community, Russell sage foundation, Newyork.

Maritan C.A. (2001).Capital Investment as investing in organizational capabilities: an empirically grounded process model. Academy of management journal, 44(3), 513-531.

Thaler, R. Tverky, A.Kahnemann and Schwartz A. (1997).The effect of myopia and loss aversion on risk taking. An experimental test. Quarterly journal of economic, 112,647-661

Pearce &Robinson (2002), strategic management. Boston. Mc GrawHill

Pearce &Robinson, R (1985), strategic management. Boston. Mc GrawHill

R J Bull (4th edition) (1980) Accounting in business: London Page Bros (Norwich) Ltd.

Slovic, P. (1966) Trust emotion, sex politics and science. Surveying the risk assessment battlefield in psychological perspectives to environment and ethics in management

Stephen R.Toney (1998), ’Risk factors in technology projects’, Systems planning

Viscusi, W.W.Magat and J.Huber (1986) Information regulation of consumer health risks. Journal of economics, 17.351-365

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