Tag Archive | Business risk

Operating leverage explained

Operating leverage refers to relative amount of costs that are fixed and variable in the cost structure of a business. Some companies will have relatively high fixed costs compared to variable costs and are said to have a high operating leverage. For example, pharmaceutical companies incur up to $1billon to develop new drugs over a 10 to15 period[1], whereas the manufacture cost pennies – just think of the price of a pack of paracetemol in your local pharmacy. Low operating leverage means variable costs are a relatively high proportion of total costs. Retailers like Tesco or Sainsbury have relatively low fixed costs and relatively high variable costs – the variable cost of each item sold (e.g. the purchase price) is likely to be much higher than the associated fixed cost for that item. The degree of operating leverage of a company can be used to assess its risk profile. Companies with high operating leverage are more vulnerable to decreasing sales e.g. sharp economic and business cycle swings. Companies with a high level of costs tied up in machinery, plants and equipment cannot easily cut costs to adjust to a change in demand. So, if there is a downturn in the economy revenues and profits can plummet. On the other hand, companies with lower operating leverage can adapt their cost structure more rapidly as it has more variable costs.

[1] http://www.washingtontimes.com/news/2009/mar/13/blocking-drug-development/ accessed  Dec 4th, 2009

Risk management and management accountants

The idea of accountants taking risks tends to go against the stereotype image that accountants get – you know, grey suit, drives a Volvo and so on.  Businesses take risks everyday, based on information available and sometimes on experience or gut instinct. Management accountants provide a lot of the information needed by managers to make decisions on a daily basis. One wonders though what happened to assessing risk in banks in recent times. I am reading a book called Downfall by Joseph Stiglitz at the moment and he sure has a lot to say about the lack of risk assessment by US (and European) banks on recent years. In one passage he talks about how banks assumed the risk of other banks failing, or of a property-crash were seen as minimal. But look what happened.

I read a piece back in January in CIMA’s Insight on risk management and management accountants. The key message from this article was that management accountants need to get the message across about risk. They are after all providers of information for decision making, and are training in risk management.  As noted in the piece, defining exactly what risk is is not that simple. It seems risk managers may not have been overly involved in decision-making at high levels in recent times. The author suggests that risk managers and managements accountants work closely together to get the message across about risk. I couldn’t agree more. Management accountants may have shook off the dull, boring stereotype and are now often part of the management team and/or board. Thus, as the article suggests, risk managers might piggy-back on the organisational knowledge of management accountants and get active in the areas where risky decisions are being discussed or taken – i.e. at board level.

Risk in business

Any business faces risks at some time or another. Some may be easy to avoid or foresee, and thus measures can be taken to avoid or reduce them. Student Accountant (the ACCA’s student magazine) of June 16th last includes a feature on the recent volcanic ash cloud take caused chaos over European airspace on April this year. It might be something the airlines had not really thought about before now, but you can bet they now include disruption from volcanic ash in their assessment of business risk. The estimated losses from the disruption are in excess of $1bn – not exactly what the already recession hit airline sector needed.  Can all business risks be eliminated ?  Of course not, but businesses can try to minimise or reduce risks. As mentioned in the article,  a four point TARA model can be used to assess risk:

Transfer the risk to another organisation such as an insurance company.
Sometimes this is the only option open with some risks that cannot be controlled, or are not cost-effective
to control.
Less likely here (after all, it may be hard to do anything to stop the volcano erupting!) and so may not be relevant
in this case.
For example, never let your key staff out of the country, or place business travel restrictions on senior decision
makers (at the very least put them all on separate flights – consider the recent Polish government air disaster).
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