Risk can be measured using two methods: business risk exposure, or BRE, and value at risk, or VAR. Value at risk (VAR) looks at the raw risk level and money lost because of that risk exposure without considering any mitigating factors. Business risk exposure (BRE) uses the VAR and takes mitigating factors into account to find a more accurate risk exposure level.
For both of these calculations, the raw risk is needed. In other words, how much money would be lost if the risk occurred? If 30% of a customer base is lost because of reputational risk, the raw risk would be the income lost for that 30% decline in customers. The likelihood of that risk occurring is also needed. For that same risk, if it has a 10% likelihood of occurring, then that is the probability of the event. To calculate BRE, a third number is needed, the amount that risk is mitigated. This remaining risk is then multiplied by the VAR to find the BRE.
The overall analysis and assessment of these risks are then listed in a risk index. The risks with the highest BRE and VAR are listed first.
How to Calculate Risk
VAR is calculated using the likelihood that a risk will occur times the impact (or cost) of that risk occurring. BRE then multiplies the VAR by the remaining risk after mitigating factors are taken into account. The likelihood that a risk will occur can be calculated using factors such as:
- Material quality
- Past experiences with the failure
- Expected life or standard
- Current performance and reliability
The cost of that risk occurring can be calculated by including factors such as:
- Lost business
- Fees and fines
- Safety, health, and welfare
- Repair costs
- Legal fees
Mitigating factors may include:
- Redundancy
- Spares
- Back-ups
If a lawn care company is considering the risk of a lawn mower breaking, they may first calculate the risk by assessing how old the lawn mower is, how reliable it has been, and how long previous lawn mowers have lasted. Taking all these factors into account, they may determine that a 5-year-old lawn mower has a 75% chance of breaking down within the next year. Next, the cost of the risk occurring can be calculated. This may include loss of customers because their lawn is not mowed on time, accounting for 20% of the customer base, which would account for $1000 in revenue. The VAR is equal to {eq}0.75 \times 1000 = 750 {/eq}, making the risk exposure $750. But, mitigating factors include having a backup lawn mower on hand, which would mitigate 95% of the risk (for example, the lawn mower may be available 95% of the time, or it may only take 5% of the originally calculated lost time to get the lawn mower on site). To calculate BRE, the VAR is multiplied by the remaining risk of 5%: {eq}750 \times 0.05 = 37.5 {/eq}. This puts the total risk at only $37.50. Depending on the business model, this may or may not be a risk worth taking. If it is a risk worth taking, then the new lawn mower will only be purchased after the current one completely breaks down. If it is not a risk worth taking, then a replacement lawn mower may be purchased now.
Risk Analysis
Risk analysis takes into account the risk index to determine if the risk is one that the business is okay with taking, or if they want to avoid that risk from occurring. Risk analysis may also include determining which risks will benefit the most from adding mitigating factors. A business may have the following risk indices:
- VAR is $75,000 if a $10,000 mitigating factor is added, then the BRE becomes $10000
- VAR is $10,000, a $5000 mitigating factor makes the BRE $5000
- VAR is $200,000, BRE is $50,000, no additional mitigating factors available
- VAR is $150,000, BRE is $100,000, no additional mitigating factors available
To determine the current risk index order, the BRE is compared to each other. In this case (with no additional mitigating factors added), the most concerning risk is number four, with a $100,000 BRE. Next is number one (at $75,000), then number three (at $50,000), and finally number two (at $10,000). Looking at this index, it would make sense to prioritize eliminating risk number one.
Comparing the VAR and BRE is a practical way to determine which mitigating factors will be the most beneficial. For risk number one, the addition of a $10,000 mitigating factor will change the $75,000 VAR into a $10000 BRE, saving a total of $65,000. For risk number two, the addition of a $5000 mitigating factor will only save $5000, changing a low priority risk (number four on the total index) into a slightly lower risk. In this case, even though the mitigating factor for risk number one is more expensive than the mitigating factor for risk number two, it would probably be more beneficial to implement the mitigating factor for risk number one.
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