A business is bound to face different types of risks that will impact its ability to meet its goals for growth and development. For this reason, every business should have an Enterprise Risk Management (ERM) program that lays out the plans of action should these risks arise. Two of the most indispensable parts of an ERM program are operational and strategic risks. Here is a look at what a risk is and how operational risks and strategic risks differ.
What is a Risk?
The only way an entrepreneur can begin to differentiate risks is by understanding the meaning of risk. In simple terms, a risk implies a scenario that could have negative consequences. It is the possibility of an unpleasant occurrence. The Canadian Center for Occupational Health and Safety defines risk as a probability or chance that someone will get hurt in the event of a hazard.
What is a Operational Risk?
Operational risks are those risks that are associated with the organization’s ability to implement its strategic plan. Therefore, without a strategic plan, you can’t identify operational risk. Operational Risk Management (ORM) is involved with carrying out risk assessments, implementing risk controls, and making risk decisions. An effective ORM program acknowledges risks and determines ways of avoiding and mitigating these risks.
Examples of Operational Risk Events
Some of the primary sources of operational risks include internal procedures, internal resources, internal customers (employees), and internal systems. Operational risks can either be environmental risks, financial risks, or reputational risks. Typical examples of operational risk events are as follows:
- Internal Fraud: An act of fraud is a common reputational risk event in any organization. Huge losses arise from tax non-compliance, intent to defraud, forgery, misappropriation of assets, theft, and bribes.
- External Fraud: These acts of fraud are associated with third parties, and the most popular being the financial risks. Cheque fraud, theft, and hacking a security system or unauthorized access to sensitive information can have a devastating impact on any organization.
- Employment Conditions: Failing to comply with employment or safety laws are serious operational hazards. Failing to pay employees fair compensation and denying them benefits are gross violations. This operational risk also involves the unfair termination of an employee and discrimination at the workplace.
- Customer Relations: When an organization does not fulfill its promises to its clients or violates their privacy, this amounts to a gross reputational risk. These practices may also be in the form of money laundering, product defects, unlicensed activities, market manipulation, all of which are subject to severe penalties and jail term.
- Losses from natural disasters: The likelihood of an organization’s assets being destroyed due to a natural disaster such as flooding is classified as an environmental operational risk.
- Issues with Process Management: Errors involving data entry, accounts, report, client records are very costly to any business. Miscommunication, missing deadlines, and loss of a client’s assets are operational risk events with significant legal implications.
What is Strategic Risk?
Strategic risks are measured against an organization’s objectives and business plan performance. Strategic Risk Management (SRM) helps identify, examine, and manage the risks in an enterprise. SRM usually focuses on some of the internal and external scenarios that could facilitate the achievement of a business’s objectives. A good SRM program will have a reasonable situational analysis approach and use effective methods of minimizing strategic risks.
Examples of Strategic Risk Events
- Liability Risk: A concert promoter organizes a music festival that attracts a huge crowd. The promoter lays out a strategy of involving the fire department, health, and security services to guard against being liable for any injuries to persons attending the event.
- Marketing Risk: A recording label commits to a certain amount of money to promote an artist. There is a risk that the artist will not be popular with, and this market spend will lead to a loss. However, the opposite could happen, and so this risk-reward potential seems acceptable
- Change Management: An organization plans to reorganize its departments with full knowledge that the employees might be opposed to the changes. However, management attempts to mitigate the risk of employee turnover and process disruptions by engaging employees and involving them in the process.
- Competitive Risk: A business plans to make conservative changes to its products. Since their competition is investing in improving its products, the company may lose its market share because of taking a conservative approach. Again, this risk-reward potential seems acceptable
- Innovation Risk: A car manufacturer decides to make new additions to their car model in an attempt to outdo their competition. However, there is a risk of quality because these additions are being made in a rush. Additionally, customers may seek other manufacturers because the brand is not consistent with their driving experience, but is quickly making changes.
Distinguishing Operational and Strategic Risks
Strategic Risk factors the entire business: its strategies and goals. Operational risk looks at the business’s risk profile. While strategic risk is mainly involved with how the external environment is going to impact your business, operational risk is involved with internal and external events that could affect your ability to implement your current strategies and achieve your goals.
Strategic risk management aims to identify events that would force you to change your strategies. The goal of operational risk management is to identify the risks that will impact your objectives, which will, in turn, affect your strategy.
Components of Operational And Strategic Risk Management Framework
All organizations have ways of identifying risk and dealing with them. The most common risk management framework has the following components:
- Identifying the Risk: This involves listing all the possible risks. After listing these risks, the next step is to classify them as core and non-core risks. The core risks are necessary for performance and growth, while the non-core risks are indispensable and can be eliminated.
- Assessment of the Risk: This involves measuring the probability of exposure to a risk and also the chance of a loss occurring due to such exposure.
- Mitigation of the Risk: After classifying and measuring the risks, you are faced with the decision of choosing the risks to minimize or eliminate and those that should be retained. Some risk mitigation strategies involve selling assets, diversification, or buying insurance.
- Monitoring and Reporting: You should regularly report on specific risk measures to ensure risk levels are at an optimum level. Some institutions produce daily or weekly risk reports. These reports are sent to risk personnel who adjust the company’s risk exposures.
- Risk Governance: This involves making sure all company employees are performing their roles in line with the risk management framework. It entails defining the duties of employees, distinguishing their roles, and assigning authority to committees to approve core risks, risk reports, exceptions to risk limits, and risk limits.
Summing It Up
Every organization should have a risk management program to guard themselves against the potential of risk events. There are different kinds of risks that a business may be exposed to. Some of the most common risks in many organizations are operational and strategic risks. These risks differ in the sense that operational risks are those risks that prevent you from achieving your goals while strategic risks are those risks that you mitigate or eliminate in the advancement of your objectives.
It is crucial for businesses to use the appropriate risk management framework to identify and distinguish operational and strategic risks. Ultimately, with an effective risk management program, you will be able to anticipate threats and opportunities accurately and achieve your long-term goals.
