Risk Management In Small Business
Part 2: Reducing Your Operational Risks
After you have considered extraordinary events, which could adversely affect your company, and have purchased suitable business insurance, you are now prepared to turn your full attention to reducing the day-to-day risk of running a business.
Through risk management you can limit your possible financial losses caused by unsuccessful normal business operations. It's essential to contemplate the things which could go wrong within your business and to evaluate the financial cost to you if these events happen. Then you can seek to intelligently reduce your financial exposure caused by these events. Or, you can try to avoid the event entirely.
Let's take a simple case. Suppose you've invented a new product, say a board game. We'll call it "Boardmania." One of the biggest risks is that the game just won't sell. If you retooled your manufacturing plant to produce one million games per year and you're only selling fifty games a year, you are in trouble. If you borrowed $5 million dollars to retool the plant, you are in more trouble. If this is your company's only product, you are in a whole heap of trouble!
Large capital expenditures often represent big financial risk to small companies. The danger is that the capital investment will not yield the desired return, increase in efficiency, cost savings, or future sales will not justify the capital investment. The only practical recovery method may be to sell the capital item, recouping what money you can.
Physical depreciation or lack of market demand for the capital item could lead to a substantial loss on the item's sale. That's assuming the item is sellable at all. In the case of retooling your plant, there may be substantial, capital costs which cannot be recovered.
For example, the dies and molds to make the specific game pieces have little value to anyone not making your Boardmania game pieces. And, knowing how unprofitable Boardmania manufacture is, it's unlikely anyone will want to produce them!
Several options exist to reduce your financial risk with capital investments. First, if the investment is made to create a new product, test the market's acceptance of the product. The best products are those which have clear market demand.
An untested, speculative product cannot demand a large capital investment. A much smaller sum should be risked to test the product. And, if the product proves successful, do not assume the future demand is unlimited. Always continue to monitor your capital expenditures and ask, "What happens if the expected level of future sales fails to materialize?"
Second, try to minimize the costs involved if you decide to go ahead with the capital investment. Can you purchase used equipment to reduce the capital outlay? The dies and molds had to be custom-made. So, they are new. But, maybe, some other items can be acquired used. Frugality in capital purchases reduces the amount of money you put at risk. The less specialized capital items are, the more likely someone else will have use for them, and the more easily they will be sold.
Leasing is another option. Business people often dislike leasing, because over time leasing usually costs more than buying. Hence, your product's profitability will be reduced. However, leasing can reduce your financial risk. You don't need to commit to purchasing the item, but you acquire its use for a contracted time period. That puts less money, overall, at risk in the event that the item proves less than profitable.
Always examine lease contracts carefully. Is the lease an operating lease or a capital lease? Capital leases are installment sales, which effectively transfer the risk of ownership to the lessee.
Small business owners should actively seek ways to acquire the productive use of assets without incurring the risk of ownership of the assets.
Bob Reiss, author of Low Risk, High Reward, who has considerable experience in the real-world game industry, outsourced the manufacture of his best-selling TV Guide Trivia Game. Outsourcing is one way to greatly reduce your capital risk.
There is probably some manufacturing company which could produce your Boardmania game very cost effectively and easily. Outsourcing manufacture reduces capital at risk. There would still be custom dies, but most of the operation would already be in place. In exchange for its manufacturing services, the company must be reasonably compensated, so you would necessarily expect less profitability per unit on your game sales. But, your possible financial loss has been reduced substantially. You no longer are making major capital investments.
Depending upon your arrangement with the game manufacturer, you may or may not incur financial risk with the inventory of games made. If the manufacturer charges you a fixed amount for the production of a given number of games, you still have money at risk. The money at risk is now in inventory, which you own.
Conversely, the manufacturer to whom you outsourced has incurred no risk at all. He profits when he manufacturers and ships the games to you. He profits whether or not your board game sells. If the games don't sell, you stand to lose the amount invested in inventory. Money tied up in inventory is money at risk.
If, however, you've agreed to share potential profits from game sales with the manufacturer, you may not have any initial investment at risk. Rather than give the manufacturer a fixed amount per unit, payable whether or not the game sells, the manufacturer gets a higher per unit price, based upon the units actually shipped to your customers.
Of course, if the game does really well, you expect to earn less money overall, because the manufacturer is then being compensated for the extra risk he is taking in betting upon the success of your game. Yet, the manufacturer is not risking nearly as much as you would if you acquired manufacturing facilities. He already has much of the capital equipment, whether or not he produces your game.
Now that your game's manufactured (or, the manufacturing potential is in place), how will you generate sales? Marketing a product involves publicity or advertising or both. Money spent on advertising is money at risk. Maybe, the advertising won't generate the sales you hoped it would and the money will be lost.
But, there are ways to reduce or eliminate advertising risk. In Low Risk, High Reward Bob Reiss discusses how he effectively eliminated the risk of spending money on advertising. Reiss partnered with TV Guide and gave TV Guide a percentage of the potential revenue the game generated. This way he didn't risk a substantial amount on expensive advertising which might prove ineffective.
The structure of your business agreements, contracts, and deals determines your company's financial risk. Seek contracts with other companies which lessen your financial risk. In the best situations, the actual risks of both companies are reduced.
Peter Bernstein's Against The Gods: The Remarkable Story Of Risk tells how futures contracts came into existence. They didn't originate with speculators who wished to bet upon the future price of corn or hogs! Rather, farming was inherently a volatile business in that the open market price for crops varied greatly.
It was possible for a farmer to work hard all growing season and have a productive year. Then, the farmer arrived at market only to find that his produce was unsaleable or the going price was far too low to compensate him for his effort. Maybe, the going market price wouldn't even allow him to repay the debt he acquired to produce the crops. A drop in market price for his crops could prove financially fatal.
Food producers faced the opposite risk. Maybe, if the growing year had been bad and crops were in short supply, the price increased significantly. Then, the food producer incurred far greater expenses than anticipated, adversely affecting his profits.
When the farmer signed an agreement with a food producer to deliver his crops to the food producer at a set price, both the farmer and the food producer reduced their operating risk. The farmer locked in a price, which helped the farmer assure a profit. The food producer limited his future expenses, which helped the producer assure a profit. Both parties benefited.
An increase in price represented no risk to the farmer. A drop in price represented no risk to the food producer. Each party could trade their risk to someone who would not be as adversely affected by the same risk.
When seeking to minimize financial operating risk, consider other parties who might not fear absorbing the risk you fear. Sometimes, intelligent contracts and partnerships can greatly reduce your risk while benefiting another company.