Category MBA

Enterprise Risk Management Function

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Enterprise risk management refers to the new strategic process of structured identification and evaluation of all the risks and opportunities of the enterprise, determination of appropriate ways of managing and controlling such risks, and monitoring of this risk management process.

History of risk management

The origin of risk management as a role within a company is attributed to Fayol who is regarded as a father of management. In his 1916 article he proposed 6 functions of management which included a security function. The security function was associated with protection of people and property. The current risk management function is much more comprehensive but Fayol’s security function was a first glimpse of the current risk management function. The importance of a proper risk management function was acknowledged in 1960s in USA and thereafter spread around the world.

The term “risk management” was formally used only from the 1950s. Initially, the risk management function was closely associated with insurance. This slowed down the development of the function. The first book on risk management was entitled “Risk management in the business enterprise” was written by Robert I Mehr.

Enterprise Risk Management and Culture

Enterprise risk management incorporates risk awareness into the culture of the organization. The risk culture of the organization significantly contributes to the success of the enterprise risk management. Employees need to see risk as an integral variable which needs to be managed, controlled and monitored. Each employee needs to understand their role in the risk management of the enterprise. Leadership support of the importance of risk management significantly contributes to adequate risk management culture.

Enterprise risk management uses advances in technology for management of risk.

Enterprise-wide in the enterprise-wide risk management refers to the elimination of barriers between functions, departments and other groupings within the organization.

Risk management infrastructure & risk management capabilities – To ensure effective enterprise risk management processes, organizations need to establish an adequate set of risk management capabilities. Risk management capabilities refer to the abilities of an organization that allow it to undertake effective risk management processes. It includes abilities which allow for identification, measurement, management and monitoring of risks.

An appropriate set of risk management capabilities allows the organization to have a clear understanding of how their risk management decisions affect the bottom line and long term wealth maximization of the shareholders, which is the ultimate objective of the enterprise.

If an evaluation established that additional risk management capabilities are required, it is important to undertake cost-benefit analyses to ensure that the cost of additional risk management capabilities will be more than offset by the benefits that it will bring.

Certain risk capabilities which are adequate in one company to manage specific risk may be inadequate for another company which attempts to manage the same risk. Each organization must select risk management capabilities suitable to its particular individual needs, based on the particular risk exposure.

Risk management process monitoring and adjustment

The existing business environment is very turbulent. Risk exposures and factors affecting risks may alter all the time. Therefore, ongoing risk monitoring and adjustment of risk management strategies become an increasingly important step in the enterprise risk management process.

An organization needs to gain a good understanding of the risk management process. The main goal of the risk management monitoring process is to assess how effective the risk management process is.

Why risk management monitoring is important?

The main goal of risk management monitoring is to determine effectiveness of the enterprise risk management process. If the risk management process is not adequately monitored, shortcomings of the process may negatively affect achievement of the strategic objectives of the enterprise.

Ongoing monitoring of the performance of the risk management process and risk management environment leads to continuous improvement of the entire enterprise risk management process.

To monitor risk management performance, risk management performance standards should be established against which performance can be measured. Such standards may include areas such as time tables within which certain goals should be achieved, budgets and specific areas of enterprise’s performance which is vital for organizational success. After performance standards are established, they must be monitored on an ongoing basis.

The Rise of Corporate Governance

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Over the last few years Corporate Governance became a very important consideration for any business around the world. After corporate scandals such as Enron and Worldcom in the USA and Independent Insurance Co in the UK, investors and governments demanded better corporate governance practices by the businesses.

Various measures were taken by governments to prevent further corporate scandals. For example, US introduced the Sarbanes-Oxley Act 2002, to comply with which placed a significant financial burden on businesses.

Ehlers and Lazenby define corporate governance in the narrow sense as the formal system of accountability of the board of directors to shareholders and in the broad sense as an informal and formal relationship between the corporate sector and its stakeholders and the impact of the corporate sector on society.

To succeed in contemporary environment, companies need to have reputation of having a strong corporate governance. Triple bottom line principle (“people, planet, profit” or “the three pillars”) became prominent. It refers to the principle according to which enterprises measured by and must report on it’s economic, social and environmental performances. This is in contrast with the past when only reporting on economic performances (single bottom line) were required.

Corporate governance is beneficial to the firm in many respects. What is most important is that it increases long-term performance on the enterprise-wide basis. Therefore, it increases shareholder’s wealth, which is the main objective of the business.

Proper corporate governance also benefits society and country as a whole. For example, if country’s businesses are known for maintaining proper corporate governance, foreign capital will flow into the country as foreign investors will be interested in investing in the country’s businesses.

Within the country, resources also will be used more efficiently due to good corporate governance. In such environment investors will be investing into companies with biggest potential to deliver value to customers and inefficient management will be replaced in underperforming businesses.

Further, society and communities will benefit in various ways. For example, enterprises with proper corporate governance comply with laws and regulations, such as requirements with respect to pollution. Overall, good corporate governance benefits all stakeholders of the enterprise and is a prerequisite for success of any business.

 

Risk Categories

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There are two main risk categories, speculative risk and an event risk.

The ultimate goal of the firm is to maximize shareholder’s wealth. The environment is changing rapidly and any change may result in additional risks and losses. Therefore, effective enterprise risk management is essential to ensure achievement of the main objective of the enterprise, which is maximizing wealth of the shareholders. Both risk categories should be diligently managed.

Speculative risks can result in a gain or loss, such as fluctuating interest rates. An enterprise may protect itself from adverse effects of speculative risks by various techniques such as hedging. Speculative risks are further subdivided into core business risks and incidental risks.

Core business risks are part of the main business of the enterprise and reflected in the mission statement. Core business risks may negatively impact the operating profit of the enterprise. Core business risks can be specific (unsystematic) and market (systemic).  Specific risks include risks which impact only the enterprise and do not impact the economy as a whole. Specific risks include those associated with sales variability, operating leverage, resource risk, profit margin and turnover. Specific risks are also called diversifiable risk. Systemic risks are risks which impact the economy and the enterprise. Systemic risks entail occurrence of a negative market-wide event such as the risk of collapse of an entire market. It is also called un-diversifiable risk. Investors require higher returns for increases in systemic risk.

Incidental risks are risks that occur naturally in the business but are not part of the main business. However, control of such risks is vital to ensure survival of the enterprise.

Whether a risk is considered to be core or incidental sometimes depends on the activities of the enterprise. For example, interest rate risk will be a core business risk for financial institution and incidental business risk for a manufacturing enterprise.

Event risks can result in losses, such as fire, or can result in no loss but cannot result in any gain. A business may protect itself from adverse effects of event risks by various techniques such as insurance. Event risks can be fundamental or particular.

Fundamental event risks refer to impersonal losses on the macro level.

Particular event risks refer to personal losses on micro level such as a car accident.

Event risks are subdivided into operational and external downside risks:

Operational risks further subdivided into people, processes and systems risks. It refers to risks which occur due to failures during execution of operations.

External downside risks are risks that cannot be directly controlled by an enterprise and which can occur due to external factors. External downside risks are all risks that occur due to external factors that may have no affect or adverse effect on the enterprise. External downside risks are very difficult to manage. Examples of external downside risks include natural disasters, terrorist attacks, criminal threats and litigation.

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The Theory of Probability

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Probability refers to the chance that an event will occur. To calculate probability of the outcome we need to take number of occurrences and divide it by total number of possible outcomes.The lowest probability is 0 and the highest is 1.

Probability = number of occurrences / total number of possible outcomes

For example, we can take number of household fires over certain period in a certain area and divide it by total number of households in the same area. This will give us a probability of fire in the households in this particular area.

 

What is Risk?

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So what is risk? Risk is the possibility that actual results will differ from desired or expected results. It implies the presence of uncertainty (uncertainty about the occurrence of event and uncertainty that it will display a particular outcome).

The degree of risk is determined by 2 factors:

  1. How often an event will occur?
  2. What is the probability the particular outcome will occur?

In business, it is generally accepted that as the risk increases, the expected or required return should also increase. It is not good for businesses to eliminate all risk because with elimination of risk, profits will likely decrease.

When thinking about risk and uncertainty the following description may help. Risk is binary. There is either risk or there is no risk. It’s either a yes or no. The degree of risk is the uncertainty. So we can say that yes, there is a risk it will rain in Paris today. We think there is high certainty it will happen. We are 80% confident it will happen. So there is either a risk (1) or no risk (0). The degree of risk (uncertainty) can be any number from 0 to 1. Risk is a possibility while uncertainty is a probability.

What is needed for an effective risk management process?

Risk management processes refer to the procedures that consist of systematic control activities and monitoring of risk management performance to ensure that risks in the organization are adequately managed.

According to Lore and Borodobsky, risk management have 3 dimensions:

  1. Upside management – taking advantage of opportunities where the business has very good chances to achieve success.
  2. Downside management – controls must be implemented to prevent or decrease losses due to operating environment.
  3. Uncertainty management – using techniques and methods to decrease deviations from expected results.

For effective risk management, organizations must deploy consistent risk measures, identify and manage all important risks, undertake proper management controls and support management of risks through performance evaluation on the business unit and organizational level.

Certainty and uncertainty

Certainty occurs when the outcome is 100% going to happen as expected. For example, the sun will rise tomorrow.

Uncertainty occurs when one does not have knowledge about future outcomes. Uncertainty is not the same as risk.There are different degrees of uncertainty, from almost certain to completely uncertain. Uncertainty increases the further into the future we attempt to plan. One’s access to information and ability to use available information in the decision making process determines the perceived degree of uncertainty.

 

The 4 Ps of Marketing Mix

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The term marketing mix was first used in 1953 by Neil H. Borden in his presidential address of the American Marketing Association and later in his article entitled “The concept of the marketing mix”.

In 1960, a well-known marketer E.J. McCarthy categorized elements of the marketing mix proposed by Neil H. Borden into four main categories. According to E.J. McCarthy, marketing mix consists of four main elements:

  1. product
  2. place (distribution)
  3. promotion
  4. price

These elements commonly called 4Ps of marketing mix.

Maximizing performance of the marketing mix is what marketing as a function of organization focuses on. Of course, the ultimate objective of managing the 4 Ps marketing mix is the same as of any other action of the organization, to increase the wealth of the shareholders of the enterprise.

The 4Ps of the marketing mix

Product – Product, as an element of marketing mix, refers to products and services produced by companies for consumption by the population. Various marketing decisions have to be made concerning the product element of the marketing mix. Such decisions include decisions on packaging of the product, branding of the product or service, and on the product warranty.

Place (distribution) – Place (distribution), as an element of marketing mix, refers making products and services available for the customer. It also refers to the site where the product or service is made available to customers. Management of place as an element of the marketing mix includes various vital decisions such as decisions regarding the distribution channel and inventory management.

Promotion – Promotion, as an element of marketing mix, incorporates everything that companies do to attract customers to its products and services. Management of promotion, as an element of marketing mix, includes management of the “promotional mix” which consists of sales promotion, advertising, sponsorships, direct marketing, personal selling and public relations (publicity).

Price – Price, the last of the 4 Ps, refers to the amount, in monetary terms, that the producer requires from consumer in order to part with the ownership of or ability to use the product or service which is offered for sale. One of the key elements of the marketing mix is pricing strategy.

 

Growth of a Small Business

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Entrepreneurs have different preferences towards the growth of their businesses. Some desire rapid growth, others pursue manageable and reasonable growth while others prefer not to grow their businesses at all but only to maintain the current size of the business.

Growth of a small business can be incredibly challenging if it is not planned for. One of the reasons for this is due to the fact that growth usually requires additional financing which has to be obtained before the additional profits appear as cash inflows.

This growth problem is further exacerbated due to the difficulty of obtaining external financing. Business may need additional financing to hire more personnel to handle increased sales and to buy extra inventory and raw materials. Therefore, the situation may occur where a rapidly growing business is profitable but has cash-flow problems. This is referred to as a “growth trap”.

 

Distribution, distribution channels and distributors

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One of the important sub-concepts in supply chain management (SCM) is distribution. Distribution is also one of the four Ps of the marketing mix. The four Ps of the marketing mix are product, price, place (distribution) and promotion. After the product is manufactured or service produced is ready for consumption – it has to be distributed.

Distribution describes the activity of distributing products or services from producer to the final consumer.

Distributors, which are also called intermediaries, assist in the distribution of products or services to the final consumer. Examples of distributors of products could be an agent, wholesaler or retailer. An example of distributors of services could be an employment agency which distributes the labour of job seekers to employers.

Some distributors take a title and are called merchant middlemen. Examples of merchant middlemen include wholesalers and retailers. Those distributors who do not take a title are called middlemen (as well as brokers and agents). An, example of a middleman is an insurance broker.

Distribution channels

There can be direct or indirect distribution channels:

A Direct distribution channel does not involve the help of an intermediary (distributor). In the case of a direct distribution channel, the product or service is distributed directly from the producer to the final consumer. An example of direct distribution channels is the case when an organization distributes its products directly from its website.

Indirect distribution channels involve the help of an intermediary (distributor) which acts as a middleman between the producer and final consumer. There can be one or more levels of distributors between the producer and final consumer. For example, the product can be distributed to an agent who in turn distributes it to the wholesaler who in turn distributes it to a retailer. The final customer buys product from the retailer. In this case there are three levels of distributors between the producer and final consumer.

If the company uses a combination of distribution channels it is called dual distribution. An example of dual distribution occurs when the company offers its products directly from its website (direct distribution channel) as well as via local retailers (indirect distribution channel). Dual distribution may allow the company to achieve higher profitability.

There are various factors that must be considered in selecting a distribution channel. Those factors include: nature of the product, strategies followed by competitors, availability and reliability of intermediaries, customer preferences and characteristics, cost of involving intermediaries, size of the business (capacity to deal with a large intermediary such as a national retailer) and warranties (capacity to offer warranties that may be demanded by the intermediary).

Disadvantages of using intermediaries include a generally higher price to consumers, lower degree of control over level of customer service provided to the final consumer, reliance of eagerness of intermediary to promote the product and lower degree of communication between producer and consumer.

Advantages of using intermediaries include the fact that, especially for small businesses, it may be much cheaper to use an established distribution infrastructure than to create its own (intermediaries specialize in distribution activities and can usually execute such activities more cheaply than the producer of the product). Some of the costs and activities such as storage and promotion are undertaken by the intermediary so the business can focus on its core competency – producing the product, and some of the business risk may be overtaken by merchant middlemen.

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Supply Chain Management

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Supply chain refers to the network of organizations linked by movement of goods through various stages of production, storage and delivery until it becomes available to the final consumer.

Supply chain management (SCM) is a step by step integrated and coordinated process of movement of goods from raw materials stage all the way to the final product which is distributed to the final customer.

Supply chain management consists of three main flows which are product flows, financial flows and information flows. Product flow refers to the flow of products through the supply chain process. For example, products can move from raw material form to manufacturer to wholesaler to retailer and eventually to the final consumer. Financial flow refers to financial matters concerning purchasing and sale of products such as credit terms and payment schedules. Information flow refers to flow of information with regards to purchase and sale of products which move throughout the supply chain management process.

Within the strategic management process (SCM), management decision making and activities are usually grouped into strategic, tactical, and operational levels.

Strategic level – At the strategic level, a “big picture,” high level and long-term decisions with regards to supply chain management (SCM) are made in relation to the organization as a whole. Such decisions may include allocation of resources, consideration of partnerships and consideration of product life cycle (PLS) management.

Tactical level – At the tactical level, medium-term decisions are made on the subject of supply chain management (SCM) of the business. Such decisions may be on matters with regards to inventory, production and transportation.

Operational level – At the operational level, day-to-day short-term decisions are made with regards to supply chain management (SCM) of the enterprise. Operational level decisions may concern matters such as daily delivery and production.

The distinction between tactical and operational level decisions is often vague within organizations. This occurs because to meet daily orders (which occur at an operational level) organizations need to allocate resources (which occurs at the tactical level). Therefore, as with any other framework, various levels of decision making provide guidance for effective supply chain management (SMC) which should be supplemented with common sense and intuitive guidance.

There are numerous supply chain management software available, which significantly simplify supply chain management within organizations. Furthermore, the Internet has made communication within supply chain much more easier and faster compared to pre-Internet times.

Effective supply chain management (SCM) can decrease costs associated with supply management activities such as transportation, storage and packaging costs. This can contribute to obtaining  a competitive advantage over peers.

 

Product Life Cycle (PLC)

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The only way an organization can continue its existence and growth is by rejuvenating its product mix. This is important because products go through the product life cycle.

Product Life Cycle (PLC)

The idea of a product life cycle (PLC) was introduced by Theodore Levitt in his Harvard Business Review article entitled “Exploit the Product Life Cycle” which was published in November of 1965. Product life cycle is based on the biological life cycle and starts with introduction of the product (introductory stage) which is followed by growth and maturity stages and eventually decline stage.

The duration of the product life cycle depends on the product and can range from few months to few decades and beyond. Understanding of the product life cycle (PLC) assists management in enhanced understanding of what they can expect with regards to product performance based on where it is in the product life cycle and in developing appropriate strategies. Organizations need to ideally introduce new products before the old product reaches its peak stage.

In terms of profits and losses from new products, at the beginning of the introductory phase a loss is usually made. Then, at some point during introductory stage break even occurs. After break even profits generally rise up until its peak which occurs approximately close to the end of the growth stage which is followed by decline in profits.

Organization’s marketing, financial, human resource, purchasing and manufacturing strategies for the product should reflect the stage of the product in the product life cycle.

Stages of Product life cycle

Introductory stage – During this stage a product is developed and introduced to potential customers. Awareness about the product should be created and the market needs to be established. Marketing communication usually focuses on educating potential customers about the new product. If relevant, intellectual property protection should be obtained.

During beginning of the introductory stages losses are usually incurred. This occurs for a number of reasons such as the high costs of advertising involved in introducing a product to the market as well as the high costs of actual development of the product. Then, at some point during the introductory stage, break even occurs. After that point the firm starts making small but increasing profits. E-conferencing is an example of a product in the introductory stage.

Growth stage – Growth stages are characterised by rapid growth in sales and profits. If economies of scale are possible then profits are further accelerated. This is the stage when a company usually invests substantial economic resources to promote the new product and build the brand. Competition in the growth stage is drawn to the market. Market shares of market players tend to stabilize at this stage. Profits continue to rise up until its peak which generally occurs close to the end of the growth stage. This is usually followed by declining profits. Email is an example of a product in the growth stage.

Maturity stage – Maturity stage characterised by acutely increased competition. Intense competition may lead to price wars and concentrated attempts of rivals to differentiate its products. Companies experience decreased margins and some leave the market. Profits of a company generally continue its decline in the maturity stage. However, overall profits of the market for this particular product tend to be the highest at this stage of the product life cycle; although it is heavily splintered amongst many medium size to small players. There are usually 1 or 2 market dominant companies. Credit cards are an example of a product in the maturity stage.

Decline (saturation) stage – At the saturation stage consumers’ interest in the product dramatically declines. This can happen due to the introduction of more superior products to the market or changed consumer tastes.

Profits continue its decline in the saturation stage until profits reach zero (break-even point). The company may try to prolong this stage by finding ways to cut costs. Companies may also try to rejuvenate products by adding new features and looking for other ways in which product can meet customers’ needs. Markets itself tend to shrink at this stage. Eventually the product is withdrawn from the market. Typewriters are an example of a product in the saturation stage.

In conclusion, it is important to note that not all products will go through each stage of the product life cycle. Some products, for example, may experience the decline stage right after the introduction stage. Therefore, product life cycle (PLC) is a useful formal framework which can be used. However, common sense and intuition should also be applied in making product life cycle decisions.