Planning & Decision Making · Topic 10 of 11
Risk & Control Measures
Theory
Every action we take in our daily lives involves an inherent element of risk. Whether it is in business or daily life, we constantly assess potential risks and take actions to minimise or prevent them.
1. Control Measures
These preventative actions are called control measures.
Control measures are actions taken in an attempt to reduce the risk of a financial loss, and can include buying insurance policies or paying for additional resources such as extra staff or equipment.
2. Cost-Benefit Analysis
To evaluate whether a risk is worth taking, or a control measure is worth paying for, companies use a process called a cost-benefit analysis.
This involves comparing the financial cost of implementing a control measure against the expected penalty of doing nothing.
3. Direct vs. Indirect Costs
When a project fails or is delayed, a business must consider two types of costs:
- Direct Costs: Immediate, measurable financial losses, such as having to repay a fee, refund a customer, or pay a contractual fine.
- Indirect Costs: Longer-term impacts, such as a damaged reputation, increased stress, or the loss of potential future business.
4. Calculating Expected Costs
To compare options fairly, we calculate the "expected cost" of each choice:
- Expected Penalty (Doing Nothing) = Probability of the event × Financial Penalty.
- Expected Cost of a Control Measure = The upfront cost of the measure + the new expected penalty (because a control measure rarely reduces the probability of failure to absolutely zero!).
Worked examples
Example 1
Example 1: Direct and Indirect Costs
A wedding photographer has been booked for a large event. If they fail to provide the photographs by the agreed deadline, their contract states they must refund the couple the full £1,500 fee.
State one direct cost and one indirect cost the photographer would face if they missed the deadline.
Direct Cost: The £1,500 refund they are legally required to pay.
Indirect Cost: A bad review online, a damaged reputation, or a loss of future bookings.
Example 2
Example 2: Insurance as a Control Measure
A graphic designer is purchasing a new high-end tablet for £2,400. They estimate the probability of accidentally breaking the tablet within the first two years is 0.06. The electronics store offers a 2-year damage protection plan (insurance) for £130.
(a) Calculate the expected cost of the risk if the designer does not buy the protection plan.
(b) Use your answer to determine whether the designer should purchase the protection plan.
(a)
.
(b) The expected cost of doing nothing is £144. The cost of the insurance is £130.
Because £130 is less than £144, the designer should purchase the protection plan as it is the more cost-effective choice mathematically.
Example 3
Example 3: Staffing as a Control Measure
A landscaping firm is building a large patio for a client. If the patio is not completed by the agreed date, the firm will be fined £4,500. The firm estimates there is a 0.22 probability that the project will be delayed due to bad weather slowing down their current team.
As a control measure, the firm could hire an extra temporary labourer for £600. If they do this, the extra help reduces the probability of a delay down to 0.05.
(a) Calculate the expected penalty if no control measure is taken.
(b) Calculate the expected cost if the firm hires the temporary labourer.
(c) Based on your calculations, should the firm hire the temporary labourer?
(a) Expected penalty (no control measure):
.
(b) Expected cost (with control measure): You must add the upfront cost of the worker to the new expected penalty.
.
(c) Conclusion: The firm should hire the temporary labourer, because the expected cost of doing so (£825) is lower than the expected penalty of doing nothing (£990).