Updated July 15, 2023
Introduction of Operational Risks
Operational risks are the company’s uncertainties and threats in its regular business activities. Various factors cause operational risks; they can be both internal and external.
Operational risks are hazards and uncertain situations the business encounters in its daily operational business activities. It is an event that disturbs the normal business process and can result in financial loss or damage to the business operations and image of the company.
Some of the internal factors that cause the risk to business operations are internal procedures, systems, people, policies, etc.; the external factors are political situations, economic events, or other events affecting the whole industry and business operations. This type of risk is known as systematic risk. There can be some operational risk associated with a specific industry or company, known as unsystematic risk. Generally, operational risks can control by continuous risk assessment and management policies through internal control, Insurance, risk control strategies, etc.
What Does Operational Risk Include?
Operational risk includes both internal factors and external factors that cause risk. Risk can be both measurable and quantifiable, as well as subjective and qualitative.
- Internal Operational Risks: Errors caused by company employees, failure of IT systems, fraudulent activities, loss of key management people, health and safety of the employees, etc.
- External Operational Risks: Business interruptions caused by economic or political events, product failure at the market, litigations against companies, loss of critical suppliers and raw materials, natural disasters, loss of image/reputation, etc.
Examples of Operational Risks
Z Corp is a consultancy firm that manages the financial books of many entities. ABC Ltd is one of their clients, and their books of accounts are being prepared and organized by Z Corp. Mr. X, an employee of Z Corp, handles ABC Ltd’s accounts. While making an entry, by mistake, he entered an expense as $1,000,000 instead of $100,000. This increased the expense and vendor payables and made the financial statements incorrect.
Due to this operational risk, chances are there where Z Corp can lose its clients as there is no quality service.
Types of Operational Risks
Below are the types of operational risk :
1. Errors Caused by People
Errors caused by employees of the organization can affect operational activities and may even cause financial loss. Various factors like lack of skillset, incomplete information, lack of understanding and knowledge, genuine input error, etc., cause this error. Though these errors are inadvertent, they may affect business activities. (E.g.) Excess payment made by cashier by mistake.
2. Technical or System Errors
Technical or system errors can affect business operations like system failure, system crashes, connectivity issues, system slowdown, errors caused by software applications, etc. Technical defects can produce a wrong output, making it tough to identify and rectify. (E.g.) Wrong interest calculation on loans done by banking software.
3. Frauds
In some instances, internal people within the organization intentionally commit fraud. Every organization has standard rules and regulations for employees to remove conflicts of interest and fraudulent activities. Fraudulent activities can cause financial loss and damage the reputation of the organization. (E.g.) An employee deals with a supplier for purchases and enjoys a commission from the supplier.
4. Uncontrollable Events
A few uncontrollable events affect business operations, like political changes, weather changes, economic scenarios, technological advancements, etc. These factors can impact operational activities, affect revenue and profitability, and put the organization at risk. (E.g.) A change of ruling party will impact the government project execution and may involve the contractor.
How to Identify Operational Risks?
Operational risk needs to identify so that it can manage. Failure to identify possible risks can result in inadequate monitoring and management of operational risks, adversely impacting business operations and profitability. Operational risks can identify by using different techniques. “Brainstorm” is a common technique used across different organizational layers to identify the possible risks associated with a particular process. This technique helps to identify predominant risks in a short period. “Risk-based audit” is another technique used to identify organizational risks. This technique determines the risk by automatic or judgmental assessments, a risk assessment matrix, or risk ranking.
Another technique to identify risks is to look for critical dependencies of the company in people, policies, processes, systems, etc., and identify the potential risk from the key areas. Once risks are identified, they are categorized across functions and procedures, and risk monitoring and management systems are in place to control them.
How to Manage Operational Risks?
Operational risks can manage by evaluating them and should be within the organization’s risk appetite. Risk tolerance varies from organization to organization, depending on its size and nature.
Below are the following methods to manage operational risk :
- Identifying, Evaluating, and Accepting the Risk: Internal control system establishes to identify and evaluate the risks. Some risks are inherent and cannot avoid entirely, like errors in work made by employees. The internal control system helps to reduce the risks predominantly, and some inherent needs accept as they cannot avoid and may cause material impact.
- Transferring the Risk: Insurance is the most common method for sharing the risk from the organization (e.g.) Insurance of buildings and properties.
- Reduction of Risk Identified: Once a risk is identified, steps and measures need to be taken by management to reduce the risk by establishing some internal checks and control processes.
- Avoiding the Risk: Few risks can avoid by acting proactively and establishing a proper control system in the organization (e.g.) Maker-Checker concept, Bill preparer and approver cannot be the same person, etc. It helps to avoid the risk of errors and fraud.
Risk is not a permanent concept; it changes occasionally with the evolution of business, economic and political conditions, etc. So, risk mitigation strategy and risk assessment should be monitored regularly to avoid and reduce operational risks.
Conclusion
Every business has to deal with some or other risks in its business operations. Operational risk deals with uncertain and unavoidable situations that can place the organization at risk. A proper risk management strategy and a risk management team must be formed and put in place to manage the risk. Establishing internal controls helps to avoid errors and detection of fraud. Proper risk assessment and strategy help the business continue its operations without interruption.
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