Academic journal article Journal of Management Information and Decision Sciences

Managing Risk in Operations

Academic journal article Journal of Management Information and Decision Sciences

Managing Risk in Operations

Article excerpt

INTRODUCTION

Risk is defined in a variety of ways, depending on context and the presumed interest of the reader. Amram & Kulatilaka (1999) assert, "The adverse consequence of a firm's exposure is risk." Mandel (1996) employs two broad categories for risk: idiosyncratic and structural. Idiosyncratic risks affect a single company while structural risks affect economies, sectors or industries. Usual treatments of risk (Weston & Copeland, 1998) address market risk, financial risk, and business risk. Business risk is the combination of revenue risk and operating leverage, that is, the variability of EBIT (earnings before interest and taxes) and the ratio of fixed costs to total costs.

Notions about the inevitability of, and appropriate response to, risk vary around the world. In economies that practice Strategic Trade (as contrasted to Free Trade), risk is viewed as inherently bad and economic policy and governmental action are devoted to reducing risk and variability in markets, (Fallows, 1994). State capitalism (Bremmer, 2010) exhibits similar characteristics. Significant inefficiencies typically result. At the firm level, excessive attention to risk can result in overspending on risk reduction with corresponding reductions in operating margins. Excessive inventories are a common and visible manifestation of this phenomenon.

As our interest centers on operations in the organization, we apply the treatment suggested by Weston & Copeland (1998), and recognize operational risk as a major source of variability in EBIT. Risk in Operations arises from internal variation and from the environment. Further, risk may be due to either common or special causes (Deming, 1982). In the following, we provide a structure for categorizing the ways in which operations can mitigate risk or its effects on the organization.

OPERATIONS

We define Operations as revenue-producing activities carried out by the firm, specifically, those activities that 'deliver' the value proposition of the enterprise. The measure of the performance of an operation is its productivity. Economic theory defines productivity as (McConnell, 2008):

Productivity = output/ inputs (1)

In this form, the equation is may be applied to a firm, an industry, a sector of an economy, or an entire economy. As defined, output and inputs are flow rates stated in physical terms. Converting the equation to "per period" terms moves towards a construct useful to the manager and establishes consistency with accounting convention. Converting inputs and output to their monetary equivalents illustrates the relationship between Productivity and EBIT. Output monetized is revenue and current inputs become COGS (Cost of Goods Sold). Variability in productivity relates directly to variability in EBIT.

Typically, discussions of productivity proceed with a focus on the partial factor productivity of labor (output stated in terms of labor input). Eschewing this direction, we pursue a path that acknowledges the variety of inputs and has the objective of developing the relation between productivity and the managerial decisions that affect it. As developed, this relation will provide a framework for characterizing risk in operations. We develop what we call the "Productivity Equation," in (2) through (4) following.

Begin with a restatement of the definition to emphasize both period and linkage to financial statements.

Productivity = output delivered/inputs acquired (2)

The Equation (2) (still in physical terms) defines the scope of operations as ranging from input sourcing and hiring decisions (including both fixed and variable inputs) to outbound logistics management. In this form, the expression may represent a supply chain or may be limited to the internal operations of a single enterprise.

The operating manager's objective is to produce steady growth in productivity, contributing to growth in EBIT. …

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