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What is risk analysis?

Last updated

6 April 2023

Reviewed by

Hugh Good

There are many potential negative outcomes that can adversely affect organizations. Risk analysis is the process of identifying, understanding, and mitigating such events. In this article, we'll examine the types of risk analysis, their benefits as well as limitations, along with guidelines on developing an effective risk analysis strategy.

What are the three basic objectives of risk analysis?

While it's never possible to completely eliminate risk, it can be beneficial to raise awareness of such potentialities so that appropriate preparations can be made. Here are the three basic objectives of risk analysis:

  1. Provide a process for identifying and managing risk

  2. Understand the potential impact of problems Help form a strategy to minimize or mitigate risk 

Risk analysis and probability

There is usually a certain amount of risk accompanying any action, whether it's making an investment, launching a product, opening a new branch of business, or taking out a loan. An important function of risk analysis is to determine the probability of an unwanted outcome.

Negative events can be specific to an individual or organization or they can be due to economic or societal conditions outside our control. The latter are sometimes called black swan events. Examples include economic recessions or depressions, the Covid pandemic, and even terrorist attacks.

Why is risk analysis important?

While certain events cannot be predicted, in many cases the probability of positive or negative outcomes can be quantified. For example, financial advisors can calculate the probability of a stock or other asset rising or falling based on past performance. When starting a business or launching a product, market conditions and the performance of competitors are considered to calculate risk.  

The following are some instances when risk analysis can be especially useful:

  • In the planning stage of a project

  • Planning any action that requires a significant financial investment

  • Understanding the impact of emerging and disruptive technologies such as blockchain and artificial intelligence

What are the benefits of risk analysis?

There are several advantages to having a risk analysis strategy, as it allows you to:

  • Identify potential threats. Awareness of possible negative events makes it less likely you'll be caught by surprise.

  • Avoid actions where the risks outweigh the potential benefits. 

  • Increase organizational awareness of threats. For example, employees who are aware of security threats are more likely to take proper precautions

  • Make better budgeting decisions to be prepared for cyclical or one-off economic shocks due to an analytical understanding of risk. 

What are the 3 essential components in determining risk?

The three essential components in determining risk are:

  • Danger —  nature of the threat

  • Exposure — who or what can be affected

  • Vulnerability — likelihood that humans, property, or assets will be damaged

What is the objective of risk process planning?

Risk process planning is necessary so that an organization has a definite strategy in place for assessing and managing risk. 

Types of risk analysis

There are several types of risk analysis.

Qualitative vs quantitative risk analysis

Risk analysis falls into two general categories: qualitative and quantitative. Quantitative risk analysis assigns a numerical value to risk. This may involve tools such as a Monte Carlo simulation, used to predict the probability of a variety of outcomes when random variables are present.  

Qualitative risk analysis looks at risks without identifying a numerical value associated with them. This can be done using models such as SWOT analysis and game theory. For this type of risk analysis, it's not possible to assign a risk value. This approach requires more thoughtful discussion and analysis. It may be combined with quantitative risk analysis. 

Risk-benefit analysis

Weighing risks or costs against benefits is probably the most familiar type of risk analysis. For example, before launching a product a business will typically calculate the costs and compare these to the likely profits. 

Needs assessment

An organization may conduct a needs assessment to identify any needs or gaps. For example, a company may decide that it needs to upgrade its technology to stay competitive. 

At the same time, investing in new products or services entails a certain risk, such as the possibility that the returns won't justify the costs. A needs assessment should, therefore, include a risk analysis of any proposed solutions.

Business impact analysis

A business impact analysis (BIA) is done to calculate the impact of an event or trend that is likely to cause disruption. This may include an economic recession, emerging technology, the growth of a competitor, regulatory fines, a product with a known defect or high return rate, a natural disaster, or any other potentially disruptive issue.

Root cause analysis

Root cause analysis (RCA) is a type of analysis that focuses on the fundamental causes of a problem. By understanding exactly what happened and why, leaders can take steps to prevent similar problems from arising in the future. Risk analysis is part of RCA in that you want to understand the risks of the problem recurring. 

Additionally, there's the need to measure the risks of any proposed solutions. For example, if a company notices that sales are down in the previous quarter, RCA may identify the primary cause, such as a new competitor offering a similar product at a lower price. One solution might be to lower the price to be more competitive. The risk of this approach is lower profits.

How to perform a risk analysis

The following are the steps for performing a risk analysis. 

Identify the risks facing your organization

Before you can analyze risks, you must be aware of them. There are always a variety of potential risks, so you need to focus on the ones that are most relevant to your current concerns. For example, if you're considering a major purchase, such as equipment or costly service, you'll want to look at the risks such an investment poses.

Assess the degree of uncertainty

When assessing the likelihood of a problem occurring, you need to identify uncertainty. Examples of uncertain variables include the behavior of financial markets, actions taken by competitors, and customers embracing new technology. 

Estimate the impact

What are the most serious possible consequences? Who will it impact? Some problems may cause a temporary inconvenience while others can be catastrophic to the organization.

Calculate risk value

Risk value is calculated by multiplying the probability by cost or impact. This is fairly straightforward when measuring financial risk. For example, if a product launch costs a company $1 million and there's a 25% chance of failure, the risk is 1,000,000 x .25 = 250,000. 

To interpret risk value, you need to consider your situation and what you can afford to lose. For a large company, $250,000 may be a relatively minor risk. For a startup with limited funding, it could place the entire future of the business in peril. 

Create an analysis model

An analysis model takes all available data into consideration and generates probabilities and outcomes. There are several types of analysis models, including:

  • Monte Carlo simulation — A model based on gambling that is useful for estimating the probability of a wider range of possible events. 

  • Mind maps — Diagrams that outline the components of a project.

  • Organizational charts — Hierarchical charts that show the relationships or chain of command in an organization.

  • SWOT analysis — SWOT stands for strengths, weaknesses, opportunities, and threats.

  • Wireframes and prototypes — Wireframes are useful for websites to illustrate page interfaces. Prototypes are models for products that exhibit essential features.

Identify solutions

Once you've analyzed the data, it's time to come up with a plan of action. In some cases, this could mean not moving forward with a project because the risks are too high. It could mean moving forward cautiously or doing more consumer testing for a product. 

Risk analysis is essential for every organization

Risk analysis is essential for identifying, understanding, and mitigating factors that can negatively impact an organization. Analyzing risks puts you in a much better position to avoid problems or at least minimize their effect. It's a process that increases security and helps you make better financial decisions.

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