Risks Are Part Of Running A Business

We are told that the cost of a product or service is the sum of all the expenses to produce it. The problem with this approach is that it fails to consider the risks which have not yet happened. Unfortunately, the risks every business faces are virtually infinite, and failing to factor them in your calculations can bring unexpected losses with no cash buffer to cushion the blow.

Some of the risks are common enough that everyone is aware of them. For example, almost every businessman obtains fire insurance because everybody knows about the danger of fires. The payment for the insurance premium is recorded and is recognized as a business expense. Still, there are many other risks that businesses do not take into account.

This year, the natural disasters we went through have brought fears to many entrepreneurs. It is difficult enough to make a profit without worrying about the loss of all your assets by forces beyond your control. Even though business owners know the impact of natural disasters, most still do not factor these in their costing. They think that doing so may price them out of the market or that these catastrophes are unlikely to happen. But ignoring the risks does not make them safe.

Even if no insurance is bought, just knowing about the risks could enable one to manage expectations. I happened to talk to a relative who has been engaged in planting sugar cane somewhere in Central Luzon. She said she could earn P100,000 if the harvest is good; but if a typhoon destroys the crops before its due, then the value would be almost nothing. From long experience, she has been able to gauge the risk of the worst case scenario close enough to make a sound decision. She expects to earn on the average around P50,000.

However, there are many risks that occur very rarely—like a direct hit from a super typhoon or an earthquake of magnitude eight. These are some cases that people neglect to plan. Even if the probability is very remote, the chance of a rare event occurring within your lifetime is still something that you should prepare for.

One way to mitigate these risks is insurance, like I mentioned earlier. What people should realize is that in buying insurance, you are normally paying more than the actual cost of the risk. For example, if you are fully insuring your inventory valued at P1 million for a premium of P2,000, rest assured that the actual projected cost to the insurer is less.

The insurance company may have estimated that there is only a one percent risk of fire totally destroying your stock. They then add their overhead and profit margin to the projected cost to come up with the premium to bill. Note, however, that this is just a theoretical example and that I personally do not know how big a percentage is the overhead and profit in the premium. Nevertheless, I believe they are substantial, especially for risks that are not commonly insured and so have a lesser chance of being compared.

Even if you do not know the actual composition of the premium, knowing the premium rates offers a rough guide to the risks that you are exposed to. For example, if your premium rate is one percent, then the chances of the risk occurring in any given year should not exceed one percent. This should give you better data than simply relying on your own estimate since insurance companies have far more information and actuaries working for them (these are professionals that deal with statistics to compute insurance risks and premiums). This approach may not apply in unusual risks since the profit margin may be very high in such cases.

Since it is expensive to pay for insurance, many companies opt to self-insure. What it means is that you act as your own insurer. If your company has plenty of cash to cover the risk you want to self-insure, then it may be feasible not to buy insurance. The truth is, every company self-insures to a certain extent. After all, you cannot buy insurance for every conceivable risk as that would be too costly.

In conclusion, risks must be considered as part of the cost of running a business. Certain risks, but not all, could be neutralized by buying the right type of insurance. Be aware though that you can save money if you self-insure in certain situations assuming you have large enough cash reserves. Neglecting to include the effect of risks on cost could lead to problems like setting prices that are too low to make satisfactory profits. Research on risks that may affect your business and be prepared before a calamity occurs.

*Originally published by the Manila Bulletin. D-4, Sunday, November 24, 2013. Written by Ruben Anlacan, Jr. (President, BusinessCoach, Inc.) All rights reserved. May not be reproduced or copied without express written permission of the copyright holders.