Risk, expected return and expected cost

It is impossible to operate a business which is not subject to risk. Risk is inevitable. For example, there is a risk that competitor activity will impact upon the existing level of business or a business may commit resources to new projects that will be undertaken in an uncertain future. Organisations are willing to accept risks in the hope that they will become more successful. However, not all risks are acceptable.

Risks may be unacceptable because:

• they may not generate any return, or
• the return may be inadequate to compensate for the risk being taken, or
• the risk may not fit the corporate strategy, or
• risk might be greater than what the organisation’s stakeholders are prepared to accept.

It is essential that only acceptable risks are taken, and that those risks are properly understood and managed. The risk management process should identify opportunities for creating positive value, as well as managing threats.

Expected return

A positive return is the surplus over the amount invested. For example, an investment of EUR100 is made, the return is EUR120 so the return is EUR20. A negative return means that the amount received back is less than the amount invested.

Returns can be variable and the return for a business is the profit that it makes. The profit for most businesses can vary considerably from what was expected and is driven by a range of factors such as economic conditions (including foreign exchange rates and interest rates) and demand for the products and services.

Links to risk

Investors look for the best return at a given level of risk. If there were two investments with equal expected returns, the investor would rationally choose the investment that offers the least amount of risk. Conversely if two investments had the same level of risk, an investor would choose the one that offers the highest return.

Risk and expected return

Organisations try to reduce the level of risk, although risk reduction usually comes at a cost, such as the cost of taking out insurance. Any cost of reducing risk lowers the expected return on an investment.

Risk and expected return trade-off

When the risk is relatively low, so are the expected returns, e.g. a company might decide to slightly amend the wrapping on one of its food products, in an attempt to attract more customers. The risk of losing existing customers is low, but so is the possibility of gaining substantially more.

On the other hand the company might decide to sell its products in a previously untried country. The risk is high, partly because of the costs of establishing a presence in the new market. If the venture is successful, however, the return will be high.

Risk and expected cost

Cost managers may choose to reduce the risk, or variability, of the expected costs they are managing. This risk reduction comes at a cost. A good example is insurance. A home or business owner may choose to pay for insurance against burst water pipes. Although the insurance comes at a cost, the risk has been reduced because in the event of a burst pipe the repairs won’t have to be paid for.

When the cost is relatively high, e.g. when insurance is purchased, the risk is lowered. When the cost is lower, e.g. when insurance isn’t purchased, the risk is higher, because a repair to a burst pipe would have to be paid for.