Cost risk

From CEOpedia | Management online

Cost risk - is the foreseeable loss associated with the failure of a certain part of the company's undertakings. According to neoclassical enterprise theory, the cost of risk is a cost component of the enterprise (Z. Yalian,2009, pp. 2-5). The cost of risk can be defined as all the costs incurred by a company. in relation to the risks associated with its business. They are costs occurring as a result of risk and costs incurred to hedge against risk. Costs risks arise in all areas of the company's operations and include in different cost groups (Z. Yalian,2009, pp. 2-5). The following costs shall be treated as costs of risk with the risks inherent in the undertaking, whether or not covered by subsystems financial and management accounting (Z. Yalian,2009, pp. 2-5).

The subject of measurements in accounting are, among others, the following incurred by the company costs of conducting business activity. In financial accounting, these are the costs of actually incurred in the past, which are recorded in the accounting records and are presented in the financial statements (Z. Yalian,2009, pp. 2-5). In management accounting, however, there are the estimated future operating costs of the undertaking as well as the cost of lost profits (opportunity costs). Costs that are determined or estimated in accounting may be separable, incurred by the undertaking for the risks associated with operating the business economic (Z. Yalian,2009, pp. 2-5). This is a specific issue of cost accounting, which is carried out by both for the purposes of financial and management accounting. Measurement of cost risk is certainly a specific issue of cost accounting. It can be considered for a dual-issue, in relation to the estimation of cost risk, which is an issue primitive cost management (Z. Yalian,2009, pp. 2-5).

Essence of the cost risk

The visible cost risk may be included in the different cost components of the activity. Companies entered in the accounting records. They may, therefore, be included in the costs grouped in different breakdowns, i.e. according to (A. Białas,2016, pp. 28):

  • variety of activities,
  • types,
  • locations,
  • emissions,
  • products.

Invisible cost risk is determined on the basis of indirect estimates. It is particularly difficult to estimate the costs of lost benefits due to the occurrence of above-average risk of the company's operations. Carrying the risk cost in such a situation is due to a lack of information or inaccurate identification of risk factors (A. Białas,2016, pp. 29). The risk cost relates to different aspects of a company's activities. They are incurred as a result of different risk factors. Moreover, they are specific in nature, which makes it very difficult for them to be exhaustive characteristics (A. Białas,2016, pp. 29).

Classification of cost risk

The risk costs may vary in nature and it is, therefore, advisable to classify them according to specific criteria. The overriding classification criterion is the relationship between costs with an inherent risk on the basis of which it can be distinguished the following categories of risk cost (M. Rausand, 2011, pp. 28-36):

  • costs caused by the existence of risk,
  • costs of risk impact,
  • the costs of inefficiencies that result from risk avoidance.

Costs due to risk are those costs incurred by the enterprise to cover losses due to business risks. The costs of impact on risk are those cost items that are incurred to hedge against the risks to which the company is inevitably exposed. On the other hand, the costs of inefficiencies that result from avoiding risk are costs that arise when an undertaking fails to take appropriate action to respond to the risks involved (M. Rausand, 2011, pp. 28-36).

Risk costs may also be classified according to the life cycle phase of the enterprise. Using this criterion can be distinguished (M. Rausand, 2011, pp. 28-36):

  • costs of risk occurring at the stage of undertaking the activity,
  • costs of risk incurred in the course of business,
  • the cost of risks associated with the closure of the business.

A similar classification of the risk costs can be made for the costs of considered the life cycle of the product. In this case, three phases of this cycle are distinguished (A. Białas, 2013 pp. 49-64 ):

  • the pre-market (pre-production) phase,
  • the market (production) phase
  • the porcelain phase (post-production).

In each of these phases, specific types of risk costs are incurred. The scale of risk accompanying costs in particular phases is also different.

In turn, the criterion for classifying the risk costs is the temporary demarcation of risk, three categories can be identified (A. Białas, 2013 pp. 49-64 ):

  • costs of ex-ante risk,
  • the cost of risk in time,
  • ex-post risk costs.

Risk costs may also be classified due to the possibility of recording in the accounting system and disclosure in the financial statements. Based on this criterion, two groups of these costs can be distinguished (A. Białas, 2013 pp. 49-64 ):

  • visible risk costs, which are directly measurable, recorded and recorded and presentation in accounting,
  • costs of invisible risks that are not directly measurable in the company's accounting system.

Examples of cost risk

One example of risk cost costs arising when a company is in financial difficulty, in particular when it is threatened with bankruptcy (Riegg Cellini S., J.E. Kee, 2010, pp. 53-58). The following can then be regarded as costs of risk take the difference between the interest rate of loans in the event of financial difficulties and the interest rate in the absence of such a threat. Similarly, during a period of financial difficulty, a deterioration is usually observed. financial liquidity (Riegg Cellini S., J.E. Kee, 2010, pp. 53-58).

It is often the case that the cost of a loan The cost of trade credit is higher than the cost of trade credit. The difference between these the amount also represents a kind of risk cost Other risk costs occur when selling products and merchandise with deferred payment terms. If receivables are deemed to be time-barred, written off or uncollectible, they will be treated as costs (other operating costs). The specific risk cost may arise when the development of certain economic figures in the future were not accurately predicted (Riegg Cellini S., J.E. Kee, 2010, pp. 53-58).

Risk cost management

Risk cost management should be an integral part of risk management in any undertaking. Risk management is a process carried out while establishing the company's strategy and undertaking undertakings for the benefit of the company to make it happen (B. Fischhoff,2015, pp.527-530). The actions of management and managers in this area should enable the identification of probable events that could affect the level of cost risk, which are the result of any economic activity (B. Fischhoff,2015, pp.527-530).

Risk cost management in an enterprise is designed to support the achievement of key business objectives. Such an objective is undoubtedly to increase the efficiency of the use of company resources. It should have the effect of reducing the costs incurred in achieving a certain range of activities (B. Fischhoff,2015, pp.527-530). This, in turn, contributes to increase the financial results achieved. In the long run, however, it is about o increase in the value of the company (equity). The effectiveness of risk cost management depends to a large extent on from the knowledge of the company's functioning conditions, both internal and external, as well as the external ones (P. Ricci, 2006, pp. 71-111).

Awareness of the factors influencing the engagement and consumption of the company's resources is the basic condition for identifying the risk of using the company's resources. In risk cost management it is necessary to, first of all, come to the original causes of incurring the following costs, on the one hand, it is a matter of identifying events that may result in incurring costs that are excessive in relation to those postulated (P. Ricci, 2006, pp. 71-111). On the other hand, it is necessary to take advantage of all the opportunities that may be offered by contributing to lower costs than expected. The main task of cost risk management is to rationalize a company's operating costs, which should contribute to improving financial performance (P. Ricci, 2006, pp. 71-111).

Advantages related to Cost risk

The advantages of cost risk are:

  • It helps to identify potential risks in a business operation, which enables organizations to take preventive measures or put in place a backup plan in case of a risk occurring.
  • It can help organizations to develop cost-effective risk management strategies that can reduce the potential for losses.
  • It can help to identify and prioritize risks according to their probability and impact, allowing organizations to focus their resources on the most important risks.
  • It can help organizations to allocate resources to mitigate the risk, thus enabling them to reduce the cost of managing the risk.
  • It can help to identify areas where the organization can reduce costs and increase efficiency.
  • It can provide a platform for organizations to review and revise their existing risk management strategies.

Limitations related to Cost risk

  • Cost risk is difficult to measure accurately, as it involves predicting the potential losses that could occur due to the failure of certain parts of the company’s undertakings.
  • Cost risk analysis is often subjective and may not take into account all potential risks associated with a given project.
  • Cost risk can be difficult to manage and may require significant investment in risk management processes and systems.
  • Cost risk can be difficult to manage over time, as the potential risks associated with a given project may change over time.
  • Cost risk can be difficult to transfer to other parties, as the other parties may not have the same level of risk tolerance as the company undertaking the project.
  • Cost risk can be difficult to mitigate, as it can be difficult to determine the most effective way to reduce or eliminate the risk.

Other approaches related to Cost risk

  • The expected cost approach: This approach calculates the expected cost of a risk event by multiplying the probability of the event occurring by the estimated cost of the event.
  • The cost of capital approach: This approach views risk as an increase in the cost of capital, as investors are likely to demand higher returns for taking on additional risk.
  • The decision tree approach: This approach uses decision trees to analyze the costs associated with different courses of action.
  • The portfolio approach: This approach looks at the portfolio of risks that a company has and the overall expected cost of those risks.

In summary, cost risk is a concept related to the foreseeable loss associated with the failure of a certain part of the company's undertakings, and there are several approaches which can be used to analyze and measure the cost of risk, such as the expected cost approach, the cost of capital approach, the decision tree approach, and the portfolio approach.


Cost risk — recommended articles
Total risk — Insurance risk — Residual risk — Cost behavior — Design risk assessment — Hidden cost — Capital planning — Risk response — Uncertainty and risk

References

Author: Dominika Pasek

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