Operating risk is the risk related to a company’s cost structure. More specifically, it is the risk the company faces due to the level of fixed costs in its operations. Together with sales risk, operating risk is one of the two components of business risk.
Business risk is the risk related to a company’s operating income. We can break up business risk into two components:
Operating risk: Related to a company’s cost structure and level of fixed cost.
Sales risk: Related to the uncertainty of generating sales due to the variability in the price and volume of the goods and services sold.
The measurement of operating risk can be done through the application of the concept of elasticity. More specifically, we can use indicators such as the degree of operating leverage (DOL), which is a very popular indicator of operating risk.
The degree of operating leverage measures the sensitivity of operating income to the variations in units sold. It is measured as the percentage change in operating income divided by the percentage change in units sold:
DOL = Percentage change in Operating Income / Percentage Change in Units Sold
For example, if we calculated the degree operating leverage for Company A and found a value of 3, it means that Company A would experience a 3% increase in operating income for every 1% of growth in units sold.
The DOL is a Dynamic Measure
The degree of operating leverage is not a static measure, but its value changes based on the level of output.
- At levels of output for which operating income is negative, the degree of operating leverage is also negative.
- At levels of output for which operating income is very close to zero, the DOL is very sensitive to variations in units sold.
- At the level of output for which operating income is equal to 0, the DOL is undefined because the denominator in the formula is 0.
Cash cycle risk
All cash collections must be properly identified, control totals developed, and collections promptly deposited to limit risks associated with recording cash receipts or withholding or delaying the recording of cash receipts. All transactions should be promptly and accurately recorded in sufficient detail on proper accounting records and appropriate reports issued to prevent unauthorized transaction substitution with unsupported credits or fictitious expenditures.
All transactions are properly accumulated, classified and summarized in the general ledger; balances are correctly reconciled with bank statement balances in a timely manner to prevent cash balance misstatement or the offsetting of unauthorized transactions.
Common risks associated with embezzlement, fraud, and your cash cycle include:
- The authorization or accuracy of cash receipts, the failure to record cash receipts or withholding or delaying the recording of cash receipts.
- diverted cash receipts; unauthorized cash disbursements or loss of funds
- Covering unauthorized transactions by substituting unsupported credits or fictitious expenditures to cover misappropriated collections; under or over estimating cash or receivables.
- Misstating cash balances; covering unauthorized transactions by falsifying bank reconciliation.