When making an important decision, there are many factors to consider. From the effects that your decision may set into motion to the various risks and benefits, there's a lot of information to evaluate. You can use the process of risk analysis to make better-informed decisions by understanding all the possible outcomes. In this article, we discuss what risk analysis is, why organizations use the process and the six steps to perform an effective one.
What is risk analysis?
Risk analysis is a specialized tool for decision-making that identifies and analyzes potential challenges within a project, plan or initiative. The process uses critical thinking and problem-solving to determine what issues may arise, how likely it is a problem will occur and the consequences of those problems. It is essential to understand that the severity of risks can vary drastically.
Organizations use risk analysis in many industries and sectors. It can vary from highly detailed and technical to the informal review of safety risks before starting a job. Many types of professionals complete risk analysis, including high-level corporate executives and team supervisors. The fundamental concept and process are the same regardless of the position.
It's worthwhile to note that risk analysis-specific positions exist in many industries. A risk analyst is in a specialized position concentrating on preparing and analyzing risk data to create concrete risk management plans. Organizations typically employ risk analysts within the financial, computer technology, security and data management sectors.
In what situations do you use risk analysis?
Risk analysis is useful in any situation where the probability of risk is present. Here are several situations where risk analysis applies:
- improving safety standards in the workplace, bringing awareness to potential accidents
- planning a project, to minimize potential uncertainties that could affect the timeline
- preparing for events, need to foresee obstacles like equipment failure
- evaluating whether to move forward on a new project, to determine all risks and benefits
Why do organizations use risk analysis?
Organizations use risk analysis because it provides a model of the probability of events and consequences of a project, decision or initiative. Here are the typical reasons companies conduct a risk analysis:
- evaluate risks and reduce the impact of adverse effects
- determine the likelihood of risks occurring
- get a clear picture of the risks versus the benefits of a decision
- create a company plan in response to emergencies or adverse events
- make a comprehensive preventative plan to manage risks
How to complete a risk analysis
Before beginning a risk analysis, you must have a clear and well-defined project, concept or initiative. It helps to understand the eventual goal or deliverable. To complete a risk analysis for most situations, follow these six steps:
1. Identify all conceivable risks
Start by brainstorming all potential risks and threats that could result from working on your project or initiative. No matter how small or large, create a master list. Talk to various people on your team or within your environment to gain different perspectives and ideas you hadn't considered. There are three formal processes you can follow to identify risks and threats. They include scenario analysis, failure mode, effects analysis and SWOT analysis.
A SWOT analysis looks at four specific areas. It stands for strengths, weaknesses, opportunities and threats. This process identifies the positive and negative aspects of the decision you're analyzing. SWOT analyses include internal and external factors that contribute to the overall success, and you can use this information to weigh the pros and cons of a decision.
Risk and threats can come from a variety of sources. Some areas to consider might include:
- people: including illness, injury, resignation or other loss of key individuals
- technology: including advances in technology, technical security or equipment failure
- financial: including economic fluctuations, changes of interest rates or ability to secure financing
- operational: including disruptions to distribution or raw supplies, failures of internal systems or changes to fixed assets
2. Define the levels of uncertainty
Once you have a master list of all possible risks, it's time to determine how much uncertainty surrounds each risk and threat. You need to estimate the impact of each risk and the significance. There is a certain amount of variability with each possibility, making it difficult to quantify precisely.
Not all risks carry the same level of consequence. For example, suppose you're completing a risk analysis about warehouse safety. In that case, the risk of leaving a forklift unattended with its forks in the air could result in someone bumping their head, or the forks coming down on a worker and causing serious injury. Being aware of all potential levels of uncertainty provides the best analysis.
3. Estimate the impact of uncertainty
Now that you have determined all the potential risks and threats, and the likelihood of those events, it is time to estimate the impact of uncertainty. It's critical to take your time with this step. Begin by collecting data related to the potential costs of all possibilities. If you don't have current data, you can estimate appropriately or use historical information to develop a cost. You also need to determine the probability of each event occurring as a percentage.
The most direct method to estimate the value of each risk is to take the probability of the event occurring and multiply it by the cost of the event:
- (Probability of the event occurring) X (cost of the event) = (risk value)
To apply the calculation, imagine that you have identified a risk to raw materials for a product you manufacture increasing substantially over the next year. Based on all available information, you believe that there's an 80% chance of the price increasing. The cost to your organization is approximately $100,000 if the price of raw material goes up. You would calculate the risk value like this:
- 0.80 (the probability of the event) X $100,000 (the cost of the event) = $80,000 (the risk value)
4. Complete the risk analysis model
Once you have clearly defined the risk and threats of a decision and the levels of certainty, you can create a risk analysis model. You design this by using simulation or quantitative programs to determine the potential outcomes. Compile a list of all identified variables, known as "inputs." The model then allows you to evaluate all potential outputs, which are the various uncertainties and possibilities of each happening during the project. The inputs are estimated values, so the outputs provide a range of potential outcomes.
You can complete a risk analysis model using specialized simulation software or a simple Microsoft Excel spreadsheet. The purpose of the model is to create a complete picture of all risks, probabilities and costs so you can interpret and analyze the data.
5. Analyze the results of the risk analysis
You have a logical model that presents you with all available information. Now, you need to analyze the results. You can use several methods to analyze the results, including graphs and charts, scenario analysis, and sensitivity analysis. It's up to your discretion to find the best way to understand the information within the model.
Graphs and charts are very effective tools to present complex information in an easy-to-understand visual format. These are impactful ways to show others the cause and effect of various probabilities. Some examples include pie charts, line graphs and bar graphs.
Scenario analysis often uses computer software to manipulate individual variables to provide a "what if" example. You can adjust single or multiple variables to see various predicted outcomes.
Sensitivity analysis typically uses computer software to manipulate data to provide a quantifiable result. It shows how unique sources of uncertainty using a mathematical design contribute to the model's overall uncertainty.
6. Decide and implement a solution
Once you have completed your analysis of the risk model, you must decide on a direction. You can choose one, or a combination of four options:
- Avoid the risk. Sometimes, you want to avoid the risk altogether. Upon analyzing the data, you may realize the risks far outweigh the benefits of completing the project, opening a new location or expanding your services.
- Accept the risk. After careful consideration, you decide the benefits outweigh the potential risks, and you choose to move forward with the new idea, project or initiative.
- Share the risk. You conclude the benefits outweigh the risks but are interested in sharing the potential risks with others, such as another department or location.
- Manage the risk. You accept the risks involved and create a comprehensive, preventative plan to minimize the impact of potential risks.
As you create and execute a solution to move your decision, project or initiative forward, use the "Plan-Do-Check-Act" model for control and continuous improvement throughout your implementation. The four phases of this cycle include:
- Plan: create a detailed plan with processes to deliver a specified aim.
- Do: implement the created plan on a smaller scale.
- Check: review the results of the plan and adjust and change the plan accordingly to minimize risks.
- Act: implement the modified plan on a larger scale. Monitor the progress and adjust as necessary.