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What is Operating Risk in Finance?
Operating risk is associated with a company’s cost structure. It is the risk a company faces due to the level of fixed costs in the company’s operations. As the name suggests, operating risks are associated with the operations of the business. This may include risks due to failure of fixed assets or unpredictable operational risks that cannot be foreseen.
Business risks are of two types − Operating risk and Sales risk.
Operating risk is related to the cost structure and fixed costs of a company.
Sales risk is the risks associated with the loss of revenue due to fewer goods and services sold.
Fixed Costs and Operating Risks
Operating risk is proportional to the fixed cost of a company. The higher the level of fixed costs, the more is its operational risk. It is easy to understand why. As the fixed cost is related to assets, losses in terms of fixed assets are included in such types of risks. Therefore, when there is a chance of loss due to fixed costs, the operating risk goes up.
High fixed costs make a company less flexible, as it cannot vary fixed costs to match it with the sales.
Higher sales can lead to huge profits, but the company is vulnerable to huge losses too due to operational losses.
Unlike variable costs that depend on the level of production and sale, fixed costs do not vary depending on the changes in revenues generated.
How to Measure the Operating Risk?
We can use the degree of operating leverage (DOL) to measure the operating risk. DOL considers the sensitivity of operating income to the proportion of units sold. It is measured as a percentage of income divided by the percentage of units sold.
$$\mathrm{\mathbf{DOL\; =\; \frac{Percentage\: of\: Change\: in\: Operating\: Income}{Percentage\: of\: Units\: Sold}}}$$
DOL is a dynamic tool to consider the effect of operating risk.
When the operating income is negative, the DOL is also negative because the percentage change of operating income is negative.
When operating income is positive, the DOL is also positive.
When operating income is 0, the DOL cannot be defined.
The operating risk is an important measure for companies to stay healthy. Therefore, the management may willingly control it so that the business does not have to face huge losses when conditions are unfavorable.
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