Risk is a broad term that can apply to many situations. For this article, we are talking about ways to mitigate business risks to inputs and outputs.
Use contract employees to scale up/scale down employment needs. The potential downside is having to train temporary employees.
Use contract employees that allow for exit if project fails. A long term contract should be avoided for risky projects, which will likely result in higher negotiated costs.
This is best employed in low skilled positions where experience is not at a premium.
Option: Put or Call
Premium: Training cost of contract employees, potential higher labor cost vs. internal employees.
Exercise Point for put: Demand goes down.
Exercise Point for call: Demand goes up.
Use commercial off the shelf (COTS) components instead of fit for purpose components. Fit for purpose components may have a higher initial investment or require a long term purchase contract, but have a lower per unit cost.
Using a COTS components may result in reduced performance or higher cost. The upside is usually shorter lead times, and if the component is based on an industry standard, multiple suppliers may be used.
COTS components can be used for feasibility testing prior to spending money on tooling, engineering, or minimum buys. If for some reason, the project were to be cancelled, initial investment would also be saved.
Option: Put, call, or switching
Premium: Higher cost versus fit for purpose design.
Exercise Point for Put: Scale back production due to low market demand.
Exercise Point for Call: Scale up production due to high market demand. Possibly add new supplier due to demand.
Exercise Point for Switch: Switch suppliers when one’s price is sufficiently lower to justify switching.
Hedging contracts for sales
If market price fluctuations need to be risk managed, a hedge contract can be used. In effect, you sell a futures contract to sell your asset or product at a specific price in the future. This allows you to guarantee a sale price. The trade-off is that at the time of the sale, the spot market price may be higher or lower than your contract price. If higher, you lose out on potential revenue. If lower, you gained additional revenue.
Examples: Selling farm commodity futures contract, selling company stock futures contract.
Hedging contracts for purchasing inputs
If inputs to your business, such as raw materials, are subject to price fluctuations, then a hedge contract can be used to lock in prices. The trade-off is that at the time of the purchase, the spot market price may be higher or lower than your contract price. If lower, you will pay more than the going rate. If higher, you saved money.
Examples: An airline buying a futures contract to purchase fuel, a manufacturer buying a futures contract to purchase steel.