Profit risk
Encyclopedia
Profit risk is a risk management
tool that focuses on understanding concentrations within the income statement and assessing the risk associated with those concentrations from a net income perspective.
industry, in that it complements
other risk management methodologies commonly used in the financial services
industry: credit risk management and asset liability management
(ALM). Profit risk is the concentration of the structure of a company’s income statement
where the income statement lacks income diversification and income variability, so that the income statement’s high concentration in a limited number of customer accounts, products, markets, delivery channels, and salespeople puts the company at risk levels that project the company’s inability to grow earnings with high potential for future earnings losses. Profit risk can exist even when a company is growing in earnings, which can cause earnings growth to decline when levels of concentration become excessive.
strategies commonly used for investment asset allocations, real estate diversification, and other portfolio risk management techniques.
, which states that approximately 20% of a company’s customers drive 80% of the business. This rule and principle may be appropriate for some industries, but not for the financial services industry.
According to Rich Weissman, it is true that this small group of customer/member dominates the income statement, but the old "80/20" rule ~ it does not longer applied. "There are real-life examples where financial institutions have seen profit risk ratios as high as 300 percent. Their top 10 percent of customer/member relationships accounted for three times net earnings - a "300/10" rule!"
, or profitability systems that they use to keep track of their customer/member relationship activities. The data in these systems can be analyzed and grouped to gain insights into profitability contribution of each customer/member, product, market, delivery channels, and salespeople. Reports illustrating the concentrations of net income are used by senior management to show (1) the location of the concentrations in the income statement, (2) the levels of the concentrations, and (3) the predictions for future earning losses to be drawn from the concentrations. Often, these reports examine earnings
contributions by decile
s (groupings of customers or other units of analysis by 10% increments), illustrating concentrations for each 10% group.
Risk management
Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities...
tool that focuses on understanding concentrations within the income statement and assessing the risk associated with those concentrations from a net income perspective.
Alternate definitions
Profit risk is a risk measurement methodology most appropriate for the financial servicesFinancial services
Financial services refer to services provided by the finance industry. The finance industry encompasses a broad range of organizations that deal with the management of money. Among these organizations are credit unions, banks, credit card companies, insurance companies, consumer finance companies,...
industry, in that it complements
other risk management methodologies commonly used in the financial services
Financial services
Financial services refer to services provided by the finance industry. The finance industry encompasses a broad range of organizations that deal with the management of money. Among these organizations are credit unions, banks, credit card companies, insurance companies, consumer finance companies,...
industry: credit risk management and asset liability management
Asset liability management
In banking, asset and liability management is the practice of managing risks that arise due to mismatches between the assets and liabilities of the bank. This can also be seen in insurance....
(ALM). Profit risk is the concentration of the structure of a company’s income statement
Income statement
Income statement is a company's financial statement that indicates how the revenue Income statement (also referred to as profit and loss statement (P&L), statement of financial performance, earnings statement, operating statement or statement of operations) is a company's financial statement that...
where the income statement lacks income diversification and income variability, so that the income statement’s high concentration in a limited number of customer accounts, products, markets, delivery channels, and salespeople puts the company at risk levels that project the company’s inability to grow earnings with high potential for future earnings losses. Profit risk can exist even when a company is growing in earnings, which can cause earnings growth to decline when levels of concentration become excessive.
Description of profit risk
When a company’s earnings are derived from a limited number of customer accounts, products, markets, delivery channels (e.g., branches/stores/other delivery points), and/or salespeople, these concentrations result in significant net income risk that can be quantified. A loss of just a handful of customer accounts, a loss of a limited number of products, a loss of a select market, a loss of a small number of delivery channels, and/or a loss of a few salespeople can result in significant net income volatility. At this stage, income loss risk is present and the company has reached a level of profit risk that is unhealthy for sustaining net income. The method for quantifying and assessing this potential income loss risk and the volatility that it creates to the company’s income statement is profit risk measurement and management. For financial institutions, profit risk management is similar to the diversificationDiversification
Diversification may refer to:* Diversification involves spreading investments* Diversification is a corporate strategy to increase market penetration...
strategies commonly used for investment asset allocations, real estate diversification, and other portfolio risk management techniques.
Basis of profit risk
The concept of profit risk is loosely akin to the well known "80-20" rule or the Pareto principlePareto principle
The Pareto principle states that, for many events, roughly 80% of the effects come from 20% of the causes.Business-management consultant Joseph M...
, which states that approximately 20% of a company’s customers drive 80% of the business. This rule and principle may be appropriate for some industries, but not for the financial services industry.
According to Rich Weissman, it is true that this small group of customer/member dominates the income statement, but the old "80/20" rule ~ it does not longer applied. "There are real-life examples where financial institutions have seen profit risk ratios as high as 300 percent. Their top 10 percent of customer/member relationships accounted for three times net earnings - a "300/10" rule!"
Measuring profit risk
To measure these concentrations and manage profit risk, the most important tools for financial institutions may be their MCIF, CRMCustomer relationship management
Customer relationship management is a widely implemented strategy for managing a company’s interactions with customers, clients and sales prospects. It involves using technology to organize, automate, and synchronize business processes—principally sales activities, but also those for marketing,...
, or profitability systems that they use to keep track of their customer/member relationship activities. The data in these systems can be analyzed and grouped to gain insights into profitability contribution of each customer/member, product, market, delivery channels, and salespeople. Reports illustrating the concentrations of net income are used by senior management to show (1) the location of the concentrations in the income statement, (2) the levels of the concentrations, and (3) the predictions for future earning losses to be drawn from the concentrations. Often, these reports examine earnings
contributions by decile
Decile
* In descriptive statistics, any of the nine values that divide the sorted data into ten equal parts, so that each part represents 1/10 of the sample or population* In astrology, an aspect of 36 degrees-See also:*Percentile*Quantile*Quartile*Summary statistics...
s (groupings of customers or other units of analysis by 10% increments), illustrating concentrations for each 10% group.
See also
- Pareto principlePareto principleThe Pareto principle states that, for many events, roughly 80% of the effects come from 20% of the causes.Business-management consultant Joseph M...
- Risk managementRisk managementRisk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities...
- Credit riskCredit riskCredit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
- Asset liability managementAsset liability managementIn banking, asset and liability management is the practice of managing risks that arise due to mismatches between the assets and liabilities of the bank. This can also be seen in insurance....
- DMA (Database Marketing Agency)Database Marketing AgencyDatabase Marketing Agency is a database company headquartered in Beaverton, Oregon. It is a provider of profitability systems to financial institutions in the U.S. and Canada that offer financial services in the forms of both retail banking and business banking. Banks in the U.S. are overseen by...