Risk Quotient: Measure the Risk of Growth

Remodeling is a risky business. It's a minefield of permits and inspections, hazardous material testing and remediation, and safety concerns. In addition to managing the complex processes of project design, resource scheduling, and product selection and installation, remodelers have to establish and maintain client relationships that are often the most fragile commodity on the site. The slightest irregularity -- delayed delivery of a special order, slight imperfections in finish materials, misunderstandings over contract language -- can trigger a chain reaction of client emotion that quickly escalates from disappointment and annoyance to stubborn anger and even rage.

Is the risk worth it? For most remodelers, there's a lot of satisfaction in avoiding all the pitfalls, producing a product of enduring value, and building lasting relationships with customers. But real financial risk has to be balanced by real financial reward. We need to know we're being adequately compensated for the risk we assume.

One measurement is what Les Cunningham of Business Networks calls the "risk quotient." It's part of a "Crucial Data" report all of his clients receive at their semi-annual meetings, and it's calculated with this simple formula:

Risk Quotient = Produced Gross Sales/Owner's Total Compensation

Cunningham uses the risk quotient, along with a dozen or so other ratios, to help his remodeler clients understand the effects growth can have on their financial well-being. Most remodelers look to their compensation as a measure of their success, without giving the risk a second thought. "Some young guys are risk junkies," Cunningham says. "They like going to the edge of the cliff and laughing at it." But as companies mature and more is at stake, evaluating the risk-reward proposition becomes more important. The lower the risk quotient value is (while remaining positive), the better the business balances risk and reward for the owner.

In the table above, Companies E and F, which are on the lower end for total revenue, have low risk quotients. By comparison, Company B, which has the second highest revenue, also has the highest risk. More important, notice that while the owners of Company A and Company C are compensated nearly equally, the owner of the smaller Company C takes half the risk. "It's a lot easier to go upside down with a company that's too big than with a company that's small," says Cunningham.

One factor the risk quotient doesn't take into account is the size and number of jobs a company undertakes. Is there less risk if all revenue comes from a small number of jobs? Or is it better to spread risk over a larger number of jobs so that when something goes wrong, it has less effect on the bottom line? Can the risk quotient be modified to take job size and number into account? Stay tuned.

Most of the seven insurance restoration companies in this table have a commercial arm, but these values are based on actual 2001 performance for residential work only. Owner's Total Compensation includes salary as well as indirect forms of compensation ( see Benchmark, December 2002.)