Business model. A company's business model comprises its organizational structure and processes, and its choices in these areas can have a major effect on its operational risk. Both State Farm and Progressive Insurance are major players in the U.S. auto insurance market, yet they have adopted very different business models. State Farm sells through 16,000 agents across the United States, while Progressive has chosen a direct sales model. In addition to its sales model, the degree to which a company standardizes policies, uses technology, deploys best practices, and effectively manages employees affects its operational risk profile.

Benchmarking tools can assist managers in understanding the business-model risks they are incurring. For example, The Hackett Group has found a strong correlation between the adoption of best practices in basic customer and supplier processes -- such as billing, accounts receivable, and accounts payable -- and the cost, productivity, and quality of these processes. A best-practice company spends up to 50 percent less on these processes than the average company; at the same time, it achieves twice the productivity of the average company and makes as much as 80 percent fewer processing errors. Organizations that fail to adopt best practices are incurring much higher levels of operational risk.

Execution risk. This variable reflects how well an organization performs. This is, perhaps, the area that is best-served by today's business performance management systems, since measures of execution risk include most output- or results-based metrics -- for example, revenue, earnings, cycle time, service levels, and productivity. To measure execution risk, a company focuses on the results it realizes given the structure of the markets in which it participates and the business model it has chosen to adopt.

An organization's total operational risk can be expressed in the following manner:

Operational risk = f ( Market structure x ( Business model + Execution efficiency ) )

Exhibit 3 illustrates the fundamental drivers of this equation, and exhibit 4 lists some of the factors that contribute to each of the equation's variables.

One of the most relevant insights to be gained by using this approach is the understanding that the first two variables -- the company's market structure and operating model -- are major drivers of its execution efficiency. A company that operates in a fast-moving, highly volatile market and chooses a decentralized organizational model with few standardized processes incurs higher risks than a company that competes in a more mature market and operates within a more centralized, uniform business model. The first company has not necessarily made mistakes; it simply operates in a different environment and adheres to a different strategy. For both companies, the important thing to understand is the implications their level of operational risk should have for management decisions.

Even within an industry, two organizations can have very different risk profiles, based on their choice of business model and their ability to execute. The relative dominance that market leaders such as Wal-Mart, Southwest Airlines, and Dell Computer have achieved illustrates the importance of making the correct business model choices, then executing well. Each of these leaders started with the same opportunities as companies that ended up struggling, acquired, or bankrupt. Their business model choices and method of execution are the elements that separate Wal-Mart from Kmart and Sears, Southwest from United Air Lines, and Dell from Compaq and Gateway.

Two studies that offer further insights into the effects of the choice of business model and the ability to execute are described in Tom Peters and Robert Waterman's "In Search of Excellence" (Warner Books, 1988) and Jim Collins' "Good to Great" (HarperCollins, 2001). These best-selling books show that the key differentiators separating companies identified as "excellent" or "great" from other organizations are their business model and their execution efficiency.