Obsolescence Risk

Allocated Loss Adjustment Expenses (ALAE)

What is the risk of obsolescence?

The risk of obsolescence is the risk that a process, a product or a technology used or produced by a company for profit ends up becoming obsolete and therefore no longer competitive on the market. This would reduce the profitability of the business.

The risk of obsolescence is greatest for technology companies or companies whose products or services are based on technological advantages.

Understanding the risk of obsolescence

The risk of obsolescence is a factor for all businesses to some extent and is a necessary side effect of a prosperous and innovative economy. This risk comes into play, for example, when a company decides how much to invest in new technologies. Will this technology stay superior long enough for the investment to pay off? Or will it become obsolete so soon that the company will lose money?

The risk of obsolescence also means that companies that want to remain competitive and profitable must be prepared to make large capital expenditures whenever a major product, service or factor of production becomes obsolete.

Budgeting for the risk of obsolescence is difficult because it is difficult to predict obsolescence and the exact rate of technological innovation.

Example of risk of obsolescence

A publishing house is an example that faces the risk of obsolescence. As computers, tablets and smartphones have become more popular and affordable, more and more consumers have started reading magazines, newspapers and books on these devices rather than in print.

In order for the publishing house to remain competitive, it must minimize its investments in old paper publications and maximize its investments in new technologies. Even if it operates this change, it must remain attentive to new and unimaginable technologies which could supplant the currently popular modes of reading and require even more investment.

Stock “cemeteries” are littered with dead companies whose products or technology have become obsolete. Examples are the Control Data and Digital Equipment technology companies on the Morgan Stanley “recommended” shopping list in 1982.

Key points to remember

  • The risk of obsolescence arises when a product or process risks becoming obsolete, generally due to technological innovations.
  • Reducing the risk of obsolescence means being ready and able to spend capital and invest in new technologies and processes.
  • Technology companies or those that rely on technological advantages are the most vulnerable to the risk of obsolescence.

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