Risky Business

Risky Business
MiBiz • September 20, 2004
by Jim Gillette

Did you ever think of yourself as a risk manager? Ask some auto suppliers and they might tell you their business often feels like all risk and little return. The complexity and intensity of global competition in the auto industry requires that supplier managers adopt an eclectic approach to recognizing and dealing with the plethora of risks they face. Gone unmanaged, many forms of risk easily lead to business failure.

In preparation for talk I will be giving, I recently made a list of the various types and sources of risk to a typical auto supplier. I categorized the list into three types: business risk, financial risk, and event risk. Without covering the whole list (there isn’t space), here is a sample to give you an idea of the types of risk under each:

Business Risk

Product/Market Risk – unexpected variance in product demand, loss of key customers, new competitors, price wars, etc.

Technology Risk – obsolescence, shift in materials use, electronic components replace electro-mechanical, etc.

Operations Risk – equipment failure, product defects, etc.

Input Risk – Input prices (oil, steel, energy, etc.), labor strikes, loss of key employees, failure of an important supplier, etc.

Financial Risk

Financial Market Risk – restrictions in the availability or cost of funds.

Credit Risk – loss of liquidity or threat of default resulting from actions taken by the firm.

Exchange Rate Risk – exacerbated by the increasingly global nature of the auto industry.

Event Risk

Legal Risk – lawsuits arising from product liability, disgruntled shareholders, employee actions from many causes, and patent infringements.

Regulatory or Government Risk – changes in laws or regulations involving taxes, environmental protection, foreign trade, etc.

Disaster Risk – hurricanes, earthquakes, fire, terrorists, etc.

While the list is certainly not exhaustive, it does illustrate some of the many risks facing management today.

A number of risks are insurable; that is, we pay a third party to accept risks we do not want to assume ourselves. More traditional examples include insurance for fire, workers compensation, and healthcare. Foreign exchange risks can be hedged for a period of time through the use of forward and futures markets. More recently, companies can purchase credit insurance on their accounts receivable and warranty and recall insurance.

Can’t insure against market demand risk

Many, and perhaps the most potentially damaging of risks businesses face are not insurable; market demand variability for example. Let’s say your customer, an automaker, is launching a new product. The automaker’s purchasing manager issues a Request For Quote stating that annual production will be 180,000 units. From past experience with this customer, you are skeptical that actual production will be anywhere near this number.

You may argue with the purchasing manager over the “forecast,” but it will likely be a waste of time. The problem lies in the fact that incentive structure at your customer is tilted toward transferring risk to you.

The customer’s purchasing manager is motivated to provide you with a number higher than the most likely forecast for two reasons. First, the higher the annual production number, the more units to absorb fixed cost over thereby lowering the average piece price. Second, your customer wants to be certain that its suppliers are able to fill orders during periods of peak demand. While the production rate of 180,000 units per year may occur only once or twice during the life of the program (or, more likely, not at all), your customer wants to minimize the possibility that a shortage of parts will stop the production line.

How many Allantes?

There are numerous other agendas and incentives running through your customer’s operations that also foster biased forecasts. Maryann Keller, the widely respected auto analyst, gave another example in her 1989 book about General Motors problems during the 1980s, Rude Awakening. Faced with a rejection from financial overseers for an investment in the proposed Cadillac Allante because it did not meet the minimum hurdle of 15% return on investment, the market analysts simply revised their sales forecast upward.

Careful analysis had indicated a most likely forecast of 3,000 units per year, a number inadequate to cover the fixed costs. According to Keller, Cadillac’s general manager, John Grettenberger expressed confidence that they could sell 7,000 Allantes the first year.

New numbers were sent to the accountants and, of course, the project was approved. Sales peaked at a little over 3,500 units for the car’s best 12-months before succumbing to horrific quality problems that eventually caused its demise. The financial verdict: while the Cadillac product marketers got their project, the car was a big loser for the company.

Whole systems of incentives are structured both explicitly and implicitly in all companies. Incentives are structured differently at the various automakers depending on their management philosophies and operational structures. It has been repeatedly shown that typical incentives used by North American automakers tend to reward individual behavior rather than encouraging companywide value optimization.

The better Japanese automakers, on the other hand, attempt to balance risks and rewards throughout their supply chains to eliminate waste and maximize the value of all enterprises involved. Unless very carefully crafted, rewards for individual behavior can serve to increase a firm’s risk.

Possible solutions

Given that demand forecasts are always going to be wrong simply due to errors caused by the complexity of the process or due to bias from whatever cause, what can a supplier do to hedge or mitigate the risk?

First, while it may seem self-serving (as I work for an automotive information firm), obtaining additional information about vehicle programs, your customers, and industry trends in general can significantly reduce risk. The fact that your customer demands a quote based on their volume assumptions doesn’t prevent you from preparing for worst (and best) case scenarios.

Second, try to target business at automakers with a better record at forecasting demand for their product. Easily said, of course, but difficult to do.

Third, invest in capital equipment that makes your manufacturing operations as flexible as possible. Very often, flexible manufacturing costs more in the beginning, but pays off later by giving you the ability to deal with highly volatile demand. You may also want to consider ways to phase-in investment for a particular program that will allow you to wait as long as possible to commit capital.

Last, but not too optimistically, I have heard of cases where Toyota in particular has partially compensated its suppliers for excess capital expenditure when demand fell far short of the initial forecast. Keep plugging away at this one.

If you would like to dig a little deeper into the demand variability issue and how it affects suppliers, Michael Robinet, Vice President of Global Forecasting, and I will be discussing this at an Original Equipment Supplier Association (OESA) breakfast meeting in Troy, MI on September 30.