November 1, 2013

Hunting Black Swans

Strategic planning and risk assessment are key to handling uncertainty. Why are they not done more effectively?


When the financial crisis hit hard in late 2008, senior executives instinctively reached for their companies’ long-term plans and risk mitigation strategies—the ones senior staff developed in allegedly rigorous, if soporific, annual forecasting and budgeting rituals. What they found made them profoundly unhappy: obsolete, Pollyanna-like outlooks that made room for minor swings in supply and demand but looked irrelevant, if not ridiculous, in the face of a plummeting stock market and expanding credit crunch. 

Despite a burgeoning army of consultants, chief risk officers and academics insisting that, post-recession, companies—especially big companies with global economic exposure—get serious about planning for the future, many firms still have no distinct strategic planning processes. In fact, the opposite has occurred: A survey by Bain & Company earlier this year showed a steep drop in the use of strategic planning from nearly 90% of respondents before the crisis to around 50% today. 

Within the metals services industry, firms are inclined to stick with what they know—even if it doesn’t work well—rather than re-jigger their processes and risk uncertain results. But, say experts in the field, strategic planning and risk management don’t have to be expensive or time-consuming undertakings, especially at smaller firms where senior management can fit in one conference room.

“We don’t call anything we do strategic planning anymore because people have become jaded to the term; they sort of cringe when they hear it,” says Billie Blair, an organizational psychologist and president of Change Strategies, Inc. “It hasn’t turned out to mean what it should have meant, and the results haven’t been good.”

Less than one-fifth of executives say their firms have a distinct process for creating corporate strategy, according to data released in 2011 by consulting firm McKinsey & Company. The same survey found that those who gave their companies a thumbs-up in strategy were much more likely to have a formal, consistent process and were less likely to focus on short-term financial metrics.

“There’s a lot of lip service,” admits Bill Watts, principal with Chicago, Illinois-based accounting firm Crowe Horwath’s risk consulting practice. Watts notes that most companies he speaks with want to do a better job of analyzing risk but are often confused about how to proceed effectively. 

Roy Berlin has made two big strategic decisions in his career running his family firm, Berlin Metals. The first, in the late 1980s, involved a painful choice to surrender the part of his business that turned coils into sheets; customers were shifting to buying directly from mills and squeezing Berlin on prices in the process. Selling off machinery raised enough capital to focus on cutting coils into narrower gauges for a more diverse group of customers—a long-term strategic move—but it also involved slashing the company’s sales in half during the transition. The second big decision, in the 1990s, involved adding a new product line—along with associated equipment and personnel—that now accounts for a third of the company’s revenue.

For both decisions, which represented big risks for the small Hammond, Indiana, company, Berlin relied on his firm’s longtime planning strategy: Get the five top people together in a room and talk it through.

“We worked for a bunch of years with a business plan we updated every couple of years,” Berlin says. “Frankly, I’ve found that you get business plans down on paper and they’re outdated the minute you [finalize] them.”


A Larger Company’s Approach

At companies with thousands of employees and hundreds of business units, rapidly pushing changes through the organization can require more formal processes. “You don’t want strategic planning to substitute for the day-to-day operation of your businesses,” says Worthington Industries Chief Financial Officer Andy Rose. “You want it to be high-level, deep thoughts about where you want the business to be five, seven years from now, because then you make decisions today that drive you in that direction.”

The $2.5 billion publicly traded metals processor keeps its strategic and risk planning processes separate from annual budgeting and forecasting, as well as operational planning, to give senior managers and board members room to imagine and plan for the future, Rose says. 

Worthington’s approach is formal but not overly complex, Rose says. The process begins shortly after Jan. 1 and results in a presentation to the board in June. Business unit managers present their own analyses of the company’s competitive position and a plan for growth. Senior executives, meanwhile, pick apart the financial performance of each unit, approve individual plans and decide how and where to invest the firm’s capital, including selling or closing underperforming units. 

They also engage in brainstorming with the company’s board members to help identify and understand big but far-off risks and opportunities, such as the possibility that the automobile industry, an important Worthington customer, may move toward using more aluminum or carbon fiber to meet stringent pollution regulations. The company has a separate risk management program, Rose says, that focuses on accidents, plant shutdowns and other “things that could happen tomorrow.” Other macro trends on Worthington’s radar include an aging global population and a boom in U.S. domestic energy production. 


Guidelines and Horizons

In some industries, two years is a long-range plan, says Kenneth Merchant, a professor of accounting at the University of Southern California who studies corporate planning. “But if you run a utility, you’re planning out 25, 40 years. If you want to get a nuclear power plant approved, you’re pushing [the year] 2100, so the horizons vary significantly across industries.”

Still, Merchant says, the idea behind long-term planning isn’t complicated: Align a firm’s mission with its investments, resulting in better near-term budgets and decision-making. And no matter the firm’s size or industry, strategic planning typically involves senior managers sitting down together and talking through decisions on where to invest, or divest, the firm’s resources.

“Scenario planning is a formal part of some large companies’ strategic planning and risk management processes,” he says. “A small company does similar things, but less formally.”

At Entropic Communications, a San Diego, California-based semiconductor firm where Merchant sits on the board, senior managers gather periodically to review what-if scenarios, particularly around competitors and rapidly changing technology, and present a strategic plan to the board for approval.

“We talk about what if [competitor] Broadcom does this, what if Intel acquires our competitors,” Merchant says. “If you’ve pre-thought out the problems, your chances of making the right decision are improved. It’s a roundtable discussion.”

Brainstorming is not an unusual way to get started, says Watts of Crowe Horwath. “It can be very informal. Get executives in a room and brainstorm through risk,” he says. Human resources executives may view risk differently than the operations team, and meetings among key managers help the firm get a grip on how this strategy or that risk affects different parts of the organization. Surveys, rankings and voting mechanisms are also common tools for identifying possible risks. 

After identifying major risks, Watts says, he tells his clients to determine their tolerance for each and then focus on no more than a handful, typically five to 10, that present the biggest challenges. Solutions can range from buying insurance to currency hedges to more rapidly updating internal figures. The final step is monitoring the risks a company is most concerned about. 

But gauging the cost-effectiveness of possible solutions can be difficult. For example, in commodity industries such as aluminum where vendors differentiate themselves by service to their clients, customer satisfaction is often quickly identified as a major risk, Watts says. Firms will often then install customer feedback mechanisms or spend more on customer service staff without penciling out the numbers.

“They go overboard and say, ‘I’ll triple my customer service,’” Watts says. “My view would be, let’s look at the risk appetite. Is it worth tripling your budget? If you lose this contract, can you remedy it?”

Likewise, Watts says, companies looking to jump-start their risk management can overspend on technology. Most enterprise risk software packages function as bolt-ons to existing resource planning programs, the workhorse applications that big firms use to manage their inventory and operations. But Watts describes them as primarily designed for the largest firms, not the average company. 

“You’re buying a Ferrari to drive around the golf course,” he says. “It doesn’t make sense.”


The Need for Flexibility

If there’s a common refrain among boosters of formal planning, it’s that companies should scrap ritualistic annual forecasting and budgeting for something more fluid and responsive to external factors, such as economic indicators, and more realistic, given company politics. Merchant advocates relying more on unit and line managers for real-time data on how the business is doing, not waiting for annual reviews to invest in promising ideas or opportunities. 

Within metals, a lot depends on a firm’s position in the value chain, says David Carlson, U.S. manufacturing and auto industry practice leader with Marsh Risk Consulting. Upstream, primary producers are exposed to long planning cycles that involve sinking substantial costs. They also have to worry about “conflict” materials as well as a host of regulatory, political and environmental uncertainties. Downstream, the risk is mainly in the supply chain: Smaller metals companies are likely to have a few big suppliers and customers.

Just as important, companies can get lulled into complacency when times are good. Right before the financial crisis hit, for instance, the booming economy made many companies feel as if planning for the worst was little more than an exercise.

“Strategic planning was already on its way out,” says Blair, the organizational psychologist. With markets climbing, CEOs were chalking up rising share prices to savvy planning and execution. “What the recession did for folks is they realized that the strategic planning, the strategic thinking they thought they had done, really wasn’t having any benefit for them. Companies realized many things had changed since they last looked at planning for their organization.” 

Metals producers and processors were caught unaware, despite their sensitivity to changes in global economic activity. “The timing, depth and speed of the drop in demand certainly took the entire industry by surprise,” McKinsey wrote in a 2010 review of the global metals industry. “Distributors—traditionally focused on regions and products, rather than on application industries and customer segments—were blindsided by a lack of market intelligence.”


The Impact at Berlin Metals

For Roy Berlin, when the financial crisis hit, like many metals processors he found his company with more inventory and more labor than his rapidly shrinking order book warranted. After a solidly profitable year, demand suddenly began to plummet in October 2008, he recalls. “The phones just started ringing less. It was notable. By November we realized there was a dramatic shift happening,” he says.

Berlin huddled with his four top managers, three of whom had been with him a quarter-century or more, and decided to cut where they could: first by laying off newer hires and then, as the crisis deepened, by squeezing Berlin’s inventory, a process that took months. The firm established a reserve for bad debt, historically less than 1% of the company’s $50 million in sales, and braced for customer bankruptcies.

“The risks commercially are really simple,” Berlin says. “You are left with a big cash-flow shortage because someone has just not paid you $1 million.”

In all, sales fell around 25%, but after losing money for three months, Berlin Metals returned to profitability by February 2009, before the stock market bottomed. And by late 2009, it had hired back most of the 15% of staff it had let go. 

Berlin says his company still forecasts sales and expenses annually by starting with the previous year’s numbers and extrapolating, while management discusses how they think their biggest customers will fare in the year ahead. 

On the risk side, Berlin’s plans are a little sketchier, and limited, perhaps, by his firm’s small size: He has the usual lines of business insurance but admits his single-location operation could suffer an act of God that he’d be powerless to do anything about. He installed a diesel generator a few years back to keep his office powered during an outage (so he could ship finished products), but it’s not enough to keep his machines processing inventory. Nearby competitors with whom he is friendly could be called on to help if needed, an informal arrangement that has kept rivals going during labor stoppages and other disturbances.

“The good news is, steel isn’t flammable,” he jokes. 

Berlin is skeptical that businesses like his could have done more to plan for the crisis or that they should be doing more now.

“The reality in our business is we’re a surfboard rider—we’re riding the waves of commercial activity, and our job is to stay on the wave,” he says.