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January 1, 2006

Managing in Chaotic Times

There is no such thing as a legitimate business surprise—really.

Klein Steel Service Inc. in Rochester, New York, was nowhere near the path of Hurricane Katrina, but the company still felt its wrath in an unexpected way. A shortage of liquid hydrogen, which is produced and shipped by tanker cars from New Orleans and used in annealing, led to mill shortages in galvanized, cold-rolled steel in September.

“No one in the metals universe thought about hydrogen,” says President Joseph Klein. “It’s a plentiful element.”

The panic was brief but demonstrated that even when a company doesn’t take a direct hit, the shock waves from unexpected events can blindside it.

More common and with seemingly less certainty than an oncoming hurricane, dramatic swings, tectonic shifts in supply and demand, can lead to scary shortages and gut-wrenching price spikes. A change in the fortunes of an OEM and its market or the emergence of a competitor can zap a supplier overnight or send it into a slow painful decline.

Events that catch business unaware add to uncertainty and the unpleasant surprise element of an already changeable business environment. Too many executives take the fatalistic attitude that cataclysmic events can’t be predicted. Somehow it seems easier to be reactive than to figure out how to manage in apparently chaotic times. But with potential consequences so dire, shouldn’t you try to plan for the unimaginable?

“Maybe you don’t know what it will be, but you know there will be a continued series of disruptions,” says Deborah Hewitt, a business professor at the Graduate School of Business at the College of William & Mary in Williamsburg, Virginia, and a researcher on the predictability of business cycles.

Given the certainty that there will be uncertainty, there is plenty that businesses can do to prevent being buffeted by disasters, either natural or man made. Up-to-date market data, as long as it is used to inform day-to-day decisions, goes a long way to demystify business chaos. (See Research.)

THE 10 MOST COSTLY INSURANCE LOSSES 1970-2004

Insured loss
[in millions US dollars, indexed to 2004]
Victims Start date Event Location
$21,542 43 8/23/92 Hurricane Andrew U.S., Bahamas
20,035 3,025 9/11/01 Terror attack on WTC, Pentagon and other buildings U.S.
17,843 61 1/17/94 Northridge earthquake [M 6.6] U.S.
11,000 124 9/2/04 Hurricane Ivan; damage to oil rigs U.S., Caribbean: Barbados
8,000 24 8/11/04 Hurricane Charley U.S., Caribbean: Cuba
7,831 51 9/27/91 Typhoon Mireille/No 19 Japan
6,639 95 1/25/90 Winter storm Daria France, U.K.
6,578 110 12/25/99 Winter storm Lothar France, Western Europe
6,393 71 9/15/89 Hurricane Hugo Puerto Rico, U.S.
5,000 38 8/26/04 Hurricane Frances U.S., Bahamas
Source: Swiss Re, Zurich

THE 10 WORST CATASTROPHES IN TERMS OF VICTIMS 1970-2004

Victims Insured loss
[in millions US dollars, indexed to 2003]
Start date Event Location
300,000 11/14/70 Storm and flood catastrophe Bangladesh
280,000 5,000 12/26/04 Seaquake, tsunamis in Indian Ocean* Indonesia, Thailand
255,000 7/28/76 Tangshan earthquake China
138,000 3 4/29/91 Tropical cyclone Gorky Bangladesh
66,000 5/31/70 Earthquake, rock slides Peru
50,000 166 6/21/90 Earthquake, landslides Iran
25,000 9/16/78 Earthquake in Tabas Iran
25,000 12/7/88 Armenia earthquake Armenia, ex-USSR
23,000 11/13/85 Volcanic eruption on Nevado del Ruiz Columbia
Insured loss: refers to property and business interruption, excluding liability and life insurance losses
Victims: refers to dead and missing
Source: Swiss Re, Zurich
*While the tsunami ranked No. 2 in casualities, a lack of damage to large buildings meant loss was $5 billion, ranking it No. 11 in terms of cost.

 

NO SURPRISES

To some extent, it’s human nature for executives to stick their heads in the sand and avoid wrestling with the unimaginable and unthinkable. That’s unfortunate, says Kenneth G. McGee, research fellow at Gartner Inc. in Stamford, Connecticut, and author of the 2004 book, Heads Up: How to Anticipate Business Surprises and Seize Opportunities First, because mishaps don’t arrive without warnings. “There’s no such thing as a legitimate business surprise,” he says.

More breakdowns are the result of a failure to pick up warning signals—what McGee terms early detection. In the case of the hydrogen that was in short supply after Hurricane Katrina, McGee says the burden was on steel mills to determine an unforeseen upheaval because they are responsible for securing hydrogen for the annealing process. Mills and service centers both bear the burden of forecasting—and adequately preparing—for other sorts of business threats.

Once a possibility is identified, it becomes a straightforward business calculation to establish the best alternatives for backup: Should the gas be stored? Produced on-site? Should long-term energy contracts be signed in anticipation of price rises? Should inventory be cut due to a possible/probable downturn in demand?

McGee would argue that the 9/11 attacks should have been detected by the U.S. government and that failure led to not only the horrific loss of life but also a wrenching upheaval for the metals industry and the economy as a whole.

In a 2001 report, the International Monetary Fund calculated the direct costs of the attacks at $21.4 billion but found that there were far reaching indirect costs, such as higher expenses for security and insurance and higher inventory levels required because of less reliable air and rail transportation.

The terrorist attacks underscored the need for business to anticipate a range of possible scenarios.

“We play, ‘what if,’” says Martin J. Napoli, partner with Jack R. Napoli of Napco Steel Inc. in West Chicago, Illinois. “What if there’s a steel shortage? What if there's a hit in our economy?”

“Through our relationships with vendors and financial institutions we feel the strength of 30 years of working together,” Napoli says. If there is a steel or scrap shortage, you have to “rely on your past history and loyalties,” he says. “You all work as one team so all can be successful.”

Hedging is another way to minimize the risk of unforeseen events, says Anthony Chan, managing director and senior economist at JP Morgan Asset Management in Columbus, Ohio.

The spike in energy prices following Katrina highlighted the desirability of using the futures markets. Big energy users worried about rising costs can buy future contracts and presumably profit on rising prices,
offsetting the loss in the physical market. The same holds true for other commodities or financial instruments such as interest rates.

Martin J. Napoli, Napco Steel Inc., West Chicago, Illinois

Some mills already use futures markets to limit exposure to price swings in natural gas or in currencies. Steel tubemaker IPSCO Enterprises Inc., based in Lisle, Illinois, for example, has an ongoing natural gas purchase program “designed to reduce its exposure to fluctuations in spot prices through forward-priced physical gas purchases and financial hedging contracts,” the company said in its 2004 annual report. John Comrie, director of trade policy, government relations and communications, says the hedging program is ongoing.

Service centers, historically not big energy users, still might want to consider hedging so they don’t get burned on soaring oil and gas prices.

“Any user should hedge to remove uncertainty,” Chan says.

EGGS IN THE BASKET

The science of contingency planning—that feeds into strategic planning, risk mitigation and scenario forecasting—helps companies ready themselves for disruptions in the supply chain, natural disasters or a terrorist attack. Pinpointing the most crucial links for a service center might involve lining up alternate mill sources, telecommunications suppliers or trucking contractors. Trucks, for example, were in short supply after the hurricanes as many were diverted to haul supplies to the stricken region. This type of planning often is difficult for managers in industries such as metals, who are used to dealing in the here-and-now, says Billie Blair, a California consultant and organizational psychologist who works with steel industry clients. “Their view is, ‘things happen as they happen,’” she observes. “It requires a change of discipline for these managers to pay attention to the signs that are out there.”

But there are concrete, definable steps that can be taken. For example, it’s helpful to identify and contact alternative suppliers “so when the time comes, you’re not scrambling around to get basic information,” Hewitt says. It may only be necessary to have an informal conversation with potential backup suppliers covering basic pricing and identifying where customers are located.

If diversification is not an option, consider collaborating on resources with a service center that operates in another part of the country and doesn’t compete directly. “You might have an agreement, ‘I’ll help you if you help me,’” Hewitt suggests.

Most products are widely available, but it takes some research and effort to set up the backup supply, she adds. Making that effort today could pay off later, because the last customer to reach a supplier usually ends up paying a premium. Perhaps, more importantly, it could mean the difference between keeping and losing customers and sales. “The key is to get back up quickly or the customer will go somewhere else,” Hewitt warns.

Larger steelmakers generally have well-developed networks to ensure security of supply. “People don’t go out and make purchases because they are worried about a terrorist attack,” says Comrie of IPSCO. But he notes that it’s general business practice not to be dependent on one supplier as a hedge against disruptions and to ensure competitive pricing.

It’s less of a top-of-mind concern for service centers. Bob Embry, president of Delta Steel LP in Houston, says that his company carries the normal three months of inventory, “so it’s not like you’re out of business right away.” The distributor would be more inclined to make the phone calls when the need arises. “You try to put in safeguards without going overboard,” he says. “You need to balance everything.”

Too much diversification on the supply side can be counterproductive. Many distributors would rather give their business to one or two suppliers and remain an important customer. Spreading it around can put a customer in a secondary position in a supplier’s pecking order. “You don’t want to put your eggs in so many baskets,” says Klein of Klein Steel Service.

For most problems that arise, managers need to use common sense, some good scrambling and problem solving skills, he says. “You don’t have to have a contingency for every critical thing.”

Many service centers enjoy a natural advantage in the market because they are often small, aren’t very bureaucratic and can turn on a dime. Still, as they get larger, there always is the risk of complacency and becoming set in their ways.

TICK, TICK, TICK

Every company goes through its share of pilferage, maybe even robbery. But the sort of wholesale fraud that brought down Tyco Inc. and WorldCom shake the entire business community. At the very least, shareholders learned that top brass in positions of fiduciary responsibility don’t always have their interests in mind.

When companies are smaller or still privately run, it’s possible for owners like Marty and Jack Napoli to personally keep tabs on all the numbers. “In regard to staff, customers and support teams,” Napoli says. “We always give the personal touch.”

That’s not always possible as a company grows larger. At that point, it becomes all the more critical for a company to have the right procedures for screening, especially supervisory and management applicants, training them and holding them accountable. A board of directors—or an advisory board in the case of privately owned companies—can help. If directors are doing their job and not merely rubber stamping, they should be reviewing financial statements and asking tough, skeptical questions.

Of course, even early detection of problems doesn’t necessarily move a company to action. Many large, established companies turn a blind eye to internal or external threats because corporate culture, ingrained habits and cozy relationships stand in the way of an intelligent response.

“Some people,” says Michael D. Watkins, co-author of Predictable Surprises: The Disasters You Should Have Seen Coming and How to Prevent Them, “will defend their practices until the walls fall down.”

WEATHER REPORTING

At a minimum, service centers need to prepare for the unexpected physical catastrophe, whether it’s a hurricane, a fire or a terrorist attack. A good financial cushion will keep businesses functioning, and business interruption insurance is a must.

In a sense, the vast, and vastly expensive, preparations for Y2K (the disaster that never happened) lulled some people into a false sense of security. Those same companies, however, were able to use some of those plans after the 9/11 attacks. With the nation’s financial nerve center crippled, the importance of duplicating data-orders, payables, receivables and financial statements—and storing them offsite was underscored. With the nation in a state of panic, communications networks became essential. (See Forward, Nov/Dec 2005.) Indeed, in the years after 9/11, many businesses secured some kind of disaster backup and recovery system and even did some rudimentary planning.

Last year, at service center Delta Steel LP, President Bob Embry invested in a secondary server that enables the company to operate out of Phoenix, Arizona, if its Houston headquarters is stricken. That enables the distributor, which operates seven locations, to shift operations within 30 minutes.

“There’s some expense, but it’s an insurance policy for the future,” Embry says.

Steel mills often have elaborate emergency plans because there are so many things that can go wrong—fires and explosions, hurricanes and tornados, utility failures or security threats. IPSCO Enterprise Inc. has extensive procedures for its dozen North American plants. During Hurricane Katrina, a crew set up shop in its Mobile, Alabama, mill to monitor the shutdown, make sure employees were safe and track down emergency supplies.

“After three hurricanes, you get better at dealing with these things. Everyone is a lot smarter,” says John Comrie, director of trade policy, government relations and communications.

Simple geographic diversification—maintaining offices, warehouses and fleets in different markets—can cushion a distributor or manufacturer from a natural disaster.

“If you’ve got 50 trucks [at various locations], you’re hurt but it’s not that bad,” says Fariborz Ghadar, director of the Center for Global Business Study at The Pennsylvania State University. “If you’ve got 50 trucks and they’re all in Mississippi, you’re
in trouble.”