Executives are suddenly preoccupied with risk management. The number of distressed companies is rising, credit rating downgrades are ubiquitous, and equity markets are volatile. Add recent and highly visible accounting scandals to the mix, and it is no surprise that many CEOs rank risk management as one of their top priorities.1
Industrial companies grappling with risk face a particular problem. Though many have long been aware of the need to better manage risk, scant few have advanced very far along the learning curve. Few tools tailored to industrial companies’ specific needs exist. Naturally, many industrial executives turn to approaches borrowed from other sectors, such as financial companies, to calculate sensitivities to individual risks. This can be a costly mistake.
For example, the conventional wisdom that derivatives are dangerous and must be checked carefully would suggest that an industrial company should take inventory of its derivatives exposure. Yet this would be of limited use. While the derivatives portfolio of some financial firms often constitute an important element in overall risk exposure, for most industrial companies they represent only about 10 percent of total risk.
Likewise, a comprehensive audit of a company’s exposure to risks from fluctuating commodity prices, exchange rates, interest rates, fire hazard, and production loss offers senior managers little substantive help. These audits typically produce just a long list of risks, individually quantified. Knowing that a company could, for instance, lose $300 million if commodity prices were to move to their lowest historical level is of little value if such a dramatic event is unlikely, as it frequently is. Moreover, such calculations ignore correlations with other risks, such as foreign exchange or demand swings. Nor do they shed any light on the potential impact on a company’s long-term growth strategy and financial stability.
From our work with industrial companies we have developed insights into some of the most important distinctions between off-the-shelf approaches to risk management and the unique needs of industrial companies. For starters, industrial companies need a more sophisticated approach to measuring risk, which will help them to spot underlying risks, identify what they are already spending to mitigate risk in uncoordinated programs, and frame the key tradeoffs between managing risk and its cost. A clearer picture of risk can also better prepare CEOs to time acquisitions, add capacity, and make operations more stable and productive. They also often uncover new opportunities to benefit from risk, including cross-commodity arbitrage and systems optimization.
We have found that solid risk measurement efforts undertaken by large industrial companies have at times uncovered between $30 million and $50 million per year, mostly by eliminating unnecessary hedging practices, managing the balance of debt to equity, and improving contract practices with customers and suppliers. BHP Billiton, a diversified resources company, eliminated its hedging program after an exercise in measuring corporate risk indicated that the reduction in volatility from the program was negligible and not worth the hedging cost.