A McKinsey classic, “Risk: Seeing around the corners”

Here is an excerpt from another classic article, written by Eric Lamarre and Martin Pergler for the McKinsey Quarterly and published by McKinsey & Company. To read the complete article, check out others, and obtain subscription information, please click here.

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As all of us know, during the last 20 years the free world has had the greatest, most sustained economic advance in history. Most of us believe that this has been a time not merely of forward movement, but of vast economic change.

The facts and figures, however, do not support this impression. They show, instead, that our era has actually been a time of unprecedented non-change. It has been largely a period of linear forward movement along old trend lines, of adding new stories to an old building according to the old architectural design.

Imagine an economist in 1913, just before World War I, taking the economic trend lines of what were then already the advanced countries, and projecting each of them ahead to 1966. He would have hit it on the nose for Japan, Western Europe, and the United States, in fact for every one of the developed nations with one important exception—the Soviet Union, which is significantly below where it would have come out on our economist’s projection. The reason for this, as all of us know, was that the Russians imposed a political straitjacket on agriculture and froze farm technology just at the worst possible moment, when the technological revolution in farming was getting under way. Worse, they froze the agricultural population. By making it possible for anybody who stayed on the farm to be fed, no matter how poorly, they removed the economic pressure that elsewhere in the world has pushed the farmer off the farm, brought about fantastic productivity jumps in agriculture, and provided labor for the expansion of industry.

Suppose, again, that our economist, having made his projections in 1913, fell into a 50 years’ sleep. When he woke up, he would have found the industrial geography of the world virtually unchanged. Every country that is today an industrially advanced nation was well past the takeoff point in 1913. Not a single new one has joined the club, unless you count satellite economies like Canada, Australia, South Africa, and Mexico. Brazil, which has a long and distinguished history as a country of the future, may join the club tomorrow, but it isn’t quite there yet.

Compared to this linear movement, the 50 years before 1913 present the greatest imaginable contrast. During those five decades the industrial map of the world had been changing as rapidly as the physical map of the world changed in the fifteenth and the early sixteenth centuries—the Age of Discovery. Right after the Civil War, the United States and Germany emerged as economically advanced countries and rapidly overtook the old champion, Great Britain. A quarter of a century later Russia and Japan emerged, along with the western part of Austria-Hungary—the present Czechoslovakia and Austria, with Northern Italy. In short, the 50 years before 1913 were a period of very rapid shifts in economic power relationships.

Since World War I, however, such changes have been absent. This explains why economists of today are so concerned with economic development. Before 1913, it was taken for granted, but since then we’ve apparently gone sterile. And we don’t know how to start it up.

Perhaps the greatest shock to our Rip Van Winkle economist, however, would be the fact that, with the exception of the plastics industry, the main engines of growth in the past 50 years were already mature or rapidly maturing industries, based on well-known technologies, back in 1913.

The dynamos of growth

Our most rapidly advancing industry in the last 20 years of expansion has been agriculture. The productivity of farming has been increasing twice as fast as the productivity of manufacturing in all the developed countries except Russia. Yet the average farmer of today in the United States is not farming in a much more advanced way than the top farmer of 1913. Hybrid seed is about the only new development of any consequence.

And the next dynamo has been the steel industry. World steel capacity has expanded fivefold since 1913. Yet 99 percent of all steel capacity in existence today is built on a technology that was considered antiquated—and Lord knows was antiquated—in 1913.

Our third engine of growth has been the automotive industry. Yet in 1913 Henry Ford was already producing and selling 183,000 Model T’s, and a year later the figure had climbed to 261,000—more cars than the Soviet Union has ever produced in a single year. Even the Ford Motor Company of 1913 would be a major producer in today’s free-world automotive industry.

Much the same is true of the electrical apparatus industry. Neither Westinghouse, nor GE, nor Siemens was exactly unknown in 1913. They were blue chips. And this is also true of the organic chemical industry.

Plastics is the only industry based on new technology that is economically important today in terms of contribution to gross national product, employment, and so on. As far as the economic statistician is concerned, other industries hardly exist as yet. The airplane began to have an economic impact when the jets came. But the real impact will come with the big freight jets, which will make every airstrip in the world a deep-water port. In a few years, they may make the ocean-going freighter, man’s oldest efficient transportation, look roughly the way the railroads began to look around 1950. This will be one of the greatest changes in transportation we’ve ever had. But it is still ahead of us.

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Risk-assessment processes typically expose only the most direct threats facing a company and neglect indirect ones that can have an equal or greater impact.
The financial crisis has reminded us of the valuable lesson that risks gone bad in one part of the economy can set off chain reactions in areas that may seem completely unrelated. In fact, risk managers and other executives fail to anticipate the effects, both negative and positive, of events that occur routinely throughout the business cycle. Their impact can be substantial—often, much more substantial than it seems initially.At first glance, for instance, a thunderstorm in a distant place wouldn’t seem like cause for alarm. Yet in 2000, when a lightning strike from such a storm set off a fire at a microchip plant in New Mexico, it damaged millions of chips slated for use in mobile phones from a number of manufacturers. Some of them quickly shifted their sourcing to different US and Japanese suppliers, but others couldn’t and lost hundreds of millions of dollars in sales.
More recently, though few companies felt threatened by severe acute respiratory syndrome (SARS), its combined effects are reported to have decreased the GDPs of East Asian nations by 2 percent in the second quarter of 2003. And in early 2009, the expansion of a European public-transport system temporarily ground to a halt when crucial component providers faced unexpected difficulties as a result of credit exposure to ailing North American automotive OEMs.What can companies do to prepare themselves? True, there’s no easy formula for anticipating the way risk cascades through a company or an economy. But we’ve found that executives who systematically examine the way risks propagate across the whole value chain—including competitors, suppliers, distribution channels, and customers—can foresee and prepare for second-order effects more successfully.

Risk along the value chain

Most companies have some sort of process to identify and rank risks, often as part of an enterprise risk-management program. While such processes can be helpful, our experience suggests that they often examine only the most direct risks facing a company and typically neglect indirect ones that can have an equal or even greater impact.

Consider, for example, the effect on manufacturers in Canada of a 30 percent appreciation in the value of that country’s dollar versus the US dollar in 2007–08. These companies did understand the impact of the currency change on their products’ cost competitiveness in the US market. Yet few if any had thought through how it would influence the buying behavior of Canadians, 75 percent of whom live within 100 miles of the US border. As they started purchasing big-ticket items (such as cars, motorcycles, and snowmobiles) in the United States, Canadian OEMs had to lower prices in the domestic market. The combined effect of the profit compression in both the United States and Canada did much greater damage to these manufacturers than they had initially anticipated. Hedging programs designed to cover their exposure to the loss of cost competitiveness in the United States utterly failed to protect them from the consumer-driven price squeeze at home.

Clearly, companies must look beyond immediate, obvious risks and learn to evaluate aftereffects that could destabilize whole value chains, including all direct and indirect business relationships with stakeholders. A thorough analysis of direct threats is always necessary—but never sufficient (Exhibit 1).

Competitors

Often the most important area to investigate is the way risks might change a company’s cost position versus its competitors or substitute products. Companies are particularly vulnerable to this type of risk cascade when their currency exposures, supply bases, or cost structures differ from those of their rivals. In fact, all differences in business models create the potential for a competitive risk exposure, favorable or unfavorable. The point isn’t that a company should imitate its competitors but rather that it should think about the risks it implicitly assumes when its strategy departs from theirs.

Consider the impact of fuel price hedging on fares in the highly competitive airline industry. If the airlines covering a certain route don’t hedge, changes in fuel costs tend to percolate quickly through to customers—either directly, as higher fares, or indirectly, as fuel surcharges. If all major companies covering that route are fully hedged, however, that would offset changes in fuel prices, so fares probably wouldn’t move. But if some players hedge and others don’t, fuel price increases force the nonhedgers to take a significant hit in margins or market share while the hedgers make windfall profits.

Companies must often extend the competitive analysis to substitute products or services, since a change in the market environment can make them either more or less attractive. In our airline example, high fuel prices indirectly heighten the appeal of video-conferencing technologies, which would drive down demand for business travel.

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Unknown and unforeseeable risks will always be with us, and not even the best risk-assessment approach can identify all of them. Even so, greater insight into the way they might play out can provide a more comprehensive picture of an industry’s competitive dynamics and help shape a better corporate strategy. Thinking about your risk cascades is a concrete approach to gaining that insight.
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Here is a direct link to the complete article.

Eric Lamarre is a director in McKinsey’s Montréal office, where Martin Pergler is a consultant.

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