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, learn more about the firm, and sign up for email alerts, please click here.
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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).
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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