Systemic Risk And Manufacturing – Something New To Worry About
A Right Recruiting Newsletter, Sept. 2009
I think that if someone had Googled the phrase “systemic risk” before last year they would have only gotten a handful of hits. Most of them would have been about probability and math issues. Now, the phrase “systemic risk” has touched many of our lives, knowingly or unknowingly. Its impact has not been positive. A misunderstanding of systemic risk is assumed to be the major cause of last year’s financial meltdown which, in turn, affected the lives’ of almost every person getting this Newsletter. A definition of systemic risk is included below:
Systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries" It refers to the risks imposed by interlinkages and interdependencies in a system or market, where the failure of a single entity or cluster of entities can cause a cascading failure, which could potentially bankrupt or bring down the entire system or market.
Please note the focus on finance and financial systems in the definition. I think that’s too narrow a view of systemic risk. The definition hints at this in its second half when it mentions risks exposed by interlinkages and interdependencies. That broader view may have implications for almost any business unit or discipline, not just for finance.
Business has become increasingly complex. Of course, that’s such a cliché as to be almost meaningless. Production outsourcing, international supply chains, third party sales organizations and other tools and methodologies have become so commonplace as to be almost invisible. I remember in the mid-1990’s how shocked people were when Sara Lee decided to sell all their manufacturing plants and outsource all production. To many it seemed that Sara Lee, a company that made food, couldn’t exist if, in fact, they stopped actually making food. For the general public that was a very tough concept to wrap their arms around. Of course, from a business and corporate viewpoint it was a defendable decision. They wanted to focus on product development and marketing. Today, that’s a common concept in many industries. In fact it’s so common that it’s considered unusual to find a company that actually makes all of their components and products internally. What used to be common is now rare. What used to be rare is now common. I am sure there is a profound statement in there somewhere, something about the great wheel turning, I suppose.
So, to a greater extent than ever before, a business is a part of a larger system. Each business is interrelated within a network of customers and vendors. As such, each business relies on a unique group of system components. It may sound a bit mystical, but your business is part of a great cosmic, ever-changing system. Your business network has been growing piecemeal over years and decades, often unnoticed. Herein lies the danger. It brings to mind the story about the frog and boiling water. Put a frog in a pot of cold water and slowly bring it to a boil and the frog will not try to escape. Throw the same frog into a pot of already boiling water and it will frantically try to escape. Bad things can happen to good people and bad things can sneak up on you. This might be the time to take a step back and look at your relationships and your business system through the prism of systemic risk.
Earlier this year I read about a company that made electronic components. They were a small firm based in the Mid-West. They sold their products to another manufacturer who then sold their products to a third manufacturer. In the end, their products were used in a final product somewhere. In January, their business dropped dramatically and the CEO was interviewed about the cause of their plummeting sales. It appeared, he said, that they were affected by weakness in consumer electronics. Because of the general consumer slowdown and Circuit City bankruptcy, fewer people were buying expensive TV’s. The CEO seemed to be surprised to have learned that many of his company’s components ended up being used in consumer electronics and were sold to the public through Circuit City. Ponder that for a minute, please. The CEO did not know how his products were being used. He assumed he was part of a simple, linear network that sold to Company A. As long as Company A kept buying components, things were hunky-dory. He lacked the energy, intellect or curiosity to understand that his firm was part of a larger system and was a small cog in a much more complex supply chain, one he couldn’t even imagine. He missed the fact that Company A’s business was driven by Company B. Company B’s business in turn, was driven by Company C, who then sold a final product to the public through Big Box retailers like Circuit City. His sales projection were exclusively based on sales from Company A and he was unaware that the final end-user of his product was the guy down the street lugging a cardboard box home from the store. He thought his sales were secure and saw no connection between a Circuit City Chapter 11 and his business.
That is surely an extreme example of systemic risk myopia. But, it does illustrate how we all face complexities in our business life now. Many of these complexities have been created over time. In some instances they are a series of band-aids built without an understanding of the interlinkages and interdependencies. Not only that, since professionals change jobs and companies have turnover, we are inheriting risks without being privy to the calculations required in assessing them. We assume that due diligence has been done on these issues by our predecessors and we hope that the due diligence was done thoroughly.
Remember SARS. Back in 2003, it scared the bejabbers out of Asian citizens, governments, businessmen and the international health community. Appearing at the peak of the Asian outsourcing boom, the disease had the potential to cause havoc with human populations worldwide. In the middle of the furor I happened to be speaking to a VP of Supply Chain at a client of mine. He needed someone to source vendors in China. It seems that his company had been given a corporate directive to cut costs. They could save significant labor costs by sending most of manufacturing to China. Since I am a simple soul, it appeared to me that the middle of a potential health epidemic was a curious time to be making that change. I asked him if the SARS situation had been considered in the decision. After all, it would be tough to sell a product if the labor force you use to build it is all in the hospital. My contact shrugged and said that production for next quarter was not his problem. His job was to show signed contracts that demonstrated lower costs. He assumed that all downside risks had been calculated before he got his marching orders. Hopefully he was right.
In a recent article in the Financial Times, Gillian Tett analyzed commonalities in risk evaluation between securitized mortgages and manufacturing supply chains. Western manufacturing, she said, has become more and more dependent on international systems of production to make manufacturing more efficient. Facilities are placed in regions of lowest possible cost. They are shuffled around the globe based on dollar-centric metrics. She saw unwelcome similarities between complex supply systems and the creation of integrated capital markets designed to increase banking efficiency. The obvious concern is that manufacturing may be making the same mistake that finance did in not appreciating systemic risk.
One of the contributing factors to the financial collapse was a compensation system that rewarded risk-taking in the short term and did not balance that with systemic risk calculations to protect against disaster. A trader’s bonus was built on personal trade profitability. He would accrue a very large bonus if he traded well. If the trades went bad a year later, no harm would come to him. It was to his benefit to push the risk/reward envelope. He was responding to the incentives his employer set up for him.
Remember the VP setting up an Asian supply chain in the midst of an international health crisis? Wasn’t he doing a similar thing? His bonus meant that he needed to focus on metrics given to him from corporate. These were short-term goals based upon specific task performance. My guess is that those who gave him his short-term bonus objectives were responding to their own short-term bonus goals. If everyone in a company is responding to short-term incentives, who is looking out for the long-term?
From an HR and compensation perspective, short-term goals are great because they are easily measurable. The entire premise of many compensation systems is that goals must be clear and measurable for them to be fair and effective. This is pretty much gospel in the business world and it has permeated most compensations plans. However, I think that most of these short-term goal oriented plans open the door to danger down the road.
There is a game I sometimes play. It’s called “the Conventional Wisdom Game”. In it, I remind myself of all the things that were once considered facts that now, with the luxury of hindsight, we now see as absurdities. Let me list some things that were once accepted as common knowledge:
1) The sun revolves around the earth. Everyone knows that. Paging Mr. Galileo!!
2) Man will never fly, let alone walk on the moon. Misters Wright and Neal Armstrong beg to differ.
3) Women shouldn’t vote. They don’t have the intellect. Except for the millions today in professional and managerial positions.
4) We are in danger because the earth is cooling. Yet, 20 years ago many of the same institutions warning us about Global Warming were saying the opposite about the future.
5) Wine is bad for you but a suntan is a sign of good health. Paging George Hamilton!!
6) The Phillies will never win a World Series before the Eagles win a Super Bowl. ‘Nuff said!
These are just examples. It’s important to remind yourself that each one of these outdated concepts, at one time, was considered as an established fact. If you disagreed with it you would be laughed at.
OK, the next part of this game is to ask yourself the following question – “Self, what is today’s conventional wisdom that will be laughed at tomorrow? What do I consider as an established fact that will be considered nonsense in 5, 10 or 50 years?” After all, history has shown us that most of what we believe at any one time will undoubtedly be proven wrong at some point in the future. Humility is a virtue.
In a rambling way, we’ve come to two issues that I will try and blend together shortly. The first issue is, are their any business dogmas that we accept today as gospel but which in the future might prove inaccurate or harmful? As an example, is extreme outsourcing yesterday’s fad? Well, there are signs supporting that. The CEO of Philips was recently quoted as saying that he expected most large firms like his to move away from far-flung international supply chains. Among the reasons he cites are energy costs in transportation and general business risks. He predicts smaller, more regional supply chains in the future. This is supported by a recent report by Ernst & Young that specifically warns of a concentration of risks in supply chains. An overly elaborate supply chain can easily hide unrecognized risks. Examples exist. After an earthquake in Taiwan in the late 1990’s, semiconductor prices doubled because of loss of capacity. In other words, everyone’s supply chain for semiconductors intersected in an earthquake zone – an unforeseen systemic risk. Another example - Porsche had to stop production because a minor vendor that made components for its seat belts went out of business. A supply chain is only a strong as its weakest link. That’s another way of saying that a supply chain should never be exclusively evaluated based on cost. It’s tough to measure the price of a catastrophic supply chain disaster but, just because something is not measureable, does not mean it does not exist. It’s also tough to quantify good judgment, except in the long-run. More on that later.
The second issue is an organizational variation of the Peter Principal. As it applies to people, the Peter Principal states that individuals will keep getting promoted until they get into a job that they can’t do and will then fail in that job. I think there is an organizational corollary to the Peter Principal. Organizations, businesses and systems, if left untended, will increase in complexity until they reach the point of failure, re. the US Tax Code. In other words, systems will grow topsy-turvy until they reach the point of failure – systemic risk is actual certain at some future point.
Isn’t that what we saw in finance late last year? Mortgages and loans were sliced and diced into tranches that were so complex that, when the loan went bad, no one could even determine who owned it. For manufacturing, and technology companies, I think it’s incumbent to take a step back and evaluate what you’ve actually created over the last decade or so. After all, by overly quantifying a professional, executive or managerial bonus plan you may have swapped basic judgment for a series of short-term metrics. Said in another way, many businesses have created a complex mathematical compensation system that, in itself, may carry systemic risk. These bonus-focused compensation plans, in turn, incent managers and executives to create systems in order to reach their personal short-term goals. In other words, there may exist a series of systems that intersect in unforeseen ways that don’t always perform in the manner planned. To add to the danger, the person who designs one system may have a different agenda than the person who designs another system, yet both must work together. Your CFO or VP HR wants a clearly designed executive bonus system that makes the executive team focus on short term goals. This is understandable because a well-defined plan eliminates subjectivity. Oddly, a lack of judgment is now considered a good thing. It’s current business dogma. But it’s an executive’s job to judge the performance of his staff. It’s a manager’s job to judge the performance of his team. Have many companies, in obedience to today’s business dogma, created systems that remove any judgment from performance and force professionals to work to a series of discrete numbers, numbers that are isolated from the day-today long-term reality of the business?
I can give you the perfect example of systems gone awry, one with which you probably have personal familiarity. Have you ever called customer service at a large company and gotten a decision tree? Have you ever followed that tree with an increasing level of frustration, at each stop having to say your account number despite having punched it in at the beginning of the call? Then, after all that, have you ever ended up speaking to someone 6,000 miles way who couldn’t speak English? Well, whoever designed that system undoubtedly used a series of metrics centered around call volume, time per phone call, etc. All of those metrics made sense in the short-term confines of the system but, in the larger universe of the actual business/customer relationship, those metrics break down. Individual judgment has been replaced and the call management system has grown to the point of failure. Not only that, but while the consultant who designed that system is patting himself on the back for creating a system that manages millions of calls, hopefully someone else is aware that a large number of calls to customer service, even if well managed, may show a product or service failure that has become invisible because it’s been buried under a series of numbers.
In this Newsletter, we’ve discussed systems, risk and judgment. If we can draw any conclusions from last years financial crash it’s that systems will eventually grow in complexity to eventual failure. Employees, managers, executives and owners are all part of a larger system. It’s easy to get caught up in the minutia of day-to-day business decisions and forget the true goal of why everyone came to work. It’s taken me 4 pages to realize that I can probably get to the point in 2 sentences. Here they are:
Don’t confuse management with leadership. Manage problems by leading people.
Evaluate your systems and decision trees. In doing so, remind yourself of the last customer service call you made. Then consider whether you might have something akin to that monstrosity buried in operations, supply chain, purchasing or compensation. Take a step back and question your team about the potential long-term ramifications of the systems and goals that they and you have inherited and grown. Play the “Conventional Wisdom Game” with yourself and your staff.
As ever, thanks for getting this far and don’t forget Right Recruiting for all your employment needs. Jeff Zinser
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