GROUP 1

1. GROUP 1 CHAPTER

2. IDENTIFYING STRATEGIC RISK

3. Sources of Risk: Defined An unexpected event or set of conditions that can inhibit or interfere with a business manager’s ability to implement the intended business strategy of the firm.

4. Operations Risk • A breakdown in the core function of the operating process in a firm: Either in their manufacturing, operations, or process capabilities. • All firms that create value via any or all of the above capabilities are exposed to some varying degree of RISK.

5. Instances of Operational Process Break Down • Shipping of defective products • Bank transactional errors • Online trading delays in the actual executions • A contaminant in a product formulation for one of Merck’s top drug lines. • AOL’s inability to handle customer demand due to inadequate planning in their server capacity

6. Sources of Risk Franchise risk Customers Competitors Business Strategy Asset Impairment Risk Competitive Risk Suppliers Regulators Operations risk Employee Error

7. What Should Firms Do? • Analyze the operational process according to the inputs > process > outputs model: Define key processes that must be standardized & tightly controlled. • Identify points where systems errors could damage key operations and imperative assets • Use TQM, benchmarking, various types of studies

8. Asset Impairment Risk • Asset impairment occurs when an asset loses a significant portion of its current value because of a reduction in the likelihood of receiving those future cash flows. • It becomes a strategic risk if there is a deterioration in the financial value, intellectual property rights, or the physical condition of assets that are important for the implementation of strategy.

9. Types of Asset Impairment Risks • Financial Impairment • Impairment of Intellectual Property • Physical Impairment

10. Financial Impairment • Results from a decline in the market value of a significant balance sheet asset held for resale or as a collateral. • An asset becomes impaired when the future cash flows accruing to the firm are no longer sufficient to support the asset’s balance sheet valuation.

11. Categories of Financial Impairment Risk • Credit Risk • Sovereign Risk • Counterparty Risk

12. Impairment of Intellectual Property Rights • Impairment due to unauthorized use of intellectual property by competitors, unauthorized disclosure of trade secrets to a competitor or third party and failure to reinvest in the intellectual capital as asset quality deteriorates over time.

13. Physical Impairment • Asset impairment due to the physical destruction of key processing or production facilities. This impairment may be due to fire, flood, terrorist action or other catastrophe.

14. Competitive Risk Risks inherent to market competition • Result from changes in the competitive environment that could impair the business’s ability to successfully create value and differentiate its products and services

15. Competitive Risk • Faced by all businesses that compete in dynamic markets • Present as long as there are active competitors and demanding customers

16. Competitive Risk • Customers- What employee actions could drive customers away? • Suppliers- What employee actions could cause suppliers to stop supplying? • Substitute Products- What employee actions could drive customers to competing products/services? • New Entrants-What employee actions could cause new competitors to enter the market?

17. Franchise Risk Problems, or set of problems, that threaten the viability of the entire enterprise • Unlike Operations, Asset Impairment, and Competitive Risk, not a source of risk but a consequence of excessive risks from other sources

18. Franchise Risk Also known as reputation risk, most easily exampled by a lack of confidence in a brand or entire corporation Operations -ValuJet and Florida Keys - Pan Am and Lockerbee Asset impairment -Savings and Loans Crisis -Music Industry and file sharing Competitive -Apple Computer -K-mart

19. Franchise Risk Reputation is an important and critical competitive resource in maintaining customers’ demand for the firm’s product or service • Public accounting firms • Defense contractors • Pharmaceutical firms • Food processors, distributors and retailers • Hospitals and medical personnel

20. Common Risk IndicatorsOperations Risk • System downtimes • Number of errors • Unexplained variances • Unreconciled accounts • Defect rates relative to quality standards • Customer complains

21. Common Risk IndicatorsAsset Impairment Risk • Unhedged derivatives on balance sheet • Unrealized holding gains or losses • Concentration of credit or counterparty exposure • Default history • Drop off in product sales

22. Common Risk IndicatorsCompetitive Risk • Recent competitor product introduction • Recent regulatory changes • Changes in consumer buying habits reported in trade publications • Changes in distribution system

23. Common Risk IndicatorsFranchise Risk • Customer or bids lost to competitors • Unfavorable news coverage • Pending lawsuits or legal actions • System downtimes • Competitor business failure

24. Assessing Internal Risk Pressures • Understanding how strategic risks are exacerbated by the organization’s operating context • A variety of pressure points in a business cause strategic risk in a crisis situation • Some of these pressures are due to: • Growth • Culture • Information Management

25. Assessing Internal Risk Pressures Cont’d • These internal forces can “surprise” managers in the form of: • Operating errors • Impairment of assets • Crises of customer confidence • The Risk Exposure Calculatoris a diagnostic tool can estimate the internal pressures; they are additive and build upon each other.

26. Risk Exposure Calculator

27. Risk Pressures Due to Growth • High pressure for continuation of high growth can lead to “growth at all costs” mentality • Rapid expansion can make control difficult as the infrastructure design need changes and the infrastructure does not • Rapid growth also necessitates hiring large numbers of new (unknown and untrained) employees, increasing the potential for error

28. Risk Pressures Due to Culture • Lack of consistent values: employees and managers • Risk taking attitudes • Willingness (or lack of) to pass on “bad news” as well as good • Internal competition rather than cooperation

29. Risk Pressures Due to Information Management Issues • Transaction velocity: high volume and processing speed increase the risk of problems • Transaction complexity increases the risk of errors through lack of understanding and knowledge of control needs • “Missing” performance measures: ones that should be used but are not • Decentralized decision making: lack of centralized knowledge of what is going on

30. Misrepresentation & Fraud • Managers and/or employees may knowingly subject the firm to unacceptable levels of risk. • Employees may misrepresent their performance or misappropriate company assets. • Bad decisions can be covered up and expose the firm to loss of valuable assets. • Although most are small amounts, sometimes these actions severely damage the businesses in which these people work. • Joseph Jett / Kidder, Peabody & Company

31. Misrepresentation & Fraud Cont’d. • Contrary to the inherent nature of people assumptions. --- Organizational blocks can overturn these tendencies and lead to dysfunctional behavior. • Confusion about how to contribute • Temptation and pressures • Conflicting demands with too few resources • Fear of failure

32. The Dangerous Triad • Pressure • Employees are often under pressure to meet difficult performance goals through incentives. • Salary Increases, Bonuses, Promotions • Personal Problems bring pressure to misuse resources. • Debts, Addictions, Crises • Opportunity • Employees can only engage in wrongful acts if the opportunity presents itself. • Coupled with Pressure is dangerous ~ TEMPTATION! • Rationalization • Employees are unlikely to succumb and engage in wrongful acts unless they can rationalize their behavior.

33. The Dangerous Triad Pressure Opportunity Temptation Rationalization

34. Lessons Learned • Companies like Enron have hopefully learned about the consequences of material misrepresentation. • Vicarious learning - Will hopefully deter other companies from suffering similar mishaps and failures they may witness in other firms. • Ex. Kidder Peabody was damaged due to the questionable trading practices of Jett. Management by exception obviously was not successful in this instance.

35. Lessons Learned Cont’d • Review your companies operations and try to pinpoint the cause/effect for downturns in revenues and identify questionable business practices. • Remain true to the company’s core competencies. • Do not set unrealistic performance measures for your employees as this may set the stage for unscrupulous activities and inaccurate benchmarks for the company.

36. Quick Review Sources of Risk: • Operations Risk - in business processes • Asset Impairment • Financial Impairment • Intellectual Property • Physical Impairment • Competitive Risk - Competition can be fierce • Franchise Risk - Loss of consumer confidence • Internal Risks - Growth, information management, culture • Misrepresentation & Fraud - The Dangerous Triad * Managers must learn to control these risks to ensure the viability of the business

37. …GOT SOMETHING TO SAY TO ME?!!