Expanding ERM to Embrace Strategic Risk

Emerging ERM Trends

Companies across all industries increasingly face many high-stake risks that they are not protected against.  These strategic risks are defined as the array of external events and trends that can ravage a company’s path of future growth and shareholder value.  Over the past 20 years, strategic risks have become more apparent with the remarkable decrease in the number of stocks receiving a high quality rating by Standard & Poor’s and an increase in the number of low-quality stocks.  A company’s response to these threats should include developing and implementing a systematic approach to manage strategic risks. 

The popularity of risk management has grown in recent years.  Many firms are adopting an “enterprise risk management” approach to manage risk.  Enterprise risk management integrates available risk management techniques in a comprehensive, organization-wide approach.  Most companies use this approach to focus on financial, hazard, and operational risks.  However, according to the report authored by Adrian Slywotzky and John Drzik, managers need to consider strategic risks because they can have an even greater destructive effect on their company.  The key to managing strategic risks is knowing how to address and respond to them.

Most firms that have adopted enterprise risk management only focus on the financial, hazard, and operational risks and have ignored the strategic risks beyond these common risks.  These firms can realize greater value by taking a disciplined and systematic approach to minimize these strategic risks that threaten their entire business.  Also by managing strategic risks companies can put themselves in a better competitive position and take advantage of hidden growth opportunities.  Such benefits make strategic risk management crucial for executive officers.

No risk management technique can anticipate every risk.  Therefore, it is extremely important to manage those risks that can be identified and prevented.  Certain industries face common risks.  Being the first company to mitigate a common industry risk can create a competitive advantage.  It is important to understand how to deploy countermeasures to neutralize risk and possibly capitalize on it.

Types of Strategic Risks

There are seven major classes of strategic risks:  industry, technology, brand, competitor, customer, project, and stagnation.  Within each class are different types of risks.  Particularly dangerous risks and countermeasures for each will be discussed for each major class.  Strategic risks can be divided into seven major classes. 

1. Industry Margin Squeeze

As industries evolve, a succession of changes can occur that threatens all of the companies within that sector.  One particular threat is that profit margins will be eroded for all companies in that sector and the industry will become a no-profit zone from factors such as overcapacity and commoditization.  The best countermeasure for this margin squeeze is shifting the compete/collaborate ratio among the firms.  When the industry is growing and margins are large, companies can compete nearly on all fronts and ignore collaboration.  However this 100 to zero ratio of competition to collaboration should dramatically shift when the margins start to decline.  Collaboration may include sharing back-office functions, coproduction or asset-sharing agreements, purchasing and supply chain coordination, joint R&D, and collaborative marketing. 

2. Technology Shift

Technology risks can impact a company’s performance.  But the entrance of new technology into the industry can make companies’ products and services obsolete quickly.  For example, the film processing industry experienced a major shift with the introduction of digital imaging into a formerly film-based process.  However, most firms don’t always know how and when a technology will succeed in the marketplace so risk managers can double bet-that is, invest in two or more versions of a technology simultaneously so no matter which version prevails the company comes out as a winner. 

3. Brand Erosion

Brands are susceptible to an array of risks that can appear overnight and threaten to destroy the brand.  One of the most effective countermeasures to brand erosion is redefining the scope of brand investment past marketing to other factors that affect a brand like service and product quality.  Another countermeasure involves continuous reallocation of brand investment based on early detection of weaknesses by measuring the key dimensions of the brand continuously. 

4. One-of-a-Kind Competitor

Competitors are one a company’s major sources of risk, whether from the threat of new products or lower cost structures.  One of the most detrimental risks is the one-of-a-kind competitor that emerges in the market and seizes most of the market share.  Constantly scanning the market for this type of competitor is crucial because once one is identified the best response is to rapidly change the business design. This response allows a company to minimize the strategic overlap from the competitor and establish a profitable position in an adjacent marketplace. 

5. Customer Priority Shift

One of the biggest risks associated with customers is the shift in customers’ preferences.  Two effective countermeasures are the continuous creation and analysis of proprietary information, and fast and cheap experimentation.  Continuous creation and analysis enables companies to detect the next phase of customer preferences in the industry.  Fast and cheap experimentation helps managers to quickly determine the right product variations to offer different customers.  These approaches help companies retain and grow their customer bases and over time increase revenue per customer and overall profitability. 

(Customer priority shift is another form of strategic risk.  Customers’ preferences can change gradually or overnight without any prior notice to a company.  To help understand customers’ preferences companies need to continuously create and analyze proprietary information.  Also, companies should use fast and cheap experimentation methods with customers.  This helps companies identify the right product variations to offer to different customers.)

6. New-Project Failure

All projects face risks; but a new project faces the chance of not working properly, not attracting profitable customers, that competitors will copy it, or that it grows too slowly.  The best protection against these types of risk is to begin with a true assessment of the project’s chance of success before it is launched.  The next step is to review past projects’ performances, both internally and externally.  Three methods to help a company systematically improve the project’s odds of success are smart sequencing, developing excess options, and employing the stepping-stone method.  Smart sequencing means launching the better-understood, more controllable projects first.  Developing excess options while planning the project will also help to ensure the best one is used.  The stepping stone method involves creating a series of projects that lead from uncertainty to success and using that to make the ultimate project a success.

7. Market Stagnation

Many companies have had their market value plateau or even decline because they could not find new sources of growth.  In order to counter this risk of stagnating volume growth demand innovation can be applied.  This involves redefining a company’s market to expand the value offered to customers beyond product functionality.  This could include reducing company costs, capital intensity, cycle time, and risk, which would improve profitability. 

The Upside of Risk

Strategic risk management allows a company to move from the defensive to the offensive with regards to risk.  People tend to focus on the downside of risk and therefore they try to minimize it.  But in order for a company to pursue growth aspects it has to take on more risks, to place bets on products, new channels, customer segments, and business models.  Strategic risk management helps companies to limit the downside of risks but is also helps them to improve their chances of success by forcing them to think more systematically about the future and identify the growth opportunities available to them.  A new view of the relationship between risk and reward has begun to emerge over the last few years and companies are beginning to see that creative risk management along with a good business model can allow a company to improve on both sides.  With the right mind-set and the use of the countermeasures discussed previously companies can manage their risks and find the right risk/reward spot for them.

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Citation: Slywotzky, A. & Drzik, J. “Countering the Biggest Risk of All” Harvard Business Review. Apr. 1, 2005.