When fuel prices started to go up, most airlines were unprepared for the consequences. The financial divisions of companies like American Airlines and United failed to see the impact that higher prices would have on supply, and the operations team failed to see the financial impact of sustaining the supply of fuel. Both of the functions assumed that the other had planned how to deal with the unanticipated price shock, but they found out that neither was. Only one airline was fortuitous enough to have made financial hedges to balance out the higher cost of fuel with inventory needs: Southwest Airlines.
Southwest’s success in an otherwise gloomy airline industry is a story that is relatively widely known. However, it speaks to a larger issue that companies of all sizes and industries face: in the global economy, running a business is especially risky when finance and operations are ignorant of the other’s business. The global business risk factors go beyond the usual challenges of matching supply and demand; They include unanticipated commodity price shocks, volatile exchange rates, and unexpected supply disruptions as a result of forces beyond our controls, such as physical disasters and terrorist attacks.
“Operations and financial decisions interact heavily,” said Panos Kouvelis, the Emerson Professor of Operations and Manufacturing in the Olin School of Business at Washington University in St. Louis. “That’s the reality of the business place. Businesses have long assumed that this was a legitimate approach, but to assume that finance and operations are independent is not safe.”
Kouvelis and colleagues from universities around the country met at Washington University in June to discuss why the old model of departmental segmentation and functionally independent decisions is not good business. The conference was a call to academics to begin to seek solutions that will help firms make cross-functional decisions, with particular emphasis on how to coordinate operations and finance.
“Both finance and operations need to understand how the other functions and then reflect that understanding in the way they make decisions,” Kouvelis said. “Companies are buying and selling commodities in environments of price, supply and demand uncertainties. Operations experts tell them what the optimal inventory level should be to match supply and demand, and financial experts advise what the optimal hedging of uncertain prices is given the inventory. But nobody is telling them what is the optimal way to consider all the risks and decide both hedging and inventory at the same time while optimizing firm’s profits. It’s not an easy thing to do and, unfortunately, we in academia don’t have adequate models to help businesses yet. But business managers have to struggle with such issues every day, and adopting functionally myopic ways to deal with them is not serving their shareholders’ purposes.”
But models need to be developed, Kouvelis said, and there is no better time for doing it than now. Without it, there is too much at risk in a world where globalization plays such a large role in everyone’s business. He said that aligning operations and finance would not only save companies millions of dollars, it would also mitigate risks from the impact of currency fluctuation or sudden changes in the market.
Of course, companies differ in their approaches to hedging such risks. Some companies prefer to rely on the flexibility and agility of their supply chains when responding to the economic shocks in their global operations, thus following the so called operational hedging approach. Others prefer to rely heavily on exotic financial products that attempt to hedge such shocks via appropriate investments in correlated market traded instruments, the so-called financial hedging approach. BMW is a company that has frequently favored the financial hedging approach of exchange rate shocks, while 3M has been a strong proponent of hedging via operational flexibility. Kouvelis advocates an integrated risk management approach that combines the use of operational and financial hedging. This combination is exactly what BMW is doing after recently suffering from strong appreciation of the Euro in its heavily European based production operations. BMW has announced expansions of production and sourcing facilities in the North American and Asian continents in an effort to create a more globally diversified supply chain, thus adopting more of an integrated risk management approach in its handling of global risks.
Exchange rate shocks and their business risks are often the topic of heated discussions. This is especially so today when we deal with a depreciated dollar over the Euro, and the potential of a freely fluctuating Chinese currency. In understanding their impact history is a perfect guide. Take what happened in the late 1990s when the Asian currencies collapsed, Kouvelis said. Companies whose entire operations were in North American suffered tremendously because there was a sudden influx of extremely cheap goods and American companies couldn’t compete with those prices. Kouvelis points to a consulting project he worked on with Solutia as an example of how currency fluctuations can hurt a business that hasn’t diversified its operations and that hasn’t already figured out how to hedge financially for fluctuating exchange rates.
In 1997, Solutia had been producing acrylic fibers that were sold to fabric makers and eventually were made into clothing. When the Asian crisis hit, there was suddenly a lot of acrylic products available cheaply from Asia. Solutia was at the back end of the acrylic fiber supply chain. Their buyers suddenly weren’t purchasing as much fiber since the Asian products were selling to customers better than the American-made brands. With all of their fabric producers located in the U.S., Solutia had no other options in the supply chain to circumvent the problem and they were stuck with a glut of acrylic fibers. Their production manager in Decatur, Ala. learned a harsh but valuable lesson. He had always dealt with North American suppliers and sold to North American customers, and would have never thought that he was exposed to the risks of fluctuating Asian currencies, such as the Taiwanese dollar and the Indonesian rupee. But it was such risk exposure that resulted in the unprecedented vulnerability of his supply chain and drove the need to consider plant closure, which unfortunately ended up happening a few years later.
Kouvelis said there really is not a single “best practice” recipe to handle these kinds of cases and risks. But the best way to think about them and proceed is to invest and create flexible and adaptable, globally diversified supply chains. Managers of global supply chains should realize that they’re coordinating three types of flows: material, information and cash flows. While their best operating practices optimize their handling of material and information flows, the management of cash flows and associated risks is not independent of their operating practices and associated risks, and vice versa. The integration of financing and operations decisions, and the combined operational and financial hedging of global risks is the only way to guarantee competitive success and profitability in a complex and uncertain world.
“No matter the industry, managers and businessmen have to make complex and risky decisions without knowing the best way to think about it,” Kouvelis said. “We’re hoping that by getting financial experts and operations experts working on this problem, we’ll be able to offer models for business within a few years. The conceptual and computational seeds of a powerful integrated risk management framework could be sensed in the talks of the business experts of our conference last month. We are excited and optimistic about it. ”