Consequences of Ignoring a Key Risk Indicator-Ford Case

Source: CFO.com

Wall Street was shocked in January 2002, when Ford Motor Company announced a $1 billion writeoff of its stockpile of precious metals, primarily palladium. Why had the number-two carmaker taken such a risk, building up a big inventory of a precious metal that, as it turned out, was not being included in designs for future exhaust systems? What did Ford miss in its analysis of the future use of palladium? What could it have done differently to avoid such a large and costly writeoff?

Before this mishap, Ford took pride in being a leader in the emissions technology field. Its research and development (R&D) department’s walls were adorned with various certificates of patents that had been granted for their advances in the field. In the 30 years before 2000, progress in exhaust systems had relied on the use of precious metals such as platinum, palladium and rhodium. The metals were dissolved in liquids and spread thinly over ceramic honeycombs within the catalytic converter and dried. They had the unique ability of stimulating chemical reactions in hot exhaust that converted pollutants into harmless compounds.

The results were great, but the supply of the metals – from remote mine locations in South Africa and a giant Arctic complex in Russia – was unreliable. What’s more, the supplies' unpredictability led to huge swings in their pricing.

While platinum was initially viewed as the more effective metal catalyst, it came at a cost of $100 an ounce. Ford’s R&D department discovered it could lower costs and still meet federal emission standards by substituting palladium for platinum. By the 1990s, most of Ford’s converters relied heavily on palladium and were using less than an ounce of platinum per vehicle.

Between 1992 and 1996, the global auto industry’s demand for palladium nearly quintupled to 2.4 million ounces. But prices for palladium began to rise along with its demand. Russia, which had been a large supplier of palladium, in 1997 shocked the market by holding up shipments. By early 1998, this disruption resulted in a spike of the price of palladium to $350 an ounce.

Ford’s first reaction was to ride the wave of panic, determining that price spikes would pass without a need for the company to change its strategy. But by the spring of 2000, major metals exchanges in Tokyo froze the price of palladium at a whopping $700 an ounce.

In a panic, Ford’s top managers approved in 2000 a proposal allowing the company’s precious-metals procurers to stockpile palladium and line up long-term supply contracts. But in doing so, they failed to consult with Ford’s treasury and R&D departments.

Had the precious-metals department taken the time to make two important phone calls, it would have realized that:

• Its treasury department had strategies to hedge against volatile risks such as the purchase of precious metals.

• The R&D department had already found solutions to lessen the use of palladium in future exhaust systems.

By 2000, the demand for palladium was falling among automakers worldwide. And on the supply side, years of high palladium pricing had spurred mining operations in South Africa to increase production. After peaking at $1,000 an ounce, the price of palladium steadily declined, falling to $350 by January 2001.

What Could Ford Have Done Differently?
Ford could have used key risk indicators – metrics providing early signals of increasing risk exposures – to measure not only the supply, but the demand of palladium worldwide. The design of effective key risk indicators starts with an understanding of the organization’s strategic goals and the risks related to achieving those goals. That linkage helps pinpoint the most relevant information that might serve as an effective indicator of an emerging risk.

For example, had Ford set key risk indicators on the supply of palladium worldwide, it would have realized that starting in 2000 mine production of palladium in South Africa had increased, reducing palladium’s volatile pricing from the artificially high levels it reached because of Russia’s manipulations. Ford also could have created key risk indicators to monitor its internal demand for palladium from its R&D department, as well as the global auto industry’s need for palladium.

Mapping key risks to strategic goals puts senior management in a position to identify the leading key risk indicators to executing their strategic initiatives. That reduces the likelihood that senior management will become distracted by other information that could be less relevant to achieving strategic goals. But Ford became distracted in the spring of 2000. It focused on the price of palladium reaching $700 an ounce instead of looking at the increased production of palladium in South Africa.

An effective method for developing key risk indicators is to identify risk events that could financially impact an organization, and then work backward to pinpoint the intermediate and root causes of each risk event. The closer the key risk indicator is to the ultimate root cause of the risk event, the more likely the indicator will give management time to proactively respond to the risk event.

Incorporating key risk indicators into an enterprise risk management program can provide senior management with up-to-date risk information to help with their decision-making processes. In advance, management could determine trigger levels or thresholds for each key risk indicator. That can alert management to adjust strategies proactively in order to effectively manage risk.

An organization’s leaders should ask themselves:

• What are our key risk indicators?

• How should we capture and share key risk indicator information throughout the organization?

• How will key risk indicator information be aggregated to provide relative data to senior management?

With this in mind, organizations can side-step mishaps and capitalize on opportunities, which in Ford's case could have meant avoiding stockpiling palladium, thereby saving the company a $1 billion writeoff.

Kristina Narvaez is president and CEO of ERM Strategies LLC.