Re-appraising risk appetite, management and governance structures in the manufacturing sector in Australia
25 September 2020 | Minutes to read: 5

Re-appraising risk appetite, management and governance structures in the manufacturing sector in Australia

By Jeffrey Luckins

Heraclitus of Ephesus was an Ancient Greek, born in 535 BC; he was an influencer of Plato and arguably therefore an influencer on all Western philosophy. He is considered most famous for his insistence on ever-present change or flux becoming the characteristic feature of the world, as stated in his famous assertion that “The only constant in life is change”.

A sector of stability

While the manufacturing sector can claim to be an original disrupter in global commerce from the 19th century – as a consistent innovator and industry sector which has embraced robot technology, artificial intelligence and improved efficient systems for the supply, manufacture, production and distribution of goods – historically the rate of change seems to have been somewhat stable and consistent.

The manufacturing sector is considered to be orderly, stable and procedural; it has parameters and systems which are well accepted, normalised and implemented all over world. The margins of error are well known, even the off-takes and by-products have systems in place for their useful integration and value-producing. Rates of return are steady and stockpiles are carefully managed with an eye to the needs of customers in the future. Inventory obsolescence is understood and minimised and management has structures closely aligned with their production processes.

Then along comes the global pandemic of 2020, forcing businesses to re-appraise their risk appetite, management and governance structures.

The COVID-19 disruption

It was January 2020 when the world became aware of the lockdown in Wuhan China, the capital of Hubei Province which accounts for a little over 4% of China’s economy, which is now the second largest economy in the world after the US. With manufacturing at the heart of Wuhan commerce supplying the world with products and components, the knock-on effect to the rest of the world was enormous. With China accounting for 40% of all manufacturing among the top 10 manufacturing countries in the world (per the United Nations Statistics Division) there was a sudden realisation that the West had “placed all its eggs in one basket”.

The world relies on many products being made in China which are then exported to other countries and assembled into products. So when many supply chains worldwide are dependent on manufactured products from China, the effect of a manufacturing shut-down or even slow-down in China has cascading negative impacts around the world.

As the world approaches the end of 2020, the flow-on effects of the pandemic remain; the build-up of sales orders remains high and the economic dependency on China is problematic for businesses which have relied on China to produce quality product quickly and at the most competitive rates. The West has effectively outsourced its mass production activities to a country with excellent infrastructure and a well-trained relatively low paid workforce.

The balance of people and processes

Over time, Australia has embraced Advanced Manufacturing because we could not compete with the lower unit costs of production in China and similar countries in Asia, Mexico and Turkey to name a few. Advanced Manufacturing is the implementation of innovative technology to improve products or processes, with the relevant technology being described as “advanced,” “innovative,” or “cutting edge”. Advanced manufacturing has been the strategy with these industries increasingly integrating new innovative technologies into both products and processes, and typically requiring higher quality labour and producing lower quantities of a high-quality product.

It seems like a perfectly sensible strategy to have mass manufacturing in low wage countries with great infrastructure and leave the advanced manufacturing to the highly educated developed nations. However, with escalating trade wars and geopolitical tensions between nations rising to very concerning heights, it raises the question of:

whether businesses should re-appraise their tolerances to risk and how they manage their business processes and people?”

Australia has enjoyed great stability through nearly 30 years of consistent economic growth and the risks of operating business in a growing stable economy have been so low that many businesses within their risk management framework would not have considered for one moment a seismic change in how they operate and indeed whether higher risks of operating businesses should be reflected in their pricing decisions in the first instance or secondly whether they actually want to be in manufacturing business at all?

The great unknown risk that kept manufacturers in Australia awake at night was found in foreign exchange rates. Depending upon whether you were importing manufactured product for your own assembly here in Australia or exporting Australian manufactured products would depend upon how you reacted and considered your tolerances for risk. Invariably many manufacturers moved operations to South-East Asian nations which was also ideal for the distribution of product around the world, via Singapore or Malaysia for instance.

The 6 key risk factors

Given factors including delays in supplies to Australia, geopolitical issues and foreign exchange issues, businesses are, and quite right should be, re-considering their tolerance levels. Questions to be considered as part of this should include:

  1. Risk Management: Do you have a risk management function within your business which actively reconsider identified risks and re-evaluate ratings?; have you considered whether new risks are emerging which need to be identified, rated and mitigated? If there is no Risk Management Committee in place, the Board or business owners should be considering the risks, the potential consequences and any necessary mitigation actions.
  2. Funding: Does your business have the supply of capital (debt and/or equity) to withstand the uncertainty and greater level of inherent risks (i.e. risks beyond your control as business owners)?
  3. Profitability: Even if you have the financial means to continue trading, is it profitable? Does the return on equity justify the continued investment in the business? Are there lower risk alternatives that owners of capital can and/or should consider?
  4. Supply Alternatives: Are there alternative avenues available to address the delays in supply chain from overseas and the emerging geopolitical risks? Can parts be sourced locally?
  5. Product Mix: Consider whether the right product mix is in place? Perhaps what you are doing now is destined to fail without an urgent analysis of business plan, costings and likely demand for your products?
  6. Skills Matrix: Re-evaluation of the Board and management may be a worthwhile consideration at this point. Do they have the right mix of knowledge and experience to address the changing landscape? Are there new skills or indeed culture which could be considered?

The power of proactivity

If there is one key message to take from this analysis it is that being proactive is your friend in a crisis and making the best business decisions should be based on logic, evaluation of the facts and a considered view of where the future of manufacturing, innovation and technology is going and of course the likely market demand factors of your customers.

Ultimately, you have the power to choose your own destiny, even if the inherent risks of business, of governments, politics and pandemics are beyond your control. Consideration of merger and acquisition opportunities should form a key part of your decision-making.

For businesses with a strong balance sheet (including strong brands/IP, etc), now maybe the best time to begin discussions on acquisition strategies, especially where the target entity is considered to be in a weak financial position. Alternatively if your financial position is weak and your analysis suggests a likely going concern basis issue which is unlikely to be resolved through financial or capital management strategies, then a merger (i.e. getting acquired by a larger competitor) may be the best overall strategy available. Note that delaying merger discussions could reduce the existing value of your business if economic conditions continue to deteriorate.

Be proactive and be prepared to challenge your thinking because…

“The only constant in life is change”.

Re-appraising risk appetite, management and governance structures in the manufacturing sector in Australia

Jeffrey Luckins

Jeffrey is a Partner in our Audit and Assurance Division with extensive experience in auditing listed Australian and multinational public companies, large private corporations and groups, and preparing Investigating Accountant’s Reports. Jeffrey’s expertise spans many industries, including technology, manufacturing, mining and exploration, importing, retail and agricultural.

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