When Arthur Andersen, an audit and accounting giant formed in 1913, collapsed in infamy in August 2002, it should not have come as a surprise to as many people as it did. As chief auditor to energy giant Enron, it was convicted with being complicit in accounting fraud and obstruction of justice by shredding documents to help Enron’s management overstate profits by $100Bn. When Enron’s share price rose consistently because of this deception, executives went further by engaging in insider trading and manipulating public investors for their own personal gain. Board effectiveness, management oversight, financial controls and the legal framework of both firms were found severely lacking in effectiveness, leading to the biggest bankruptcy filing in history (at the time) by Enron. Firestone Tyres led itself into crisis in 2000 by failing to intervene in supply chain issues which it had known about for at least six years. This simple yet consistent disregard to effectively communicate these issues led to over 270 fatalities, 23 million tyres being recalled and the destruction of one of Firestone’s longest customer relationships — with Ford Motor Company. The complexity within European aircraft manufacturer Airbus’ organisational structure was one of the core reasons the A380 project faced such prolonged delays. These delays, which were caused by a simple wiring issue, could have been avoided through better integration of their core departments — aircraft design, design IT, technology, procurement, manufacture and assembly — but instead resulted in the company losing upward of $5Bn in revenue.
While entrepreneurial resilience can be a deeply personal and unquantifiable force, Business Resilience is not. In fact, it’s probably been studied in some form or another since the very first business failed, and has been a prime focus area for academic research for at least 50 years. Simply put, Business Resilience is the ability of an organisation to anticipate, prepare for, respond and adapt to incremental change and sudden disruptions in order to survive and prosper. Because businesses are, at their core, a set of people, processes and systems that combine to create value, it should be possible to derive a framework for thinking about how disruptions/crises could affect a specific business’s ability to create that value. This, along with attempting to rank the resilience of key industries and business models in use today is what this post will try to do, with the ultimate aim of providing founders with a framework to understand how any crisis could affect a specific business in a specific industry — and therefore how to avoid it or prepare for it.
The Destruction of Value
Disruptions to business (or crises) come in a huge variety of flavours, from the short-lived ones to those that cause permanent change, and from the small, perhaps inconsequential ones to those that can bring entire economies down. Also, because of how interconnected business systems are internally and with the outside world (both locally and globally), understanding a crisis and responding effectively to it depends critically on who these connections are with, and how important they are to all parties involved. In business lingo, this is equivalent to saying crisis response is dependent on a company’s position in its value chain.
Simply put, a value chain is the set of activities that are required to turn raw materials (or expertise) into products (or services), and a company’s position within it is a useful starting point to understand the effects a crisis may have on it. Thinking of this set of activities as a chain can help to understand the ripple effects that any disruption at one “link” has on all the others. For example, in the (badly drawn) picture above, any disruption to the left of the company (the “upstream” chain-links) will directly affect the company’s ability to produce its product or service, whereas if specific products (one of the “downstream” chain-links) are destroyed, only specific customers may be affected directly.
A caveat here is that depending on the severity and scale of the crisis, customers could choose to not buy from the specific company anymore, which would create a backward ripple of sorts, which could then significantly affect the company. Customers form the demand side of the chain while suppliers form the supply side, and the most severe crises — such as the current COVID-19 crisis — simultaneously affect both sides, which is what makes these sorts of crises particularly devastating to companies and economies.
A final dimension that must be considered in today’s globalised world is that very few companies actually operate entirely within one market (regionally or nationally). Even if you’re an organic farmer that uses only local seeds and fertilisers to grow your crops, chances are your tools and equipment— or parts of them — were sourced and assembled in different factories around the world. With increasing globalisation, companies tend to specialise in one part of the production process that they are particularly skilled at or equipped for, while sourcing other parts from other companies that are better at it. In economics-speak, this is called specialisation and the division of labour, and is a widely implemented methodology to drive efficiency.
This suggests a good way to think about the severity and scale of crises. Specifically, they can be gauged from 3 key areas:
- What the cause of the crisis is (from natural disasters to protests — see the picture below for a breakdown of the main ones). This will help understand how isolated or widespread the crisis is likely to be. One company’s crisis due to an issue of non-compliance is not likely to spread as much or as fast as a sanction on an entire country, for example.
- Whether it has primarily demand-side effects (downstream effects), supply-side effects (upstream effects), or both. The larger the portion of the supply chain that is affected, the more severe the crisis and the more potentially long-lasting its effects.
- The epicentre of the crisis and the level of dependence other regions have on it. Whether the epicentre is a country or company, knowing its place and prominence in the supply chain will help understand where it is most likely to spread to and what its effects might be. As an example of this, think of the German chemical plant fire that originated in the small town of Marl that nearly brought down the entire auto industry because of its prominence in the the global supply chain.
A Triad of Trouble Zones
Expanding on the previous image of a basic value chain, once a crisis has been understood in terms of its severity and scale, its effects on a specific company can generally be thought of under one of three headings: its Supply Chain (the upstream/downstream analysis), its Organisational Structure (Primary vs. Support functions in a company) and its Relationship with Stakeholders (internal vs. external).
But the Value Chain view isn’t useful enough to understand what separates resilient businesses from non-resilient ones, because resilience is borne out of a combination of the activities and processes that the company has to execute to monetise value from it’s industry — in other words, resilience is business model dependent. The picture below expands on the above theory and blends together a company’s value chain (what the company does) with its business model (how the company does it), while keeping in mind both internal and external stakeholders. This can be used as a rough starting point for thinking about how a company will be affected by any specific crisis.
Referring to the case studies at the beginning of this post, its easy to see this framework in action: Firestone Tyres knew about the issues in its supply chain (upstream), but did not act effectively, leading to a devastating effect on its revenue and brand. If Airbus had better integration between its primary and secondary functions, it may well have reduced production delays in its A380 line of aircraft and the associated losses. Finally, Arthur Andersen and Enron neglected its shareholders — both externally and internally — by choosing to deceive investors and the general public, ultimately leading to the destruction of both businesses and powerful legal repercussions.
These 3 cases (among many others) highlight why it is critical to put processes and systems in place that monitor these three zones of resilience vulnerability. Information visibility, the concept where leaders have ready access to key metrics of the company at all levels and function, and proactive monitoring of risks need to be a core part of corporate strategy, rather than solely being part of the disaster management plan.
A home is only as strong as its foundation
If we collect businesses that operate in the same value chain with the same (or very similar) business model, we get a view of that company’s industry, where resilience plays a part as well. Over time, some industries have proved to be fundamentally and structurally better at absorbing the effects of a crisis than others. This is usually because these industries — the resilient ones — serve more fundamental consumer needs and are therefore less affected by short-term changes in behaviour or disruptions to their demand and/or supply. The precise way in which a company in that industry chooses to deliver that product or service to its customers may differ, but taken in the aggregate, consumers will continue to want these products or services.
Take the Housing industry, for example. While some companies such as AirBnB address the need of people wanting a roof over their heads by automatically connecting them with those who have spare space in their homes, and others like Knight Frank have a team of expert real estate consultants who work with clients to help them find ideal properties, both companies serve the same basic need — housing. Because of how fundamental the need for housing is, a crisis is not likely to permanently impact businesses in the industry. As a slightly different example, consider the Travel industry. This is an industry that serves a core need — at the local, domestic and international levels — but is also one that has seen decades of companies dying out to newer and more innovative businesses. People still need to travel, but the ways they will go about doing that and the value they expect from the experience is continuously changing, leading to a resilient industry with non-resilient companies (in startup lingo, the travel industry has seen a lot of disruption). An easy example that fits here is the travel agent business, where consultants would help clients establish and book itineraries — a process that companies like TripAdvisor have managed to significantly (and perhaps permanently) disrupt.
A non-resilient industry is one that simply won’t continue to exist because it is either not serving an essential need or can be wholly disrupted to the point where all businesses within it fail. An example here is the Switchboard Operator industry. If you consider the value chain here, this industry included all those who manufactured, assembled and distributed switchboards as well as the training institutes and recruitment agencies that helped staff positions within companies in the industry. Once automatic telephone exchanges were invented by Almon Stowger in 1888, the need for manual operators gradually reduced until the industry no longer existed. Very few industries completely die out like this, however. What is more common is that the industry broadens its focus and evolves with technological advances. Ones who can do this faster tend to be more resilient to change and crisis.
A layman’s framework for thinking about which industries are resilient and which aren’t could involve two parameters: the industry’s degree of essentiality and its ability to adapt to change quickly (this includes having a flexible supply chain that has either (i) an abundance of alternate suppliers or (ii) a robust infrastructure that reduces reliance on any one supplier).
Both halves of the picture above represent the same information through different lenses. The top half takes an adapted view of the GICS sub-industry classifications and groups them based on the two dimensions of resilience mentioned in the previous paragraph: degree of essentiality and ability to adapt to change quickly. The bottom half takes a slightly less granular view and zooms out to the industry perspective, to make the top half more understandable.
A note on the methodology used here: This was not an in-depth scientific study and does not claim to be so — the aim was simply to bring a little more rigour to the analysis process.
Degree of essentiality was inferred by blending together various government definitions of essential services and an industry’s adherence to Maslow’s hierarchy of needs. To gauge an industry’s ability to adapt to change was more difficult to generalise, and so a proxy was used: the industry’s ability to digitise, and the level of digitisation already achieved. This was considered a good proxy for flexibility because it allows for agile, hybrid infrastructures and processes, flexible networking capabilities, consistent user experience, integration with ancillary services that add value, quicker disaster recovery and management architectures, collaboration and workforce engagement, automation of repetitive tasks leading to productivity gains, ability to have distributed teams, on-demand access to all functions, increased all-round security, improved supply chain management (including the ability to be more open to future partners joining easily), inter-departmental integration leading to a closer knit organisation, ability to leverage technology like big data, AI, etc for better decision making. All of this translates to better competitive advantage in execution. Performance of an industry was scored on these two metrics and averaged out to arrive at the final rankings.
A key note here is that industry resilience can’t be objectively measured through an analysis of the industry’s success during a specific crisis alone, but rather by taking a long-term view of the industry’s performance, preferably over several different crises.
Business Model Resilience
While value chain resilience and industry resilience are largely not under any entrepreneur’s control, the resilience of their business model is. To recap, the business model is the “mechanism” the business uses to capture value from its value chain. For example, both Western Digital and Dropbox compete in the digital storage industry, but while Western Digital manufactures, sells and distributes physical hard drives to customers (that the customers then own), Dropbox owns all its customers’ storage capacity and simply “rents out” parts of this capacity out to customers for a subscription fee/rental fee. While the core value proposition being provided to customers is the same— customers being able to store their digital files on a storage device — their business models are very different, and therefore, so are their respective levels of resilience.
A business model needs to do 3 things to be effective:
- It must be able to predictably produce a desired value proposition. Another way of saying this is there must be customers out there who are willing to buy or use the company’s product or service.
- It must be able to predictably sell this value proposition to those customers, with only minimal and expected frictions in this process. This includes the predictability of inbound logistics, outbound logistics and the production process itself.
- Once delivered, it must be able to predictably collect revenue from customers in sufficient amounts that it can continue operating its business.
Crises and extreme circumstances will always affect business models by causing disruptions to one or more of these three areas: either the product/service provided by the business is no longer in demand (or as much in demand anyway), or it becomes harder to sell/deliver the product or service effectively, or there are delays/halts in revenue collection. Of these alternatives, the first is the most devastating, because it means the product or service simply isn’t demanded by consumers as much anymore (Crisis Zone 1 in the image below is affected). Companies that are successfully disrupted usually face this crisis and it could end with one being driven out of business (think of what Netflix’s model did to Blockbuster).
Breaks in the supply chain, key people leaving the team, technology failures, reputation/brand fails, etc. fall into Crisis Zone 2. While complex to solve and often very destructive, it may be possible to salvage the situation without causing permanent damage if the company had a crisis management plan in place and was sufficiently “agile” in execution. Companies that fall into this category are prime targets for turnaround management.
If Crisis Zone 3 is independently affected, it can be relatively simple to solve. This falls in the realm of general consulting, and usually involves cutting down costs, building revenues and streamlining processes to avoid unnecessary risks. The reality is that during a major crisis however, Zone 3 is affected as a result of either or both of the previous Zones being affected. If the crisis is short-lived, the company may have sufficient cash reserves to pull through, but smaller companies and those who did not have sufficient risk management processes in place usually take the largest hits.
In a time of crisis, operational stress falls on parts of the business model that are harder to measure and manage. While under normal circumstances, tangibles like number of orders received, inventory turnover, supply chain efficiency etc., are good indicators of how well the business is likely to do in the near future, during a crisis, none of them are. Instead, intangibles such as brand loyalty, culture and leadership quality, among others, become key to the business’s survival.
When assessing your own business’ resilience and crisis strategy now, the steps become simple:
- Gauge Severity: Understand which crisis zones are being affected to get a sense of how seriously it might affect your business model.
- Assess Predictability: Score your model from 1–10 on the 3 main predictability criteria (produce, sell, collect) to better understand your core operational resilience.
- Evaluate Insulation: Study the intangible factors above how protected your business model is because of the intangibles you’ve worked on. [remember to include organisational grit]
- Streamline Operations: Deep dive into the tangibles to understand what you could focus on now to to drive your business out of crisis. Specific additional tangibles for startups include unit economics, burn rates, discount rates, stickiness and retention, repeatability, CAC trends, M-o-M growth (%)
How have you dealt with crises in the past? What strategies have you used to build business resilience? As always, post your comments and suggestions below, and see you in the next one!