Wednesday, December 07, 2005

Strategy Under Uncertainty

What makes for a good strategy in highly uncertain business environments? There are three alternatives to answer the question: [1] shaping the future with high-stakes bets, [2] hedging bets by making a number of smaller investments, or [3] investing in flexibility that allows companies to adapt quickly as markets evolve. How should executives facing great uncertainty decide whether to bet big, hedge, or wait and see? Unfortunately, executives would love to pick traditional approach, although traditional strategic-planning processes won’t help much. Firms utilizing traditional frameworks first focus on their core competencies and then try to see if these competencies can be used to reach the destination. It is virtually impossible to see multiple options with this traditional approach. One danger is that traditional approach leads executives to view uncertainty in a binary way-to assume that the world is either certain, and therefore open to precise predictions about the future, or uncertain, and completely unpredictable. Such systems clearly push managers to underestimate uncertainty in order to make a compelling case for strategy. Underestimating uncertainty can lead to strategies that neither defend against the threats nor take advantage of the opportunities that higher levels of uncertainty may provide. Risk-averse managers who think they are in very uncertain environments don’t trust their gut instincts and suffer from decision paralysis. They avoid making critical strategic decisions about the products, markets, and technologies they should develop. They focus instead on reengineering, quality management, or internal cost-reduction programs. Although valuable, those programs are not substitutes for strategy. What follows, then, is a framework for determining the level of uncertainty surrounding strategic decisions and for tailoring strategy to that uncertainty.

Four Levels of Uncertainty
Even the most uncertain business environments contain a lot of strategically relevant information. First, it is often possible to identify clear trends, such as market demographics, that can help define potential demand for future products or services. Second, there is usually a host of factors that are currently unknown but that are in fact knowable-that could be known if the right analysis were done. The uncertainty that remains after the best possible analysis has been done is what we call residual uncertainty. Courtney (et all) classify the situation into four categories. Level 1: A Clear – Enough Future, managers can develop a single forecast of the future that is precise enough for strategy development. Level 2: Alternate Futures, the future can be described as one of a few alternate outcomes, or discrete scenarios. Analysis cannot identify which outcome will occur, although it may help establish probabilities. Level 3: A Range of Futures, a range of potential futures can be identified. That range is defined by a limited number of key variables. The actual outcome may lie anywhere along a continuum bounded by that range. Level 4: True Ambiguity, multiple dimensions of uncertainty interact to create an environment that is virtually impossible to predict. The range of potential outcomes cannot be identified, let alone scenarios within that range. Level 4 situations are quite rare, and they tend to migrate toward one of the other levels over time. Nevertheless, they do exist.

Tailoring Strategic Analysis to the Four Levels of Uncertainty
At least half of all strategy problems fall into levels 2 or 3, while most of the rest are level 1 problem. A different kind of analysis should be done to identify and evaluate strategy options at each level of uncertainty. To find solution for level situation, managers can use the standard strategy tool kit – market research, analyses of competitors’ cost and capacity value chain analysis Michael Porter’s five – forces framework, and so on. Level 2 situations are a bit more complex. First, managers must develop a set of discrete scenarios based on their understanding of how the key residual uncertainties might play out. Secondly, a classic decision-analysis framework can be used to evaluate the risks and returns inherent in alternative strategies. The analysis in level 3 is very similar to that in level 2. A set of scenarios needs to be identified that describes alternative future outcomes and analysis should focus on the trigger events signaling that the market is moving toward one or another scenario. Situation analysis at level 4 is even more qualitative. Managers need to catalog systematically what they know and what is possible to know. Managers can also identify what information they would have to believe about the future to justify the investments they are considering.

Postures and Moves
A company may have three strategic postures in dealing with uncertainty: shaping, adapting, or reserving the right to play. In addition, there are three types of moves in the portfolio of actions that can be used to implement that strategy: big bets (focused strategies with positive payoffs in one or more scenarios but a negative effect in others), options (decisions that yield a significant positive payoff in some outcomes and a small negative effect in others), and no-regrets moves (strategic decisions that have positive payoffs in any scenario). Fundamentally, posture defines the intent of strategy relative to the current and future state of an industry. Shapers aim to drive their industries toward a new structure of their own devising. Their strategies are about creating new opportunities in a market in industries with higher levels of uncertainty. They play a leadership role in establishing how the industry operates, for example: by setting standards or creating demand. Adapters pursue to win through speed, agility, and flexibility in recognizing and capturing opportunities in existing markets. While Reservers tend to invest sufficiently to stay in the game but avoid premature commitments.

Strategy in Level 1’s Clear-Enough Future, in predictable business environments, most companies are adapters. The best level 1 adapters create value through innovations in their products or services or through improvements in their business systems without otherwise fundamentally changing the industry. Strategy in Level 2’s Alternate Futures, shapers in level 1 try to raise uncertainty, in levels 2 through 4 they try to lower uncertainty and create order out of chaos. In level 2, shaping strategy is designed to increase the probability that a favored industry scenario will occur. Shaping strategies can fail, so the best companies supplement their shaping bets with options that allow them to change course quickly if necessary. Strategy in Level 3’s Range of Futures, shaping takes a different form in level 3, if at level 2 shapers are trying to make a discrete outcome occur, at level 3, they are trying to move the market in a general direction because they can identify only a range of possible outcomes. Strategy in Level 4’s True Ambiguity, even though level 4 situations contain the greatest uncertainty, they may offer higher returns and involve lower risks for companies seeking to shape the market than situations in either level 2 or 3.

A New Approach to Chaotic Situations
At the heart of traditional approach to strategy lies the assumption that by applying a set of powerful analytic tools, executives can predict the future of any business accurately enough to allow them to choose a clear strategic direction. In relatively stable businesses that approach continues to work well. But it tends to break down when the environment is so uncertain that no amount of good analysis will allow them to predict the future.

Traditional approach may sometime leading to the trap of inside out thinking – focusing on what you do best and not if this is something that you should be thinking about. Basically, inside – out is the wrong way to think about strategy. However, focusing on customer needs is of little help in visualizing multiple business models. The question is then, what is the ultimate outcome the customer is looking for? Traditional market research and focus groups are not very useful in identifying out-comes. Companies are much better off observing customer behavior and rephrasing their needs in term of outcomes. The notion of competitive objective allows us to understand the logic of the output that we can deliver. The competitive objective should be designed not only to ensure that the outputs can deliver the customer outcomes, but also to avoid any increased risk of loss.

Reviewing three risk categories, demand risk represents the risk that customers will not but the firm’s product or service at the expected level. Competitive risk represents the risk that competitors can imitate what firm does and take customers away. Capability risk represents the risk that a firm may not be able to deliver the value to its customers and capture some of the value for shareholders. Three-steps process to identify and mitigate these three risks when designing a strategy. First, in order to sell what a firm makes, managers must ensure that whatever the firm is doing internally (internal objectives) must results in delivering the outcomes that customer are willing to pay for. The next step is focus on the most promising objective(s) and articulates the objective in manner that captures how the strategy will make money. These then followed by choosing between a differentiation (avoid competitive risks) or low – price (avoid demand risk) strategy to capture some of the value that a company is giving to its customers. Finally, the strategy designers need to repeat the process by selecting a second set of objectives until they are comfortable with the risk at each stage.

Symbolic Politics (SP)
SP can be defined as a political process, in which certain goals and measures are announced and enforced, which already at the very early stage of publication either represent sheer rhetoric and thus only target a signaling effect, or are designed in such a way that these goals and measures should or could not be realized and implemented in the same way as they are announced. SP occurs basically in two different forms. First, it can be regarded as a tolerated or even calculated failure of politics, as regulation for some reason does not reach its final goal. Second, SP might be designed as a tool to initiate processes in society by announcing certain intentions which government is not willing or able to fulfill. For some business, SP would be seen as a problematic since often it creates chaotic situation leading to uncertainty. SP often focused on issues not yet fully explained by scientific evidence.

In response to SP, a company takes a strategy depending on two factors: degree of transparency in the regulated field of politics, and corporate involvement in the political process. Risk Oriented strategy and proactive strategy will be taken when degree of transparency is high while corporate involvement is low. On the other hand, when both transparency and involvement are low company tends to ignorance or apathy. These are in contrary with the situation where corporate involvement is high. Industry applies self-regulation and stakeholder collaboration when transparency is high, but still striving for compliance strategy or PR/Communication-based strategy even when transparency is low.

Pronouncements of important corporations
Organizations have considerable prestige. The corporation is the organization of choice of the western democracies for the conduct of economic activity. The great corporations are the producers of the most sophisticated products even when government might be the customer as for infrastructure and instruments of war. Several authorities question the role the corporation plays in society and attribute many of society’s deficiencies to the lack of corporate account-ability. In many survivals is not realistically in question although it is frequently mentioned to keep everyone on their toes
In this complex world people in general and investors in particular draw comfort from rules or conventions to guide their decisions. One class of decision-making support is follow the sure fire rule especially if everyone else is doing the same. The economic cycle is thought to follow a repeating pattern whereby certain sectors lead or lag economic growth up to the peak that leads into decline and ultimate recovery and repeats. This stylized image suggests that investments follow a predictable pattern akin to the hours of day. The investment decision is thus determined not by inherent worth of the stock or sector but by whose turn it is. *****

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