Strategic planning in an age of turbulence

RELEVANT TO ACCA QUALIFICATION PAPER P3
© 2012 ACCA
Strategic planning in an age of turbulence
For an organisation, turbulence can be defined as unpredictable and swift
changes in its external or internal environments that affect its performance.
Internal events usually limit their effect to the organisation in which they occur.
External events are much more wide-reaching, often affecting all organisations
or all organisations within an industry sector. These events would often be
identified, though not necessarily predicted, through a PESTEL or Porter’s 5
Forces analysis.
Examples of turbulence
External events Internal events
The banking crisis  Loss of a major customer or contract
The Euro crisis  Loss of key staff
The ‘Arab spring’ Liquidity problems
The Japanese earthquake and tsunami A discovery
Rapid changes in technology Taking over another company
A decade ago, economic growth, interest rates, the impact of the internet and
so on were moving in fairly stable patterns. Of course, even during this period
of relative stability, music companies were trying to work out how to respond
to MP3 downloads, and a company like Kodak was trying to tackle the impact
of digital cameras. But the environment as a whole didn’t spring too many
nasty surprises and businesses felt confident to plan for the future. How
different the last few years have been, as shown above in the examples of
external events. Furthermore, once turbulence is established it can be some
time before things settle down again. So we are now, undoubtedly, in the
middle of a turbulent period.
Our current environment is not uniquely turbulent and there are many
examples of turbulent periods from the last 100 years or so: World War I, the
great depression of the 1930s, World War 2, social changes in the 1960s, the
disintegration of the Warsaw Pact, events following the attack on the World
Trade Center. Turbulence seems to be inevitable, though few people recognise
that, perhaps because its cause and effect cannot be predicted in any detail.
But we know something unexpected always happens. The inevitability of
turbulence should have very important implications for how organisations
should plan for their long-term survival.2
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Knowns and unknowns
All planning requires us to peer into the future as far as we can, and based on
what we see and our forecasts we devise plans. However, there is a huge range
in what we are capable of foreseeing and with what reliability. It is useful to
divide future events into three classes, as did Donald Rumsfeld, the former US
Secretary of Defense. He was derided at the time but – at least in this matter –
he made perfect logical sense, though somewhat clumsily expressed:
‘There are known knowns; there are things we know we know. We also know
there are known unknowns; that is to say, we know there are some things we
do not know. But there are also unknown unknowns – the ones we don't know
we don't know.’
• The known knowns – for example, an organisation might know that its
drug patents will expire in three years, or that it will be relocating in six
months. These events are relatively easy for planners to handle and to
build into budgets and objectives.
• The known unknowns – for example, an organisation might know that its
competitors are going to launch an important new product but it is not
sure exactly what the characteristics of that product will be. (Think of the
launch of the Apple iPad: everyone knew something was coming, but no
one outside Apple knew any details.) Or, organisations might know that
interest rates will rise but are not sure when or by how much. These
types of unknown can be handled by making estimates and possibly by
assigning probabilities to the various outcomes. Decision trees, expected
values, and sensitivity analysis are all very useful techniques.
• The unknown unknowns – do you know when there will be a powerful
earthquake that flattens the city of London? (Of course, by definition, we
don’t know if there will ever be one.) In 2007, no one knew, or
suspected, that Lehman Brothers would fail. Unknown unknowns cannot
be planned for, but organisations should assume that they will happen
and should therefore build into their plans robustness to protect
themselves against negative events and an ability to exploit positive
ones.
These unknown unknowns are by far the most difficult to manage. They are
sometimes termed ‘black swan events’ (1) because before black swans were
discovered in Australia, no one could imagine the existence of a swan that
wasn’t white. Black swan theory was developed by Nassim Taleb to explain:
• the huge impact of unpredictable, rare events that are outside our
normal experience and without historical precedent
• the non-computability of the effect of these rare events because there is
no data on which to base calculations3
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• the psychological bias that blinds us to the possibility and impact of rare
events. We tend to assume that things (such as property price increases)
will continue in a predictable way.
The phrase ‘black swan event’ is therefore used as a metaphor for the frailty
and limitation of any system of thought and planning: bounded rationality. This
means that we cannot know all-important factors that will affect the future
(and, anyhow, do not have time to evaluate them). We are, in practice, likely to
suffer from bounded rationality even with the known knowns because of
imperfect research or pressure of time. However, in a period of turbulence,
more events will be in the last two categories and this makes planning more
difficult. So how should organisations respond to the threat of unknowns while
still trying to move forward in terms of gaining competitive advantage?
Planning approaches
Three approaches to strategy are summarised in Johnson, Scholes and
Whittington’s strategic lenses:
(1) Strategy as experience. Here, strategic development is the adaptation
of past strategies based on experience. In this view, strategy is greatly
influenced by taken for granted assumptions, one of which is that the
world will advance in a gradual, linear and relatively predictable way.
(2) Strategy as design. Here, strategy development is a process of logical
and rational thought. Developments that arise are evaluated, resources
allocated and specific strategies are followed.
(3) Strategy as ideas. Strategies are needed to cope with uncertain,
unpredictable and changing environments.
There are analogies here with a suggestion made by Professor Vijay
Govindarajan – namely that organisations should place their planning projects
into three boxes:
• Short term – projects here are about managing the present and would
include process improvement, product and market development. These
projects are in response to linear (therefore non-turbulent) changes in an
industry.
• Medium-term – projects here concern ‘selectively forgetting the past’
and they are driven by non-linear changes such as the Internet and the
‘Arab Spring’. Projects here are aimed at moving into areas
neighbouring the organisation’s core activities.
• Long term – entirely new business ventures. Very speculative, and based
on many assumptions.
It is important to realise that the three approaches in each model are not
mutually exclusive and that all three will be carried on in parallel:
• It is important that the present is managed carefully and making use of
experience and expected developments.4
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• It is also important that organisations move forward steadily and adapt
to changing opportunities.
• At the same time, organisations should be aware of, or should attempt
to predict, more radical longer-term changes. Although those changes
might not be in place for 10–20 years, work to prepare for them might
have to begin now.
In relatively stable times, a company might divide its projects and efforts over
the three categories in the ratio 50/30/20. Note that even under conditions of
stability, substantial effort should be given to long-term projects.
In turbulent times, companies that are panicked will have projects in category
1 only. They become obsessed about clinging to the safe and familiar, and
important longer-term projects might be abandoned. However, a better
approach would be to keep projects in all three categories, but perhaps reduce
the number in each. Reducing the number in each provides some safety
because less investment spent on projects provides something of a buffer in
turbulent conditions. However, this approach allows attention still to be paid to
the long-term future of the organisation by insisting that longer-term projects
are always important.
Responsive, robust and resilient
Kotler and Caslione (2) address the problem of chaotic or turbulent
environments. They suggest that organisations need to plan to be:
• responsive – the ability to react quickly to change
• robust – the ability to withstand stresses and to cope well with change
without losing functionality
• resilient – the ability to rebound to a position of success.
Consider human resources management when there is a severe and
unexpected turndown in business. HR management would need to be:
• responsive – it might be necessary to block all hiring, to ban overtime, to
freeze pay and to make redundancies
• robust – care is needed when choosing who should go so as not to
jeopardise functionality; care is also needed to preserve motivation and
to try to keep good staff
• resilient – instead of redundancies, it might be better to ask employees
to move to shorter working weeks so that valuable talent is not lost for
ever. Then, when the economy recovers, the company is ready to bounce
back immediately without a delay for recruitment.
Practical approaches
Flexibility
Responsiveness, robustness and resilience are really an expansion of the 5
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concept of flexibility. It is essential to try to build flexibility into any strategic
plan – even in relatively stable conditions. One of the standard criticisms of the
rational planning approach is that it lacks or inhibits flexibility (though that is
more a criticism of how the plan is used rather than a criticism of planning
itself). Examples of building in flexibility include:
• leaving headroom in any financing plan. For example, arranging lines of
credit
• having break-clauses or extension options in lease agreements
• building in the ability to upgrade or extend operations
• use of currency options
• buying from a range of suppliers. For example, some companies that
relied on just-in-time inventory had problems after the Japanese
earthquake because their supplies were quickly exhausted. Now
manufacturers try to build flexibility into their supply chains
• stand-by and disaster recovery plans for IT systems
• a mix of permanent and sub-contracting staff
• pilot operations to gain experience in new ventures. If successful the
operations can be extended and can make use of experience gained
• joint ventures to spread risk and finance, and to make use of a wide
range of expertise.
Scenario planning
Scenario planning attempts to take into account the many things that could
happen and from those to build a number of believable, alternative futures. Not
all the events that could happen are likely to happen together, so those
permutations can be eliminated. For example, if an election is likely and we
believe that a change in government would lead to a cut in public spending and
a drop in interest rates, then there is no point considering a scenario of the
new government reducing public expenditure and increasing interest rates as
that is an implausible scenario. This greatly helps to reduce the number of
‘universes’ we have to consider and allows the organisation to concentrate on
the few most likely ones and plan its response to each of the plausible
scenarios.
Interest
rate = 5%
Interest
rate = 2%
Government 1
Lower public spending
Implausible
combination
Scenario 1
Government 2
Maintained public spending
Scenario 2 Implausible
combination
Sensitivity analysis
Investigate the effect of assumptions about the future changing. Investigate
sensitive assumptions more to get greater assurance. Look for ways of
defusing high risk areas.6
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© 2012 ACCA
Decision trees
Decision trees can be used to map out the various patterns of events that can
occur. Expected values can be used to evaluate the possibilities, or if
probabilities are too difficult to estimate, the possibilities can be examined
under conditions of uncertainty.
Note, however, that although expected values are often calculated, this
approach to strategic planning is almost always inappropriate. Expected value
calculations reduce detail into a single figure, that is usually not ‘expected’ to
occur, and this is the reverse of what is required to encourage responsiveness,
robustness and resilience. All of these require attention to detail.
For example, Quandary Co could spend $8m and then either have earnings of
$20m with a probability of 0.6 or could make a loss of $5m with a probability
of 0.4. Let us assume that the project lasts 10 years and that all financial flows
are in present value terms.
Outcome Probability $m
1 0.6 20
2 0.4 (5)
The expected value of this project is:
-8 + 0.6 x 20 + 0.4 x (-5) = $2m
However, this positive result conceals the 40% chance that the company will
have an adverse cash flow of $13m ($8m cost and then a $5m loss). Often,
that type of adverse outcome could lead an organisation into liquidation, so
ignoring the downside risk (and there might also be additional unknown ones)
is certainly not a robust methodology.
Furthermore, this approach, as presented, does not show responsiveness or
resilience. Cash flows and probabilities are both subject to change and the
company seems to be signing up to a 10-year project that is all or nothing.
Although sometimes the nature of a project will mean there is little or no
flexibility, it is beholden on companies to look for flexibility.
Now assume that further investigation shows that the project can be broken
down into two, consecutive five-year blocks. The initial cost will be $5m and
this will generate half of the original amounts: either a profit of $10m or a loss
of $2.5m. Assume that after the first five years have passed, the company will
have gained information that allows it to predict with certainty what the
outcomes of the second five years will be. This is not unreasonable as the
passage of time allows more information to be collected that can be used for 7
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© 2012 ACCA
further analysis. Also, events that had been a long way off are now closer and
easier to predict. Therefore, the income figures shown below for the second
five years are not known at the outset but are known after the first five years.
If the company wants to continue after five years, expenditure of another $4m
will be needed to generate the same earnings as would have been earned with
the original one-stage investment. ($3m to bring the cost up to the original
$8m plus a premium of $1m for the delay).
Alternatively, enhancement expenditure of $8m would then increase earnings
to $12m or $15m depending on the state of the world economies (this will be
known after five years). This possibility wasn’t even suspected at the very start
of the project, but has now opened up.
If Quandary didn’t wish to invest further funds after five years, the project
could be abandoned at the end of the first five years for no further cost. If the
outcome had been poor in the first five years, it will be poor in the second five
also, irrespective of any attempt at enhancement.
The choices and outcomes are now:
The company’s game plan could now be as follows:
(1) Assess the likely outcomes from the first five years. As far as has been
forecast, this will either be a net profit of $5m (10 – 5) or a loss of
$7.5m (-2.5 -5). The expected value of the first five years alone would
result in break-even (0.6 x 5 – 0.4 x 7.5 = 0). Within that figure there is
a high chance the loss will occur and the company should have a good
hard look at whether it is robust enough to stand a loss of $7.5m (plus
a bit more for headroom).
p = 0.6
Earnings =
 $10m 
p = 0.4  
Loss =
-$2.5m D
Initial
cost,
$5m
Abandon
Years 0–5              Years 6–10
A
C
Abandon
Cost, $8m, earnings $12m or $15m
 Loss = -$2.5m
Abandon
      Cost, $4m, earnings $10m
B8
STRATEGIC PLANNING IN AN AGE OF TURBULENCE
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© 2012 ACCA
(2) If Quandary Co embarks on the project and makes a loss in the first five
years, then, to avoid further loss, the project can be abandoned. This
option provides responsiveness.
(3) If Quandary Co embarks on the project and makes a profit in the first
five years, the company can reassess what it should do then. Its
choices are:
• abandon the project. This could be done if the economy then
looked very poor so that the company didn’t want to risk a
further $4m or didn’t feel robust enough to do so
• spend $4m to earn $10m; a profit of $6m
• spend $8m in the hope of earning either $12m or $15m; profits
of $4m or $7m. (The company would, in fact, presumably not
spend $8m to earn $12m because that profit of $4m is less
than the profit of $6m that the first option gives.)
These provide responsiveness and also resilience because Quandary Co has
been able plan to spend to rebound if economies improve.
Of course, as it turned out, none of these happened. A black swan was
sucked into the cooling inlet pipe of the local nuclear power station causing
a meltdown of the core. All homes and businesses, including Quandary Co,
within a radius of 20 km had to be abandoned.
Ken Garrett is a freelance lecturer and writer
References
(1) The Black Swan, Taleb NN, Penguin, 2010
(2) Chaotics, Kotler and Caslione, Chaotics, Amacom, 2009