Setting strategy in a vacuum is a fool’s errand. Protiviti’s Jim DeLoach offers five tips on how companies can best consider risk when developing strategy.
Lessons over the years point to the importance of integrating risk into strategy-setting. If this integration theme is ignored, risk becomes an afterthought to strategy and an appendage to performance management. In an age when disruption is the norm and not the exception, this should never happen.
Risk to the execution of the strategy as well as from the strategy itself are two important dimensions for senior executives and their boards to consider. A third dimension is the strategy being out of sync with the organization’s core values.
All three of these dimensions are emphasized by the Integrated Framework on Enterprise Risk Management of the Committee of Sponsoring Organizations of the Treadway Commission (COSO). In reflecting on learnings over the years and the guidance from COSO, here are five considerations for executives and directors to keep in mind when integrating risk into the process of formulating and executing strategy.
What we don’t know may be more important than what we do know
Focusing on what we don’t know may, to some, seem to be an oxymoron. Indeed, it requires a process. One approach is to identify the critical assumptions defining management’s view of the business environment during the strategic planning horizon. These assumptions reflect management’s thinking regarding the enterprise’s capabilities, competitor capabilities and likely actions, expected customer preferences, technological trends, capital availability, geopolitical environment and regulatory trends, among other things. They are what Frederick Funston and Stephen Wagner refer to as management’s “white swans” and are important because the strategy is typically based on them (at least tacitly).
One way to cope with uncertainty is to consider the impact on the strategy and business model if one or more strategic assumptions become invalid. Once management’s assumptions are explicitly defined, contrarian statements are developed to suggest plausible as well as extreme scenarios that could affect one or more of them.
Management and directors then select the contrarian statements that are likely to have the greatest impact on the company’s ability to execute its strategy and business model if they were to transpire. These forward-looking statements ordinarily reflect situations that would arise from events about which the organization currently lacks sufficient information, and about which management would likely rationalize after the fact, “Why didn’t we see it coming?”
For the high-impact contrarian statements, management develops implication statements. An implication statement resolves the conflict between the strategic assumption and the contrarian statement by addressing two questions — “How would we know if the assumption is no longer valid or is becoming invalid?” and “What would we do if this assumption underlying our strategy was no longer valid?”
Answers to the first question provide the foundation for forward-looking trending and other metrics to monitor the vital signs that provide insights regarding the continued validity of the assumptions. These early warning signs are vital to fostering organizational agility. Answers to the second question form the basis for response plans. As with many strategic uncertainties, action plans arising from an implication statement had best be developed in the cool of the day rather than when the fire starts.
Since no one knows for sure what’s going to happen, the above analysis would help management and directors understand the implications of change and alternative views of the future. It would also point out what needs to be monitored closely to spot changes occurring or about to occur, and what to do either in anticipation of the change or once it occurs.
To use the 2008 financial crisis as an illustration, the financial services industry had a blind spot in that never in recorded history had there been a significant deterioration in housing in all major markets in the United States. Accordingly, prior to the crisis, many across the industry believed that property markets in different American cities rise and fall independently of one another.
Yet, with heavy concentration in high-risk, complex structured investment products, few asked the question: “What are the implications if a different scenario were to develop?” Those institutions that chose to focus on that question discovered that a nationwide house-price slump had begun as early as 2006. As a result, they got a head start of 12 to 14 months in liquidating their portfolios. These banks fared much better in getting through the crisis and found a seat in the ring when the proverbial music stopped because they proactively leveraged the time advantage offered by their strategic assessment process.
Sooner or later, something fundamental in your business world will change
Disruptive change has become a marketplace norm. It arises from technological developments, market forces and unexpected threats. Senior executives and directors should focus on understanding the factors driving disruption in their respective sectors. Examples include emerging technology trends, their implications to the industry and competitors positioning themselves as early movers in deploying them.
Artificial intelligence and machine learning, coupled with natural language processing capabilities, open the door to analysis of massive amounts of data and transform the nature of cognitive work to deliver insights that organizations can use to improve customer-facing processes, profitability and competitive position.
Emerging technologies — the Internet of Things, quantum computing, augmented and virtual reality, 5G broadband, and even advanced cloud solutions and data analytics — have enormous potential to transform business models and spur growth. Bottom line, our technology-driven world is forcing every organization to become proficient at adapting to a rapidly changing world.
But fundamentals are altered by other forces, too. The Covid-19 pandemic has hit certain sectors hard and driven attrition on a massive scale, throwing global supply chains and labor markets out of sync. Russia’s unprovoked aggression toward Ukraine has further complicated congested supply chains and the relentless spiral of inflation. Central banks are raising rates to tamp down inflation, Covid surge, dealing supply chains another blow. Geopolitical tensions are building in Asia. And volatility in financial markets continues.
Going forward, market and competitive intelligence should be aligned with what really matters. Companies need to know when they are approaching the crossroads where a strategic inflection point exists due to a major change in the market — introduction of game-changing technologies, a dramatically different regulatory environment, a sea change in customer preferences or a catastrophic loss of critical components of the value chain. These occurrences may necessitate fundamental adjustments to the business strategy.
Failure to attain ‘early-mover’ status can threaten your organization’s viability
As discussed above, an “early mover” is a firm that quickly recognizes a unique market opportunity or an emerging risk and uses that knowledge to evaluate its options either before anyone else or along with other firms seeking to seize the initiative. What separates an early mover from the rest of the herd?
Companies fall so in love with their business model and strategy that they fail to recognize changing market paradigms and the need to innovate and adjust until it is too late. In essence, they embrace the status quo, a bias that drives them to focus on doing things right (e.g., faster, better, cheaper) rather than being more future-oriented, obsessing about competitors and game-changing opportunities and how the company can innovate to create market disruption, as Adam Hartung writes in “Create Marketplace Disruption: How to Stay Ahead of the Competition.”
Failure to attain early-mover status, as we’ve defined it, can be fatal in today’s ever-changing business environment. We have pointed out the importance of recognition — meaning an early mover recognizes in a timely manner the market opportunities and emerging risks that matter — and outlines a process to facilitate timely recognition.
Of equal importance is responsiveness, meaning an early mover reacts and responds to the market opportunities and emerging risks it recognizes on a timely basis. Companies that demonstrate the ability to adapt to a changing business environment typically foster an organizational culture that encourages and stimulates managerial intuition and ingenuity to translate information regarding the reality of altered strategic assumptions into actionable revisions to strategic and business plans. In essence, they seek to make their organization resilient so that it has the ability and discipline to act decisively in response to changing market realities.
Look out far enough to see the full picture
The focus on quarterly performance, annual budgets and business plans may feed the malady of short-termism. While a three- to five-year period may be typical for purposes of assessing risk, such horizons may be limiting. For example, the World Economic Forum uses a 10-year horizon in its annual risk study.
Likewise, more companies are using a longer horizon to elevate their assessment process to a strategic level. The longer the horizon, the more likely new issues will emerge and the greater uncertainty over whether plausible and extreme scenarios may present themselves. Even risks identified over the longer term but not necessarily when considering the short term may require robust response and contingency plans. Conversely, such threats may be overlooked when the lens of relatively short time horizons often constrain traditional risk assessments.
So-called “gray rhinos” — highly probable, high-impact threats — often fall into this category. The further out one looks, the more apt these threats are seen looming on the horizon. These events are dangerous because they can occur at any time and without warning. The pandemic, dramatic shifts in the regulatory environment, evolving customer preferences, digital transformation and acceleration trends, emergence of alternative products and new market entrants, fresh cyber threats, regional conflicts and natural disasters in high-risk areas are just some examples. As I mentioned in a prior article:
Companies should organize for speed, keep an eye on relevant trends and industry developments, deploy data-informed approaches to understanding customer behavior, direct necessary changes to processes, products and services, and invest in the talent that can make it happen.
Short-termism in all of its forms can contribute to a dysfunctional environment that warrants vigilant oversight by senior executives and directors. For example, the organization may become insular in its outlook, leading it to not “reality test” its assumptions about markets and the business environment regularly. Management may continue to execute the same strategy and business model regardless of current market conditions.
In addition, unit and process owners may be prone to make artificial moves (e.g., defer investments) and manipulate processes (e.g., cut costs to the bone) to achieve short-term financial targets rather than prioritize fulfilling customer expectations by improving process effectiveness and efficiency. Management may be reluctant to consider investments that may not pay off in the short run even though there is long-term shareholder value creation potential. Worse, the incentive compensation program may reward unbridled risk taking over the short term at the expense of long-term value creation.
These and other red flags warrant attention, because they signal the possibility of unacceptable risk taking that needs to be addressed in strategy-setting. A strong focus on linking risk and opportunity can help overcome some of the blinds spots created by short-termism.
Managing to a single view of the future is a fool’s errand
Executives and directors need to be careful to avoid the kind of overconfidence that can be bred by a singular view of the future. While most leaders make bets based on what they see in the future, two important questions present themselves:
- For the truly big bets, what if they’re wrong?
- And if they are wrong, is it known how much the strategic error will hurt?
“What if” scenario planning and stress testing are tools for evaluating management’s view of the future by visualizing different future scenarios or events, what their consequences or effects might be and how the organization can respond to or benefit from them.
Because these tools focus management on identifying the likely direction and order of magnitude of changes in the business environment and on the drivers of the enterprise’s revenues, costs, profits and market share, they are an important consideration in contrarian analysis. They enable management to assess the hard spots and soft spots in different strategic alternatives or in the business plan for delivering expected performance. Such analysis can inform the selection of the best alternatives on a risk-adjusted basis as well as focus efforts to make the business plan more robust.
Scenario planning can also help management cope with uncertainty. The art of scenario planning lies in blending the known with the unknown into a manageable number of internally consistent views of the future spanning a wide range of possibilities. Scenario planning and stress testing help management challenge assumptions and expectations, address “what if” questions and identify sensitive factors in the external environment that should be monitored.
By deepening their understanding of the pain of the unexpected, management can identify when contingency plans or exit strategies are required and reinforce the need for adaptability in executing the strategy. Management must be committed to the scenario-planning exercise to ensure it is sufficiently rigorous and identifies the vital signs the company must monitor. Combining the explicit opportunity discussion with scenario and stress testing leads to a more robust strategic conversation.