- Email: [email protected]
Evaluating the risks in acquisition
38
0024-6301/82/060038~7$03.00/0 Pergamon Press Ltd.
Long Range Planning, Vol. 15, No. 6, pp. 38 to 44, 1982 Printed in Great Britain
Evaluating the Risks Acquisition David B. Hertz and Howard University of Illinois
This paper aims to illustrate
the role of strategic
Thomas,
Department
risk analysis in
the process of policy dialogue. An example of a new product diversification demonstrates the role of risk analysis in clarifying problem assumptions and in understanding the impact of uncertainty on decision-making. Risk analysis is seen as an adjunct and aid to problem formulation and resolution and not an end in itself.
Risk analysis’ 9’ was originally presented as a useful addition to the range of techniques used in financial evaluations. It was seen as a logical extension to sensitivity analysis3 and a means of explicitly taking account of uncertainty in financial forecasts. Thus, the proposition that risk and uncertainty were more accurately defined by a simulation of input variables was little questioned thereafter. Managements began to adopt some form of this procedure to examine some, if not all, significant investments where doubt existed about the risk levels involved. It was emphasized, however, that in the end managerial judgment would be required in both input estimation and decision. Although this approach was seen by many readers about methodology in to be an argument that was not the main investment appraisal, intention. Rather it was intended that it should be a cautionary note to businessmen to examine the data surrounding an investment proposal in the light of all the pervasive uncertainties in the world of which business is simply one part. Indeed, this message should have been emphasized and amplified as subsequent events have proved. seen as a planning
of Business Administration,
and thinking process.4 Namely, as an approach for forecast/uncertainty based planning (Stage II/III of Gluck’s four stages of strategic planning) in which an understanding of project risk, cash flow projections and future scenarios is developed. This paper has as its main aim the proposition that risk analysis can help strategic thinking by encouraging constructive dialogue and debate about the In such a dialogue process, risk policy options. analysis is seen as an input for the strategy development process which aids strategy formulation, evaluation, choice and implementation. In this view of the world, there is no distinction between strategic risk analysis and strategy formulation. Rather, analysis and formulation are parts of a policy dialogue process which is iterative, adaptive and flexible. This dialogue involves the consideration by management of problem and formulation through a continual repolicy examination of potential alternative strategies and problem assumptions. In subsequent sections, the role of strategic analysis in strategic problem formulation
1KEY ASSUMPTIONS
15-Year Calculations Straight-Line
l
Depreciation
R & D Prior to 1966 Not Included in DCF investments to be Made in 1967
The authors are members of Administration at the University Champaign, III 61820, U.S.A.
the Department of Illinois, 1206
of Business S. 6th Street,
Product Introduction
Figure
1
and Balance
for Discounted Cash Flow (DCF)
15 Years for Equipment 40 Years for Buildings
in 1968
risk and
1
1 O-Year Projections for Profit and Loss Statement Sheet
l
For example, risk analysis is increasingly necessary and useful adjunct to a strategic
in
Evaluating
the Risks
in Acquisition
(Annual Estimates 1968-1977)
SALES
(1) Size of Synthetic
Market
(2) Share of Synthetic
Market
r-4 1968-1977) ZOSTS (Annual Estimates
I
I
HISTOGRAM
I
/
14) $t+.J;yjz;:;
(5) Fixed Cost (a) Base Fixed Cost (b) Depreciation of Plant (Annual) = 2.5% of Building Plus 6.7% of equipment (6) Variable Cost per sq. ft. Total Variable Cost = (1) X (2) X (6) L
I HISTOGRAM
(7) Gross Profit = (4) Less (5) and (6)
(11)
Figure
R 81 D, Product
Planning Expense
Profit Before Tax = Gross Profit Less (81, (9) and (10)
2(a). Flow chart of the risk analysis
investment
(13)
Research and Development*
(14)
BUILDING”
(15)
EQUIPMENT*
(16)
Promotion*
(17)
Cash and Accounts Receivable** = 17% of Yearly Increase .in N Net Sales
(18)
Inventory** = 8% of Yearly Increase in Variable Cost
model
4 (19)
l
HISTOGRAM
Total Investment = The Sum of (13)-(18)
Expanded
During
1966-1967
** Beginning Year 1968
Figure
2(b). Investment
= (7)/(4)
(Annual Estimates 1968-1977)
EXPENSES
(10)
G;e$!J;it
II
(annual
estimates
1966-1977)
(20) b
IV
Net Cash Flow = Net Profit After Plus Depreciation Less (19)
Tax
39
40
Long Range Planning Vol. 15
December
evaluation is defined. This role is amplified with an example taken from strategic new product diversification and some conclusions are drawn.
Strategic Risk Analysis and Policy Dialogue The role of strategic risk analysis in policy formulation and choice should be to force hard thinking about the problem under consideration. That is, it should highlight what alternatives should be considered; should examine changing secondary effects and anticipate the nature and extent of the impact of uncertainty for contingency planning. Thus, it is recognized that an initial risk analysis is at problem no more than a first attempt understanding. It should encourage controversy and allow members of the decision-making group to find out where basic differences exist about
1982
problem assumptions, values and uncertainties. This controversy should enable critical comment and review to be obtained, and through policy dialogue force the re-analysis, re-examination and sensitivity testing of the problem solution. Thus, after considerable dialogue, the quality and level of debate about the problem should be improved. This should facilitate compromise and consensus around a reasonable problem solution. An example of the use of strategic risk and analysis follows, and insights gained summarized in the conclusions section.
New Project Example
Diversification
This case considers the decision problem faced by a U.S. chemical company about whether to invest in
Probability
Size of Synthetic Market (Millions of sq. ft.)
Share of Synthetic Market Venture can Obtain (Percentage)
Sales Price (Dollars per sq. ft.)
Variable Cost (Dollars per sq. ft.)
Buildings
!j!j?r
Investment (Thousands of Dollars)
Equipment Investment (Millions of Dollars)
Figure 3(a). Probability
distributions
of six significant and uncertain variables
-
1968
---
1977
Evaluating
the Risks
in Acquisition
41
a series of indicator variables or criteria, rather than in terms of a single rate of return, performance measure such as internal rate of return or net present value. In fact, six performance measures were suggested and each was calculated over its entire range of proba.ble values. The following measures were calculated for the indicated periods:
Correlated Sales in Successive Years Probability
total dollar
sales (1968-1977);
cash flow (1966-1977); -3
-2
-1
0
+1
+2
+3
+4
+5
+6
Percentage Change in Sales Level Next Year
gross profit as a percentage net profit
Conditional
Probabilities
of sales (1968-1977);
after taxes (1968-1977);
net profit as a return discounted
return
on investment
(1968-1977);
on investment
(1966-1981).
The probability profiles of some of these performance measures are presented in Figures 4-7. r
t 1968 Second Year
Figure
+
Figure 3(b). E xamples of correlated conditional probabilities
I 1969
I I 1971 1972
I 1970
-
Expected Values
I 1973
Range of 90% of Possible Outcomes I I I 1974 1975 1976 1977
4. Sales per year
sales and -
newly developed synthetic product. (Note: that the example and company are real although some of the chronological and assessment features of the problem have been disguised.) Management was faced with a seemingly attractive product, but was unsure about the longer-term competitive viability of the product. In particular, given the high capital investment requirements, there was concern about the decreasing prices of competitive products and the increasing possibilities of additional entries into the market.
Expected Values Range of 90% of Possible Outcomes
a
It was decided that a risk analysis evaluation of the new product opportunity should be undertaken. The key assumptions of the model are outlined in Figure 1 and the flow chart for the risk analysis model is shown in Figure 2. An important point to note is that management decided that they wanted the new product opportunity evaluated in terms of
L
1
I
I
I
I
I
I
I
I
I
1966 1967 1968 1969 1970 1971 1972 1973 1974 197519761!
Figure
5. Annual
77
cash flow 1968-1977
I
,
-
Expected values
I
Range of 90% of Possible Outcomes
I 8
Figure
1969
I 1970
I 1971
6. Net profit
I
I
1972
1973
as ROI
I
I
1974 1975
1968-1977
I 1976 1977
Long Range 100
80
F
Planning
Vol. 15
December
diffuse or ‘spread out’, confirming the proposition that the management team were uncertain about the future and had difficulty in confronting and assessing these future events. Figure 3(b) shows how this risk analysis model handled correlation effects. The figure shows how the procedure works in relation to correlated sales in successive years of the product’s life. In first years sales are sampled from the low range of the distribution, then the model samples a value for second year sales from the second year sales distribution assessed conditional on low sales in the first year. Similarly, if first year sales are in the middle or high range, then the second-years sales value is obtained by sampling the appropriate conditional distribution as shown by the arrows in the figure.
l-
Loss
/Expected
Value
60
\ 40 -
_ 20-
Expected Value: 12% ROI 50% Probability of 17% ROI or Better 28% Probability of 20% ROI or Better
The performance measures in Figures 4-7 were eagerly examined and discussed by the management team. The team wished to undertake further sensitivity testing, even though it was felt that the cash generation potential and the DCF return of the project were adequate.
__/’ _!20%
A_-” +10
0
-10
+20
1982
+
Percentage ROI
Figure 7. Overall discounted investment 1968-1981
return
on
A necessary input for the calculation of these probability profiles was the probability distributions of the important uncertain variables in the decision problem. Figure 3(a) show these assessments for the years 1968 and 1977. It is interesting that the distributions for 1977 are much more INPUT
VARIABLE
Figures 8 and 9 show the results of one form of sensitivity testing, that is the examination of the effects on rate of return as a result of percentile changes in each member of the set of uncertain variables. This sensitivity testing showed that the critical factors for success were the size of the synthetic market, the share of the synthetic market the new product is likely to obtain, the sales price of the final product, the variable costs and the financial resources involved in capital investment.
AVERAGE CHANGE IN VALUE OF VARIABLE 0
Size of Synthetic
Market
Share of Synthetic
Market
+ 13.63 millions of sq. ft
+ 2.84 per sq. ft
Variable
- 1.3@ per sq. ft
Building Investment
-49.5
Equipment
- 163.4 ($000)
Investment
Figure 8. Sensitivity analysis. Increase (50 percentile) for any input variable
IN ROI
1
3 I
tj
2
4 I
5
1.96%
+4.52%
Selling Price
Cost
INCREASE
in ROI
($000)
cj
2.24%
0.23%
caused by a 25 percentile
deviation
from
best estimate
Evaluating
INPUT
VARIABLE
Size of Synthetic
Market
714.46%
Selling Price
-2.96
7-j
Variable Cost
+2.196
Building Investment
+ 88.9 ($000)
Equipment
Market
Investment
Figure 9. Sensitivitv analvsis. Decrease (56 percentile) for any in&t variable
per sq. ft
+319.3
in ROI
per sq. ft
($000)
43
IN ROI
It was decided that attention should be focused very firmly on the objectives underlying diversification moves as well as the portfolio effects on the organization. Further re-analysis was considered necessary to aid formulation and it was felt that, in the meantime, the critical factors should be monitored and re-assessed. Such factors included the size of the synthetic market and environmental influences on the generation of competing products. It was decided, therefore, to postpone an irrevocable policy decision for several months, particularly given the high potential exit costs associated with failure of such a diversification move. In some ways, the greatest benefit of the analysis from its contribution seemed to come to organizational processes in terms of the reduction of controversy and the improvement of communication.
The Nature of the Strategic Dialogue of the role of strategic
3.79%
r-----j
3.73%
II
0.41%
El
caused by a 25 percentile
What this sensitivity testing achieved was the confirmation to many members of the management team that it was necessary to look even more closely at this new product decision situation. There was concern both about the realism of the problem assumptions and the influence of contingencies on policy diversifications into synthetic product areas.
should be recognition
in Acquisition
millions of sq. ft
- 3.62%
Share of Synthetic
There
DECREASE
AVERAGE CHANGE IN VALUE OF VARIABLE
-13.61
the Risks
1.31%
deviation
from
best estimate
risk analysis in the policy dialogue process. First, it was clear that the value of the iterative, cyclic process of dialogue was that it forced a morefoctlsed and of assumptions, scenarios questioning product/market concepts. It was decided, for example, that some extreme ‘what-if’ scenarios related to the growth of the synthetic market should be included in order that the team could examine and challenge project assumptions. Second, the value of sensitivity analysis3 lies in relation to its simplicity and the speed and economy with which it is undertaken. It can quickly highlight crucial uncertain areas and focus attention on contingency planning. It is, thus, a complement and a necessary adjunct to the application of risk analysis. Third, the dialogue process about six performance measures does no more than recognize that there is no single ‘best’ criterion, or set of criteria, by which strategic management of the firm’s strategic diversification should be handled. Rather it encourages all members of the management team to more fully understand policy alternatives before a choice decision had to be made.
Conclusion This strategic dialogue approach, supplemented by risk analysis, should be viewed as supportive of, and complementary to, an earlier paper5 emphasizing the value of risk analysis in the development of strategic thinking. The view put forward in this paper is that a
44
Long Range
Planning
Vol. 15
December
1982
useful measure of reconciliation amongst the various viewpoints in a management team can be achieved through a continuous policy dialogue involving analyses and assumptions. Risk analysis is presented, therefore, as a useful additional framework for understanding, formulating and resolving illstructured, complex policy and planning problems. Mason and Mitroff (1981, p. 302)6 put it another way : ‘In our view the task of policy, planning and strategy should not consist of attempting to demonstrate the superiority of one approach or framework for all situations but rather of mutual dependency. ... showing their
Whatever methods are used they should always strategic planning aid in challenging assumptions.’
References (1)
D. B. Hertz, Business
(2)
Rappoport,
Accounting
(5)
57,
169-l
and capital investment, Harvar, 81, September/October (1979).
D. B. Hertz and H. Thomas, Risk Analysis aandits John Wiley and Sons: Chichester (forthcoming).
(3) A. (4)
Risk analysis
Review,
Application:
Sensitivity analysis for decision-makiq pp. 441456, July (1967).
Review,
F. W. Gluck, S. P. Kaufman and A. S. Walleck, management for competitive advantage, Harvard Review, pp. 154-I 61, July/August (1980).
Strategi Busines
R. 0. Mason and I. I. Mitroff, Challenging Strategic Plannin, John Wiley and Sons, New York (1981).
Assumptions,
(6)
G. R. Wagner, Strategic thinking supported by risk analysis, Lon Planning, 13, 61-68, June (1980).
Range
0024-6301/82/060038~7$03.00/0 Pergamon Press Ltd.
Long Range Planning, Vol. 15, No. 6, pp. 38 to 44, 1982 Printed in Great Britain
Evaluating the Risks Acquisition David B. Hertz and Howard University of Illinois
This paper aims to illustrate
the role of strategic
Thomas,
Department
risk analysis in
the process of policy dialogue. An example of a new product diversification demonstrates the role of risk analysis in clarifying problem assumptions and in understanding the impact of uncertainty on decision-making. Risk analysis is seen as an adjunct and aid to problem formulation and resolution and not an end in itself.
Risk analysis’ 9’ was originally presented as a useful addition to the range of techniques used in financial evaluations. It was seen as a logical extension to sensitivity analysis3 and a means of explicitly taking account of uncertainty in financial forecasts. Thus, the proposition that risk and uncertainty were more accurately defined by a simulation of input variables was little questioned thereafter. Managements began to adopt some form of this procedure to examine some, if not all, significant investments where doubt existed about the risk levels involved. It was emphasized, however, that in the end managerial judgment would be required in both input estimation and decision. Although this approach was seen by many readers about methodology in to be an argument that was not the main investment appraisal, intention. Rather it was intended that it should be a cautionary note to businessmen to examine the data surrounding an investment proposal in the light of all the pervasive uncertainties in the world of which business is simply one part. Indeed, this message should have been emphasized and amplified as subsequent events have proved. seen as a planning
of Business Administration,
and thinking process.4 Namely, as an approach for forecast/uncertainty based planning (Stage II/III of Gluck’s four stages of strategic planning) in which an understanding of project risk, cash flow projections and future scenarios is developed. This paper has as its main aim the proposition that risk analysis can help strategic thinking by encouraging constructive dialogue and debate about the In such a dialogue process, risk policy options. analysis is seen as an input for the strategy development process which aids strategy formulation, evaluation, choice and implementation. In this view of the world, there is no distinction between strategic risk analysis and strategy formulation. Rather, analysis and formulation are parts of a policy dialogue process which is iterative, adaptive and flexible. This dialogue involves the consideration by management of problem and formulation through a continual repolicy examination of potential alternative strategies and problem assumptions. In subsequent sections, the role of strategic analysis in strategic problem formulation
1KEY ASSUMPTIONS
15-Year Calculations Straight-Line
l
Depreciation
R & D Prior to 1966 Not Included in DCF investments to be Made in 1967
The authors are members of Administration at the University Champaign, III 61820, U.S.A.
the Department of Illinois, 1206
of Business S. 6th Street,
Product Introduction
Figure
1
and Balance
for Discounted Cash Flow (DCF)
15 Years for Equipment 40 Years for Buildings
in 1968
risk and
1
1 O-Year Projections for Profit and Loss Statement Sheet
l
For example, risk analysis is increasingly necessary and useful adjunct to a strategic
in
Evaluating
the Risks
in Acquisition
(Annual Estimates 1968-1977)
SALES
(1) Size of Synthetic
Market
(2) Share of Synthetic
Market
r-4 1968-1977) ZOSTS (Annual Estimates
I
I
HISTOGRAM
I
/
14) $t+.J;yjz;:;
(5) Fixed Cost (a) Base Fixed Cost (b) Depreciation of Plant (Annual) = 2.5% of Building Plus 6.7% of equipment (6) Variable Cost per sq. ft. Total Variable Cost = (1) X (2) X (6) L
I HISTOGRAM
(7) Gross Profit = (4) Less (5) and (6)
(11)
Figure
R 81 D, Product
Planning Expense
Profit Before Tax = Gross Profit Less (81, (9) and (10)
2(a). Flow chart of the risk analysis
investment
(13)
Research and Development*
(14)
BUILDING”
(15)
EQUIPMENT*
(16)
Promotion*
(17)
Cash and Accounts Receivable** = 17% of Yearly Increase .in N Net Sales
(18)
Inventory** = 8% of Yearly Increase in Variable Cost
model
4 (19)
l
HISTOGRAM
Total Investment = The Sum of (13)-(18)
Expanded
During
1966-1967
** Beginning Year 1968
Figure
2(b). Investment
= (7)/(4)
(Annual Estimates 1968-1977)
EXPENSES
(10)
G;e$!J;it
II
(annual
estimates
1966-1977)
(20) b
IV
Net Cash Flow = Net Profit After Plus Depreciation Less (19)
Tax
39
40
Long Range Planning Vol. 15
December
evaluation is defined. This role is amplified with an example taken from strategic new product diversification and some conclusions are drawn.
Strategic Risk Analysis and Policy Dialogue The role of strategic risk analysis in policy formulation and choice should be to force hard thinking about the problem under consideration. That is, it should highlight what alternatives should be considered; should examine changing secondary effects and anticipate the nature and extent of the impact of uncertainty for contingency planning. Thus, it is recognized that an initial risk analysis is at problem no more than a first attempt understanding. It should encourage controversy and allow members of the decision-making group to find out where basic differences exist about
1982
problem assumptions, values and uncertainties. This controversy should enable critical comment and review to be obtained, and through policy dialogue force the re-analysis, re-examination and sensitivity testing of the problem solution. Thus, after considerable dialogue, the quality and level of debate about the problem should be improved. This should facilitate compromise and consensus around a reasonable problem solution. An example of the use of strategic risk and analysis follows, and insights gained summarized in the conclusions section.
New Project Example
Diversification
This case considers the decision problem faced by a U.S. chemical company about whether to invest in
Probability
Size of Synthetic Market (Millions of sq. ft.)
Share of Synthetic Market Venture can Obtain (Percentage)
Sales Price (Dollars per sq. ft.)
Variable Cost (Dollars per sq. ft.)
Buildings
!j!j?r
Investment (Thousands of Dollars)
Equipment Investment (Millions of Dollars)
Figure 3(a). Probability
distributions
of six significant and uncertain variables
-
1968
---
1977
Evaluating
the Risks
in Acquisition
41
a series of indicator variables or criteria, rather than in terms of a single rate of return, performance measure such as internal rate of return or net present value. In fact, six performance measures were suggested and each was calculated over its entire range of proba.ble values. The following measures were calculated for the indicated periods:
Correlated Sales in Successive Years Probability
total dollar
sales (1968-1977);
cash flow (1966-1977); -3
-2
-1
0
+1
+2
+3
+4
+5
+6
Percentage Change in Sales Level Next Year
gross profit as a percentage net profit
Conditional
Probabilities
of sales (1968-1977);
after taxes (1968-1977);
net profit as a return discounted
return
on investment
(1968-1977);
on investment
(1966-1981).
The probability profiles of some of these performance measures are presented in Figures 4-7. r
t 1968 Second Year
Figure
+
Figure 3(b). E xamples of correlated conditional probabilities
I 1969
I I 1971 1972
I 1970
-
Expected Values
I 1973
Range of 90% of Possible Outcomes I I I 1974 1975 1976 1977
4. Sales per year
sales and -
newly developed synthetic product. (Note: that the example and company are real although some of the chronological and assessment features of the problem have been disguised.) Management was faced with a seemingly attractive product, but was unsure about the longer-term competitive viability of the product. In particular, given the high capital investment requirements, there was concern about the decreasing prices of competitive products and the increasing possibilities of additional entries into the market.
Expected Values Range of 90% of Possible Outcomes
a
It was decided that a risk analysis evaluation of the new product opportunity should be undertaken. The key assumptions of the model are outlined in Figure 1 and the flow chart for the risk analysis model is shown in Figure 2. An important point to note is that management decided that they wanted the new product opportunity evaluated in terms of
L
1
I
I
I
I
I
I
I
I
I
1966 1967 1968 1969 1970 1971 1972 1973 1974 197519761!
Figure
5. Annual
77
cash flow 1968-1977
I
,
-
Expected values
I
Range of 90% of Possible Outcomes
I 8
Figure
1969
I 1970
I 1971
6. Net profit
I
I
1972
1973
as ROI
I
I
1974 1975
1968-1977
I 1976 1977
Long Range 100
80
F
Planning
Vol. 15
December
diffuse or ‘spread out’, confirming the proposition that the management team were uncertain about the future and had difficulty in confronting and assessing these future events. Figure 3(b) shows how this risk analysis model handled correlation effects. The figure shows how the procedure works in relation to correlated sales in successive years of the product’s life. In first years sales are sampled from the low range of the distribution, then the model samples a value for second year sales from the second year sales distribution assessed conditional on low sales in the first year. Similarly, if first year sales are in the middle or high range, then the second-years sales value is obtained by sampling the appropriate conditional distribution as shown by the arrows in the figure.
l-
Loss
/Expected
Value
60
\ 40 -
_ 20-
Expected Value: 12% ROI 50% Probability of 17% ROI or Better 28% Probability of 20% ROI or Better
The performance measures in Figures 4-7 were eagerly examined and discussed by the management team. The team wished to undertake further sensitivity testing, even though it was felt that the cash generation potential and the DCF return of the project were adequate.
__/’ _!20%
A_-” +10
0
-10
+20
1982
+
Percentage ROI
Figure 7. Overall discounted investment 1968-1981
return
on
A necessary input for the calculation of these probability profiles was the probability distributions of the important uncertain variables in the decision problem. Figure 3(a) show these assessments for the years 1968 and 1977. It is interesting that the distributions for 1977 are much more INPUT
VARIABLE
Figures 8 and 9 show the results of one form of sensitivity testing, that is the examination of the effects on rate of return as a result of percentile changes in each member of the set of uncertain variables. This sensitivity testing showed that the critical factors for success were the size of the synthetic market, the share of the synthetic market the new product is likely to obtain, the sales price of the final product, the variable costs and the financial resources involved in capital investment.
AVERAGE CHANGE IN VALUE OF VARIABLE 0
Size of Synthetic
Market
Share of Synthetic
Market
+ 13.63 millions of sq. ft
+ 2.84 per sq. ft
Variable
- 1.3@ per sq. ft
Building Investment
-49.5
Equipment
- 163.4 ($000)
Investment
Figure 8. Sensitivity analysis. Increase (50 percentile) for any input variable
IN ROI
1
3 I
tj
2
4 I
5
1.96%
+4.52%
Selling Price
Cost
INCREASE
in ROI
($000)
cj
2.24%
0.23%
caused by a 25 percentile
deviation
from
best estimate
Evaluating
INPUT
VARIABLE
Size of Synthetic
Market
714.46%
Selling Price
-2.96
7-j
Variable Cost
+2.196
Building Investment
+ 88.9 ($000)
Equipment
Market
Investment
Figure 9. Sensitivitv analvsis. Decrease (56 percentile) for any in&t variable
per sq. ft
+319.3
in ROI
per sq. ft
($000)
43
IN ROI
It was decided that attention should be focused very firmly on the objectives underlying diversification moves as well as the portfolio effects on the organization. Further re-analysis was considered necessary to aid formulation and it was felt that, in the meantime, the critical factors should be monitored and re-assessed. Such factors included the size of the synthetic market and environmental influences on the generation of competing products. It was decided, therefore, to postpone an irrevocable policy decision for several months, particularly given the high potential exit costs associated with failure of such a diversification move. In some ways, the greatest benefit of the analysis from its contribution seemed to come to organizational processes in terms of the reduction of controversy and the improvement of communication.
The Nature of the Strategic Dialogue of the role of strategic
3.79%
r-----j
3.73%
II
0.41%
El
caused by a 25 percentile
What this sensitivity testing achieved was the confirmation to many members of the management team that it was necessary to look even more closely at this new product decision situation. There was concern both about the realism of the problem assumptions and the influence of contingencies on policy diversifications into synthetic product areas.
should be recognition
in Acquisition
millions of sq. ft
- 3.62%
Share of Synthetic
There
DECREASE
AVERAGE CHANGE IN VALUE OF VARIABLE
-13.61
the Risks
1.31%
deviation
from
best estimate
risk analysis in the policy dialogue process. First, it was clear that the value of the iterative, cyclic process of dialogue was that it forced a morefoctlsed and of assumptions, scenarios questioning product/market concepts. It was decided, for example, that some extreme ‘what-if’ scenarios related to the growth of the synthetic market should be included in order that the team could examine and challenge project assumptions. Second, the value of sensitivity analysis3 lies in relation to its simplicity and the speed and economy with which it is undertaken. It can quickly highlight crucial uncertain areas and focus attention on contingency planning. It is, thus, a complement and a necessary adjunct to the application of risk analysis. Third, the dialogue process about six performance measures does no more than recognize that there is no single ‘best’ criterion, or set of criteria, by which strategic management of the firm’s strategic diversification should be handled. Rather it encourages all members of the management team to more fully understand policy alternatives before a choice decision had to be made.
Conclusion This strategic dialogue approach, supplemented by risk analysis, should be viewed as supportive of, and complementary to, an earlier paper5 emphasizing the value of risk analysis in the development of strategic thinking. The view put forward in this paper is that a
44
Long Range
Planning
Vol. 15
December
1982
useful measure of reconciliation amongst the various viewpoints in a management team can be achieved through a continuous policy dialogue involving analyses and assumptions. Risk analysis is presented, therefore, as a useful additional framework for understanding, formulating and resolving illstructured, complex policy and planning problems. Mason and Mitroff (1981, p. 302)6 put it another way : ‘In our view the task of policy, planning and strategy should not consist of attempting to demonstrate the superiority of one approach or framework for all situations but rather of mutual dependency. ... showing their
Whatever methods are used they should always strategic planning aid in challenging assumptions.’
References (1)
D. B. Hertz, Business
(2)
Rappoport,
Accounting
(5)
57,
169-l
and capital investment, Harvar, 81, September/October (1979).
D. B. Hertz and H. Thomas, Risk Analysis aandits John Wiley and Sons: Chichester (forthcoming).
(3) A. (4)
Risk analysis
Review,
Application:
Sensitivity analysis for decision-makiq pp. 441456, July (1967).
Review,
F. W. Gluck, S. P. Kaufman and A. S. Walleck, management for competitive advantage, Harvard Review, pp. 154-I 61, July/August (1980).
Strategi Busines
R. 0. Mason and I. I. Mitroff, Challenging Strategic Plannin, John Wiley and Sons, New York (1981).
Assumptions,
(6)
G. R. Wagner, Strategic thinking supported by risk analysis, Lon Planning, 13, 61-68, June (1980).
Range