by Juergen H. Daum

How scenario planning can significantly reduce strategic risks and boost value in the innovation value chain

News categories: the New Economy Economics, strategic enterprise management and business performance management, value based management

Traditional industrial value chains no longer dominate value creation in the developed economies. Today it is innovation, it is the seeking of new ways for meeting market demand, that is yielding the highest return on investment - much more than improving incrementally a company’s existing production line. As a consequence, companies in nearly all industries have to invest into systematic innovation and related intangible assets like R&D capabilities. The problem with such investments is that the investment-return cycle is often very long and subject to many external influences, such as changes in the market, of customer preferences, or of technology. And such influences can have a dramatic impact on the value of these investments. Innovation investments are therefore usually associated with large inherent risks. When a pharmaceutical company starts to develop a new compound it does not know if these typically very large investments will generate any benefit in the future. So, success is dependent on many factors – internal factors such as the skills and knowledge of researchers and developers, and external influences such as technology trends, demand and price developments.

From stock options valuation we know, that the higher the risk, the higher the possible return. And the value of a stock option can be exponentially increased if you are able to limit the downside, the inherent risk. There exists also a second value lever, which is the identification and leverage of sudden opportunities. And one very powerful technique to limit risks from external influences and to identify future opportunities is scenario planning.

What is scenario planning ?

Scenario planning is a discipline for rediscovering

the original entrepreneurial power of creative foresight

in contexts of accelerated change, greater

complexity, and genuine uncertainty.

—Pierre Wack, Royal Dutch/Shell, 1984

To manage risks related to innovation investments that extend long into the future, managers must be willing to look ahead and consider uncertainties. But rather than doing that, many people react to uncertainty with denial. They take an unconsciously deterministic view of events. They take it for granted, that some things will or will not happen. Not having tried to foresee surprising events, they are at a loss for ways to act when upheaval takes place. Scenario planning is a tool for helping managers to take a view into the future in a world of great uncertainty. It is a tool to manage strategic risks and opportunities.

Scenario planning is the process in which managers invent and then consider, in depth, several varied scenarios of equally plausible futures with the objective to bring forward surprises and unexpected leaps of understanding. These scenarios represent a tool for ordering the perceptions of a management team. The point is not to select one preferred future and hope for it to become true. Nor is the point to fund the most probable future and adapt to it. Rather, the point is to make strategic decisions that will be sound for all plausible futures. No matter what future takes place, a company and its management team is much more likely to be ready for it and influential in it, if it has seriously thought about scenarios. Scenario planning is about making choices today with an understanding of how they might turn out.

The history of scenario planning

The scenario planning concept first emerged following World War II, as a method for military planning. The U.S. Air Force tried to imagine what its opponents might do, and to prepare alternative strategies. In the 1960s, Herman Kahn, who had been part of the Air Force effort, refined scenarios as a tool for business prognostication. He became one of America’s top futurist. Then scenarios reached a new dimension in the early 1970s, with the work of Pierre Wack, who was a planner in the London offices of Royal Dutch/Shell in a newly formed department called Group Planning. Pierre Wack and other planners were looking for events that might affect the price of oil. And they found several significant events that have been in the air. One was, that the United States was beginning to exhaust its oil reserves. At the same time American demand for oil was steadily rising. And the emerging Organization of Petroleum Exporting Countries (OPEC) was showing signs of flexing its political muscle. Most of these countries were Islamic, and they bitterly resented Western support of Israel after the 1967 six-day Arab-Israeli war. Looking at this situation, the planning team realized that Arabs could demand much higher prices for their oil and there was every reason that they would. The only uncertainty was when. It seemed likely to happen before 1975 when old oil price agreements were due to be renegotiated. So Pierre Wack and his team wrote up two scenarios – each a complete set of stories about the future, with tables of projected price figures.

The first story presented the usual opinion at Shell: that the oil price would stay somehow stable. But in order for that to happen, a miracle would have to occur. New oil fields, for example, might have to appear in non-Arab countries. The second scenario looked at the more plausible future – an oil price crisis sparked by OPEC. But after they have presented these scenarios to Shell’s management, there was no change in behavior happening. The managers understood the implications, but no change in behavior came. So Pierre Wack went one step further and described for the scenarios the full ramifications of possible oil price shocks and he tried to make people feel those shocks through the scenario. He warned management, that the oil industry might become a low growth industry, that OPEC countries would take over Shell’s oil fields. They described the forces in the world, and what sorts of influences those forces had to have. This was when scenario planning for businesses was born. It helped Shell’s managers to imagine the decisions they might have to make as a result. And it was just right in time. In October 1973, after the Yom Kippur war in the Middle East, there was an oil price shock and of the major oil companies, only Shell was prepared for the change. The company’s management responded quickly and in the following years, Shell moved from one of the weaker of the seven large oil companies that existed at that time to the second in size and the number one in profitability.

So to operate in an uncertain world, managers need to be able to question their assumptions about the way the world works, so that they could see the world more clearly. The purpose of scenario planning therefore is, to help managers to change their view of reality, to match it up more closely with reality as it is, and reality as it is going to be. The end result, however, is not an accurate picture of tomorrow, but better decisions about the future.

Key Topic: Moving Beyond Fixed Annual Budgets

“Fixed budgets don’t work today. A budget is a too static instrument and locks managers into the past - into something they thought last year that it was right. To be effective in a global economy with rapidly shifting market conditions and quick and nimble competitors, organization have to be able to adapt constantly their priorities and have to put their resources where they can create most value for customers and shareholders. In order to do that, they need the right concepts, management processes and tools – concepts such as the Beyond Budgeting Management Model. The introduction of new management instruments such as the Balanced Scorecard, which help to better align the entire organization with corporate strategic objectives and to focus it on the essentials, has created the right foundation. Because if corporate strategy and the objectives are clear for all people in an organization, one can principally react faster to changing market conditions. But then the fixed budget comes into their way and prevents them from really doing the right things. Though what is often missing is a more flexible operational planning and control model. The Beyond Budgeting model wants to fill exactly this gap.”
Juergen H. Daum

New! - visit J.H.D.'s Beyond Budgeting Info Center
- including latest BB insight materials, interviews with BB pioneers etc. - here an extract:
| J.D.'s insight article "Beyond Budgeting" | Interview with Lennart Francke, CFO of Svenska Handelsbanken | Panel Discussion with Borealis, Nestlé, and Unilever | Interview with Jeremy Hope – co-founder of the Beyond Budgeting Round Table | Interview with J.D. on finance and IT |

How the does the scenario planning process work ?

Peter Schwartz, an expert in scenario planning, described this scenario planning technique in his book: The Art of the Long View (New York: Currency Doubleday, 1996). The book is an excellent description of the scenario planning concept including many case studies and examples. The rough concepts goes like this:

Step1: Uncovering the decision

Management has to understand its choices. For this it has to know, what will be “on the agenda”. For each company decisions loom in the near or immediate future. Management’s responses to them will determine much of its future performance and survival. So in the first step these strategic decisions that might have to be made in the future have to be uncovered. This is done by asking the right questions related to the mission and business purpose of a company such as: where is our industry going? What is the path of development of our industry ? What events might influence it and will force us to change ? Under which circumstances might we become incredible successful, under which circumstances will the company be at risk ? It takes persistent work to penetrate the internal mental defenses of human beings. Therefore this task includes examination of existing mind-sets of managers, so that prejudices and assumptions become obvious, and careful thinking whether those mind-sets would keep these managers from seeing the right future. The best way is to begin with important decisions that have to be made anyway and then built out to the environment. This step also should include an identification of the key factors of the business system influencing the success or failure of the decision.

Step2: Information-hunting and –gathering

To create scenarios, stories, that resonate in some ways with what people already know and leads them from that to question their assumption of how they see the world, observations from the real world must be built into the story. The scenario process thus involves research – skilled hunting and gathering of information. This is practiced both narrowly – to pursue facts needed for a specific scenario – and broadly – to educate the scenario planner, so that he is able to pose more significant questions. Flexibility of perspective is critical in doing it. The scenario planner has to simultaneously focus on what matters in a given decision situation, but keep awareness open for the unexpected. Because some research subjects emerge again and again in the work of a scenario planner, some planners recommend to move along these typical topics during research before looking for others. Such typical topics are: science and technology developments; perception-shaping events, that shape or change the perception of the public; new ideas that emerge in the “fringes” (that means not in the mainstream) and are spreading further.

Step3: Identifying the driving forces of a scenario

The first task in building the scenario itself is to look for driving forces, the driving forces of the macro-environment that influence the key factors identified earlier. For example government regulations might influence them. But beside government regulations, there are many less obvious external factors as well. Identifying and assessing these fundamental factors is both the starting point and one of the objectives of the scenario method. Driving forces are the elements that move the plot of a scenario, that determines the story’s outcome. Driving forces often seem obvious to one person and hidden to another. Therefore the identification of driving forces should be done in a team, by brainstorming together. By looking on such driving forces, it is helpful to run through this common list of categories of driving forces: social forces/demographic developments, technological developments, economic developments and events, political developments and events, environmental developments. Normally, companies have little control over driving forces. Their leverage for dealing with them comes from recognizing them, and understanding their effect.

Step4: Uncover the predetermined elements

Predetermined elements are developments and logics that work in scenarios without being dependent on any particular chain of events. That means, a predetermined elements is something, that seems certain, no matter which scenario come to pass. For example the most commonly recognized predetermined element is demographics, because it is changing so slowly. For example the Soviet Union experienced a sharp decline in births during and immediately after World War II. One generation later, in the 1960s and 1970s, that original “baby bust” was echoed by an even greater decline than we saw for example in the U.S.. In the mid-eighties therefore the U.S.S.R. experienced a decline in its labor force as fewer and fewer young people came of age. This might have induced its economic breakdown which has lead to its political breakdown. Since the 1960s and 1970s, the decline in labor force in the U.S.S.R. in the mid eighties was a predetermined element. Identifying such elements is a tremendous confidence builder in strategic decision making. Managers can commit to some policies and feel sure about them. There are several useful strategies for looking for predetermined elements. For example you could look for slow-changing phenomena like the growth of populations or the building of physical infrastructure. You could look for constrained situation, where companies, nations or even individuals have, at least for a certain time, no choices. Look for “in the pipeline” effects. Today we already know what the teenage population in Germany in the 2000s will be. All of them are born already and are already “in the pipeline”.

Step5: Identify critical uncertainties

In every plan critical uncertainties exist. Scenario planners seek them to prepare for them. Critical uncertainties are often related to predetermined elements. You find them by questioning your assumptions about predetermines elements and chains of predetermined elements. For example consider the publishing industry of a specific country. The readership population is mostly predetermined – it depends on demographics. Literacy is also a crucial element to estimate demand, but it is far from predetermined. It depends on decisions made by government, on its education policy in the next years. Thus, the quality of education now will influence the print media market in the next twenty years. So critical uncertainties are the variables in scenario planning and are the basis to create different scenarios in parallel. One method to identify the most important critical uncertainties is, to rank key factors and driving forces on the basis of two criteria: first, the degree of importance for the success of the focal issue or decision identified in step one; second, the degree of uncertainty surrounding those factors and trends. The point is to identify the two or three factors that are most important and most uncertain. These factors are forming then the basis for the different scenarios, because the goal is to end up with just a few scenarios whose difference make a difference to decision-makers.

Step6: Composing scenarios

To explain the future, scenarios describe how the driving forces might plausibly behave, based on assumption of predetermined elements and critical uncertainties. To describe the different scenarios, their plots, you use the uncertainties that have seemed so important. For example for the publishing industry, two scenarios may be created, depending on the degree of literacy. In scenario one, a large number of literate people spend some of their time reading. Scenario two is the opposite: people become more oriented to television and radio because reading is unable to hold their attention. But there is also a third possible scenario – even faster growth for print media, because more people spend their time with a variety of media, including the Internet, which mutually reinforce each other. So driving forces, predetermined elements, and critical uncertainties give structure to the exploration of the future. To create the scenario stories, the plot lines, the recommendation is, to bring a team together that is aware of the decision that is considered. Each member of the scenario planning team has done his or her research. Then they sit together talking and developing ideas in response to the questions: What are the driving forces ? What we feel is uncertain ? What is inevitable ? How about this or that scenario ? The goal is to select plot lines that lead to different choices for the original decision. The challenge is to identify the plots that best captures the dynamics of the situation and communicates the point effectively. The scenario writer’s task is then, to define the forces inside and outside the company, and analyze which plots they fit. Having gathered the variations that are possible, the scenario writer would tease out five or six variations that fit the case. Eventually he or she narrow and combine those into two or three fully detailed descriptions of what might happen – the scenarios.

Step7: Analysis of implications of the decisions according to scenarios

Once the scenarios have been developed in some detail, then it is time to return to the decision identified in step one. How does the decision look in each scenario ? What vulnerabilities have been revealed ? Is the decision or strategy robust across all scenarios, or does it look good in only one or two of the scenarios ? If a decision looks good in only one of several scenarios, then it qualifies as a high-risk gamble, especially if the company has little control over the likelihood of the required scenario coming to pass. The question what should be discussed then by management is, how the strategy should be adapted to make it more robust if the desired scenario shows signs of not happening.

Step8: Selection of leading indicators and signposts

It is important to know as soon as possible which of several scenarios is closest to the course of history as it actually unfolds. For that, as soon as the different scenarios have been finished and their implication for the decision determined, then a few indicators should be selected, to monitor the strategy or decision in an ongoing way. Monitoring these indicators will allow a company to know what the future holds for a given industry and how that future is likely to affect strategies and decisions in the industry. If the scenarios have been carefully developed, then the scenarios will be able to translate movements of few key indicators into an orderly set of industry-specific implications. The logical coherence that was built into the scenario will allow logical implications of leading indicators to be drawn out of the scenarios.

Summary

Risks associated with investments into intangibles, especially of investments into the strategy and in the product innovation chain of a company, is much higher than in traditional industrial physical asset type of investments. But on the other hand the upside is often unlimited. So businesses which are engaged in R&D and continuous product and market innovations must find ways to limit the downside, the risks, and to boost the upside in order to fully leverage their investments and to generate value for investors and other stakeholders. In order to do that, they have to tap into tacit information that is already available within or outside the company and to convert it into knowledge about possible future scenarios and options the company has, to react before unfavourable events take place. And scenario planning is a very good method to do that and to limit especially large strategic risks.

Key Topic: Managing Intangible Assets

“The importance of intangible assets, the immaterial value of companies such as relationships with business partners, brand awareness and new business ideas, but also know-how, corporate culture, and the ability to innovate, has greatly increased in the last two decades. One clear indication of the trend is that the portion of a company’s total market value that exceeds its book value has increased from 40 percent of in the early 1980s to over 80 percent at the end of the 1990s. Unfortunately traditional accounting and management instruments are not able to capture these new values and report on them. But what you can’t measure, you cannot manage ! At the beginning of the 20th century, industrial mass production served as the motor to generate value; this required more complex cost accounting, beyond the abilities of previous accounting practices, to enable management to control and optimize these new value creation processes. In the same way, we must now expand accounting, controlling- and management systems to a new level, to enable companies to optimize, manage and report on today’s new value creating activities and processes”.

Juergen H. Daum

visit: Intangible Assets and Value Creation (J.H.D.s thoughtleading book)
J.D.'s Insights Article "Value Drivers Intangible Assets" | Interview with J.D. on Intangibles | A European Peer Discussion…| Intangible Assets and Intellectual Capital Management | Interview with David Norton | Interview with Leif Edvinsson | Interview with Baruch Lev |

Additional resources (updated May 2008):

Business 2015 and the Role of Finance - Some "Food for Thought" - presentation from Juergen H. Daum, held at the 9th European SAP CFO Roundtable, 30 May 2008 in Barcelona, Spain (agenda), referring to scenario planning as the cornerstone of strategic enterprise management next practice.

More information about scenario planning can be found at the website of GBN Global Business Network.

Additional books about scenario planning and more forward looking management techniques can be found in Juergen Daum’s book store, section “The learning and adaptive organization”.

Introduction to Shell Global Scenarios to 2025 by Jeroen van der Veer, Group Chief Executive Royal Dutch/Shell Group

Enterprise Management, Leadership and Business Control for Value Creation
- presentation from Juergen H. Daum, held at the Executive Briefing on Performance Measurement of the Centre for Business Performance, Cranfield School of Management, 27 January 2004 in London, UK program of the briefing

Performance Management and Business Controlling in the 21st Century (Presentation held by Juergen Daum at SAP's European mySAP Financials Conference, June 2002, Strassbourg / France) deutsche Version

Approaching the next level of shareholder value management - basics (part 1) – article by Juergen Daum

Approaching the next level of shareholder value management – the art of corporate performance management (part 2) – article by Juergen Daum

New Accounting for A New Economy (an article from Prof. Baruch Lev)

A Guideline For Intellectual Capital Statements (Result of a research program of the Danish Agency for Trade and Industry where 17 Danish companies have contributed)

Intangible Assets: The Art of Creating Value - in an interview with sapinfo.net Jürgen H. Daum explains the limitations of our traditional management tools in our economies of today and why an overhaul is necessary

Juergen Daum's Beyond Budgeting Information Center - the knowledge economy of today requires companies to find a new approach to operational enterprise management and control beyond the inflexible budgeting and a command and control model

Intangible Assets and Value Creation (Wiley, 2002) – a book by Juergen Daum, focusing on a new enterprise model and on the new management system “beyond budgeting” for the new knowledge and intangible assets based economy of today, comprising many examples and case studies. It describes the new environment and its consequences for businesses, the rules that can be extracted from this understanding for the design of a new management system, and it develops a framework for a new management system and describes its elements, as well as how a company can set it up and bring it to live.
More about this book…