Sunday, January 15, 2006

Expect the unexpected

Decision-makers must allocate resources despite the lack of sufficient information about the future. For example, even after conducting rigorous analysis of the profit potential and likely competitive position of entering a new market, a company may be blindsided by an important outcome that it had not anticipated. Therefore, decision-makers should consider alternative scenarios of how the future might unfold and focus attention on the likelihood of different outcomes before allocating resources.

Scenario and uncertainty analysis are important because they help decision-makers anticipate the most significant risks to achieving the outcomes of a potential strategy. By anticipating these risks and considering how they might change their strategy in response to them, decision-makers can increase the chances that their strategy will succeed. Furthermore, by assessing the likelihood of various scenarios, executives can invest their planning time in accordance with their relative likelihood – placing more emphasis on the more likely scenario(s).

In 1982, the Consumer Electronics Group at Philips NV was facing a decision about whether to build a plant in the US in 1983 to satisfy potential demand for CDs or to import the CDs from Europe in 1983 and possibly build a plant in the US in 1984, depending on the demand. Philips considered two scenarios: (1) US demand for CDs built up slowly and (2) US CD demand grew quickly. Under scenario 1, the most profitable option would be to import the CDs in 1983 and under scenario 2, the most profitable option would be to build the plant in 1983 in order to gain economies of scale and preempt competitive entry with a lower cost position. Based on its estimate that scenario 1 was more likely to occur as well as the revenues and costs of the two options, Philips decided to wait a year. Unfortunately for Philips, demand growth was much more rapid than Philips had anticipated and it missed a significant opportunity.

Decision makers should develop scenarios that differ from their consensus expectations. Since they may be less influenced by the decision-makers’ perspectives, it often makes sense to involve outsiders in constructing these alternative scenarios. Similarly, outsiders can help in estimating the costs and benefits of various options considered under the alternative scenarios.

As the Philips CD case illustrates, such efforts do not always yield the expected outcomes. However, by taking the time to think about them, decision-makers may be better prepared to tackle unexpected outcomes.

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