Michael Mainelli, The Z/Yen Group
[A version of this article originally appeared as"Techniques: The Soft Path to the Future", Strategy,The Strategic Planning Society (March 1999) pages 16-18.]
Do We Need the Eggs?
Analytical studies repeatedly show that external observers are incapable of distinguishing the performance of firms which use popular strategic planning techniques from those which do not use strategic planning. Strategic planning cannot be proved to work, yet we still do it. There is an old joke that Woody Allen uses to explain the inevitability of amorous relationships: "Doctor, my brother thinks he's a chicken. Can you help?" "Why don't you stop him?" "We need the eggs!" Perhaps we undertake strategic planning because we need the eggs. Risk/reward philosophy is a way of looking at strategic planning and realising what we knew all along - we undertake strategic planning to help us feel better about the future.
Chance and Circumstance
The origins of risk/reward philosophy lie in risk management, an approach which surfaces in fields as diverse as banking, health, insurance, engineering and project management. The common core of risk management is the identification of risk, the handling of risk and the tracking of risk. The techniques used in risk management are similar from field to field - risks are the probability of an adverse occurrence; risks can be measured by severity and likelihood; risks can be accepted, avoided, mitigated or transferred. Risk management as a discipline has assembled a set of powerful tools culled from a variety of disciplines - actuarial tools, engineering tools and simulation tools. Risk management has been gaining in popularity. Books, seminars and courses abound; The Institute of Chartered Accountants in England and Wales (ICAEW) has issued "Business Risk Management" (January 1997); naturally, there is an Institute of Risk Management.
Risk management is a system of control, not a strategic perspective, even less a holistic approach to strategic thinking; nor have risk managers made such claims. Risk management is focused on the negative, how to minimise what could go wrong. To draw an analogy with SWOT (strengths, weaknesses, opportunities and threats) analysis, risk management is only concerned with weaknesses and threats. Risk management needs to be balanced by reward management, how to enhance what could go right. Risks and rewards are therefore measured in terms of likelihood of positive and negative impact on the organisation's objectives. In short, when risks are better understood, more risks can be undertaken. However, there is no point in undertaking more risks without increasing rewards - we call it "enchancing" the organisation. Many traditional management tools and techniques are intended to identify rewards clearly and enhance them, e.g. management information, shareholder value added, appraisals, remuneration and even strategic planning, but reward management is not yet an integrated set of techniques.
Risk/reward philosophy began ten years ago when some strategists toyed with defining strategy as a set of risks and rewards that the organisation was prepared to accept, originally as a means of constructing an organisational genotype for genetic algorithms. The resulting definition of an organisation, "an entity pursuing a set of goals which controls resources and owns a set of risk/reward contracts, both explicit and implicit, with other entities and the environment", found real use as a means of integrating tools within a strategic planning methodology. Sets of risk/reward contracts are probably best visualised as a set of probability distribution functions which encapsulate the potential future of the organisation. Risk/reward philosophy has become the "love of knowledge" of risks and rewards and the intellectual quest involved in understanding them.
Gambling on Views
People solve problems by looking at them from particular viewpoints. From some viewpoints, problems are more difficult, or impossible, to solve; from others, easier. Today's risk is tomorrow's reward; tomorrow's reward is today's risk. Risk/reward philosophy recognises the duality. A potentially world-beating new product (full of rewards) is also a potential flop (risks). A potentially weak distribution network (risk) may hasten moving to the internet (reward). Risk/reward philosophy provides a meta-viewpoint and meta-methodology for successfully solving organisational problems at all levels, from the strategic to the mundane, within an integrated framework. Risk/reward problems have included, amongst others, process re-engineering, performance improvement, private finance initiatives, culture change, fraud reduction and systems reviews.
To illustrate sets of risk and reward contracts, imagine two family firms, Tough and Friendly, engaged in supplying food to the catering industry. Assume that both firms have survival as a first objective and providing the family with income and employment as a second. One has an aggressive negotiation style with suppliers; the other is friendly and sometimes does not obtain the keenest prices for inputs. One runs its own delivery fleet; the other sub-contracts all deliveries. One pays staff by piecework; the other pays a salary. The example can continue, but already there are two distinct sets of risk and reward contracts. In practice, much of the content of these contracts will remain unspecified. For instance, Friendly may believe that it has an implicit contract with suppliers for extra service when times are hard. This belief may be expressed as a probability distribution function of creditor days or a function of crucial deliveries, but almost certainly does not exist in contract. Tough may believe it obtains lowest cost. This belief may be expressed as a probability distribution function of costs. Friendly may believe it can avoid or share fixed costs when times are hard. Friendly may be expecting loyalty while Tough may feel that it can correlate piecework pay with overall performance. These risk and reward contracts, mostly implicit, are built upon the perceptions of those people running the firms, certainly at the top, but to some degree throughout the firms. The distribution of resources on risk and reward contracts will vary as well. Friendly probably worries more about margins from its suppliers. Tough probably spends more time managing deliveries, fleet purchases, fuel costs and repairs.
A number of organisational concepts benefit from risk/reward re-definition. Culture has been defined as "the way we do things around here". This definition lacks rigour in both how culture change is achieved (just doing it differently might be sufficient) and the objectives of culture change (just to do it differently is a weak justification for change). Risk/reward philosophy focuses on a definition of culture as "the way we decide to do things around here using a common set of risk/reward beliefs". The risk/reward ethos of the organisation is captured in the common set of risk/reward beliefs shared at all levels of the organisation. For instance, it would be expected that Tough and Friendly would have different cultures. Decisions might be made in one firm against a principle of "friendly and fair", in the other firm on "tough and efficient". If "friendly and fair" were re-developed during a strategic planning exercise into "friendly, but tough", the objective of the change would not be just to do things differently, but to affect all subsequent decisions by using the implicit risk and reward beliefs inherent in the new phrase. Throughout the organisation, decisions from pay to press contact should be made by different people in line with the common set of risk/reward beliefs - a culture. Risk/reward philosophy anticipates sub-cultures. The sets of risk/reward beliefs within the accountancy functions of both firms will have elements in common, e.g. the risk of losing track and the reward of accuracy would be stronger than elsewhere, yet perhaps retain some of the overall firm culture, e.g. "friendly, but tough" credit control versus "tough and efficient" credit control.
Systems thinking, hard and soft, underpins risk/reward philosophy. Risks and rewards need to be subject to both feed-back control and feed-forward control (anticipation). Systems, and sub-systems, need to be constructed in order to develop, implement and control risk/reward beliefs. The methodology deployed in risk/reward philosophy shares a virtually identical approach to that used in general problem-solving systems, e.g. Checkland, only the tools used may be different. A typical risk/reward approach to strategy may help illustrate the philosophy more concretely.
A government organisation looked for a strategic planning approach which recognised that many popular planning tools only partially applied to them. A risk/reward strategic planning methodology was chosen as the way forward, a team assembled and a six phase plan developed using the Z/EALOUS risk/reward methodology:
Environment phase: the team confirmed their objectives, the organisation's mission, goals, values and beliefs and the overall shape of the risk/reward envelope for the organisation, e.g. public sector values, private sector involvement. The team also developed some generic risk/reward `trees' (cascading sets of risk/reward structures) from research on similar organisations.
Analysis phase: a variety of strategic planning tools, e.g. Porter's five forces, BCG models and factor analysis, were used with the simple aim of finding the risk/reward issues which affected the organisation achieving its mission. The tools were issue generators. All issues were valid, even though on later ranking of severity and likelihoods they might recede in importance. A unique risk/reward tree was built for the organisation. Political risk was the root risk in the tree.
Likelihood phase: the issues (40 to 50 major ones) were categorised as risks or rewards. Risk/reward issues were also reversed (risks became rewards and vice versa) to determine the full shape of the distribution function, as perceived by senior managers. Where the senior managers diverged, or felt that they had too little substance to support their opinions on an issue, further research was commissioned. Taking the final set of issues and their distribution functions, a Monte Carlo simulation was run, combining the risks and rewards with their severities and likelihoods, and identifying those which had the greatest impact on the organisation either achieving or failing in its goals.
Option phase: for each issue, a variety of actions were developed. Likewise, a variety of actions, which senior managers hoped to achieve, e.g. Investors in People, were correlated, if possible, with risk/reward issues. Options were ranked on categories such as impact, certainty, safety/regret and ease.
Understanding phase: both the risk/reward issues and the options for addressing them were then subjected to finding the `twist', i.e. a way of succinctly expressing the issues and options which revealed their underlying essence. In the case of the risk/reward issues, the twist was a short tale describing the scenario of the organisation. For the options, the twist was an easily remembered five-point strategy which subsumed almost a hundred actions.
Sharing phase: the issues were shared with the organisation and its stakeholders. The actions were partially re-discovered, partially re-worked with the stakeholders, including more junior management. The strategy was implemented as both a hard system, i.e. corporate plan and objectives, and a soft system, i.e. culture change to achieve greater unity in both risk/reward beliefs and their priorities. Strategy and tactics became an unnecessary dichotomy. Strategic actions addressed the highest risks and rewards, regardless of whether those risks and rewards were immediate or long-term. If the loss of ministerial support threatens survival, then that is more strategic than corporate reorganisation. Results, both successes and failures, were tracked and fed into the subsequent year's planning cycle.
Julius Caesar might have conquered all strategic planning projects with "venimus, cogitavimus, scripsimus" (we came, we thought, we wrote it up). Distinctions between the example in the paragraph above and other strategic planning exercises can be difficult to discern, but do include:
realising that organisational goals may not be solely, or even partly, commercial, but that risks and rewards must be assessed against all goals;
blending qualitative and quantitative risks and rewards - in practice this has included bond default rates being combined with trader risk perceptions or agricultural fraud rates being combined with perceptions of prosecution Simulations such as Monte Carlo, real options, genetic algorithms or portfolio maximisers may include subjective perceptions as much, or more than, quantitative data;
recognition that risks are rewards, and vice versa, typically encapsulated in risk/reward trees, and that these risks and rewards may be multifarious, reflecting the complexity of living organisations and their environments. Risks and rewards can also be assumed passively - not just what we have decided to do, but what we have decided not to do;
using a variety of tools within a meta-methodology: most common strategic tools can be used for generating risk/reward issues. Scenario planning works particularly well with risk/reward philosophy, both helping to flush out issues, but also to integrate risks and rewards within a framework people can remember;
blending hard and soft systems: realising that 'twist' is essential to gaining acceptance by people. Dysfunctional systems are those where risks and rewards are mis-aligned, either internally or externally within a larger system.
Risk/reward philosophy can be over-rated as an insight. Old saws - "nothing ventured, nothing gained", "you have to speculate to accumulate" - show that this is not a new premise. Risk and opportunity feature in the introductions to many textbooks in business studies, but at the same time many business texts obscure the fundamentally chancy nature of the firm in a welter of mostly unconnected theories. Risk, where it pops up explicitly, is often a number which is calculated as an offset to some bond rate and plugged into an option-pricing model such as Black-Scholes. Rarely is risk mentioned as the day to day life of the manager. Even less frequently is reward mentioned as part of a manager's daily routine. Decision theory brings together many of these concepts, but too often solely for large, quantifiable projects. Almost never is the manager's daily quota of decisions linked with the organisational strategy, risks and rewards cascading down from the strategic plan and flowing back up to affect the management team. Risk/reward philosophy has some problems. The highly emotive word `risk' can leave the false impression that uncertainty should be minimised. Some organisations cannot hold the open debate which is necessary for sharing risk/reward perceptions. Risk/reward can be over-intellectualised. Risk/reward is not an approach which promises quick fixes and is therefore unsuitable to some types of manager.
The key benefits of using a risk/reward philosophy for strategic planning are:
culture - risk/reward philosophy develops empowering, performance-enhancing information, process and reward systems aligned with the organisation's risk/reward, the organisation's people and their beliefs;
integration - risk/reward philosophy integrates active and passive; emergent and directive; strategy and tactics. Risk/reward works with imperfect information and directs quantitative work to the areas of highest potential return, not just the most easily available numbers. The organisation develops a commonly used set of techniques, building the stock of decision-making knowledge and unifying organisational analytical effort;
dynamism - the focus on decision-making, as well as the ability to cascade risk/reward sets both up and down the organisation, permits decisions to be made separately in different parts of the organisation while increasing the likelihood that separate decisions are complementary;
robustness - changes in risk/reward perceptions through new information or new ways of analysing the environment invigorate the strategy rather than destroy a fragile intellectual edifice. The strategy needs to be reviewed when risks or rewards change, not just on an artificial calendar cycle.
One overall benefit is holism, looking at the organisation in its entirety. The paradoxical nature of complex organisations is that decisions which make the biggest difference are often the most subtle to perceive and enact, for instance focusing on the customer or promoting continuous innovation. How can the benefits of risk/reward philosophy be measured? To paraphrase the advertising conundrum of John Wanamaker or Lord Leverhulme (a bit of uncertainty in attribution) - "I know that half of my strategic planning is wasted; the problem is that I don't know which half". Actually, the problem is worse. While firms which advertise will be better known; firms which plan may not be better planned organisations. Strategic planners are beginning to realise that philosophies, such as risk/reward, can be measured by how well they help people in the organisation cope with the future - not through prediction, not through control, but through softer measures such as confidence and shared goals.
Risk/reward philosophy helps strategic planners reduce the risk of failure on strategic planning exercises while enhancing their rewards - risk/reward enchancement of strategy.