Supply Chain Frontiers issue #55
How do you make capital-intensive decisions—such as building a production plant, automating a distribution center, or buying a fleet of electric trucks—that you will live with for a few years, when some factors that affect the decision’s outcome are uncertain and difficult to predict?
Uncertainty in the business environment is one of the biggest challenges faced by today’s executives. We possess tools for managing operational uncertainty (e.g., variation in process yield, travel times, retail demand): it can be characterized statistically using historical data and mitigated using mechanisms such as safety stocks and excess capacity. However, uncertainty in the factors relevant for capital-intensive decisions (e.g., viability of a new production process, health of economy in major markets, regulations about fuel efficiency, etc.) is much harder to model using historical data because the past may not be a reliable guide for the future in a rapidly evolving business environment.
Without a systematic approach, such decisions are often made using the “gut instinct” or “experience” of senior executives. However, human judgment is known to be biased: executives may be overly optimistic about the future business conditions or too sensitive to perceived threats. Given the importance of such decisions for a company’s operational and financial performance, can we do better than relying on biased executives’ opinions?
One method for making strategic decisions when the future is unpredictable is “Scenario Planning”. In this method, multiple scenarios (usually, two to four) are developed by taking combinations of the plausible extreme values of a few uncertainties most critical for the decision. The strategic decision is evaluated under each scenario to separate robust alternatives (whose utility varies little across the scenarios) from contingent ones (utility varies by scenario); the latter are implemented with the flexibility to change them depending on how the environment evolves.
This approach has been practiced for five decades. However, the fundamental activity in scenario planning – creation of the set of scenarios – is still seen as an “art”. The literature presents a generic process for developing scenarios, but rarely gives any justification for it. Often, this art gets outsourced to consulting firms, with the tacit assumption that the scenarios developed by external experts must be the right ones.
This status quo is challenged in a recent paper Axiomatic foundation and a structured process for developing firm-specific Intuitive Logics scenarios (ScienceDirect, October 2014, subscription needed). The authors present a theoretical basis for developing scenarios, derive a practical scenario-creation process, and demonstrate its application using a case in the U.S. healthcare sector. This approach has evolved through an iterative interplay between organizational theory and practical application in a number of real-world cases. Below are its key features.
- Scenarios are developed by combining firm-specific knowledge (obtained from experts within the firm) with industry- and macro-level trends and uncertainties (obtained from external experts and databases). We specify which sources should be chosen, and why, for the different inputs needed for creating scenarios.
- Critical uncertainties are separated into two groups based on the firm’s ability to influence them; only those outside the firm’s sphere of influence are used for defining the scenario set. This way, the scenario set contains only those contingencies that the firm cannot negotiate and must be prepared to respond.
- Implications of macro-level uncertainties (e.g., health of economy) for the strategic decision are judged by understanding how they affect local, industry-level factors (e.g., demand for the industry’s product, viability of suppliers, etc.). This provides a nuanced way to assess the impact of various uncertainties on the strategic decision.
Scenario planning provides a mental simulation to make strategic decisions when the future is unpredictable. The basis for making such important decisions is best prepared by combining expertise within the firm with external knowledge using a systematic process.
This article was written by Dr. Shardul Phadnis, Director of Research, Malaysia Institute for Supply Chain Innovation (MISI), who co-authored the paper referenced in the text.