When it comes to managing the risk of disruption to the business model, what executive management and the board don’t know can harm the organization. This article discusses why management should identify and consider the key assumptions underlying the drivers that shape the organization’s strategy. Likewise, the board should review and constructively challenge those assumptions when evaluating the strategy.
A recent study determined that strategic risks showed the largest year-over-year increase for 2014, compared to macroeconomic and operational risks.1 Risks are strategic when they could potentially affect the validity of an organization’s plans to pursue growth opportunities.
In today’s rapidly changing world, it behooves executive management and boards of directors to be knowledgeable about potential future events that could invalidate fundamental assumptions underlying the strategy. These risks can arise from both internal process issues and disruptive change in the external business environment due to actions of competitors, changing customer wants, technological advances, changes in financial markets and the economy, and actions of regulators, among other things.
Strategic risks can be lethal. They represent potential “enterprise value-killers.” More important, they might not be known to management and the board. And nothing can be more dangerous in a rapidly changing environment than not knowing what we don’t know.
To illustrate, innovation can advance quality, create new markets, reduce costs, extend a product range, replace products and services, and dramatically improve processes. Innovation can be disruptive if it improves a competitor’s product or service in ways the market does not expect, typically by lowering the price significantly or designing a product or service that transforms the way in which the consumer’s needs are fulfilled.
There are many examples of disruptive innovation – minicomputers displaced mainframes, personal computers displaced minicomputers, digital photography displaced chemical photography, laptops displaced personal computers, and tablet technology appears to be displacing laptops. The point is that innovation can be disruptive, and present both an opportunity and a threat. The questions are: On which side of the disruption wave will an organization position itself? Will it ride the wave that creates or accelerates disruption – or be swept up by it?
Innovation presents an opportunity to leapfrog the competition. Conversely, it presents a threat of being displaced due to reacting too late to competitor actions and other market developments that could make a company’s offerings obsolete. This is why a company cannot afford to “lock in” to executing its business model when that model is based on assumptions subject to change – and almost every business model is. In essence, companies have a choice. They can be “early movers” in seizing market opportunities or addressing emerging risks, or they can cede that option to competitors.
Above is an illustrative example of the forces of disruptive change involving Borders, a book retailer that filed for bankruptcy in 2011. The above scenario looks back at past events and experience to illustrate how an understanding of critical assumptions underlying the strategy could have led to identification of vital signs that should have been monitored over time to ensure disruptive change wasn’t rendering one or more strategic assumptions invalid. These vital signs might have included metrics relating to competitors’ actions (e.g., web-based sales and pricing differentials), financial performance (e.g., inventory levels, working capital trends and web-based sales versus in-store sales) and market activity (e.g., mall traffic trends, comparability of store fronts and locations with competitors, per day customer traffic, and percent of browsers who do not buy anything), among others, to gauge whether the strategy was working.
In looking forward, consider the potential effects of disruptive technological developments within the industry that could outpace the organization’s ability to compete and/or manage risk appropriately if changes to the business are not made. These disruptions may arise from substitute products, services or channels that attack the viability of the current business model. Examples include the impact of friendlier, more intelligent devices; increased mobile connectivity; bigger/ thinner TVs; 3D displays; greater bandwidth availability; and speech recognition, all of which can influence consumer behavior and the workplace dramatically.
Disruptive market forces can present a formidable impact. In addition to the effect of new competitors entering the marketplace, consider the effect of: significant demographic changes arising from aging populations and concentrations of people in resource-stressed regions; intensifying fiscal pressures on the viability of affected regions; political and social instability in emerging economies; scarcity of natural resources, resulting in highly volatile commodity markets; and regulatory changes affecting the production and delivery of products or services.
Emerging new and/or unexpected threats are another potentially disruptive force (e.g., the impact of cybersecurity incidents on critical infrastructure, brand image and reputation). To what extent could these forces of disruption affect an organization’s strategic assumptions and business model?
While death, taxes, the earth being round, and the sun rising and setting every day are fundamental truths we can count on, almost everything else is an assumption about the future. Strategic assumptions represent management’s “view of the world” for the duration of the strategic-planning horizon. They pertain to such drivers as: the enterprise’s capabilities; competitor capabilities, behaviors and actions; customer preferences and bargaining power; supplier availability, performance and bargaining power; technological trends and innovation; capital availability; legal and regulatory trends; and absence of catastrophic physical phenomena, among other things.
Each assumption generally contains an implicit expectation regarding one or more of the above (or other) drivers. Collectively, all of the assumptions provide a foundation for understanding sources of uncertainty in the strategy through identification of relevant scenarios. In effect, strategic assumptions are management’s “white swans” because they reflect management’s views of the environment in which the “extended end-to-end enterprise” will operate during the planning horizon. Disruptive change can alter these assumptions either slowly over time or in a heartbeat.2
Management’s assumptions should be developed in the context of articulating the strategy. A well-thought-out SWOT (strengths, weaknesses, opportunities and threats) analysis is one possible source of inputs into this exercise, as it is often used to identify the internal and external factors that are favorable and unfavorable to achieving a desired end state or strategic objective.
If the company doesn’t have a clearly articulated strategy, the focus may be on the assumptions underlying its business model. Porter’s Five Forces is an example of a framework that provides a useful context for identifying critical assumptions about a company’s relative positioning in its industry.
All told, it is important for management to identify the key assumptions or drivers to making the strategy or business model work. Likewise, the board should review and constructively challenge those assumptions when evaluating the strategy. This process will facilitate understanding the hard spots and soft spots in the strategy, how much the forces of disruption can hurt the organization and, more important, the specific aspects of the strategy that may require revisiting to manage the effects of disruption if and when it becomes a reality.
Questions for Boards
The following are some suggested questions that boards of directors may consider, consistent with the entity’s objectives:
- Is there a common understanding between management and the board as to the critical assumptions underlying the enterprise’s strategy?
- Is there a process for challenging underlying assumptions? Are key factors that provide insight regarding the continued validity of the critical underlying assumptions monitored over time? Does the monitoring process consider the potential for disruptive change?
- Is the board satisfied that management is evaluating changes periodically in the business environment to identify emerging opportunities and risks? Does the process consider plausible “black swan” events and result in appropriate response plans, exit strategies and other contingencies on a timely basis?
How Protiviti Can Help
Protiviti assists boards and executive management with assessing the enterprise’s risks and the capabilities for managing those risks. We help organizations identify and prioritize their risks, including emerging risks that can impair their reputation, brand image and enterprise value. We assist companies with integrating their risk assessment process with their core business processes, including strategy-setting, and with improving their risk reporting to better inform the board risk oversight process.
1Executive Perspectives on Top Risks for 2014: Key Issues Being Discussed in the Boardroom and C-Suite, Research Conducted by: Protiviti Inc. and North Carolina State University’s ERM Initiative, available at www.protiviti.com.
2The reference to “white swans” was noted on pages 86-87 of Surviving and Thriving in Uncertainty: Creating the Risk Intelligent Enterprise, Frederick Funston and Stephen Wagner, 2010.
Board Perspectives: Risk Oversight (Issue 59)