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MEASURING STRATEGY QUANTIFYING RISK AND UNCERTAINTY
“When you can measure what you are speaking about, and express it in numbers, you know something about it; but when you cannot express it in numbers, your knowledge is of a meager and unsatisfactory kind; it may be the beginning of knowledge, but you have scarcely in your thoughts advanced to the state of science.”
- Lord Kelvin .
2 © 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED
TECHNOLOGY STRATEGY FROM MY PAST
Business Case Forecast economics showed $240 MM NPV. Key issues and risks were listed, but not quantified. Decision makers were concerned about reliability.
Initial Plan • Our company had the chance to lead the medical
diagnostics industry in using new biosensor technology for diabetic glucose monitoring.
3 © 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED
4 © 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED
WHY MEASURE A STRATEGY?
Medical Device Strategic Issues § New product cost of goods § Launch timing § Design / Mkt Share capture § Recall risk / QC costs § Product support costs § Channel costs
Strategy Value ($MM) 100 200 300
Downsides range from $28 – 140 MM Upsides range from $5 – 48 MM
WHAT CONCLUSIONS WERE DRAWN?
Success would require a Quality transformation of the entire operation to mitigate the risks.
Simulation of top six benefits quantified the return: § Expected value = $165 MM for expected risk mitigation § Estimated cost of TQM/Six Sigma initiative = $12 MM
How have TQM/Six Sigma initiatives done? • Georgia Tech’s financial analysis of industry • 34% better stock price performance than benchmark firms • 43% better operating performance measured by profit growth • Sustainable advantage has been retained over a long term
© 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED 5
BENEFITS OF MEASURING STRATEGIES
Clarity § Resolves ambiguous and/or conflicting values § Communicates the purpose and aims of the decision
Transparency § Based on collaborative expertise and rationale § Alignment of personal & organizational agendas § Confers understanding of uncertainty, tradeoffs, complexity, risk
Transferability § Does not rely on one individual's special insight § Promotes systemic thinking and comprehension § Builds an environment for effective collaboration
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WHY IS THIS IMPORTANT TODAY?
To meet the fiduciary responsibility of officers/directors § “Duty of Care” means not taking information at face value, but being fully
informed when making decisions. § To identify risks and uncertainties that could have a material impact on
the business and taking appropriate mitigation steps
Quantifying the risks for their impact on value § Avoiding the “illustion of understanding” of qualitative methods § “What gets measured gets done.” - Drucker § “You get what you inspect, not what you expect.” - Deming
© 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED 7
WHAT HAS BEEN DIFFICULT OR FRUSTRATING FOR YOU IN YOUR STRATEGIC DECISION PROCESS?
© 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED 8
THE PATH TO VALUE HAS LOTS OF TRAPS
© 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED 9
Adversarial advocacy positions
Unforeseen risks or disasters dismissed Unrecognized
opportunities Lingering doubts and uncertainties
Lack of buy-in and alignment
Lack of open inquiry
Competing impressions
Misalignment among tactics and
policies
Inappropriate reliance on intuition and speculation
Analysis paralysis
MONEYBALL (AND BRAD PITT) HAVE DONE A LOT TO POPULARIZE ANALYTICS
© 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED 10
AVAILABLE DATA OR VALUABLE INFORMATION ?
© 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED 11
COMPETING ON ANALYTICS – THE SCIENCE OF WINNING
Tom Davenport and Jeanne Harris
An IBM-CFO study shows that analytics-driven organizations had 33% more revenue growth, 12 times the earnings (before interest, tax, depreciation, amortization) and 32 percent more return on capital invested.
According to Tom Davenport, “Companies that invest heavily in advanced analytical capabilities outperform the S&P 500 on average by 64%”.
© 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED 12
HISTORY HAS PROVEN THESE LESSONS WELL
Earliest recorded math table on clay tablets, perhaps used to calculate triangle dimensions for construction.
Babylonian Triples ~2000 B.C. Quipu Peruvian knot record ~1000 B.C.
Believed to be numerical record keeping system used by the Incas for keeping track of commerce.
© 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED 13
DATA ADDS VALUE BY DRIVING DECISIONS
Chinese counting boards and abacus were essential for the Emperor’s men to assess the right amount of tax to collect.
Village Lawyer by Pieter the Younger, dated 1621 with stacks of paper records for billing clients.
© 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED 14
COMPUTING SYSTEMS (1820 – 1950) ENABLED MORE BUSINESSES THE COMPETITIVE ADVANTAGE
Charles Xavier Thomas invented a mechanical calculator for his insurance business to assure accurate pricing based on actuarial data
First used in 1928 for vital statistics tabulation by the NYC Board of Health. It was IBM’s most profitable product for the next 50 years with mainframe computing for businesses.
© 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED 15
PROGRAMMED COMPUTERS 1950 – 1980 BEGAN DEMOCRATIZING IT TO SMALL FIRMS
Dan Bricklin received an award from Osborne Computer for creating VisiCalc, a program that made it worthwhile to buy a personal computer.
Lyons Electronic Office (LEO) was the first programmed device to evaluate costs, prices and margins of that week's baked output at Lyons London tea shop.
© 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED 16
ENTERPRISE SYSTEMS 1990-2000 DECADE
ERP software promises to integrate internal and external management information across an entire organization. CRM software gives business the ability to create, assign and manage requests made by customers.
© 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED 17
WEB / CLOUD IS EVOLVING – 2010 DECADE
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NEXT GEN BIG DATA IS NOW IN HYPERDRIVE
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CAN WE REALLY DEAL WITH EXABYTES?
Stage 1: Analytically Impaired – Lack of
analytical skill or executive interest. Stage 2: Localized Analytics –
Uncoordinated activities or silos.
Stage 3: Analytical Aspirations – Good intentions with slow progress.
Stage 4: Analytical Companies – Widely use analytics internally.
Stage 5: Analytical Competitors – Use analytics as a competitive advantage.
Competing on Analytics – The Science of Winning by Tom Davenport and Jeanne Harris
© 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED 20
DARK SIDE OF THE STORY - MAJORITY OF INVESTMENTS FAIL TO DELIVER
Idea Justification Single
Option
Business Case Edict or
Persuasion
Ones that Work: Improvement in understanding, participant buy-in, use of creative ideas and focus on real business results. Fr
amin
g
Crea
tive
Synt
hesi
s of
Opt
ions
Dia
log
(inte
rnal
exp
erts
) or
Pilo
t
Colla
bora
tive
Part
icip
atio
n
Four Key Phases of Projects 127 cases studied in North America
(by Paul Nutt, Ph.D., Ohio State University)
Implementation Evaluation Exploration Set Direction
% S
ucce
ssfu
l Afte
r 2 Y
ears
0%
100%
50%
© 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED 21
A QUICK EXAMPLE – AIRLINE FUEL DATA
Jet fuel costs - $2.1 billion per year Fuel Management system proposed to integrate all fuel data, improve data integrity and functionality. • Project cost - $4.5 million
Tangible savings (could put in the budget) • back office cost reduction and simplification of IT systems
Intangible benefits – (could not guarantee exact value) • reporting accuracy for fuel taxes, • inventory and fleet fuel burn per day, • fewer errors, optimized inventories, etc.
Business case – not approved due to negative ROI
© 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED 22
QUANTIFYING THE INTANGIBLES
Quantifying uncertainties: • How big a price differential is there typically? – 0.5 to 1.5¢/gal • How many fueling events are there per day? – 3200 to 3500 • How many gallons per event – thousands • How often has the lowest price been missed? – 30% to 60% Benefit range $5-25 million per year Pr
obab
ility
$5 M $25 M
What decisions could real-time data significantly improve? • Selection of fueler with lowest spot cost. • Tankering of fuel – where to fuel at low cost & tax airports
© 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED 23
HOW TO MEASURE INTANGIBLES
Do we understand what we trying to measure? • Value of making decisions with better information What does measurement really mean? • Not a precise forecast, but quantifying what we know How can we find ways to make the measurement? • Ask questions, find analogies or scenarios, etc.
Summarized from Douglas W. Hubbard - “How to Measure Anything: Finding the Value of Intangibles in Business”
© 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED 24
Major oil company approved a capital spending project of $100 million for a new global ERP system. After starting with a positive NPV, the business case was tweaked to a point where it became a whopping…
Case Study – ERP System
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MUCH HAND WRINGING ENSUED…
How can we justify the $$$? What should we do?
-------
Maybe we should cut out all of that training cost and
reduce development costs.
Would this push the project NPV back into the black?
26 © 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED
WHAT WENT WRONG?
• Poor problem framing
• Irrelevant sensitivity analysis
• Inappropriate accounting of value
27 © 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED
UNDERLYING BEHAVIORS AND TRADITIONS CAN OBSTRUCT THE CREATION OF VALUE
• Rather than quantifying the “intangible” value and risk, teams allow technical arguments and cost substitution issues to become the basis for investment decisions
• Decisions are made by negotiation or power-plays rather than focusing on expected value or fit with the strategy
• Bad ventures frequently persist for too long, wasting time and resources that could be used on better projects.
• The key to understanding and making informed decisions… is quantifying the value of the intangibles!
28 © 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED
QUANTIFYING THE UNCERTAINTIES REVEALED THE CRITICAL COST DRIVERS
simple business case value = $0
User adoption
System reliability
Data integrity
NPV $million
29 © 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED
Training
informed business case value = $80
Development Cost
Critical cost drivers
Important but not critical cost drivers
BY INVESTING MORE - THE TEAM MITIGATED THE USER ADOPTION RISK AND ASSURED THE UPSIDE VALUE OF DATA INTEGRITY AND RELIABILITY
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
1
$80
NPV $ (millions)
Cum
ulat
ive
Prob
abili
ty
Original strategy NPV range
$380
Hybrid strategy NPV range
30 © 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED
EACH STAGE RESOLVES KEY QUESTIONS BEFORE MAKING A FINANCIAL COMMITMENT
ü What is the real situation?
ü What is the opportunity?
ü What are our goals and objectives?
Discovery ü What are the decision
boundaries and open decisions?
ü What are the sources of uncertainty?
ü Can we develop an 80% confidence range for the uncertainties?
ü Is the information worth the time and cost of analysis?
Framing ü What are the effects
of uncertainties on solution goals?
ü What is the difference in value among the alternatives?
ü How much risk do we face with each alternative?
ü What insights can we create for contingency plans or options?
Evaluation ü Which path best
meets our objectives?
ü How much should we spend to control uncertainties?
ü What are the keys to implementation?
ü What resources will we need for implementation?
ü What contingent actions should we take?
Agreement
31 © 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED
Means
Contributing
Fundamental
FOCUSING ON THE OBJECTIVES IS MORE PRODUCTIVE THAN ARGUING ABOUT TACTICS
Maximize Stakeholder
Value
Capital Costs
Operational Costs
Service Execution Excellence
System Arch. HW SW System
Overhead Service
Reliability Appropriate
Tools Data
Integrity System
Complexity
32 © 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED
Discovery Phase
DECISION HIERARCHY FORCES EXPLICIT AGREEMENT ON SCOPE AND FOCUS
Policy (givens, boundaries) Decisions already made, foregone
Strategic (focus, open options) Decisions categories with sub-options to be considered now
Tactical (execution dependent) Decisions to be made later, deferred
Team Focus for Analysis
• Generate a wide array of creative, doable alternatives that are consistent with objectives
• Create alternatives as a coherent set of actions, usually one option from each decision category
• Alternatives should represent strategically different themes versus the full combination of all options
• Sets the stage to consider opportunity costs thoroughly
33 © 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED
Framing Phase
CLARIFYING UNCERTAINTIES AND LOGIC HELPS FRAME THE EVALUATION MODEL
• Captures the essence of the problem and facilitates the dialog between the team members
• Becomes a well defined model of the situation, containing all the necessary and relevant information needed to assess the situation
• Used as a means to communicate the shared knowledge of the team to the organization
34 © 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED
Framing Phase
QUANTIFYING 80% CONFIDENCE INTERVALS HELPS AVOID ASSUMPTION “BLIND SPOTS”
We recognize assumptions are really uncertainties
$ NPV
Prob
abili
ty
$0
We observe results as distributions
Simulation Engine!
Uncertainty
Uncertainty
Uncertainty
Uncertainty
Uncertainty
Objective
35 © 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED
Evaluation Phase
HOW EASY DO YOU THINK IT IS TO ASSESS A 10/50/90 RANGE OF POTENTIAL OUTCOMES?
.10! .50! .90!
80% confidence interval
p10 - 90% confident the outcome will be higher than this p90 - 90% confident the outcome will be lower than this p50 - equal likelihood the outcome could be higher or lower than this
36 © 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED
EXERCISE - WHAT IS YOUR 80% CONFIDENCE INTERVAL FOR THESE UNCERTAINTIES?
p10 p50 p90 1. The number of revenue passengers
enplaned on U.S. airlines in 2007?
2. The year that the the world’s first pure food and drink law got passed?
3. The year Attila the Hun died?
4. Annual U.S. egg production in 2008? 5. Elevation of the highest point in Texas?
37 © 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED
38 © 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED
We are trained to provide “the answer”. Uncertainty makes us restless, whereas we are comfortable
and content with the appearance of certainty Planning is much easier if we suppress uncertainty Suppressing uncertainty is dangerous in business! § we are surprised and unprepared to deal with the situation
Explicit treatment of uncertainty in planning: § improves communication of difficult issues, reducing surprises § encourages contingency planning § creates insight into potential upside potential
CULTURAL PRESSURE FOR CERTAINTY
THE RIGHT EXPERT CAN EXPLORE CAUSES OF UNCERTAINTY AND AVOID SURPRISES
Traditional Analysis (Forecaster) § Make assumptions to get to a forecast § Focus on what has to go right for success,
often blinding us to what could go wrong
Uncertainty Analysis (Desired Expert) § Explore the factors that create extreme
outcomes or contribute to uncertainty § Understand what could go wrong and what
the upside and downside may be § Develop a range of possible outcomes
39 © 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED
1.40 1.60 1.80 2.00 2.20 2.40 2.60
Product price, $/gal
p50 value $2/Gal What will be the
average price of gasoline over the next 5 years?
-10% +10%
40 © 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED
P50 ± 10% ANCHORS ON THE ESTIMATE CREATING AN ILLUSION OF THE UNCERTAINTY
Product price, $/gal
Initial p50 value
$2/gal
-10% +10%
Range p10 p50 p90
Anchored 1.80 2.00 2.20
Calibrated 1.00 2.40 3.15
Ranged p50 value $2.40/gal
Range -58% +31%
0.50 1.00 1.50 2.00 2.50 3.00 3.50
41 © 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED
AN 80% CONFIDENCE RANGE EXPLORES A MUCH MORE ROBUST VIEW OF REALITY
MONTE CARLO SIMULATION REVEALS THE VARIATION IN VALUE CAUSED BY UNCERTAINTY
• Demonstrates the aggregate effect of all the uncertainties by both their impact & prevalence
• Shows the probability of important intervals and the opportunity for optimization
• Shows if one decision dominates another
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
1
Cum
ulat
ive
Prob
abili
ty
Low High Value Metric
A B C
42 © 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED
SENSITIVITY ANALYSIS - WHAT REALLY MATTERS AND WHAT TO STOP ANALYZING
Value Measure of Primary Objective
Critical Value
Drivers
Minor Value
Drivers
0
Effect of Uncertaintyi on Value Measure
43 © 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED
ASKING “WHAT IF” QUESTIONS CAN CREATE TREMENDOUS VALUE IN A DECISION
Value of Information What if we had better information? What would it tell us? How much should we pay for it? Value of Control What if we more had leverage over critical uncertainties? What might we do? How much should we pay for it?
44 © 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED
“WHAT IF” WE COULD REDUCE THE RISK WHILE CAPTURING THE UPSIDE?
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
1
Cum
ulat
ive
Prob
abili
ty
A B
Hybrid
Hybrid Strategy
� Limits downside to A
� Captures potential of B
45 © 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED
Low High Value Metric
Policy
Strategic
Tactical
What decisions & creative strategies to consider?
Cost Revenue
NPV
What outcomes are we targeting?
Discovery and Framing
Do we understand the situation and our strategic question?
DECISION ANALYSIS PROCESS FLOW
46 © 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED
How to gain insights from the uncertainty to maximize value?
Strategy, NPV, M$
$100 $150 $200 $250 $300 $350 $400 $450 $500 $550 $600
Uncertainty One
LowHigh
Base Value: $360
Uncertainty Two
Uncertainty Three
Uncertainty Four
Uncertainty Five
Uncertainty Six
Uncertainty Seven
Uncertainty Eight
Uncertainty Nine
Uncertainty Ten
Strategy, NPV, M$
$100 $150 $200 $250 $300 $350 $400 $450 $500 $550 $600
Uncertainty One
LowHigh
Base Value: $360
Uncertainty Two
Uncertainty Three
Uncertainty Four
Uncertainty Five
Uncertainty Six
Uncertainty Seven
Uncertainty Eight
Uncertainty Nine
Uncertainty Ten
$ How to realize the value through effective
implementation? What are the ranges of uncertainty and risk?
Quantifying Insights
AUDITS HAVE SHOWN MAJOR BENEFITS OF DA OVER TRADITIONAL METHODS
Opportunity Identification
Alternatives Evaluation
Transformation Roadmap
Implementation and Change
Measurement & Optimization
Value promised in the business case
Audited results: 80% do not achieve their business case number
Eco
nom
ic V
alue
Value of focusing on the right problem
Value of framing & quantifying alternatives
Value realization from alignment and effective execution
ROI increases from measurement and continuous improvement
47 USED BY PERMISSION OF CHEVRON CORPORATION
IT FEELS LIKE MORE TIME UPFRONT, BUT A BETTER DECISION IS IMPLEMENTED SOONER
Traditional Decision Making
Def
initi
on
Solution Development
Recycle
Decision Making
time
Re-visit Decision
Quantitative Decision Analysis
Definition Create Options
Dec
isio
n M
akin
g Save time & energy, create confidence.
48 © 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED
QUESTIONS?
Gerald A. Bush, Ph.D. Tel: (678) 641-6254 Email: gabush@mac.com
Robert D. Brown III Tel: (678) 947-5997 Email: rdbrown@incitedecisiontech.com
© 2012 COPYRIGHT ROBERT D. BROWN III AND GERALD A. BUSH - ALL RIGHTS RESERVED 49
SELECTED READINGS
“Value Focused Thinking: A Path to Creative Decision-making” by Ralph L. Keeney “How to Measure Anything: Finding the Value of Intangibles in Business” by Doug Hubbard “Smart Choices: A Practical Guide to Making Better Decisions” by John Hammond, Ralph Keeney and Howard Raiffa “Why Can't You Just Give Me The Number? by Patrick E. Leach “Decision Traps” by Edward Russo and Paul Shoemaker “Against the Gods: The Remarkable Story of Risk” by Peter L. Bernstein
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