Management accounting and environmental analysis

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Management accounting and changes in the business environment

One of the key aspects of successful strategic planning and the development of business strategy is being able to respond appropriately to changes in the business environment. Hence, the need to undertake environmental analysis. The most popular framework for undertaking an analysis of the general business environment is the PESTEL framework – political, economic, sociocultural, technological, environmental, and legal. Changes in the business environment can have significant financial implications for organizations. Therefore, an area where accountants can make a significant contribution to strategic management is in helping to determine the potential financial impact that changes in the business environmental could have on an organization. The key word here is ‘helping’. Accountants cannot do this on their own, but need to work very closely with other functional specialists, such as marketers, operations, research and development staff, and so on. 

     There are several changes that are currently receiving attention in the media. Two of these have wide ranging implications for many industry sectors. The two I am thinking of emanate from the increased awareness of sustainability and environmental issues, namely the use of fossil fuels and plastics. 

Fossil fuels

Several governments around the world have announced future plans to ban the use of vehicles that use fossil fuel – indeed, some major cities already ban or make a charge for the use of fossil fuel vehicles in city centres. Consider the impact that a ban on the use of fossil fuels might have, not just on the industry for motor vehicles of all types, but on all the business sectors that are affected by the use of vehicles, or provision of the fuel. The impacts are spread across the energy industry, the transport sectors – commercial, private and public transport, delivery services, infrastructure in terms of the provision of charging points for electric vehicles, battery technology, and so on. 

     Many organizations have already developed, and are implementing, strategies to deal with this change. These courses of action need financing, and have significant cost implications, as well as generating the need to review pricing policies. Strategies also need to be evaluated and crystallized into operational plans and budgets, to facilitate monitoring and performance management.  

Plastics

The second big issue is that of reducing or, again banning, the use of single use plastics. Many organizations are now working on developing new forms of materials that can primarily be used in packaging and then recycled. Major supermarkets and manufacturers are actively announcing plans to combat the growing concerns about the use of single use plastics, but also note the desire, and sometimes contradictory, reluctance of the consumer to change habits. This is not just a research and development issue but also one of sensitive marketing and public relations, due to the necessity to work with the consumers to arrive at an acceptable compromise between the attributes of the packaging itself (product identification, product protection, convenience and product promotion), and the use of alternatives to plastic.  This also has far reaching implications for supply chain management, the underlying cost structure, and pricing strategies. As with fossils fuels, there are significant cost implications, but also the opportunity to differentiate and gain a competitive advantage. 

     Strategic responses to both issues might include product development, entailing investment in research and development, or new plant and equipment; working closely with partner organisations in the supply chain to ensure sufficient margins are achieved and sustained; changes in logistical strategy, including storage and warehousing and infrastructure; changes to marketing channels; or changes to existing products and packaging. 

MASS

These two issues are both created by the key driver for change of an increased awareness of sustainability. The potential impact on the business environment provides a useful illustration where the management accounting techniques of forecasting, investment appraisal, life cycle costing, pricing, target costing, and budgeting can be utilized to good effect in the formulation, evaluation, implementation, and review and control of strategic options. In short, they demonstrate Management Accounting in Support of Strategy. 

Learning activity: 

Think of an industry - any industry, and identify a key driver for change in the environment. Now think of the potential impact this could have on the industry and determine various strategic options that organizations may consider to deal with the change. How can management accounting assist management in the strategic management process?

Understanding the forces that impact on organisational strategy – an example using the Pharmaceutical industry 

Porter (1979) identified five forces that help shape an organisation’s strategy in what is frequently referred to as Porter’s Five Forces model. The model is useful in helping to understand how these forces will impact on the industry, and hence the profitability of the industry members. This article takes the pharmaceutical manufacturing industry as the basis of exploring how management accounting can be used to aid the analysis. 

The five forces are:

· Threat of new entrants to the industry

· Bargaining power of suppliers 

· Bargaining power of buyers

· Degree of competitive rivalry in the industry

· Threat of substitute products or services to the output of the industry. 

Threat of new entrants to the industry

The threat of new entrants is determined by the strength of the barriers to entry that exist for new entrants. The pharmaceuticals industry is dominated by several large players that enjoy significant economies of scale and are able to spend large amounts of money on research and development. They also command a significant hold over distribution channels and can afford to invest huge sums in marketing to support the development of a strong brand for their products. 

    The industry is also subject to regulatory policies related to patent protection and approval of new products by agencies, such as the Food and Drug Administration (FDA) in the US, the Medical and Healthcare products Regulatory Agency (MHRA) in the UK, the Central Drug Standard Control Organization in India (CDSCO), and the China Food and Drug Administration (CFDA) in China, to name a few of the regulatory bodies in the world. There are also advisory agencies, such as the National Institute for Health and Care Excellence (NICE) in the UK that advises the National Health Service (NHS) and can influence which pharmaceutical products are made available to the public through the NHS. In some countries the price is regulated by government bodies. 

    There would appear to be a prima facie case to suggest that there are significant barriers that might deter new entrants to the industry, and in the 1970s and 1980s this would have had a significant impact on limiting new start-ups in the industry. However, with the development of biotechnologies, and the rise of the generic product producers that provide the same product as the original patented drug once the patent has expired, some of the barriers are not as strong as they used to be. 

    For example, in the case of new start-up in the industry, the large returns that can be made on successful products means that a team of researchers are able to raise funds from venture capital sources to finance the development of new products. The new companies pose no real threat to the large companies, as one of the main exit strategies of the start-up investors is to sell out to the large pharmaceutical companies once the product has gone through the initial development phases, however, it is now easier to enter the industry than it was in the 1980s. 

    The patent protection, typically of 20 years duration, which provides the opportunity for high profits to recoup the development costs of a product, does not provide the length of benefit previously enjoyed by companies some 20 years ago. It can take up to 8 years, (some would say 13 – 15 years) to obtain the data from clinical trials necessary to gain FDA approval in the USA, which leaves little time to recoup the development costs. Once a product has lost its patent protection it can lose up to 80% of its brand name sales, as generic products flood the market. As a result, large pharmaceutical companies have been known to apply for new patents linked to the products to extend the protection and to fight generic companies in the courts to stop them producing a generic version of the product. In retaliation generic companies sue to try to invalidate these extra patents. It is argued that this legal tit for tat slows down new product innovations and a solution might be to allow patents to begin after the approval has been granted. However, due to competitive rivalry, companies often file patents at the earliest opportunity to stop competitors from stealing a potential idea before it is fully developed. This also eats into the time available to recoup investment.

    Understanding an industry cannot be achieved based on a static analysis of factors affecting the industry at a point in time, or over a particular year. The changes identified may be cyclical in nature, or temporary. Therefore the analysis needs to be undertaken over a period of time, ideally a full business cycle. The length of a business cycle is debatable but the nature of the pharmaceuticals industry suggests that the analysis needs to be undertaken over a lengthy period of time. This is due to the long R & D phase, the length of the patent protection, the fact that products can be re-positioned or re-purposed, that is, where a drug is used to treat a different disease, which can extend its product lifecycle, and the impact of generic products on profitability. Indeed, this links to PESTEL analysis in that factors within the general environment could impact on the forces affecting the industry, such as, government policies on health care, aging populations affecting demand for certain products, or technological changes that enable the development of new treatments, and so on. 

    It is not possible to respond to every change in the environment and simply creating a list of qualitative factors does not really aid strategy development. Management accounting can help to put some numbers to the issues so that the significance of the changes and emerging trends can be understood in terms of the potential impact on the achievement of the organisation’s strategy. This aids some degree of prioritisation to be undertaken so that a suitable response can be developed if necessary. 

    For example, in relation to the impact of generic products, using management accounting techniques to monitor the organisation’s own products through the process from R & D to sales and profits during, and after, patent protection can aid the understanding of the impact that generic companies have on the organisation’s performance. This not only provides comparative data that can be used to build up experience of lifecycle costs and profitability of a product, but also provides information that aids decisions, such as the costs and benefits of taking legal action to protect the patent. It is all too easy to get trapped in to believing that the patent must be protected at all costs, but ploughing millions of dollars into the legal system could actually divert significant resources away from R & D. It may prove more profitable in the long run to ensure a good pipeline of new products is forthcoming from a well-funded R & D function. 

    Pricing of products to maximise the contribution towards development cost, and fixed costs and profit during the patent protection period is another obvious area where management accounting can aid the development of strategy and resource allocation decisions. The pricing decision can be critical as setting a high price, whilst desirable as a means of recouping development costs during the patent protection period, can result in regulatory and advisory bodies, such as NICE in the UK, not recommending the product for public availability via the National Health Service, or insurance companies not being willing to pay for the drug under insurance. Deals are often done to provide the product at a discounted rate, as this not only builds up goodwill with key buyers, but also aids the development of a success rate for the branded product before generic producers jump into the market once the patent expires. Pricing, therefore, can be a key decision in stimulating demand, so, price sensitivity, brand recognition, substitute products, competitor response (including generic producers), psychological factors, and so on, are all significant factors that need to be taken into account when setting the pricing strategy. It is far more complicated than just covering product costs.   

    Techniques such as risk-adjusted net present value, decision trees and real options are useful in valuing products, although the long timeframe involved, and the high attrition rate of new products make this a difficult area to forecast with any accuracy. Building up experience over time and comparing the actual outcomes with expected outcomes is a highly valuable learning exercise that should be undertaken as a matter of course. This makes forecasting of sales and costs for new products more reliable as more experience is gained, even to the extent of being able to assess issues, such as the quality of project management, and the impact of new technologies on success rates. The cost of capital and discount rates used, as well as the timeframe considered, can also have a significant impact on the evaluation of new products. It is, therefore, always advisable, and good practice, to undertake some form of sensitivity analysis to ask the, what if? style questions.   

    Acquiring a good understanding of your own costs and processes provides a benchmark which can be used to assess competitors and understand the likelihood of new entrants being able to enter the market. Knowing the costs and expertise required enables an informed judgement to be made of any potential threat. Also understanding the cost base, such as, how much volume is required before a manufacturing plant becomes viable, what level of financing is required to develop a new product, what level of sales is required to operate a logistical network efficiently and cost effectively. Assessing these factors quantitatively and monitoring them over a period of time, can help to assess the immediate and potential threat from new entrants. Even if low at present it does not mean it will not change in the future. 

Bargaining power of suppliers

The raw materials for the manufacture of pharmaceutical products are primarily commodity products in the chemical industry. There are numerous sources of the raw material and chemical components that make up pharmaceutical products from which these can be acquired, and therefore suppliers have little power over the manufacturers of drugs. Even the price of rarer materials can be mitigated by purchasing a range of more common raw materials at negotiated discounted prices from the same supplier. The packaging companies often have a mutual dependence on the pharmaceutical companies for their business, so have little bargaining power. There are also multiple suppliers of the capital equipment required to manufacture drugs and undertake research activities. This means that switching costs are low, which makes it difficult for suppliers to lock the pharmaceutical companies into their particular products. In fact the balance of power in the negotiation probably lies more with the pharmaceutical companies than with the suppliers. Many of the larger pharmaceutical companies have their own manufacturing plants that manufacture basic materials and chemical components, and therefore do not need to engage with the whole of the external supply chain. 

    Vendor analysis and monitoring raw material costs by supplier can provide an early indication of any potential shift in the negotiating position of suppliers. Vendor comparison across a range of performance indicators can help to keep suppliers in check, particularly if operated in conjunction with an approved supplier list. 

    Monitoring the general environment for movements in commodity prices and events outside the control of the suppliers can help to determine whether cost rises are the result of inefficiencies in supplier operations, or events which the suppliers cannot control, which may result in a price rise. For example, a shortage of supply of a particular raw material due to natural phenomenon will affect the whole industry. This will inform the negotiation stance adopted by the supplier and the buyer. Understanding the effect of natural phenomena on the costs of the industry also feeds into competitor analysis, as it is highly likely that the competitor costs will rise as well. However, if the cost increase is due to supplier inefficiencies it signals that a potential change of supplier may be required. As switching costs are relatively low it puts the buyer in the stronger negotiating position. This highlights the need to understand the dynamics of the suppliers’ industry sector, in this case the market for raw materials, as well your own (manufacturing), and indeed the buyers’ industry sector.  

Bargaining power of buyers

Buyers in the pharmaceutical industry include distributors to the retail trade, health maintenance organisations (HMOs) that arrange or provide managed care for insurance companies, private individuals, hospitals, and other entities, which may include government agencies. The end patient often has very little input, although recent changes in more developed countries are now encouraging more patient participation in their medical care.  Bodies such as the National Institute for Health and Care Excellence (NICE) can also influence purchasing decisions. The large private health providers, insurance companies and government funded health care systems and advisory bodies, such as NICE, are able to exert some downward pressure on prices and choose between alternative treatments, thus putting pressure on the margins earned from pharmaceutical products. More general trends in the environment, such as aging populations, obesity, and a focus on education and prevention rather than cure, will also impact on which products are in demand, or where the price sensitivity of certain products may be susceptible to change. This has implications for R & D effort in targeting potentially lucrative areas of health care where demand may be high, or where competitive advantage can be achieved, providing the opportunity of earning higher profits.  

    Monitoring customer profitability can be an early indicator of any potential increase in buyer power. Sales force personnel often lose track of the overall trend in selling prices, particularly if key account managers only deal with certain customers. A trend that is identified from internal data may be an early indication of a more general trend in the industry. It is therefore, as important to monitor internal trends and to assess these in the light of industry wide data, as they may provide a signal of wider changes in the industry, and forewarned is forearmed. 

    Relationships with health care professionals, such as doctors, can also influence purchasing decisions and incentives. For example, the use of discounts and trial periods are common, but these need to be carefully monitored and costed as profits can so easily be given away in the pursuit of volume. The cost of branding can be a significant factor in the success of the product, particularly when linked to the effectiveness of the product in the treatment of patients. Huge sums can be spent on marketing so again careful monitoring needs to be in place and sensible methods of setting marketing budgets adopted. An objective setting approach may be preferable in which marketing budgets are set with specific objectives in mind on a campaign by campaign basis, but often large companies adopt a percentage of sales revenue as an overall marketing budget. The danger here is that the link between marketing and performance is lost, or it is not possible to track the impact of the marketing activities, which deprives the organisation of valuable information that can be fed into future decision making.  

    The earlier discussion on pricing is also relevant here, as is understanding tuge HHuge he potential impact of generic products on profitability, particularly as medical professionals can choose to switch to a generic product once it becomes available. The negotiation of supply contracts can help to create some element of switching costs, but professional buyers in HMOs, government agencies, hospitals, and over-the-counter retail organisations will be aware of the implications of long term or exclusive supply contracts.

Competitive rivalry 

The pharmaceuticals industry is characterised by high levels of competition, in both R & D activity and new patents, attracting leading researchers and fighting for market share. The development of a strong brand image can be an important aspect of competitive advantage, particularly in the fight against generic producers. The other forces also impact on the degree of competitive rivalry, such as the threat of new entrants. Although smaller companies enter the market the larger firms are often looking to acquire these to gain access to intellectual property of new products, whilst the new entrants are often looking to sell the business to a larger firm once a product is in development. The impact of supplier power and buyer power can also affect the margins earned by the industry, which also affects the competitive rivalry. However, in the case of the pharmaceutical industry competitive rivalry is more focused on market share and the need to maintain a vibrant and innovative product portfolio. This can be achieved organically or via merger and acquisition. The area of mergers and acquisitions is an obvious area where the particular skill set of accountants can be usefully employed. 

    It is not just the assessment of individual forces that needs to be made. It is equally important, if not more so, to gain an understanding of how a change in one force may impact on another. For example, a breakthrough in new technology may impact on the development of innovative products, and as in the case of biotechnology encourage smaller firms to enter the market intent on developing new products which are manufactured by other firms, essentially creating a new industry sector which changes the business model. This could in turn impact on the supply market and the cost base of large manufacturers, increase the number of alternative products, and potentially impact on buyer power, and ultimately profits margins, not to mention the potential impact on competitive rivalry. 

    Competitor analysis is important, not just in terms of their product sales and market share, but in monitoring their R & D capability, number of patents filed, their ability to raise finance to feed the R & D process, their success rate in launching new products, and their profitability and return to investors.

Threat of substitutes

One aspect of the pharmaceuticals industry is that it can be segmented in to different categories. For example: chemically derived products, biologically derived products, and prescription products and over-the-counter products.  There are also innovation derived products, which are new products developed via R & D, and generic products, which are products that are the same as the innovative products, but not sold under the original brand name. Generic products can be produced after the expiration of a patent, and are usually cheaper than the branded product. There are also companies that specialise in research, such as contract research organisations (CROs), and those that specialise in manufacturing known as contract manufacturing organisations (CMOs). What are considered as substitutes is therefore debateable depending on how one views the industry. For example, an innovative pharmaceutical company may view generic companies as substitutes for its output. For the purposes of this analysis substitutes are defined as any other means of providing the benefits of pharmaceutical products. This may include natural remedies and other forms of alternative medicines, which are becoming more socially acceptable. 

    The threat from generic producers, which could equally be consider under threat of new entrants or competitive rivalry, is now always present but can be mitigated via patent protection. However, once the patent has expired the sales and profitability of the branded drug are likely to reduce. Therefore, building up a database of past experience can be invaluable in estimating the likely impact of the generic products on any new products emerging from their patent protection. This emphasises the importance of good product portfolio management and ensuring that a well balanced portfolio is maintained. 

    The threat from alternative medicines (substitutes) is low due to the size of the pharmaceuticals market and the fact that patients do not normally seek an alternative to the prescription drugs. This largely leaves the alternative medicines within the over-the-counter range of products and health supplements, some of which are now produced by the larger pharmaceutical companies. Monitoring the financial performance of alternative providers and the growth in the segment of the market can inform future strategy development. For example, evaluating the potential impact on industry sales via trend analysis, or evaluating the cost of the organisation entering the market segment via product development, as some larger pharmaceutical companies have already done.  

Overall

It can be seen that there are a number of aspects within the industry analysis where accountants are able to make a significant contribution. The understanding of how the forces and environmental changes will impact on the industry is important for strategy formulation, but equally understanding how those forces and changes will impact on your organisation compared to the competition. Therefore, some form of competitor analysis alongside the analysis with respect to the organisation is required. This then feeds into the SWOT analysis, as strengths and weaknesses are technically relative to the competition. Also the industry analysis enables and assessment of the impact of changes in the general environment on the industry and also helps to identify not just the threats, but also the opportunities. 

References:

Porter, M.E. March-April, 1979, How competitive forces shape strategy, Harvard Business Review, 57 (2), pp.137-45.

An uncertain future

During the past few decades the business environment has become increasingly more complex and dynamic.  Changes from the disruption caused by new technologies, deregulation and disintermediation of markets, the threat of new competitive entrants, the opening up of new trade areas and alliances, and the emergence of new business models such as the gig economy, have all added to an increase in the degree of uncertainty about what the future will look like. In turn this puts pressure on senior executives who bear the responsibility for developing and implementing the strategy to deliver the corporate objectives (Oliver & Parrett, 2018). 

Forecasting and strategic planning

Organisations create forecasts to estimate how the current strategy will play out. Management accountants play a key role in the use of forecasting, as they are able to provide insight into the potential impact of known changes on the achievement of the organisation’s objectives. These can be expressed in financial terms, and used as the basis for more detailed budgeting of the forthcoming financial year. Furthermore, they form the basis for updating rolling budgets, where the plan for a set period of time, for example the next 12 months, is updated on a monthly or quarterly basis. The use of latest estimated forecasts and rolling budgets allow plans to be updated to take account of known changes. 

    Forecasts typically make use of quantitative models based on past behaviour using techniques such as time series analysis to help identify seasonal and cyclical trends, and regression analysis and econometric models to identify possible correlations and relationships between variables. However, it is not just the relationship between variables that is interesting, but identifying the driving forces for change, and responding to these in a timely manner. For example, leading indicators, such as a change in demographics created by an increase in the number of children, will impact on the market for children’s clothes, toys, and more broadly the number of schools, and so on. The time span between changes impacting on certain markets can add to the complexity. The impact of the changing demographics is relatively easy to estimate but the impact of disruptive technologies is more difficult. These can impact on certain industries, for example, the impact during the last decade of the internet on retailing and banking, and digital technology on telecommunications from the introduction of the mobile phone. The development of the smart phone has impacted on our social interactions, leisure activities, and how we interact with organisations, for example, ordering a taxi on demand, or a take-away meal via a mobile app. However, forecasting, while useful, does not necessarily prepare organisations to deal with the increasing level of uncertainty caused by the high level of complexity and dynamism in the business environment. 

    Writers such as Hamel (1996) and Prahalad (Hamel & Prahalad, 1989, 1994) emphasise the importance of looking to the future, and the dangers of becoming trapped in the ritual of strategic planning as a routine annual activity. Organisations need to be prepared to embrace change and avoid the status quo. Taking a broader look at the environment, and creating multiple scenarios of what the future may look like, can aid the understanding of the business environment by providing the opportunity for strategic conversations, in which possible views of the future are debated (Grant, 2003; Bowman et al., 2007). Undertaking scenario analysis enables an organisation to stay relevant to the times and to anticipate changes.

Scenario planning

A scenario is not a forecast, but a narrative of a possible future outcome. They are not a prediction of the future, but rather developed to enhance organisational learning about possible actions that can be taken in response to potential events and shocks to the business environment (Wright et al., 2013). They are expressed in qualitative, rather than quantitative terms. The timespan used can vary from 5, 10 to 20 years from now, but the further away the horizon, the more speculative the outcome becomes. The key benefit is that the development of scenarios allow organisations to gain an understanding of how they might respond, and to test possible strategies against changes in the business environment. This process enables organisations to be better prepared for changes should they materialise in the future. In addition possible triggers and environmental indicators can be identified and tracked, as part of an early warning system that the changes imagined in a scenario might actually happen (Wilburn & Wilburn, 2011). The more prepared an organisation is the better they are able to sense, seize and handle external changes quickly (Teece, 2007). Flexibility, responsiveness, and a willingness to change are undoubtedly key attributes for success in today’s business environment. 

    Using scenarios can have a positive impact on performance as managers are better prepared to deal with changes in the environment, and challenge the status quo (Visser & Chermack, 2009; Bouhalleb & Smida, 2018). Scenario planning does not only help to identify indicators to monitor, but also identify areas where the organisation can attempt to influence the future environment. It should not just be a case of accepting and responding to changes as they develop. Organisations can proactively engage with the environment in an attempt to change the way the industry looks in the future. For example, by lobbying governments, or developing and applying disruptive technologies and disintermediation strategies. This requires organisations to ask the question, what do we want the industry to look like in 5 or 10 years’ time, and what can we do to make sure it does? 

Objectives of scenario planning

Wright, Bradfield and Cairns (2013) suggest that there are three objectives to scenario planning: enhancing understanding; challenging conventional thinking; and improving decision making, although they felt there was little evidence to suggest that the third objective was achieved. In truth, all the objectives have a degree of subjectivity and there is little empirical research that categorically proves the benefits in quantitative terms, but the intangible benefits emerge through contributing to the process of organisational learning and an enhanced sensemaking ability from undertaking the scenario planning activity. This can be illustrated by looking in more detail at the three objectives proposed. 

• Enhancing understanding – by exploring multiple scenarios incorporating a range of possible events, emerging trends and environmental shocks, organisations can gain a better understanding of how the environment might change, and explore the possible strategic responses available to the organisation. Playing through the scenarios using role play, round table discussions, and business planning activities, can aid the understanding of how the organisation currently operates, as well as its capabilities for dealing with change. This process may suggest areas where the flexibility can be enhanced, not just to be able to deal more effectively with changes in the future, but to make improvements to operations within the current environment. This can have positive benefits in improving current efficiencies, effectiveness, and identifying possible opportunities to gain competitive advantage.
• Challenging conventional thinking - forecasting the future within known parameters is relatively easy, but to move away from the conventional thought processes and daring to imagine a new future can be rewarding. Thinking ‘outside of the box’, or opening up the mind so that ‘there is no box’, can be beneficial in stimulating change, and, even if the most radical scenarios might not materialise, the experience of exploring possible strategic responses prepares the organisation to deal with events and shocks when they do arise. This process may also generate ideas where the organisation is able to apply disruptive technologies or disintermediation strategies to change the environment to its advantage. 
• Improve decision making – the experience of playing through potential strategic responses to a range of envisioned environmental changes can enhance the decision making capabilities of the organisation due to the practice of creating and playing through the scenarios. Creating scenarios requires the acquisition of information via research skills, the organising of the information into a plausible narrative, communicating the narrative to relevant business units and participants, and analysing and evaluating various scenarios. The opportunity to do this improves the sharing of ideas, the discussion of potential impacts, and the development of strategic responses. These exercises can provide positive benefits within the effectiveness of the decision making processes in the organisation, and highlight areas where improvements can be made. The very act of creating the scenario, and playing though potential outcomes, can have intangible benefits that emerge from organisational learning and staff development, which will manifest themselves in enhancing the skills required for decision making. 

Benefits of scenario planning

There are several reported benefits claimed for scenario planning – the following are adapted from Wright, Bradfield and Cairns (2013).

• Enhanced perception and better observation of the environment. Scenario planning involves making assumptions about future environmental shocks and helps to identify aspects of the environment that can be monitored as indicators of change. This focus on the environment, and potential views of the future, serves to heighten awareness of the importance of environmental scanning on an on-going basis. 
• A structure for dealing with uncertainty. The use of scenarios to stimulate debate about the potential views of the future, which are generated from modelling the impact of potential events, emerging trends and environmental shocks, provides a framework for dealing with uncertainty. The scenario provides a rationale for confronting the uncertainties created from the increasingly complex and dynamic environment. 
• Integration of the corporate planning function. Although scenarios are not a prediction they enhance the skill set within the organisation for analysing and evaluating various strategic options. These can be translated into the activity of corporate planning so that when the indicators of change or events materialise they can be incorporated into the corporate plan. Scenario planning can be conducted at business unit level as well as the corporate level, which provides opportunities to explore how different events, and so on, impact on different business units, or functions. 
• Communication tool. Scenarios need to be communicated through the medium of a plausible narrative. The use of scenarios, and the dissemination to business units and managers within the organisation, increases the awareness of potential changes in the environment throughout the whole organisation, and potential strategic options that could be adopted. The creation and communication of the scenario also enhances the ability of those involved in its preparation to communicate information clearly and succinctly, in a way that facilitates decision making. 
• Organisational learning. The use of scenarios provides a means of generating debate about how things are, should be, and could be, done in the future. They provide opportunities for staff development, improving the current operations, and enhancing the organisation’s ability to anticipate and deal with uncertainty. If scenarios are updated and used on a frequent basis they form a useful platform for organisational learning and development. 
• Improving the process of sensemaking within an organisation. Van Reedt Dortland et al. (2014) suggest that scenario planning aids the process of sensemaking within an organisation. This is a social process in which members of the organisation interpret the environment through interactions that allow them to comprehend the world around them (Weick & Roberts, 1993). Weick (1995) stresses the importance of ‘cues’ – observable events that are inconsistent with people’s expectation and require further attention. Sensemaking involves noting and interpreting these cues into concrete actions. It is not practical to react to every cue, therefore, several cues taken together can create a ‘shock’ that initiates the sensemaking process. The typical shocks that scenario planning seeks to address are ambiguity and uncertainty. The process of scenario planning can act to challenge existing models of thinking and thereby create shocks to enhance sensemaking (Wright, 2005). Cues make sense to individuals within a certain frame or context, and therefore the process of sensemaking can encourage strategic conversations, as members of the organisation bring their own knowledge and experience to the interpretation of cues within a given context. 

There are, however, some aspects to be aware of when using scenario planning.

• Implausibility.  If the scenario is not plausible participants will not buy-in to the scenario and the usefulness of the exercise will be diminished. 
• The lack of quantitative data. Most scenarios are qualitative in nature as to apply quantitative data is difficult based on the level of uncertainty being considered. Indeed, a characteristic of uncertainty is that it is difficult to quantify. 
• High degree of subjectivity. Due to the nature of scenario planning there is a degree of subjectivity in their creation. This can be reduced by the use of expert opinion and checking the internal consistency, that is, does it make sense, and hence increase the plausibility of the scenarios. 
• Participant bias. It is important to involve a range of participants to avoid the views of influential individuals dominating the construction of scenarios, outcomes or strategic responses.  

The process of developing scenarios

There is no one set method of developing scenarios but the following phases represent a logical sequence of activities that can be compressed, extended, re-ordered, or amended, as suits the organisational needs. 

1. Define the scope of the scenario – this involves determining the time frame to be used, and the business units, products, markets, and so on, to be included. 
2. Identify the major stakeholders that can influence events or the future business environment. This helps to identify information sources and influential people to consult about the potential future scenarios that could emerge. Scenarios are inevitably subjective and are often based on extrapolations of team members’ experience, bounded by their knowledge of the environment in which they operate (Keough & Shanahan, 2008; Marcus, 2009). It is often advisable to consult with industry experts outside of the organisation, such as academics and consultants, to inject an element of externality to avoid the possibility of groupthink and arriving at a consensus of the future that is too close to the existing strategy. This reduces the potential for scenarios to be unduly influenced by the bias of the participants. The use of the Delphi technique can help to ensure a range of opinions are given due consideration, and thus avoid bias or groupthink which may result in scenarios being produced with which the current management are comfortable. It is better to take management outside of their comfort zone. The Delphi technique is a structured communication and consensus building technique in which experts are interviewed separately, or asked to complete a detailed questionnaire, to elicit their opinions on the future environment. These are then summarised and the results circulated to the participants who are asked to consider the issues again, taking into account the opinions expressed from the first round. These can be summarised again and the process repeated until a reasonably consistent view is reached. 
3. Identify the major events, trends, changes that could emerge. The use of frameworks such as PESTEL and industry analysis can be utilised to generate potential ideas. It is important, however, not to become trapped by thinking solely about known and short term factors. O’Brien (2004) noted that there is often a predominance of economic factors highlighted and there can be a lack of imagination, resulting in future scenarios staying fairly close to the current state. 
4. Identify the key uncertainties. Scenario planning is about learning to deal with uncertainties and therefore the events, trends, and so on, need to be reviewed critically to identify the real uncertainties. Garvin and Levesque (2006) suggested identifying the key focal issue, driving forces and critical uncertainties before designing the scenarios to encourage strategic conversations with real relevance to the organisation. 
5. Identify potential scenarios. It is possible that there will be a range of ideas generated. These can be merged to create possible scenarios that can be developed into workable scenarios for consideration. There are different suggestions within the literature as to the number of scenarios that should be generated but keeping it to a manageable number is the consensus view, probably around four or five. Constructing and evaluating scenarios takes time, resources and effort, not just from those involved in their construction, but also on the part of the participants engaged in the strategic conversations that follow. In practice, therefore, the number of scenarios that can be constructed and considered may be limited, in which case it is important to deal with scenarios that cover the main uncertainties that have been identified.  
6. Conduct research and construct initial scenarios. Once the initial scenarios have been identified research needs to be conducted to ensure that the constructed future is grounded on a solid observable start point. Scenarios have to be plausible otherwise managers will not take them seriously, therefore, undertaking research in their preparation is not just highly desirable, it is essential. Wilburn and Wilburn (2011) note that there are scenarios available from certain organisations, such as industry associations, government agencies, and consultants that engage in future thinking that businesses can use. This avoids the time and resources required to research the preparation of original scenarios. 
7. Check internal consistency and plausibility. The scenarios need to be plausible, otherwise those asked to participate in the discussions concerning possible strategies to deal with the outcomes will not buy-in to the exercise. The potential cause and effect relationships also need to be checked for both internal and external consistency to ensure that the scenarios developed are plausible. Checking consistency involves making a judgement about whether the event causes and effects included are reasonable and flow in a logical manner. The involvement of experts to review the scenarios before dissemination within the organisation is a useful and practical method of checking for consistency. 
8. The scenarios can be written as a narrative story and disseminated to participants to the activity. 

Schools of scenario planning

Huss and Honton (1987) suggest that there are three basic schools of thought in scenario planning. These are intuitive logic, trend-impact analysis, and cross-impact analysis. 

• Intuitive logic – the process of developing plausible qualitative scenarios that generate strategic conversations. This is the most common form of scenario planning, and is the one described above. It is often called constructive logic as the method applies intuition and logical reasoning to construct likely events and outcomes without the need for definitive proof. It is based on identifying cause and effect relationships between variables, events and trends, and can be used to consider potential strategic responses. The emphasis of the scenario planning is to uncover the causal nature of the unfolding future. The driving forces, which can be independent, can then be identified along with the areas of influence that are associated with each variable. Events, driving forces and variables can be clustered together to indicate the interplay between the independent elements. Two or three outcomes, some of which may be extreme, are determined for each event or cluster. The scenarios are checked for internal consistency in that the narrative explains the dynamic interplay of the predetermined events and uncertainties, such that the future is arrived at via a logical sequence of consequences. This ensures plausibility, as well as injecting an element of reality into the resulting strategic conversation that evaluates the various strategic responses that could be employed. 
• Trend-impact analysis – the use of quantitative models and simulations, including econometric models. This method lends itself well to the use of accounting and economic data but it is not as easy to generate a strategic conversation around the potential outcomes. Rather there is a tendency to focus discussion on the validity of the assumptions built into the data. 
• Cross-impact analysis associated with the La Perspective Institute - the use of quantitative and qualitative scenarios to which probabilities can be associated. This is a process of developing a range of scenarios to which probabilities are assigned. The process enables potential strategies to be developed and can aid the development of the best case, worst case, and most likely outcomes. 
• Backcasting or backwards logic - Gioia et al. (2002) suggest that a process known as backcasting can be used where a future state is envisaged and then a process of retrospectively looking at the events that would need to happen in order to reach the future state is undertaken. This is very similar to the backward logic method (Meissner & Wulf, 2015), in which participants try and work out what caused the future state. It uses the benefit of hindsight, or prospective hindsight, and is a form of sensemaking that helps decision makers generate potential explanations for a future event by going forward in time and then looking backwards. This can be used to help establish the degree of plausibility of an envisioned future state, in that, when looking at the changes that would need to take place to make it a reality, the probability, of it actually being achieved can be assessed. A recent trend in television murder mystery programs begin by showing the audience the murder, so the audience knowns who did it, and we then spend the next hour watching the detectives work backwards to understand how and why it happened. 

Using scenarios

The scenario planning activity can take several forms but essentially they are intended to generate discussion about the future and the organisational response. There are several ways in which scenarios can be used in practice which include:

• Role play. Scenarios can be used for role playing exercises in which various stakeholder reactions can be tested. This is particularly useful in testing different strategic responses for acceptability to stakeholders, particularly the key players. It can also enhance the participants understanding of the various stakeholder perspectives on strategic actions that can have an influence on the development of the current strategy.  
• The use of critical incidents. This is a technique in which scenarios are rigorously tested against critical incidents that could occur and participants engage in identifying a range of potential strategic responses to the question, what happens if? The potential strategies are evaluated as to plausibility and practicality. This can help to assess the organisation’s resources and capabilities to deal with uncertainty in the future. 
• Best case – worst case scenarios can be assessed bearing in mind that they are not predictions but a range of possible scenarios. These can be used to focus on strategies that proactively push the environment towards the best case scenario, and away from the worst case. This also enables the organisation to consider, and to an extent increase, its ability to deal with the worst case scenario should it materialise. 
• Multi-attribute value analysis can be applied in which various strategies, including a range of attributes, are evaluated against the scenarios. The scenarios can be used to evaluate strategies and outcomes against the achievement of different objectives. These can then be ranked which helps the organisation to enhance its degree of preparedness should events and trends materialise. 
• Developing antifragility strategies. Derbyshire and Wright (2014) suggest that scenarios can be assessed as to the degree of fragility, that is, the ability of the organisation to deal with the event, or change. Scenarios can be categorised as fragile, or antifragile. Strategies can then be developed to make all scenarios antifragile, thus increasing the ability of the organisation to deal with uncertain events.  
• A resource based view (Barney, 1991) can be adopted in that scenario planning is used to assess the resources and capabilities required and obtained in order to deal with various scenario outcomes. It is a useful methodology as resources are obtained from the environment, so environmental changes can impact on resources. Fink et al. (2005) define resources as assets which an organisation possesses, controls, or to which it has access, and capabilities are activities that an organisation performs. Capabilities are usually generated by the interaction of resources combined with the knowledge about how to use the resources in combination, and individually. Scenarios can be used to assess where resources and capabilities need to be strengthened to deal with potential events that may occur in the future. This is where anticipating the time impact of events is useful as resources cannot always be increased, or capabilities enhanced, at short notice.  
• The scenarios can be used in conjunction with SWOT analysis to develop strategic responses to potential outcomes. If a degree of quantitative analysis is applied the identification of potential strategic gaps is possible, enabling strategies to be evaluated as to their ability to close the gap. 
• The use of real options. One technique that has been borrowed from financial markets is that of the concept of options, and is referred to as real options. A real option is the right, but not the obligation, to make an investment in real assets by, or at the end of, a given period (Dixit & Pindyck, 1994). The basic idea is that large investments can be broken down into a series of smaller decision points. Following an initial investment the organisation has opportunities to take different decisions as events unfold in the environment. For example, further investments could be made (analogous to a call option) from which future benefits can be derived. The exercise price is the additional investment required to deploy the resources. Alternatively, there may be an opportunity to divest assets, or discontinue a project (analogous to a put option) thus limited the potential future losses.  The exercise price is the net value realised when exiting a business. Options may include opportunities to defer, grow, abandon, phase or select elements. This enables organisations to consider a range of scenarios and options within the individual scenarios, and also to identify the potential upside and downside of each available option. Scenarios can be updated as the future unfolds so that it enhances the understanding of the environment (Schoemaker, 1993). For example, certain long term projects can be the subject of scenario planning and analysis at several points during their lifetime. At the beginning of the project there is the option ‘not to go ahead’ or ‘abandon’, but once the project is underway, the options to ‘exit’, or ‘make additional investments’, become available. 

Conclusion

Scenario planning was popularised during the 1970’s, primarily by Royal Dutch Shell, but the practice waned a little during the 1980s. It has, however, enjoyed a resurgence in recent times with many organisations and senior executives promoting its use and benefits. The major benefit is that it encourages organisations to think about the future and the organisation’s ability to deal with uncertainties. Thinking about how the business environment might change, or could be changed, and the strategic responses, or initiatives, that can be made, ensures that organisations are better prepared to face the uncertainties of the future. 

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