This is a post for businesses to know and understand the 4 levels of uncertainty for making decisions in an uncertain world.
Small business owners and SME investors and managers are often face with a multitude of options and choices in their everyday business life.
This post gives the SME owner a framework on understanding the complexity of an uncertainty as well as provides a framework on how to address each type of uncertainty.
Most of us have made major or minor decisions at some point in our business or personal life that we have regretted later. Be it an investment choice, a major purchase, a hiring choice, a major price cut, a key strategic investment or other daily business or personal decisions or strategies, we all do wish that we have the gift and wisdom of foresight.
For those that are not familiar with the American idiom “hindsight is 20/20, it means that when you look back at something that happened in the past, it is much easier to see how something could have been done differently or how a wrong decision could have been prevented because we have more of the facts after the outcome of the decision, therefore one has a clearer 20/20 vision of the event.
So how do we deal with uncertainty in the business world? Before I answer that, I should fully credit the source of inspiration for this blog. Most business schools teach some level of managerial decision making as well as how to use the various tools and frameworks available to managers to aid in their decision making. However, any discussion of strategy or uncertainties always brings to mind for me, an excellent McKinsey Quarterly article that I read about a decade or so ago on levels and types of uncertainty. The approach and conclusions drawn by the author/s of this article has had a profound influence the way I look at uncertainty in my personal or professional life.
In essence the article stated that most strategically relevant information fell into two categories. Often it is possible to identify clear trends like demographics and macro economic data. Further, with the right level of due diligence and analysis, most remaining unknown factors like technology risks, market risks, financial risks and other risks like supply and demand side factors like competitor responses, customer adoption rates including potential elasticity to price reduction, financing coverage capability from cash flows generated are among many others that could be determined through structured analysis. The uncertainty that remains after the best possible analysis has been undertaken, is what they called residual uncertainty. Examples of this include the outcome of a legal suit, outcomes of regulatory changes or the performance attributes of a nascent technology that has not been fully deployed or adopted or one that is still under development. The authors classified the so called “residual uncertainties” into four levels.
Level 1 uncertainty – Outcome is known
In level 1 uncertainty the possible outcome is known, so no multi scenario analysis is required. However you have to be sure that decision making required on a residual uncertainty is really a level one.
Due to the fast moving pace of the telecommunications industry (a industry that I have worked for in the last 20 years, and still do), I personally feel that that most business decisions or strategies in the fast moving telecommunications industry are facing uncertainties beyond level 1.However most telecommunications managers limit the strategic analysis to level 1 uncertainty and often draw wrong conclusions.
Level 2 uncertainty – Alternative outcomes
In level 2 uncertainty, the authors described it as “as one of a few discrete scenarios”. In essence any analysis cannot predict which outcomes will happen but rather would require us to assign probabilities based on the best information, tools and knowledge available.
A classic level 2 situation is when a telecoms operator decides whether to invest in a new technology which usually costs them billions of dollars. These are choices that were grappled by the telecom players in most developed and developing markets as to whether to invest in upgrading from 2G to 3G or even now whether to invest in 4G. The telecom players are normally forced to make the high stake investments, even if the previous generation technology investments have not generated the desired returns. The value of this type of established (standardized) new technology investments are dependent on their same market competitors’ investment strategies which cannot yet be observed or predicted. If the first mover invests in a higher performance technology, others in the market will be forced to invest to minimize their opportunity costs of high probability of customer churn and rapid per unit revenue degradation. The possible outcomes and moves of the competitor are discrete and clear – Will they invest, yes or no and if yes, when? The best strategy depends on which one does and when it happens.
Level three: A multitude of possible outcomes
In level 3, there are a range of possible outcomes that can be identified. There are very few variables to range the multitude of options.
Examples of level 3 uncertainties are when a telecom player had to decide on the type of technology to enhance performance and speed of the network. For example, many telecom operators are deciding whether and when to invest in 4G technologies and which technology to choose from (HSPA+, LTE or wait for other technological advancements happening in the industry). This is a difficult decision today, as it entails billions of dollars of investments at a time when no reasonable returns have been generated from prior upgrades in the network. Further, all this investment decisions have to be made in an era of rapid price and margin erosion.
Another example is when a telecom operator in a small market have to make a choice as to, if and when to align with Mobile Virtual Network Operators (MVNOs). The significant factors that determine this sort of strategy have multiple levels of uncertainty ranging from the decision to align with an MVNO or not to, to the level of pricing, the cannibalization of revenue and customer issues, whether to limit the sales to a niche segment or to the broader market. Additional considerations could include the level of costs and customer control to be transferred to the MVNO. As you will have noted, this will require a detailed, structured and multi scenario analysis to address this complex and often an arduous task to predict the outcome of this type of uncertainties.
Any scenario development should facilitate easy decision making, therefore it is recommended that the number of scenarios be limited and the scenarios should have unique implications and should not overlap.
At the very least, developing a set of scenarios should at the least enable managers to assess the wisdom of their existing or planned status quo strategies.
Level 4 – It is the Wild West!
A level 4 uncertainty is truly ambiguous. It is hard to predict the outcomes. Level 4 uncertainties are rare in most industries, but exist in the fast moving telecommunications industry.
For example if you are in the telecommunications industry, it behooves upon the management to have a structured and purposeful strategy to address the emergence of the multiple VOIP players like SKYPE, REBTEL and other new age companies like Google, Facebook and other networks having millions of customers. No amount of analysis could have actually predicted in the early part of 2002 or 2003, the outcome of how and when they will wreck the telecom player’s voice business (the real gravy for the telecoms industry and the killer app of all time). Today, the outcomes seem a little too obvious. Yes, hindsight is indeed 20/20.
Shape or be shaped!
Assigning informed and reasonable probabilities will help them to develop investment and pricing and product portfolio rebalancing strategies that are phased to ensure that they don’t end up being the proverbial “dumb pipe”.
Addressing level 4 uncertainties requires a player to shape or be shaped, be prepared to adapt and or reserve the right to play. The choice of strategies to address level 4 uncertainties are dependent on the competitive leverage, risk averseness of the management, financial strength and a multitude of other factors like investor appetite, organizational capability, innovation orientation and others.
Vodafone’s level 4 uncertainty
Imagine a company like Vodafone. Its Western European revenues are declining. It has invested billions on 3G and HSPA+ networks and acquired many developing market telecom players to offset the anticipated decline in revenue from their developed markets portfolio. The cash flow growths in these newly acquired companies are coming under heavy pressure due to the significant price reductions to boost market adoption.
Additionally, all players in the telecommunications value chain are forcing them to expend or reinvest their free cash flow. The processor core and network vendors are upgrading their network equipment (Moore’s Law effect). Further, all it takes is an “irrational” player in any of their markets to force them to prematurely invest billions in the network. The advent of new smart phones like the iPhone and others are forcing them to subsidize heavily on the handsets and the network just to retain their existing base. The MVNOs are forcing them to drop prices just to stay competitive. Multiple content players are forcing them to rethink and invest heavily in their networks and data strategy. The new age Internet players like Skype and Google are forcing them to reduce their voice prices. The regulators are cramming them to reduce prices on their high margin roaming propositions. Informed individual customers and enterprises are demanding the best deal and the lowest prices. On top of all these factors, imagine the range of new organizational capabilities required to transform the company into a nimble new age media player.
As you can see clearly, this is a level 4 uncertainty for its management and shareholders. How does the company justify its growth assumptions baked into its enterprise valuation?
How and where do they shape, adapt or reserve the right to play? What are the portfolio of strategies, initiatives, actions, big bet moves, option and no regret plays that Vodafone should be embarking on?
Don’t let your foresight be blind!
As you can see, the range of the levels of uncertainty can range from a broad spectrum of one of a 2 possible outcomes to a wholly unknown and ambiguous set of variables.
Knowing the levels of uncertainty, thinking purposefully and in a structured way the multiple scenarios and probabilities and the strategies to address the uncertainties is essential for any manager.
Understanding and addressing the levels of uncertainty is the only way to avoid Monday morning quarter backing. The deliberate framework and tool described here can be applied to both your professional and personal life. Hindsight is 20/20. Don’t let your foresight be blind either.
John.firstname.lastname@example.org Twitter @lincolnjc