How to Make Strategic Trade-Offs

How to Make Strategic Trade-Offs

By Matt Dallisson, 24/06/2022

When CEOs lay out multiple high-level objectives, like increasing market share, entering new markets, and pursuing innovation — all at the same time — they enthusiastically tout the advantages of each. They set ambitious numerical targets. They rally the troops behind the vision. But they rarely talk explicitly about how much value they are willing to sacrifice in one of those objectives to achieve more value in another. When it comes to their strategic objectives, they naturally “want it all” and resist talking about sacrifice. In the absence of explicit guidance, executives and the managers beneath them substitute their own judgment for the CEO’s, weighting conflicting objectives differently and, by doing so, pull the organization in many misaligned directions at once.

For new CEOs who are bringing a fresh vision to a company or established leaders who are charting a new course for an organization that has begun to stagnate, the solution is to provide their team with a “calculus of sacrifice,” a specific formula for making trade-offs among objectives. For example, a CEO simultaneously pursuing a certain level of profitability and market share increases in new growth markets could make it clear that he is willing to sacrifice 10% of profits in the coming three years to increase sales in a particular growth market by 15%.

Conflicts requiring sacrifices are common across industries. How much short-term profitability is an automobile manufacturer willing to give up during its transition to becoming a producer of only electric vehicles? What are the trade-offs between a post-pandemic return to the office and the ability to hire the best talent regardless of geography? How big a hit is the organization willing to take in terms of profits, stranded assets, and higher operational costs at any given point in a journey toward net-zero emissions?

By making the degree of sacrifice explicit among such conflicting objectives and quantifying it, CEOs can reframe decision-making and give executives the tools to make decisions aligned with their vision. Instead of advocacy-based deliberations, in which proponents of different courses of action make affirmative cases, discussion focuses on sacrifice: How much of one thing are we willing to give up in order to get more of something else?

Here’s how you can establish this new way of thinking about strategic investments and introduce a “calculus of sacrifice” to ensure greater alignment in decision-making:

Determine how individual team members calculate key trade-offs.

The first step is to determine the calculus each team member employs when weighing objectives. For instance, the CEO of a global pharmaceutical manufacturer thought he had made it clear that he intended to shift the company away from conventional small molecule drugs toward new technologies, such as cell and gene therapy. Despite executives affirming that they understood the vision, progress remained slow. Recommendations for investments deviated only marginally from the current path — relying on small molecule drugs and undertaking life-cycle-management studies of current drugs for possible tweaks that would prolong their market life. Recommendations that deviated sharply from that path met stiff resistance.

The CEO initiated a series of individual interviews with members of the leadership team that covered the issue of innovation versus staying the course with small molecules and the other key areas of the CEO’s vision that turned on trade-offs: short-term profits vs. long-term profits, digital business models vs. established channels, contribution to society vs. expectations of capital markets, and research and discovery vs. commercial development.

In the case of innovation, the question became: How much probability of technical success (PTS) would you sacrifice if that leads to greater innovation? In other words, what kind of failure rate are you willing to accept in the development of a potential blockbuster drug or breakthrough therapy?

None of the team members opposed innovation; they simply weighted the underlying drivers of their thinking differently. The camp that seemed most resistant to the new vision gave greater weight to the probability of technical success — to steady incremental innovation. In their view, focusing on current technological capabilities ensured a high likelihood of development success and efficient commercialization through experience and established channels. Executives more aligned with the CEO’s vision gave greater weight to making great leaps forward in terms of innovation. They felt that embracing new technologies could broaden the company’s knowledge, attract new talent, and provide access to new markets.

Despite the best of intentions on all sides, these differing preferences were a recipe for misalignment and paralysis. For example, the head of discovery might be willing to sacrifice a high PTS of, say, 30% in a project with an unattractive technology, like small molecules, for a lower PTS of, say, 5%, in a project with an attractive technology, like cell and gene therapy. But if the head of development was not willing to sacrifice that degree of PTS, then two units that depend on each other work at cross-purposes.

When such results are shared, executive teams are often as profoundly shocked as CEOs by wide divergences in the numbers. Those who are greatly out of step with their colleagues and the CEO are led to ask themselves whether they really understand the strategy. Those who are in step gain additional confidence in knowing that they are on the same page as the CEO.

Establish a common calculus.

To preempt the undermining of the strategic vision by divergences in how to make trade-offs, CEOs should make clear how much of one objective they’re willing to sacrifice in favor of conflicting objectives. The goal is to determine how much weight should be accorded each objective, ultimately yielding a set of weighted objectives that can be used to evaluate any opportunity.

For instance, the CEO of a major supplier of technology to the energy industry had recognized the need to transition its portfolio to future technologies. This required stepwise decisions on technology investments that had the potential to cannibalize the current profitable core business.

The CEO broke down this vision into the objectives “address future customer needs” and “invest in near-term profitable solutions,” among others. Addressing future customer needs favored new technologies, such as carbon-capture-and-storage technologies or investments in hydrogen applications and their infrastructure. At the time, only a few of these technologies offered the desired profit margin to the company. So the second objective — “investing in near-term profitable solutions” — favored expanding the profitable core business or focusing on more mature technologies.

The CEO’s guidance was to focus on already profitable solutions while acknowledging that addressing future customer needs properly could lead to a greater value in the long run. But what would that mean concretely when it came to prioritizing investments?

First, the team had to develop criteria for assessing the extent to which an investment “addresses future customer needs” and represented “near-term profitable solutions.” Different companies may use different criteria for satisfying any given objective, but the point is to be able to measure the extent to which an opportunity satisfies particular objectives so that opportunities can be compared.

For the energy technology company, the criteria for “future customer needs” included, among others: 1) the ease of integrating the company’s technology with the customer’s existing technology, 2) the ability to address customer pain points, and 3) the ability to enhance the customer’s level of social responsibility such as an improved environment, social, and governance (ESG) score. The team then developed scales for scoring each criterion from 0% to 100%. Once a percentage score for each of the criteria had been determined, the percentages were averaged to arrive at an overall score for the objective.

The criteria for “investing in near-term profitable solutions” included, among others: 1) the typical profit margin of a technology, 2) current market size, and 3) current market competitiveness. As with other objectives, scales were developed for scoring each criterion from 0% to 100%, and the scores were averaged to arrive at an overall score for the objective.

To arrive at the relative weights of the two objectives, the CEO described various projects that he found equally attractive — projects whose relative advantages and disadvantages across the objectives offset each other. For example, the CEO said that he was indifferent between an investment A that scored 50% in terms of meeting future customer needs and 80% in terms of near-term profitable solutions versus an investment B that scored 70% on customer needs and 40% on near-term profitable solution. This statement of indifference made it clear that the CEO would be willing to sacrifice up to twice as much in terms of near-term profitable solutions (80% for A versus 40% for B) to achieve gains in meeting future customer needs (50% for A versus 70% for B). In other words, in evaluating opportunities, “future customer needs” should carry twice the weight of “near-term profitable solutions.”

If there had been no more than those two objectives, then their weights in the calculus for evaluating any investment would have been 67% for “future customer needs” versus 33% for “near-term profitable solutions. However, there were additional objectives that needed to be weighted. So, using this weighting of “future customer needs” as a benchmark, the CEO and team worked through similar trade-off comparisons with three other key strategic objectives to arrive at statements of indifference that yielded relative weights for all five objectives. Again, the weights added up to 100%. Any new opportunity would then be scored against the scales for each objective and each score multiplied with the weights. With this “calculus of sacrifice” in hand, the company could then evaluate all opportunities uniformly and quantitatively and team members could make independent decisions aligned with the CEO’s strategic vision.

Use the calculus to guide deliberations.

A specific calculus is particularly helpful when the executive team is allocating resources among the many proposed investments they must consider. The set of investments on which everyone agrees can be immediately approved. Proposed investments that the team ranks low can be rejected or sent back to their originators for modification. The leadership team can then focus its energy on proposed investments in the middle — those that people might disagree on. That is when the calculus for various trade-offs comes to the fore.

To be clear, the calculus can’t automatically eliminate disagreement. Team members may agree on the formula but disagree on whether a specific investment fits that bill. To achieve 15% increase in sales in China, for example, a proposal might include greatly increasing the sales force there, boosting expenditures on advertising and promotion substantially, building a factory, and other measures. Some might argue that those things aren’t enough to achieve a 15% sales increase there. Others might argue that those things will cut profits by more than the permissible amount. Some may argue that the investment will satisfy neither parameter of the calculus.

Typically, the evaluation of alternatives and investment opportunities is based on predictions and estimates about the future about which people naturally disagree. The solution is to run a “sensitivity analysis” designed to determine whether a particular difference of opinion about the effects of a proposed action actually changes the attractiveness of the alternatives in a way that would result in a different decision.

If it doesn’t ultimately change the decision, then all team members should be in favor of going ahead with the proposal, despite their differing assessments of a particular action. If the sensitivity analysis reveals that the uncertainty around the alternatives’ estimated impacts on the objectives would change the decision, then you have uncovered an external factor or an uncertainty that is so important that you need to do more analysis and delay the decision until you understand it better.

The calculus that the CEO has established for the trade-off between profit and new market penetration helps the team recognize the inevitability of sacrifices among objectives and provides them with a common reference point against which to test arguments and disagreements. This approach separates the discussion of assumptions about alternatives (what you know about a project) from the underlying preferences (what you prioritize in a project) and focuses the discussion on preferences and their relative importance. With everyone speaking the language of sacrifice and having a formula for calculating it, the team can incisively address the most controversial investments, eventually reach agreement, and explicitly align around the decision.

The lesson for leaders is clear: Assess the alignment within the leadership team and understand to what extent the understanding of objectives and their relative importance deviates from the leader’s vision. Separate what you know about a proposed project — its pros and cons — from an understanding of its relative importance and the underlying assumptions driving individual preferences. Provide clear guidance on how sacrifices should be calculated. By codifying how they weight objectives, CEOs, who as a practical matter cannot be involved in every deliberation, unleash their organizations to make better, faster decisions that are aligned with the company’s long-term strategy.

This content was originally published here.