It’s an open secret that when business unit leaders develop strategic plans, they often set targets they can be sure of reaching or exceeding. As you aggregate these plans at the corporate level, the buffers add up to a pretty large corporate sandbag—one that makes achieving the hoped-for hockey-stick growth a near certain failure. The practice of rolling up business unit plans also explains why you see so few big moves put forward at big strategy meetings: Division managers tend to view acquisitions, capital investments, and other bold initiatives as too risky to their careers, so they don’t include them in the proposals they bring into the strategy room.
Sandbagging is, I admit, a complex problem. Let’s say the leader of a business unit targets margin improvement of 10% of sales. He doesn’t want to overcommit, so he adjusts for risk and promises only to deliver 5%. He figures, if I have five “free” points, I will invest in good growth ideas. He winds up with a lot of flexibility—a sandbag. If margin does not improve by the full 10% the leader was originally targeting, he has the safety of his buffer. In fact, he may not push that hard to get the margin improvement beyond the 5% he promised. Meanwhile, he may be taking on considerable risk in the growth investments, the effects of which will only be noticed later.
There are ways to combat sandbagging. The key is to make sure that risks and investments are managed at the corporate level. Put differently, you need to shift from aggregating lots of individual budget sandbags from the bottom up to creating a single, holistic view. By making risk a shared concern, the incentive for individual sandbagging goes away.
Hold 3 separate conversations
Instead of one integrated strategy review, consider moving to three sequential conversations that focus on the core aspects of strategy: an improvement plan that frees up resources; a growth plan that consumes resources; and a risk management plan that governs the portfolio.
This approach triggers several shifts. First, it forces people to discuss growth plans without having to add caveats about eventualities that could obstruct those plans. They can focus on what they aim to achieve and the resources required to do so. But when asking everyone for growth plans, consider insisting on certain levels of ambition to make sure everyone is appropriately imaginative and aggressive. You should do the same with improvement plans. This shift also forces the team to pay a lot of attention to productivity improvements, which often get swept aside by discussions of growth. Yet, as my colleague Sven Smit recently wrote, these initiatives are essential to freeing the resources needed for big moves.
Only after people have put their best ideas on the table do you even begin to discuss risk. By letting business leaders focus specifically on risk, you change their perception that their heads alone will be on the block if the strategic risk can’t be mitigated. They will share what they know of the risks associated with their plans rather than trying to hide their concerns—or not proposing the initiative at all.
Make risk-versus-growth trade-offs at a portfolio level
You can now combine all proposed ideas with a full understanding of their growth contribution, improvement potential, and inherent risk. This makes it possible to make decisions on how much risk the company as a whole wants to take on.
This is a big deal. You can now ask people for audacious plans around growth and improvements—say, plans outlining what it would take to grow profit by 20% or even 40%. Then, when you have the explicit discussion about risk, you pool the risks for all the plans and prioritize accordingly.
You can also discuss macroeconomic or geopolitical risks that may affect various proposed initiatives—factors that rarely are explicitly recognized. You could ask business leaders to submit a minus-20 or minus-40 plan. This would also highlight the first things they would cut, and therefore how much capital you could realistically withdraw from their businesses.
To see how this shift plays out, consider the experience of a retailer that typically combined the plans of its different brands. One year, the company instead racked up the full set of about 60 investible opportunities and assessed them against one another, regardless of the brand or business unit with which they were connected. The dispersion between opportunities was striking. A portfolio-level view also led to a different answer about the right risk/return threshold than had emerged from assessments made earlier by individual divisional leaders. It turned out, perhaps counterintuitively, that there was too much capital going to the smaller businesses, while the biggest business had major underfunded opportunities.
Tailor approaches to different risk profiles
It’s critical to assess initiatives based on the level of risk they entail. I recommend three categories:
No-regret move: This type of project has known payoffs that work in all scenarios, for which standard net present value (NPV) analysis does the trick perfectly. Basic efficiency initiatives typically fit into this bucket.
Big bet: This is a high-commitment decision that has a chance of being wrong. You must make it very carefully, and apply a lot of scenario analysis and risk management.
Real option: An initiative that has a lower entry cost but gives you the option to make further bets down the road to achieve a payoff, benefiting from what you learn along the way. Because it usually starts “out-of-the-money” (is loss-making), a harsh short-term view will kill it. As a result, companies tend to eliminate the optionality in the name of today’s profits, and lose too much flexibility.
Naturally, you should adjust performance targets and incentives to reflect the risk inherent in these initiatives. This should extend to managers who do not get their initiatives approved, perhaps because their projects entailed risks the company did not want to take.
It seems that many management teams have already made such changes, or are making efforts to do so. In a recent survey, more than half of the respondents reported that their companies have put these shifts into the middle or high gear—especially in making risk-versus-growth decisions at the corporate rather than divisional level.
That’s good news, because this is among the most important of the eight shifts my colleagues and I recommend for strategy development. Allowing risk avoidance and sandbagging to fester, silent and unchecked, will inevitably keep the company from reaching its real goal: the kind of breakout performance that can vault it up the Power Curve of economic profit, the ultimate yardstick of success.
Martin Hirt is a senior partner in our Greater China office, co-leader of our Strategy and Corporate Finance Practice, and co-author of Strategy Beyond the Hockey Stick with Sven Smit and Chris Bradley.
This article originally appeared on LinkedIn.