Mihai Ionescu - Senior Strategy Consultant, Owner Balanced Scorecard Romania, Author.
When we formulate our Strategy, we have to build a chain of hypothesis, because our Strategy is all about the future. Further on, we do the same thing when we translate the Strategy into a Strategic Plan, to execute the Strategy. On one hand, we have to handle the VUCA context (Volatility, Uncertainty, Complexity and Ambiguity) of our business environment's future evolution and, on the other hand, we have to make a number of assumptions about how will we succeed in making the necessary strategic changes in our organization.
However, as we go ahead with executing our Strategic Plan, we tend to forget this and almost always use our scorecards and KPIs mainly for performance management, with little or no regard to our Strategy's chain of hypothesis and assumptions.
It was several years ago when I've noticed a series of YouTube videos made public by Ed Barrows, a visionary Balanced Scorecard practitioner and consultant, who had an instrumental role in the BSC implementation at an important US organization. If you haven't watched them, I'd encourage you to do so: Developing Measures. Why do I mention this? Because Ed spelled out publicly, for the first time, that the KPIs that we place in our BSC scorecards should be used for validating the hypothesis of our Strategy and Strategic Plan, rather than for measuring performance.
Surprised? No wonder. I've always noticed the eyebrows raising during my Strategy Management course sessions, whenever I've reached this point. The current article is aimed at explaining this fundamental concept, which isn't one very easy to digest, for most people exploring or working with the Balanced Scorecard framework. On a more anecdotal note, I wonder how much of the concepts described below will rock the way you're interpreting what the statuses of the Strategic Objectives and the KPIs in your scorecards are telling you :)
Adaptive Strategy's Hypothesis
If you have read the Adaptive Strategy System article, published several months ago, you are probably familiar with the way in which the hypothesis that we've made during the Strategy Formulation process are monitored by the Strategic Warning System (SWS) that triggers the Strategy Reformulation, whenever those hypothesis are invalidated by our business environment's evolution.
In summary, this is how it works:
Hoping that the diagram above is self-explanatory, I'd like to highlight that this is how we should react to the invalidation of our Strategy's hypothesis, as we progress along Strategic Plan's execution. It's the process of adapting our Strategy, whenever the business environment evolves in a way different from how we've anticipated.
Extending the Chain of Hypothesis
What do you think, is the future evolution of our business environment the only thing that we need to hypothesize about? Consider this: our deliberate Strategic Choices are also about the future and, even if the business environment would evolve exactly as we have anticipated, we should expect market reactions determined by the effects of our Strategic Choices (that's what the upper-left dotted lines in the above diagram symbolize). This will always happen when we'll launch new products or services, when we'll develop new sales channels, when we'll add new players to our partners ecosystem, and so on. However, the fact is that we don't know what those market reactions will be, so we have to hypothesize about them, as well.
If you want to know more about the Strategic Choices and the Strategy Models that are used for defining them, a recommendable read is the Strategic Choices and Strategy Models article.
But that's not all. As we translate the Strategy into an aligned Strategic Plan, we have to extend Strategy's chain of hypothesis even more, this time internally-focused.
For example, if we decide to adopt new Strategic Choices, the exact level and configuration of the new Capabilities required to support them is something that we have to estimate and hypothesize about, at least because some of them have never been part of our Capabilities System
Similarly, when we define specific Strategic Initiatives, aimed at closing the Strategic Gaps targeted by the corresponding Strategic Objectives, we have to estimate the effect of those initiatives. That's an additional set of hypothesis. However, if the estimated effects are not confirmed, we'll have to take Corrective Actions to address that.
We also have to make hypothesis about the Cause-Effect relationships between the Strategic Objectives in our Strategy Maps and estimate the relative weight of the multiple causality links between Driving and Driven Strategic Objectives. And so on ... a lot of hypothesis that will have to be confirmed or invalidated as we are progressing along our Strategic Plan's execution.
If we want to draw a diagram of the logic that we use for validating our chain of hypothesis made along the Strategy formulation and planning processes, it would probably look like this:
In order to correctly interpret this logic diagram, let's use an analogy: How do you know what's wrong if you push the gas pedal of your car and you don't get the desired speed? You may think that the road is slippery and the wheels are skating, or that there is something wrong with the fuel injectors, or that the gas in your car's tank has a lower octane value that required, and so on ... you see, there are a lot of thoughts that may cross your mind.
We are doing exactly the same thing when we want to interpret what the statuses of the Strategic Objectives and the KPIs in our BSC scorecards are telling us. We look at the bad results and try to figure out what went wrong. Usually, the first step, before questioning our Strategy's formulation or planning hypothesis, is checking how the Strategic Initiatives are doing. Are they delayed? Have they been ineffective due to the lack of required resources or inaccurate scope? But if they seem to be fine, we need to look further along the chain of Strategy hypothesis, trying to identify those that have been invalidated by the unexpected bad results.
A Chain of 10 Strategy Hypothesis Classes
Let's dive into more details and breakdown the chain of hypothesis along the Strategy Formulation and Strategic Planning processes workflows.
If you are familiar with the Strategy Terminology and with the Kaplan-Norton BSC framework (Execution Premium Process - XPP), the diagram should be easier to understand. If you are new to the XPP, see a quick video introduction below.
① The Competitive Advantage Cycle Hypothesis
The Hypothesis #1 is about the place on the Competitive Advantage Cycle.You might know that correctly identifying the place on the cycle is essential for formulating your Strategy. It's a hypothesis, of course, and it will be confirmed or invalidated when we'll look at the execution results of the Strategy that we've developed, based on it.
I was involved, not long ago, in the Strategy Formulation process of a local ice production company. Tempted by the diversification strategy example of a UK-based ice production company that entered one year ago the frozen drinks market, they initially intended to focus on building a new [transient] Competitive Advantage, based on a similar new category of products. But then this question was asked: Before building a new [transient] Competitive Advantage, have we fully harvested the economic benefits of the current one? The answer was a cold shower for the initial diversification intent. The addressable territory was only half covered, the sales channels were based on retail chains only, without direct distribution to the HoReCa market (restaurants, clubs & bars), and the distribution partners ecosystem was in its infancy. So, the diversification strategy was postponed for later and replaced by a strategy focused on the market & distribution development.
② The Strategic Horizon Hypothesis
The Hypothesis #2 is about the Strategic Horizon chosen for formulating our Strategy. Deciding on a wrong horizon may have devastating consequences on our economic results (see the Nokia mobile phones example).
If we've chosen the wrong Strategic Horizon, either too long or too short, we'll see how the results of our Strategy's execution will fall below our expectations, because our Value Proposition will not be synchronized with the market evolution for our category of products or services.
③ The Strategic Influence Factors Hypothesis
The Hypothesis Class #3 is related to the evaluation of macro/micro-economic Influence Factors' impact upon our future economic results, should we adopt one Strategic Choice or another.
Although analysis tools like PESTEL and Porter's Five Forces may help us here, we need to face the challenge of rating the impact of each meaningful factor upon each Strategic Choice option possible, along the Strategic Horizon considered. The outcome is a ranking of the choices that may lead to the highest expected economic returns. Please note that this is a class of as many hypothesis as the number of Influence Factors that we consider relevant for our business specifics.
④ The Strategic Positioning Hypothesis
The Hypothesis Class #4 is about selecting the Strategic Choices. After validating the feasibility* of each choice over the Strategic Horizon considered, we can define our Strategic Positioning, as a mix of the where-to-play / how-to-win Strategic Choices with the highest ranking, which allows us to build a unique Competitive Advantage(avoiding to use the same Strategic Choices mix as our competitors).
* see the Strategy's Feasibility Validation article, for more details.
It is important to understand that this is where the trace-ability of our Strategic Plan construct starts. Each Strategic Choice that we bring into our Strategic Positioning represents a hypothesis that will be chained down to the KPIs that we'll have inside our scorecards. Similarly to the Hypothesis #3, this is a class of as many hypothesis as the number of selected Strategic Choices in our mix.
⑤ The Required Capabilities Hypothesis
The Hypothesis Class #5 is about defining the Capabilities System required to support the Strategic Choices of our Strategic Positioning. We need to identify the exact level and configuration of the existing or new Capabilities required and this is something that we must hypothesize about, as well, because some of them have never been part of our Capabilities System.
Once more, it is important to understand that the correlations between the Strategic Choices and their supporting Capabilities and corresponding Strategic Gaps will alsochain down to the KPIs that we'll have in our scorecards. So, any hypothesis that we make here will be validated or not by what the Strategic Objectives' statuses and their KPIs will tell us. This is a class of as many hypothesis as the number of Strategic Gaps that are derived from the required Capabilities that we have to change, develop, add or acquire.
⑥ The Strategic Objectives Hypothesis
The Hypothesis Class #6 is about the definition of our Strategic Objectives, extending the chain of hypothesis from the Strategy Formulation area into the Strategic Planning process.
What do we have to hypothesize about at this stage? It's mainly about grouping the Strategic Gaps under the Strategic Objectives that we'll place within our Strategy Maps. We have to identify clusters of gaps that determine the resulting objectives to target connected or related operational processes or resources. Why is this important? As we'll clarify further below, this stage will have an impact on the selection of the Lag KPIsand the Strategic Initiatives that we'll attach to each Strategic Objective, so it's not that hard to make some wrong hypothesis at this stage that will show-up in our scorecards. This is a class of as many hypothesis as the number of Strategic Objectives that we have within our Strategy Maps.
To have a complete picture of the Strategic Objectives Hypothesis, we have to add a sub-class of hypothesis related to the SBUs aligned to each objective and to the weighting of the contribution of each child-objective to the parent-objective.
⑦ The Cause-Effect Hypothesis
The Hypothesis Class #7 is about the causality relationships between the Driving and Driven Objectives in our Strategy Map. It might be useful if you're familiar with How do we calculate Strategic Objectives' statuses and this is also valid for the last three hypothesis classes.
There are three types of hypothesis that we have to make at this stage. First of all, we have to rate the Cause-Effect relations' strength and time-lag between each valid pairof Driving and Driven Objectives. Secondly, we have to decide about the modelling level and about which Cause-Effect relationships will be represented in the Strategy Map. Even if we use Driving/Modelling Coefficients, this level will have a significant impact on the calculation of the Targets Tree, with obvious implications on what will the Strategic Objectives' statuses and KPIs in our scorecards tell us. Thirdly, we have to attach a weight hypothesis to each Cause-Effect relationship of each Driven Objective (careful here, this is something else than the initial strength defined for each pair of objectives).
If unclear about the modelling level, please remember that any model is a compromise between the manageable simplicity and the complexity of reality. There is no way around this, otherwise we wouldn't be using any management models.
⑧ The Strategic Initiatives Hypothesis
The Hypothesis Class #8 is about the estimated effects of the Strategic Initiatives that we believe that will lead to the full accomplishment of our Strategic Objectives, when expected.
Our hypothesis at this stage deal with the correct understanding of how can we close the Strategic Gaps behind each of our Strategic Objectives, through the Strategic Initiatives linked to them, but also of the Initiatives Realization time-frame, for each Strategic Initiative, and their sequencing. Will the results displayed in our scorecards depend on the validity of these hypothesis? You can bet they will.
You might not have noticed it, but this article is an oldies but goldies classic about the Strategic Initiatives Management.
⑨ The Lag KPIs Hypothesis
The Hypothesis Class #9 is about the correct selection of the Lag KPIs and the weight allocated for calculating their contribution to Strategic Objectives' statuses.
This class of hypothesis is strongly-driven by the correlation of the Lag KPIs with the Strategic Gaps that have been grouped within the Strategic Objective they are linked to and is dependent on the Value Gaps calculated for their objectives, based on the Targets Tree.
⑩ The Lead KPIs Hypothesis
The Hypothesis Class #10 is about the correct selection of the Lead KPIs and the weight allocated for calculating their contribution to Strategic Objectives' statuses.
This class of hypothesis is strongly-driven by the correlation of the Lead KPIs with the Strategic Initiatives that are designed to accomplish the Strategic Objective they are linked to and is dependent on the Targets set for the Lag KPIs linked to the same Strategic Objective.
Wrap-up: How to use Strategy's Chain of Hypothesis
Once we have understood the chain of hypothesis and classes of hypothesis that have as final effect end-point the statuses of the Strategic Objectives and of their KPIs in our scorecards, we have to clarify how do we use this understanding for correctly interpreting what they are telling us, every time when they show bad results.
Let's pause for a moment and highlight the fact that the Balanced Scorecard is a management system with at least four highly-important roles:
A strategy management framework that provides a series of Quick Wins, once implemented in any type of organization
An excellent communication tool that enables the communication of Strategy's mission and objectives to all employees, and a teamwork environment for establishing a continuous Strategy Dialogue within the organization
An organizational Alignment system that enables the focus of people from various departments or business units on the shared Strategic Themes, towards common or linked Strategic Objectives' accomplishment
A powerful strategic Decision-Support System that assists the management team, at organizational and departmental level, to take the most adequate Corrective Actions, based on the right understanding of what the statuses of the BSC Strategic Objectives and KPIs are telling us
Returning to the chain of 10 Strategy Hypothesis classes and considering the last role highlighted above, let's see how can we use the purposely-built Strategy hypothesis trace-ability of our K-N BSC-based Strategy Management System for taking the correct decisions that will keep our Strategy Execution on the right track.
Imagine that you are in a monthly Strategy Review Meeting and have to take the Corrective Actions determined by the red statuses of some of the Strategic Objectives in your Strategy Map and of some of their KPIs in the BSC scorecard. What logic do we apply here and what analysis steps?
The first things that we have to check are the statuses of the Lag vs. Lead KPIs linked to each Strategic Objective with a red status, or that changed status from green to yellow/amber. For example, if the Lag KPIs have a better status (e.g. green) than the Lead KPIs (e.g. red), we should look at the Strategic Initiatives associated with that objective, because that's what the Lead KPIs are telling us: there is something wrong with the output of those initiatives
But what happens if we check those Strategic Initiatives and find out that they are fine, neither delayed, nor derailed from scope or budget, nor in lack of the required resources? Here comes the first Strategy Hypothesis validation step. The Lead KPIs Hypothesis #10 might be wrong, because they are most probably not correctly coupled with the output of the Strategic Initiatives, or the Lag vs. Lead KPIs weight has been wrongly set
Let's say that we have a different situation: the Lag KPIs have a bad status (e.g. red) than the Lead KPIs (e.g. green). What validation step should we perform now? The first thing we have to check are the Hypothesis #9, because the Lag KPIs might not be correctly linked to the Strategic Gaps of the Strategic Objective, or the Lag vs. Lead KPIs weight has been wrongly set
What if there doesn't seem to be anything wrong with the validation steps above? What else do we have to check? The Hypothesis #8, looking either to the possible ineffectiveness of the Strategic Initiatives, or to the Realization time-frame, which might not have been adequately estimated
But what should we do next, if the validation steps above confirm the respective Strategy Hypothesis? If the Strategic Objective has one or more Diving Objectives, we have to look at the Hypothesis # 6 and #7, as there might be something wrong with the way we have grouped the Strategic Gaps under the respective objectives, but even more likely, we have wrongly defined either the Cause-Effect relationships between each relevant pair of driving-driven objectives, or the weight of the driving relationships of our driven objective
If the above validation steps show that the respective Strategic Hypothesis have been correct, then we need to question the hypothesis considered as part of the Strategy Formulation process. Please note that from this stage forward, we might need to look at the statuses of more than one Strategic Objective, as the correlations are more complex. We need to first validate the required Capabilities and their corresponding Strategic Gaps (Hypothesis #5)
If all the above hypothesis seems to be valid so far, then we need to look at the evaluate the Strategic Hypothesis #1 - #4, which regard the way we have defined the Strategic Positioning, the [transient] Competitive Advantage, the Strategic Horizon and the impact of the Influence Factors upon the possible Strategic Choices and the way we have rated their level of impact
I bet that if you have reached this far with reading this article, you might have at least some moderate doubts that the Strategic Objectives and KPIs in our BSC scorecards are used for performance management. If that's the case, then this article has accomplished its main goal.
As always, your feedback, questions, observations or critique are more than welcome.