Comparation 4 Strategic Plann and Risk MGMT

JANOS ACS
A COMPARISON OF MODELS FOR STRATEGIC

PLANNING, RISK ANALYSIS AND RISK
MANAGEMENT
1. I N T R O D U C T I O N
Growing risks, uncertainties in business firms and their environments

characterize the economic development of our last decade. As a conse-
quence of the business community's expectations for scientific help in
management, academic and professional researchers set out to bring more
rationality into the decision-making process. The main results of these
efforts rely among others, in the present stage of the theory and practice
of strategic planning on models, most of which were not applied or
even known 15--20 years ago. The developed methodology of strategic
planning, the new concepts and models could make considerable contri-
butions to the theory and practice of risk analysis and risk management.
By Albach [1] strategic planning is a possible tool of risk management in
the future.
Paradoxically, although strategic planning was developed to match the
growing risk and uncertainty in business, its theory and practice have
ignored until now the latest development of risk management. There are
only a few cases known, where the instruments of risk analysis and risk
management are explicitly considered in the process of strategic planning.
The reason for this curious development lies, among others, in the fact that
risk management was regarded by ~rnany academic theoreticians only as
some sort of insurance management. In the prevailing present discussion
about the scope of risk management there are opinions which understand
by risk management only a very limited field of management activity. This
is the more surprising because in the German business administration
there were important research works done under the topics of risk policy
by Nicklisch [2] and Leitner [3] as early as the beginning of this century.
Some academics are now rediscovering these works and they consider risk
management as a very important part of corporate management. Some
Theory and Decision 19 (1985) 205-248. 0040-5833/85.10

9 1985 by D. Reidel Publishing Company.
206 JANOS ACS
enthusiasts go even further and equate risk management with corporate

management. This view cannot be accepted because there are management
functions which are not closely connected with uncertainty and risk.
The objectives of this paper are: (1) to describe the application of some
known and some new models of risk analysis in strategic planning together
with their problems and limits; (2)to describe and discuss a sort of
Decision Support System (DSS) in strategic planning; and (3) to present
a concept of risk management in strategic planning.
2. RISK AND UNCERTAINTY IN STRATEGIC

PLANNING MODELS
2.1. Competitive Strategic Planning and Deterministic Portfolio
Optimization Models
Strategic planning models are important analytical tools for evaluating
strategic decisions. Annex 1 lists in schematic forms and Annex 2 and 3
summarize the main characteristics of the portfolio models according to
Wind [4]. The paper of Naylor, Vernon and Wertz [5] presents a good
survey of the most important strategic planning models, but we will not
discuss here all of them in detail. Competitive strategy models (BCG)
originally proposed by the Boston Consulting Group, later adapted by
Little and McKinsey, and more recently by Porter [6], emphasize the
interdependence of a business with its competitors. In fact, one of the
greatest innovations in management science and practice was the division
of the firm into strategic business units. The BCG model is based on the
growth-share matrix and the experience curve. The basic concept of this
model has been discussed exhaustively in literature and applied world wide
by many companies.
Unfortunately, the problem of risk and uncertainty is not a property
considered by the BCG-model; the pitfalls in its application are numerous.
General Electric, Texas Instrument, Xerox and Mexico's Grupo Industrial
Alpha have embraced the portfolio approach to strategic planning and
have recently encountered a series of problems which were discussed in
literature. The majority of the optimization models described in textbooks
is of a deterministic type; in spite of the fact that the essence of develop-
ment of corporate strategy should be the analysis of risk. We may explain
STRATEGIC PLANNING, RISK ANALYSIS AND MANAGEMENT 207
this fact in the following way: Such a planning model cannot take any risk
into account, and the reason is that it cannot scale the risk which, however,
is used in Gulf. The goal of any planning model is certainly to determine
risks at the lowest level in the planning cycle. Risk should conform to the
level of the Strategic Business Units which, in return determine the capital
requirements that influence the alternative business plans and then flow
these alternative, projected risk plans upwards to corporates. In agreement
with Ball [7], we find that it is necessary to work with a consistent
definition end risk for the large number of the diverse business units. There
are other problems, namely of how to determine the level at which risks
are consolidated, to what extent they should be consolidated, and which
techniques of computing should be used. The final problem here is to
determine the formal, quantitative amount which expresses the risk atti-
tude of the corporation in question. In the case of the application of
deterministic portfolio models risk and uncertainties could be taken into
account by a pessimistic scenario based on the main pessimistic environ-
mental dates. But such a scenario is highly unrealistic because the uncer-
tainties are not always positively correlated. On the other hand, not
positively or even negatively correlated uncertainties or risks (e.g.
demands in various business units), also termed statistic uncertainties, are
very important from the point of risk sharing.
2.2. The Capital Asset Pricing Model
The relationship between expected returns and systematic risks and the
valuation of securities in this context is the essence of the Capital Asset
Pricing Model (CAPM) which has been proposed to be applied as a
strategic planning tool for corporations that manage a portfolio of
businesses, divisions, strategic business units, etc. A good description of
the CAPM is published, e.g., by Sharpe [8] and Linter [9], and its appli-
cation to strategic planning by Naylor and Tapon [10]. This issue is to be
reviewed in our paper, because of its importance. Markowitz was the first
who showed that the variance of returns on a portfolio of financial
securities depends not only on the riskiness of the individual securities in
the portfolio but also on their relationship, e.g., on the covariances among
the securities. The variance of a portfolio of securities may be less than the
smallest variance of an individual security if there are sufficient negative
208 JANOS ACS
covariances among the securities; e.g., in the case when the return from
one security is above its average value, while the return from the other is
below its average value.
The CAPM determines the worth of an investor's financial assets under
the consideration of the behavior of all investors in the stock market. The
following assumptions are necessary: (1) the investors are expected utility
wealth maximizers for a single period (e.g., one year) with preference of
securities on the basis of mean and variance of return; (2) risk-free interest
rate; (3) identical subjective estimates of the means, variances, and co-
variances of all securities; (4)perfect competitive financial market;
(5) fixed quantity of securities; (6) all securities are marketable without
significant transaction costs; (7)there are no taxes; and (8)in case of
application of the CAPM for a whole corporation the businesses must
have the same properties as the securities.
The expected value of the multidivisional firm Vcan be calculated by the
following (discounted cash flow) equation provided that its profit stream
and its expected rate of return will continue indefinitely:
R - Qrma
(1) V --
i
where i is the risk free interest rate, R is the expected rate of return, a is
the standard deviation of the rate of return, r,~ is the correlation coefficient
between the company's rate of return and the rate of return of the entire
portfolio of all n firms (securities) in the market, and 0 is the market price
of risk determined by the stock market (in a perfectly competitive capital
market this is a constant value).
The product Orma is the risk premium which implies that for every
additional unit of risk rma borne by investors, the rate of return demanded
must increase by the amount q r m a .
The variance a 2 of the company's rate of return with a portfolio of rn,
different businesses can be expressed by the following equation:
j=l j=l k=l

j#k k#j
where m is the number of different businesses (divisions) owned by the
company, Wj and Wk are the proportion of the company's assets invested
S T R A T E G I C P L A N N I N G , RISK A N A L Y S I S AND M A N A G E M E N T 209
in division j, and in division k respectively, aj is the variance of return for

division j of the company, and trjk is the covariance between return earned
by division j and the return earned by division k.
If the total amount I invested in the parent company is greater than V,
the expected value of the company, is a non-profitable investment. Like-
wise, investment in business (or division)j is profitable as long as the
expected value of j, Vj is greater than the amount o f / j invested in that
business.
2.3. Capital Asset Pricing Model as a Possible Tool for

Strategic Decision Making
The objective of the management making strategic decisions within the
CAPM framework is to maximize V, the expected value of the firm's
common stock. A glance at the equation for V shows that the company's
management wields little or no influence over the risk-free interest rate i
and the risk premium Q. It is obvious that the management has partial
control over the company's rate of return R, the standard deviation of the
company's rate of return tr, and the correlation coefficient between the
company's rate of return and the market rate of return rm. Strategic
decisions should increase R and decrease a and r,,.
The expected rate of return of the firm is the weighted average of the
expected returns from the various businesses in its portfolio,
(3) R = ~ WjRj,
j=l
thus the management should increase the rate of return of every one of the
individual businesses.
The variance tr2 of the company's rate of return depends not only on the
variance tr~ of the businesses constituting the portfolio but also on the
relationship between these businesses characterized by the covariance trjk.
A portfolio including businesses with low positive or even possibly nega-
tive covariances can reduce the dispersion of the probability distribution
of possible returns. Finding businesses with such statistical properties is
the main task of the strategic management. The correlation between the
company's rate of return on the entire market portfolio r,, (not to be mixed
up with the company's own portfolio) it is obviously partially controllable
210 JANOS ACS
by the management, rm should be as close to zero as possible or maybe

even negative. As a result of this effort the value V of the conglomerate
firm's share would raise.
There are various cases where such a diversification strategy is pursued.
Operating in basic and diverse fields the covariance of returns between
businesses is kept much lower than in case the company has concentrated
its investment in one field alone.
2.4. Critical R e m a r k s on the Capital Asset Pricing M o d e l
The application of the CAPM as a strategic planning tool is strongly

influenced by a number of serious limitations: as it was partly summarized
by Naylor and Tapon [10].
1. The assumptions underlying the CAPM are too strong for a
portfolio of actual businesses. It is practically impossible to divide the
company's assets (including financial assets, plants equipment, inven-
tories, organizational structures, staff, goodwill, etc.), functions,
employees into independent elements with a considerable degree of
autonomy. Practical problems of a planned exit of a particular business
can make a realization of a strategic decision illusionary. Also behavioral
problems, staff fluctuations can affect the divisibility and liquidity o f a
business.
2. The equation for the calculation of the expected value V and the use
of value maximization as a decision criterion are based on the Law of
Large Numbers, and hence in some cases (e.g. "one shot" decision, in
which a single decision must be made in a non-replicable environment) it
is an inappropriate decision rule.
3. The expected value criterion fails to consider extreme values of
random variables, a problem which is connected with the so-called
St. Petersburg Paradox.
4. The estimation of R, r,, and tr at a company's and business unit's level
can be influenced by a host of practical and statistical problems. There are
few marke data to estimate these parameters for business units. The
problems of the subjectivity of the estimates, influenced by possible
interests, the hierarchical level and organizational structure are still un-
solved. Parameter estimates of risk and return involve a combination of
time - series and cross-sectional data which may not be independent.
5. Strategic decisions deal with dynamic problems, whereas the CAPM

is essentially a static equilibrium model.
6. For the management of purely financial assets the parameters of the
CAPM give sufficient information for determining the entire ballgame. In
the case of portfolio of businesses a host of different (economic, behav-
ioral, political, organizational, social) factors have to be taken into
consideration.
The problem of the reduction of businesses to portfolio terms means a
tremendous loss of information because businesses consist of people,
equipment and material which have considerable interactions in actual
practice.
In spite of the discussed limitations CAPM offers a company with a
portfolio of risky businesses, a useful conceptual framework for viewing
the problem of long term strategic planning and risk analysis. Our sol-
utions convene with the proposals by Naylor and Tapon [10]; we repeat
them here in a slightly modified form. If capital-asset pricing is to be useful
for management, it should be linked to, or incorporated into, corporate
simulation models. Why not have a series of business simulation models,
as proposed by Naylor and Tapon, one for each business in the portfolio
of a company? Each of them will generate a specific value for Rj and j for
that business, beside other output values which are of interest to the
management. Any corporate consolidation model that is able to compute
the value of the company V from the above Equation (1) is, of course,
necessary and a conditio sine qua non. We should not forget that such a
consolidated model has to analyze the interdependencies between the
business firms as well as the company's interdependency with the market
portfolio expressed by rm. Thus the consolidated model must guarantee to
compute the values of R, rm and, and of V.
On the one side, we agree with Naylor and Tapon that the use of the
capital-asset pricing model and its theoretical framework, inspite of its
mathematical difficulties, is an important output of any corporate simu-
lation model. On the other side, the growth-share matrix and the
experience curves which have been proposed by the Boston Consulting
Group and others might equally well be considered as outputs of business
simulation models.
There is no doubt that the competitive strategy models and the CAPM
212 J A N O S ACS
models are becoming an ever increasing, powerful tool for predicting and
evaluating the economic and financial consequences of any strategies
which may be used by business or a portfolio of businesses.
Companies with considerable experience with corporate simulation
models from the 1970s have begun to use optimization models as strategic
planning tools. An attempt to optimize the values of the firm V would be
a big step in developing new decision-making tools.
2.5. The Index Method of Ahlers
The difficulties of estimating variances, covariances got the simpler and

more obvious "index method" developed. In practical utilization the
variance and the covariance must be estimated. As, on the one hand, the
case of dependent (correlated) outputs represent the normal case, and, on
the other hand, the estimation of many covariances is rather troublesome,
the simpler and more obvious "index method" has been already developed
and published by Sharpe [11]. This explains the correlation of the indi-
vidual rates of return through its dependency of the same economic value
("index"), which itself is subject to uncertainty. If these correlations, for
instance, are to be explained in a regressional analytical way, one has only
to estimate the future distribution of the value. The variance of a portfolio
is given then without any further estimations as a result of relatively simple
calculations, based on regressional analysis.
Less known is the further development of the index method proposed
by Ahlers [12]. It uses the complete probability distribution of the total
rate of return as an evaluation measure of a portfolio. Instead of alter-
native values of one index, three alternative scenarios with subjective
estimated probability distributions are used. Bonds specialists estimate for
each bond three conditional distributions of the rate of return (triangular
distributions), which correspond with the three scenarios. Now it is easy
to produce the distribution of any portfolio by simulated spot checks: first
one makes a spot check for the determination of a scenario, and then one
makes spot checks of the individual rates of return of those conditional
distributions which correspond with the scenario. On this basis, the
planner has the total probability distribution of the total rate of return of
any portfolio at his disposal. The search for appropriate portfolios can be
continued until one gets a distribution which corresponds with the
planner's idea about output expectation and risk limitation. It is evident

that the probability distribution of the rate of return proffers more infor-
mation about risk than variance and expected value.
3. APPLICATION OF STOCHASTIC PROGRAMMING IN

STRATEGIC PLANNING
3.1. Probabilistic Constrained Model for Strategic Planning
In strategic planning the rate of return of business j usually cannot be
forecast exactly; it has to be considered as a random amount. Thus the
application of stochastic models in strategic planning is evident and in the
optimization procedure the methods of stochastic programming may play
an important role.
We use the same notation as in the previous section on the Capital Asset
Pricing Model (CAPM). We introduce the random variable /~j, which
means the random rate of return of business j. It has the expected value
Rj and the standard deviation a i defined previously, Wjdenotes the propor-
tion of the company's total assets invested in business j. The decision
variables are the proportions of assets W~. . . . . Iu invested in m different
businesses (divisions) owned by the company. The criteria of optimal
investment may be different. One possible way is the principle of prob-
abilistic constraint. Here we introduce a level d that is the minimal expec-
ted rate of return. It has to be surpassed by the total rate of return of the
company, which can be expressed by Z?= 1 Wj/~j. Since the rate of return
/~j is random we can only prescribe that the random rate of return of the
company surpasses d by a given probability p. The level o f p is chosen by
the decision-maker. Depending on the risk aversion it should be chosen to
be 0.9 or 0.95 or any other probability near to 1. The optimal investment
strategy according to our probabilistic constraint is the one that results in
the minimal expected rate of return d as high as possible, and warrants the
prescribed reliability. Thus it can be formulated in the following way:
(4) maximized subjectto P(jX=~ Wj[ Rj~> d ) ~ > p ,
~ Wj = 1, Wj ~<0, j = 1. . . . . m.
j=l
214 JANOS ACS
In this model special attention has to be paid to the probabilistic con-

straint. Using some transformations an equivalent deterministic formu-
lation will be derived,
o- or
where o~ is the variance of the company's rate of return and has the same
form as in the CAPM model [formula (2)]. If we know the probability
distribution function F of the random variable
j=l
the probabilistic constraint has the form of
It can be expressed by the inverse function F-1 of F in
(7) J=,
Furthermore
(8) d.< ~ R ~ + . F l(1 - p).

j=l
Since d is to be maximized, our stochastic programming problem has the
following deterministic equivalent
(9) maximize Ij~Rj~+ aF-l(l-p) 1

subject to Z ~ = l, ~/>0.
j=l
If the random rates of return Rj (j = 1. . . . . n) have a non-degenerated

joint normal probability distribution our distribution function has the
form
F(x) = I ~ exp ( - t2/2),
which is the well-known standard normal distribution function ~(x). For
this case Kataoka [13] published the first probabilistic constrained model
and he proved that the nonlinear programming problem (9) is a convex
one. There are various methods in nonlinear programming that can be
applied for the solution of problem (9) in the convex case. In general this
problem is not a convex programming problem. For arbitrary distribution
F(x), it may have many local optima and finding the global optimum may
be very difficult. For practical cases, however, having a good starting point
for the solution, a local optimum may be satisfactory.
3.2. Connection of the Capital Asset Pricing Model and the

Probabilistic Constrained Model
The CAPM can be formulated as a model to maximize the value of the
firm V, by choosing the best proportion ~ (j = 1 , . . . , m ) of the
company's total assets invested in businessj. Since V = 1/i(R - Qrr,cr), if
i is the constant risk-free interest rate and R = E~=~ Rj Wj it means to
(10) maximize (j~=~RjWj-Ormtr)
subject to ~ Wj = 1, Wj /> 0, j = 1. . . . . m.
j=l
We see the close connection with the deterministic equivalent (9) of the
Probabilistic Constrained model (PCM), where the value of F-~(1 - p)
is negative in cases interesting in practice as p is large (e.g., for normal
distribution for p > 1/2). Thus in both models the company's expected
rate of return minus a constant times the standard deviation of the
company's rate of return is to be maximized. Let us consider, which
factors influence the value of this constant in both models. In the CAPM
model the correlation coefficient rm between the company's rate of return
and the rate of return on the entire portfolio of all firms in the market is
216 JANOS ACS
included. The PCM model does not consider this factor, due to the
auxiliary influence of other firms; it considers only a closed system of the
company's own portfolios. The factor Q is the market price o f risk, the rate
at which the market is willing to trade extra risks for increased returns.
This is in equivalence with the choice o f p in the PCM model. As the risk
aversion increases p should be chosen closer to 1. It means a higher
evaluation of reliability at higher risk aversion. In this case the value of
F -I (1 - p) is decreasing, it means a greater negative multiplier of a in
accordance with a greater value of Q.
If the market is perfectly competitive, the value of Q is constant. The best
choice o f p in the PCM model - considering the influence of other firms
through the correlation coefficient rm, too - is the one according to the
CAPM model for which
--or,,, ----- F - I ( 1 - p), that is p = 1-F(-Qrm).
3.3. Safety First Principleand StochasticDependentReturns

If the minimal amount d of the expected rate o f the company's return is
prescribed, an advisable strategy is the one that maximizes the probability
that this rate of return will be fulfilled. This is the so-called safety first
principle of stochastic programming which was first introduced by Roy
[14] and Marschak [15]. Using the CAPM notations defined above, this
model can be formulated for the problem of optimal investment:
(11) maximize P(j~= WjRj>>.d)
subject to Z Wj = 1, Wj I> 0, j = 1. . . . . m.
j=l
Here we can derive an equivalent nonlinear programming model similar

to the case o f the probabilistic constrained model. The reformulated
problem is the following:
maximize 1 -- F -- 9
O"
subject to the same constraints as in (11). Here we cannot see the

immediate connection with the CAPM model as it was the case with the
probabilistic constrained model.
The safety first principle has a greater importance in the sense that it can
be generalized in a straightforward way. Let us assume that the vector of
the random returns C = (CI . . . . . (~m) is a linear function of the vector
W = (W~ . . . . , Win). The latter denotes the proportion of the company's
total assets invested in the m different businesses. ~ = /~- W where/~
is a matrix with random elements of tr~ (i, j = 1. . . . . m). Here the rate
of return ~ of business j may also depend on the investment Wk in
other businesses k. Until now it was a linear function of the single invest-
ment Wj only, in the form ~ = /~/~. Thus the m a t r i x / ) has the special
structure
RI 0 ... 0 1
0 R2 ... 0
(12)
0 0 Rm ~
The generalization for arbitrary random m a t r i x / ) allows us to consider
the stochastic interdependence among the different business investments
and returns, which may be an important factor when choosing the optimal
strategic plan.
In this generalized case the minimal amount of the expected return for
each business j can be prescribed. The vector of these minimal levels
is d = ( d l . . . . , din). Thus the safety first principle can be formulated
as to
(13) maximize i , ..... m)

subject to Z Wj = 1, W/ ~< 0, j = 1. . . . . m.
j=l
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3.4. The Safety First Principle in Multiobjective Optimization

of In vestmen ts
The generalized model (13) can be interpreted as a stochastic multi-
objective optimization model. Let us consider n different objectives. Each
of them is a linear functionof the investments Wj ( j = 1. . . . . m) in the
form ff~ = )'~7= 1 5/j ~3 where 5 Uis a random amount of each i = 1. . . . . n;
j = 1 , . . . , m . The multi-objective optimization problem
(14) maximize (jX=l 5~ i= 1. . . . m )
subject to ~ Wj = 1, Wj i> 0, j = 1. . . . ,m
j=l
has no meaning; not even if the objective is a weighted average (7~,

i = 1. . . . . n) of the single objective functions in the form
i=1 j=l i=1
since the values 50 are random. One can take the expected value 5~ of each
5 Uand solve the problem as a deterministic multi-objective one, but in this
case all information about the random character of the objective function
is lost. One possible way to preserve these valuable pieces of information
together with the multi-objective character is to apply the safety first
principle. Here we prescribe the minimal amount of each random objective
value (7i /> di and maximize the probability that these limits are fulfilled
by choosing an investment vector W = (W~ . . . . . Win):
(16) maximize P(jX=,f0Wj>>. di, i = 1. . . . . n)
subject to X Wj = l, ~ -N< 0, j - - 1. . . . ,m.

j=l
The transformation of models (13) and (16) into deterministic problems is

still possible similarly to model (16). Here the m and/or n respectively
dimensional character of the probability distribution has to be considered.
This may imply a lot of technical difficulties especially with the evaluation
of the multidimensional probability distribution function.
One possible and effective solution method has been published by
Prrkopa [16] for the special case if the rows of the random matrix/~ are
independent, normally distributed random vectors and their covariance
matrices are constant multiples of a fixed covariance matrix. If these
conditions which ensure this property are not valid, the solution of the
above problem is still possible. Starting from different feasible solutions
several local optimal solutions may be achieved and then the best of them
can be selected. For the evaluation of the multidimensional probability
distribution function Monte Carlo methods are often necessary.
3.5. Critical Remarks on the Stochastic Programming Methods
The application of the stochastic programming methods has some serious

limitations:
1. Some of the problems arise as they do in the applications of the
Capital Asset Pricing Model such as the division of the company's assets
into free standing strategical business units. In this respect the model of
stochastic dependent returns may help us in considering the dependence
among the different divisions.
2. Our models of stochastic programming do not use the maximization
of expected value as an optimization critierion. By doing so they avoid
partly the problems described concerning the CAPM model. We use the
available information about the probability distribution of the random
rates of return. The most serious problem is the choice of appropriate prob-
ability distribution and the estimation of the parameters of distribution.
3. The estimation of the correlation coefficients between return earned
by different divisions has the same difficulties of data requirement and
subjectivity of the estimates as with the CAPM model. The correlation
coefficient between the company's rate of return and the rate of return of
the entire portfolio of all firms in the market is not considered explicit in
the stochastic programming models. There is an implicit way to take into
account this auxiliary influence by the appropriate choice of the prob-
abilistic constraint level p described in Section 3.1.
4. Effective solution methods for the described stochastic program-
ming methods are available only in some cases, if the multidimensional
220 JANOS ACS
distribution function is of a special structure. This is especially valid for

the model of stochastic dependent returns and of multi-objective opti-
mization of investments. These models are able to consider stochastic
dependencies which are not possible in any other published models of
strategic planning. For the assumption of independent distribution the
solution has no technical difficulties.
5. The stochastic models in their form described in this paper are static
models. There are different possible ways to reformulate them to dynamic
decision models. Such models have been published by Prrkopa-Szfintai
[17], but an effective solution method is known for them only for some
special multidimensional distributions.
6. The problem of the reduction of businesses to portfolio terms means
a loss of information in environmental, subjective, behavioral, organ-
izational and other factors. Thus strategic planning decision is a very
complex procedure. The stochastic programming models may help the
decision-maker in suggesting optimal portfolios under mathematically
defined conditions. The determination of these conditions is mainly the
task of the decision-maker. It can be realized only in an interactive way,
by trying many different alternatives. An interactive procedure of
computer and decision-maker is necessary for an effective solution, which
can be realized by a decision support system.
4. THE ROLE OF DECISION SUPPORT SYSTEMS IN STRATEGIC

DECISION-MAKING AND RISK ANALYSIS
4.1. The Necessity of Decision Support Systems in Strategic

Decision-Making
The common characteristics of the above described methods for strategic
decisions in uncertainty and risk are among others: (1) the necessity of
great numbers of quite sophisticated judgemental information to be
obtained from the decision maker-and/or experts, (2) the iterative nature
of the decision-making process and a lot of time and efforts wasted by the
decision maker and/or experts, and (3) the necessity of the skilled analyst
to conduct the decision-making process.
These and other reasons make the proposition for cooperation of
decision maker and computer in the decision process evident. As a result
S T R A T E G I C P L A N N I N G , RISK ANALYSIS AN D M A N A G E M E N T 221
of these efforts various software packages have been elaborated for

Decision Support Systems. In strategic decision-making such a system has
to contain interactive procedures and is to be rather universal, since it has
to enable the decision-maker to construct models and solve decision-
making problems with continuous and discrete sets of alternatives,
different kinds of the attributes scales (ordinal and cardinal ones), and
different forms of objective functions. It may not be necessary for the
decision maker to be familiar either with programming languages or utility
theory because the application package must be realized as a sequence of
dialogue procedures interconnected by common judgemental information.
Functions of information gathering, testing, processing, storing and
correction have to be built in nearly all the interactive procedures, thus the
decision maker (expert) has an opportunity to interrupt a decision-making
process at any appropriate point, starting again from this or another
earlier point. A software package with such possibilities can be regarded
as a Decisions Support System for Ill Structured Problems (ISPs) in the
sense of Carlsson et al. [18]. It is known that ISPs is a residual concept;
according to Simon [19] a problem is an ISP if it is not a well structured
problem (WSP). A WSP has the following characteristics:
1. there is a definite criterion for testing any proposed solution, and a
mechanizable process for applying the criterion.
2. there is at least one problem space in which the initial problem state,
the goal state, and all other states that may be reached, or considered, in
the course of attempting a solution of the problem can be represented.
3. attainable state changes (legal moves) can be represented in a prob-
lem space, as transitions from given states to the states directly attainable
from them. But considerable moves, whether legal or not, can also be
represented - that is, all transitions from one permissible state to another.
4. any knowledge that the problem solver can acquire about the
problem can be represented in one problem space or more.
5. if the actual problem involves acting upon the external world, then
the definition of state changes and of the effects upon the state of applying
any operator will reflect with complete accuracy in one problem space or
more the laws (laws of nature) that govern the external world.
6. all of these conditions hold in the strong sense that the basic pro-
cesses postulated require only practicable amounts of computation, and
222 J A N O S ACS
the information postulated is effectively available to the processes - i.e.,

available with the help of only practicable amounts of search.
Strategic decisions are I11 Structured Problems; the role of the Decision
Support System in the solution process has growing importance in turning
an Ill Structured Problem in a Well Structued Problem together with the
interactive participation of the decision maker.
4.2. Multiobjective Optimization of Investment Using

Independence Assumptions
The idea of a DSS for strategic planning is the problem of "the best
decision" selected from the feasible set X with respect to the countable set
of objectives
R1 . . . . . Rj,...,Rm, considering the uncertainty.
In accordance with axioms of utility theory (see, e.g., Keeney and Raiffa
[20] or Fishburn [21]) "the best decision x* is such that maximizes expected
utility:
(17) E(u(x)) = ~R u(r)f(rlx) dr
where R = {R~} is an appropriate set of attributes, j = 1. . . . . m. r =

(rl .... ,rj,...,rm) is the consequence expressed in terms of attributes'
values; u(r) is a multiattribute utility function reflecting the decision
maker's preferences and risk attitude; f(rlx) is a density function of the
joint probability distribution f(rlx) reflecting the decision-maker's
(expert's) judgements concerning the subjective probability of obtaining
the consequence r for the given decision x.
The maximization of the expected utility in form (17) is one of the most
general model formulations of decision-making in a static case. The
solution in this general form is practically impossible. One possible way is
to make specific assumptions concerning the attributes, utility function
and joint density function. Solving the above problem under different
conditions of this kind is discussed in details among others in the papers
of Keeney and Raiffa [20], Fishburn [21] and Raiffa [22]. The solution of
the multiobjective optimization of investments by the known solution
process referred to above is possible only if independence assumptions are
fulfilled. Different types of independencies are defined and are used in the
solution method.
Performance independence given a specified resource allocation x means
that the performance according to a particular attribute is stochastically
independent of other attributes. It means that the joint density function
can be formulated as the product of marginal (one-dimensional) density
functions
(18) f(rlx) = fl(rllYq)f2(r2lYc2)...fm(rmlSCm).

Here ~ denotes the set of decision variables upon whichf(r~l. ) depends
conditionally, in an extreme case it can be a single decision variable.
The multi-attribute utility function u(r) can also be greatly simplified if
the following two additional independence conditions hold: (1) attribute
R i is utility independent of the other attributes if the preferences to R~ do
not depend on how the other attributes are fixed, and (2) the two attri-
butes Ri, Rj are preferentially independent of the other attributes if
preferences or consequences differing only in the values of R~ and Rj do not
depend on the fixed values of the other attributes.
In this case either
(19) u(r) = X kiui(ri)

i=1
or
(20) 1 + Ku(r) = 11 [1 + Kk, ui(ri)],

i=l
where the one-dimensional utility functions ui are scaled from zero to one,
the ki's a r e scaling constants with 0 < ki < 1 and K > - 1 is a non-zero
scaling constant. (See Keeney [23, 24].)
The resource allocation problem of strategic planning then becomes the
finding of the allocation x, which
(21) maximizes E[u(rlx)],
where
(22) E[u(rlx)] = X k~u~+(5ci)

i=1
224 JANOS ACS
or
(23) E[u(rlx)] = ~, [1 + Kkiu~(YQ] - --

i=1 K
with
(24) u+(Yci) = ~[R~ u'(ri)fi(rilYO dri' i = l, 2 9 m.
4.3. Approximate Solution o f the Multiobjective Optimization

and its Sensitivity
One implementation of the solution algorithm in an interactive system was

published by Viliums and Sukur [25]. The major steps of it are illustrated
in Figure 1. The most interesting aspects of the solution from the point
of view of practical application, discussed in greater detail here are
(1) decision making with a continuous set of alternatives, (2) the reduction
of necessary information, and (3) the sensitivity analysis of the solution.
In the course of the solution the greatest difficulties arise in the assess-
ment of f(ril2i) or its probability distribution t}(ril2i) (see step 7 in
Figure 1). In the case of a continuous set X of alternatives x this is
practically impossible, thus different approximation formulae have to be
applied. Some of them have been published by Keefer and Pollock [26].
These interpolations are based on the ~-fractiles of the distribution
r ~), meaning the value ri(ct) for which
,r (~)
(25) J0 f ( r , s dr i =
is valid.
The general approximation formula of the one dimensional utility
function is the following
k
(26) 2,(22,) = ~ cjui(ri(cQ),
i~l
where the constants cj, ctj and k are different for the various methods. The
greater the k, the closer the approximation exact utility. But in this case
the decision maker is obliged to estimate much more function values of u~,
which efforts involve more judgemental information. Considering the
S T R A T E G I C P L A N N I N G , RISK A N A L Y S I S A N D M A N A G E M E N T 225
1. Problem formulation ]
_1 2. Choice of feasible set of alternatives ]
3. Determining the set of attributes [
4. Construction of the attributes scales [
5. Verification of the structural independence assumptions [

r I
6. Preparameterization step
-t
7. Assessment of the ~(rjlxj), J E 1, m
8. Assessment of the uj(rj), j E I, m
9. Evaluating the scaling constants k and kj, j e 1, m
10. Transformation of the decision-making

problem into convenient form and solution
I
1I. Sensitivity analysis
I
12. Examination of results obtained during step (II)
unsatisfactory satisfactory
13. Presentation of the results to the decision-maker
unsatisfied I satisfied
Implementation
Fig. 1. General scheme of decision-making process

226 JANOS ACS
multiattribute utility function, this increased amount of experts' judge-

ment may cost a lot of time, effort and money. In this respect let the
decision maker decide himself how much he is willing to pay for the
inreased accuracy of the model. This is the so-called preparametrization
step in the general scheme of the decision-making process. (Step 6 in
Figure 1). The preparametrization step is again a decision making process
under uncertainty and with a multiple objective, thus the same opti-
mization process can be applied for it as for the original problem.
After choosing a parametrization, the assessment of the functions
O(ril~i) and ui(ri) (i = 1. . . . . m) follows (steps 7 and 8) by using the
necessary information determined by the parameters. The solution of the
optimization problem with the above functions is executed, and then is
followed by the sensitivity analysis of the solution (steps 9 to 11).
The use of approximations underlines the increasing role of the sensi-
tivity analysis step during which the sensitivity of the approximate sol-
ution to errors in information, data, estimation and experts' judgement
has to be examined. The following parameters influence the solution
(1) scaling constants K and kj ( j = 1. . . . . m), (2)parameters cj, and
(3) set of fractiles rj(~j).
For all parameters in which the change of the parameter does not
change the structure of the optimal solution the intervals have to be
determined. For those parameters where this interval is very small special
steps have to be taken, and perhaps even a new parametrization has to be
chosen. This decision is the expert's task.
4.4. Strategic Decision Making by an Interactive System

It is emphasized in Section 4.1 that a close cooperation of decision-maker
and computer is necessary for effective strategic decision making. Most of
the ideas of a decision support system described here are realized in the
interactive program system developed by Viliums and Sukur [25], which
thus can be considered as a general tool of strategic planning. It enables
managers to carry out the major steps of strategic planning listed by Wind
[4], (Fig. 2). The cooperation of problem solver and computer is illustrated
on Figure 3. The main steps of a system activity model can be realized by
the program system on the following way:
Monitoring C ~ t and Antic~ted ~ t

~menud
OocNfifiOnl
Corporate Competitive Mmte~nl (technololi~,
v-~-,~ Objectives and Market su~cu,~ and en~onment economic,iqal,
l~aotma~ demand actions (channel) cultural,etc.)
<
L
S~Its~ion Ana[y~
1. Product performance maUix
2. Product positioainZ by sqment snalysis
3. Product/mm-k| vuia~bility 4
4. Marketin8rmponm hmc~ons of the fh'm
and its compefiton
1
5. Corporateand industry resouromand
consmums a,,dym
Peoduct lM~'l.et Ponl'ol~oDectrlam
1. Produc~ra~et/dbUitmti,-- analysis
2. S4~cflon of ta.,Net portfolio
1
j c~.~, c.,,~., ~t/M.~,, ~,,eo~ t . !
/ I. New product deveiopmmt J -
I
"r 2. g ~ * r s and agquimimu ]'
| 3. Productmodification and r
4. New minter development
It
, I 1
C~nm-stion and Evaluation of Mm'ketinl Pmlnum
Conditional fongast ~ ProduCtp m i t ~ by tmlet raiment(s) J
and ~muiation J ation
P,o a ~ H I
_ Corporatesgratqic
plans and tmdpm J/ ~ ~ Price
i
1
4,. Channebof, dbzributioa
t..lAd~ and promotion
p~s
I
1
szw.-tim of t ~ "Best" Adaptive
M~etinS t~qmun
tI /
1
L--- l~ ~-~ OrganO.attonfor Markstin| Action,
lm/a~m,um,,.tma, mid ~ a , aJ
Fig. 2. A strategic marketing planning model.

228 JANOS ACS
Activity of decision maker Activity of computer
1. Problem formulation, practical

decision making
2. Choice of feasible set of
alternatives possible values of the
decision vector X (e.g., resource
allocation among the different
projects, or market divisions, or
R and D activities etc.).
X may have discrete alternatives
(to choose a project or not) or
may have continuous ones (how
much money to allocate for a
project).
3. Determining the set of attributes
R 1 , . . . , R m , e.g., profitability,
market-share, business strength,
competitive position,
attractiveness, risk, return
4. Construction of the attribute
scales and accuracy demanded.
Cost of information has to be
considered
--* 5.
5. Parametrization: making the
decision of how to choose the
best information for the accuracy
demanded in step 4.
6. Sensitivity analysis consideration
of risk
..o, 7.
7. Examination of steps 5 and 6
and decision about acceptation of
the parametrization 8 or to make
new parametrisation with finer
scales
--~ 5.
8. Solution of the resource
allocation problem
--* 9.
9. Decision making about
acceptance STOP or N E W
parametrisation
--~ 5.
Fig. 3. Interactive system for strategic planning decision.

1. Determination of the corporate mission, objectives, means deter-

mining the set of attributes. The model allows multiple objectives with
ordinal and cardinal scales. The only, but severe condition of the model
of Viliums and Sukur is that a probabilistic independence of the attributes
is assumed. In practice, it is often not true. However, the case of stochastic
dependency is very common, though it is difficult to achieve the necessary
data characterizing the measure of dependence. On the other hand, in the
general model formulation there are enormous technical and method-
ological difficulties of the solution in the case of dependence. Here specific
model constructions are necessary. One possible way has been shown in
Section 3.3 of this paper by using stochastic programming methods.
The determination of resources and constraints is the task of the decision
maker. The program system can consider them as explicit constraints on
the decision variables in the form of inequalities or else the feasible set of
alternatives can be specified by the decision-maker.
2. Monitoring the current and anticipated environment is also the
decision-maker's task. Since there is usually a large number of environ-
mental factors and a complex relationship between them, effective
planning calls for the identification of relatively few environmental
scenarios. The choice of a feasible set of alternatives is based on these
scenarios and on the resources and constraints as described above.
3. The situation analysis has to answer the questions: where is the firm
now and where it is proceeding to assuming changes in strategy? These
questions need rather descriptive answers, which are difficult to formalize.
It can be considered by choosing the firm's strategy which takes shape in
the choice of a feasible set of alternatives.
4.5. Portfolio Analysis in an Interactive Way
Market/product portfolio analysis is the main task of a Decision Support

System for strategic planning decisions. It must be applicable for both
phases of (1) the analysis of current portfolio, and (2) the selection of the
desired portfolio.
The consequences of the earlier decisions can be measured by the utility
function. The values of the multiple attributes represent the current status
of a portfolio. A deeper analysis is possible through the method of factor
listing suggested by Wind. It takes into account those factors used in
230 JANOS ACS
making decisions on the product mix required to reach the desired market
segments. These factors include corporate objectives, resources, current
marketing strength, current and future demand estimates, competitive
offers and other environmental factors.
The product portfolio models are listed and the key characteristics of the
major portfolio models are summarized by Wind (Annex 1, 2, and 3).
These models offer a structured set of dimensions on grounds of which the
current product portfolio of the firm can be analyzed. The model and the
method of Viliums and Sukur can be considered as a generalized real-
ization of these models listed by Wind. They have the following charac-
teristics according to the classification of Wind [4]: The degree of
adaptability is similar to the model 5 of the product performance matrix.
The specific dimensions are selected by the management. There is a possi-
bility also for a normative set of dimensions (as, e.g., by the BCG model).
The choice of the specific dimensions and the parametrization of the scale
can be realized in an iterative way by an interactive connection between
decision-maker and the computer (see Figure 3). This allows a wide degree
of freedom and adaptability.
This freedom of choice makes the work of the decision analyst more
complicated than the simple rigid models. It needs a wide spectrum of
analysis in construction of the multi-attribute utility function reflecting the
decision-maker's preferences and risk attitude. On the other hand, a lot of
expert judgements concerning subjective probability of obtaining conse-
quences of a given decision is necessary. The model allows the decision
maker an adaptive series of measurement and control. It means that during
an iterative procedure in each step the analyst first decides about the
necessary precision and parametrization, then the computer chooses the
best way and the necessary amount of data to be collected. Next, the
analyst has to get these data. On the basis of the existing data the computer
makes a sensitivity analysis. The decision-maker has to analyse the sensi-
tivity and decide about the acceptance of the precision or increase it. In the
second case new parametrization has to be given by the decision-maker
and then the computer chooses again the best way and the necessary
amount of data to be collected for the new situation. Earlier results are
considered for this new choice and this requires adaptability of the data
collecting process.
Specific dimensions: there are no specific dimensions. They are deter-

mined by the decision-maker. The parametrization is an interactive
process between decision-maker and computer.
Allocation rules: Optimal allocation among all items of the portfolio are
determined algorythmically. The allocation may be also realized on an
interactive basis by decision-maker and computer. The optimal decision is
such that maximizes expected utility. The multi-attribute utility function
reflects the decision-maker's preference and risk attitude. The decision-
maker has a great freedom in choosing the appropriate objectives and
utility functions. The only but important restriction is that a stochastic
independence of the utilities is assumed. It must be assumed because of
mathematical and technical reasons. If the utilities are stochastically
dependent it is very difficult to give a general solution method. However,
in special cases known solution methods of stochastic programming are
available. The model of Viliums and Sukur is applicable to decide on the
desired target portfolio. The target may include not only products but also
market segments and distribution outlets. It reflects the management's
objectives, the desired direction of growth, and the interactions among
products, markets and distribution outlets. In choosing the feasible set of
alternatives different ways may be given by the decision-maker to reach the
target portfolio: (1) the addition of new products, (2) the modification of
existing products, (3) decision on existing products, and (4) changes in the
allocation of resources.
These strategies are usually applied together in order to obtain the
desired portfolio. Besides the product decision a much more complicated
task is the marketing decisions of price, distribution and advertising. A lot
of different strategies should be generated and each of them should be
evaluated through the model of Viliums and Sukur [25]. The time and
money constraints and the difficulty in data management render only the
examination of a limited number of different strategies possible. The
procedure is the following: (1) generating a type of strategy by the decision
maker, (2) optimizing the data requirement, (3) giving the necessary data,
(4) optimizing the strategy parameters and calculating the sensitivity of
the solution, and (5) deciding about the acceptance or generating a new
strategy or getting more data.
232 JANOS ACS
4.6. Critical Remarks on Decision Support Systems for

Strategic Decision-Making
The decision support systems available and applicable for strategic
decision-making offer a lot of further problems and limitations:
1. The idea of free standing strategical business units remain similar to
the other models described in this paper. It can be replaced by other ideas
if the satisfactory mathematical formulation has been solved. The depen-
dence among the different units can be described by the stochastic pro-
gramming model of Section 3.3. There is a possibility of building the
decision support system into this model.
2. The model underlying the optimality, namely the maximization of
the expected utility, is subject to the same problem as the Capital Asset
Pricing Model concerning the expected value maximization. The opti-
mality criteria of probabilistic constraint or the safety first principle may
avoid this problem. As a compromise it seems to consider the optimization
according to different criteria and allows the decision-maker to decide
about the correct one. The data requirement and the computation time are
the limits of this procedure.
3. The estimation of the fractiles rj(ctj) may be problematic in practice,
especially if, according to the sensitivity analysis, a fine parametrization is
necessary. The subjectivity of the estimation cannot be avoided: it must be
taken into consideration in the analysis of the optimal decision suggested
by the automatic method. The interactive way allows the decision-maker
the correction before taking the step of optimization.
4. The different independence assumptions may be very restrictive,
often they do not hold good in practice.
5. The dynamic character of the decision-making process may be real-
ized through interactive possibility. The rolling horizon method is one way
to take the increasing amount of available information into account.
6. The business need not be reduced to mere portfolio terms. Other
factors may be also taken into consideration, but the information in
environmental, behavioral, organizational etc. factors are very difficult to
formalize. So in practice they are hard to build into the automatic
procedure of the computer, the analysis has to be executed by the decision-
maker.
5. L I M I T A T I O N S OF RISK ANALYSIS IN STRATEGIC PLANNING
Even though risk analysis is a popular topic in many theoretical works and
papers, a formal risk analysis is not used very often as a practical decision-
making tool. We give here our explanation for this phenomenon (see also
Naylor, Vernon and Wertz [5]): which follows equally well from our
analysis. It is clear that most of the models and approaches described in
the literature assume silently that the decision-maker has at his disposal
empirical or apriori knowledge of the probability distributions of the
random variables in question. But the main problem is that the key
random variables of interest are usually unknown or only partly known;
they are therefore not a significant representation of reality. What should
we really understand by the apriori probability of any executive's evalu-
ation? Do we not make idealized figures out of corporate executives by
demanding that they should be able to express accurately their apriori
probabilities?
There is another grave problem. Risk analysis can be very expensive,
especially when we use simulation models which have to be repeated very
often, up to 1000 times. In the case of a large and comprehensive model
these iterations require enormous amounts of computer time which
average firms cannot afford.
Finally, there are too many unsolved methodological problems con-
nected with simulation models, for example: validation, the experimental
designs and the analysis of all the data which are generated by the
simulation model itself.
It is clear that it is difficult to sell the formal analysis of any model to
the top managers, simply because only a small number of them are trained
enough to be able to understand what probability distributions, random
variables and the standard deviation and the whole theoretical framework
really mean for their practical decisions. We agree, therefore, with most of
the authors that sensitive analyses with the help of computer models may
be the best and actually the most often used tool for risk analysis. If, for
example, we investigate an oligopolistic model of a market, we cannot
know in advance what price the competitors will charge, therefore we have
to run the simulation experiments on the basis of several merely assumed
pricing policies of the competitors. We will take, for example, high, low
234 JANOS ACS
and average prices. This is a very intuitive and easily understandable way
of simulating because it is clear to every manager that the prices of our
goods will depend on the impact of the assumed price levels of the
competitors. Thus it is clear that the simulation is able to evaluate the
sensitivity of our sales compared to the different pricing policies on the
market. Thus computer simulations are widely used in corporate decision
making and they do not demand any sophisticated understanding from
the corporate managers who use them (see also Naylor, Vernon and Wertz
[5] who come to similar conclusions).
6. FROM RISK ANALYSIS TO RISK MANAGEMENT
6.1. The Concept of Risk Management

The difficulties of using risk analysis in practical decision-making has led
to the Concept of Risk Management which, generally speaking, goes
beyond the traditional scope of insurance management. Risk management
is understood as a systematic analysis, influence and coordinated control
of all risks of a company. Albach [1] defines risk management from a more
operational aspect: Risk management is the attempt to place the firm in
a position where all risks can be identified, valued and, with the help of the
instruments of risk policy, mastered in a way that the existence of the firm
itself can never be endangered by its environment.
According to these definitions risk analysis is a part of risk manage-
ment. Do its limitations influence the applicability of the Concept of risk
management? The reply can only then be affirmative if risk analysis is
limited to the a priori knowledge of the probability distributions of the key
random variables of interest in a decision problem. If risk analysis is
regarded as risk identification and risk evaluation, and beside the quan-
titative methods also the qualitative ones are accepted, the concept of risk
management is applicable in theory and practice.
Figure 4 shows a taxonomy of risks and uncertainty in business and of
what is traditionally meant by risk management according to Carter and
Doherty [27]. As to the functions of risk management various authors give
different definitions. Figure 5 lists the different views of this subject. Other
authors try to give a process oriented classification of the main functions
M
>
l Riskand Unceltainty in Business ]
. I ,.
I
I( Busing.Ill.t,, ] Pure Ri~s ]
Management Sciences) J (Risk Management)
I Z
I Z
I I I I I z
Technical Social Economic Political ] I SocialDeviations ]
from expected
standards of conduct
[ !
I I I I
e.g. e.g. e.g. e.g. e.g. e.lg. ;>
(i) Unforeseensnags in (i) ('hanger in consumer (i) Changesin level of (i) Nationalization 111 "l'neft (i) Death Z
new prOCesses tassel economic activity (ii) Political unrest (ill Fraud (il) Sickneu >.
(ii) Lack of knowledge (U) Labour umcst (ii) Inflation Oil) War (lii) Riot (iii) Injury .<
(iii) Mongtuy and fiscal policy (iv) Trade restrictions (iv) Negligence
(iv) Actionsof competitors
Physical effuctsl >
I ' Z
I 1
i Production ] I ,,e,ing I 1 'ina+, J
I I I >
e.g.
I ! Z
e.g. e.g. e.g. e.g.
(i) Interruption of production (i) Errotsin forecasting (i) Bad debts 10 Windstorm ] (0 Brcakdown of plant
(ii) Change in expected costs total demand (it) Changes in availability (ll) Earthquake i (it') Failme of ssfcty devices
Iiij) Restrictions on supply o f (il) Louof markets to ot cost ofcr9 (iii) Rood (iii) Ilazatduus proceu,es
law mtqalab competitors
z
Fig+ 4. Taxonomy of risk and uncertainty in business.
236 JANOS ACS
Gallaf~her,[14] Crist),, [30] Risk Management Handbookof Risk Parkinson~[33]

Position, 1964, Fundamentals,1965, Manual,[31] 1971,ft., Management,[32] Role, 1976,
1 ft. 1.085 ft. Introduction, 7 ft. 1974ft. 4.01 ft. lift.
Risk Analysis RecognizingRisks Identificationof Risk Identification Risk Identification
Risk Identification Exposure
Risk Evaluation Risk Evaluation Risk Evaluation
Risk Appraisal Evaluation of Risk
Risk Abatement Risk Reduction Risk Removal
ControllingRisks Risk Control
Risk Transfer Elimination Insurance, Risk Risk Reduction
Avoidance Risk Finance Retention
Risk Accounting Preventionof Risk Re-evaluation
Loss Risk Management
Protection Administration Risk Assumption
against Loss
Risk Transfer
MeetingLosses
Noninsurance
Use of Insurance
Fig. 5. Functions o f risk management.
W i l l i a m s - H e i n s , [34] Denenberg-Eilers- Baglini, [36]

M e l o n e - Z e l t e n , [35]
R i s k M a n a g e m e n t , 2, 1971, Risk, 2, 1974 Risk M a n a g e m e n t , 1976,
23 f. 68 ft. 28.
I d e n t i f i c a t i o n o f risks Discovering the D i s c o v e r i n g t h e firm's

sources of e x p o s u r e s to loss
M e a s u r e m e n t o f t h e losses p o s s i b l e loss
a s s o c i a t e d w i t h these risks Analyzing and measuring
Evaluation of the t h e loss p o t e n t i a l
Considering the alternative financial i m p a c t
tools and decision-making o f losses o n t h e Developing alternative
firm methods for dealing
Effective i m p l e m e n t a t i o n o f w i t h these e x p o s u r e s
the decisions made Selecting t h e m o s t
efficient m e t h o d C h o o s i n g the best
or methods of method or combination
treating the of methods
v a r i o u s risks
Implementing the chosen
method(s)
M o n i t o r i n g t h e results
Fig. 6. Process oriented function of risk management.

of risk management, which we have put together in Figure 6. According

to Helton [28] risk management has the following functions: the identifi-
cation of risks, risk-analysis, risk evaluation, decision-making. In this
context it is understandable that the critic of the concept of risk analysis
has to be reinterpreted: it is only one function or only one tool of risk
management. The shortcomings and pitfalls of risk analysis ought to be
compensated and amended by the other tools of risk management.
6.2. Application of Risk Management in the Strategic Planning

One of the most important new developments is the differentiation of the
strategic planning process. Wind [4] blames the present still valid theory
and practice concentrating primarily on financial and organizational
considerations and presents the system model for strategic marketing
planning that has been applied in a number of cases to achieve more
marketing orientation in strategic planning (Figure 2). A closer investi-
gation of the systems models of Wind and the evaluation of the practice
of strategic planning shows the necessity of the situative approach of
strategic planning, which results in a better identification of the main
global risks and uncertainties of the firm. Figure 7 shows new system
models of the strategic marketing planning process, which has been
developed by the author. This framework and its possibility of access to a
computer render it possible to generate a better strategic decision under
risk and uncertainty. These models enable the analysts to consider the
tools of risk management.
The following two examples will explain the practical application of the
concept of risk management in strategic planning.
6.2.1. Management of Product Liability Risks

Because of the increasing protection of consumers, the problem of product
liability is not only a matter of producing goods and services, but is also
increasingly risky concerning the marketing and financing organizations
in business. To explain some difficult aspects of product liability risks,
Helton [28] presents the case of a machine factory delivering equipment to
produce plastic bottles. Due to a mistake in construction the bottles are
leaking. The fault has been recognized after a certain part of the order was
finished. The producer of the bottles now faces financial losses as he
238 J A N O S ACS
EXTENDED ]
"[MARKETING-AUDIT ~
ADAPTATION OR
NEW STRATEGY CORRECTION OF
YES CURRENT
STRATEGY I- r
IL GENERATION OF
POSSIBLE
STRATEGIES
LOW
SUCCESS RATE
~ IDT~E[
Ip~AEWI
~T~RO~M~/
MARKET
] YES
/I
NO _1 CHOI~EOF
_ ,N,ASSERTI~E~
I STRATEGY
r POSSIBILITYOF "~
WITHDRAWAL FROM
MARKET J
PLANNING OF
WITHDRAWAL
STRATEGy
I
1
_l IMPLEMENTATIONL
-I OFTHEST"TEGY F
-I
J CONTROL [
Fig. 7. Process structure of strategic planning for stagnatic market.

cannot satisfy his customers. A catalogue of risk management of failures

in construction could be defined as follows: risk avoidance, which means
the renunciation of risky products; risk reduction means a change-over to
other technologies, connected with less risks or increasing quality control;
risk sharing could mean organizing independent sections for research and
development, for example as a limited company. This is the same as with
the foundation of corporate laboratories together with business partners;
risk transfer means contract-liability or the delegation of risks to suppliers
or customers. In an optimal risk-portfolio all these instruments have to be
combined with each other.
6.2.2. Management of Risks in Foreign Countries

Credits inforeign countries are endangered through economic and political
factors. Let us explain the possible strategies of risk policy against political
factors: risk avoidance means having no business with an unstable
country; risk reduction: restricted activities in such countries; risk sharing:
regional diversification; risk transfer: securities through international
contracts; etc. In an optimal risk portfolio these instruments have to be
combined properly with one another. The present state of risk manage-
ment does not provide proper instruments for every problem of the
strategic planning process. For specific problems new instruments of risk
management have to be developed and applied in the decision-making
process. It is an urgent task of research to find new, adequate instruments
of risk management which have to be combined with other well-proven
instruments. The above considerations hold good mainly in case of one
decision maker, with a specific risk behavior. The situation markedly
changes in case of group decision-making in a firm. This behavior differs
considerably when the interests of the various groups (or members of the
same group) clash. It is empirically proved that individual decisions are
more risk averse than group decisions (Acs [37]). For this reason the
structure of the strategic planning process influences the risk management
considerably. Interested parties seize risk assessments that favour their
position and try to use them as conclusive arguments. It would be naive
to expect that such a misuse of risk analysis could be curtailed by exhort-
ing analysts to reform their practices. Institutional changes, among them
rules of the game, are to be introduced and strengthened respectively.
240 JANOS ACS
7. S U M M A R Y
Risks, uncertainties in firms and their environment are increasingly dealt

with strategic planning, risk analysis and risk management. The present
state of strdtegic planning enables us to consider the greatest part of
internal and environmental risks mainly qualitatively - due to the
fact that the majority of planning models used are of a deterministic
type.
The application of CAPM in strategic planning could take risks into
account explicitly and maximize the expected value of the firms' common
stock. Linked to a corporate simulation model or a DSS it could generate
a series of values for the expected rate of return, its standard deviations as
well as other output variables important for the management. The diffi-
culties of the use of CAPM are numerous but an attempt to optimize the
value of the firm would be a big step in developing new powerful instru-
ments for evaluating the economic consequences of alternative strategies.
The problems of CAPM lead to the considerations of the application of
stochastic programming in strategic planning. For special cases solution
methods can be developed and applied. The implementation of the
Decision Support System in strategic planning could help to find "the best
decision" in an interactive way - as suggested in this paper for the case
of strategic marketing planning. DSS renders the consideration of other
factors relevant to strategic decisions possible; businesses need not be
reducedto portfolio terms. The limitations of CAPM, stochastic program-
ming and the difficulties of the implementations of DSS for strategic
planning could be partially avoided through the concept of Risk Manage-
ment. On this concept strategic planning represents only one instrument
of Risk Management and is a powerful tool of risk identification. In this
paper the other instruments have been shortly demonstrated for the cases
of product reliability and risks in relation with foreign countries. The
development of new instruments for special cases (e.g., siting problems,
specific strategic decisions, etc.), the considerations of risk behavior in
individual, group and inter-organizational or even international decision
making are now the main topics in the urgent task of research in risk
management.
REFERENCES
1. Albach, H.: 1978, 'Strategische Unternehmensplanung bei erhrhter Unsicherheit', in:

ZfB, 48, 702-715.
2. Nicklisch, H.: 1922, 'Allgemeine Kaufmfinnische Betriebslehre als Privatwirtschafls-
lehre des Handels (und der Industrie)', Leipzig, 1912, 6, auf I., Wirtschaftliche Betriebs-
lehre, Stuttgart.
3. Leitner, F.: 1915, Die Unternehmungsrisiken, Berlin.
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A. A. Zoltness (eds.), Marketing Decision Models, North Holland Publ. Co.,
pp. 207-250.
5. Naylor, T., Vernon, I., and Wertz, K.: 1983, Managerial Economics, New York.
6. Porter, M. E.: 1980, Competitive Strategy, Free Press, New York.
7. Ball, B. C.: 1978, 'The Use of Management Science Techniques in a Corporate Strategic
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8. Sharp, W. F., 1954, 'Capital Asset Prices: A Theory of Market Equilibrium under
Conditions of Risk', J. Finance 19, 425-442.
9. Linter, J.: 1975, 'The Valuation of Risk Assets and the Selection of Risky Investments
in Stock Portfolios and Capital Budgets', Rev. Econom. Statist. 47, 13 37.
10. Naylor, T. H. and Tapon, F.: 1982, 'The Capital Asset Pricing Model: An Evalu-
ation of its Potential as a Strategic Planning Tool', Management Science 2/t, 1166-
1173.
11. Sharpe, W. F.: 1983, 'A Simplified Model for Portfolio Analysis', Management Science
9, 277-292.
12. Ahlers, D. M.: 1975, 'An Investment Decision Making System', Interfaces 5, Part 2.
13. Kataoka, A.: 1963, 'A Stochastic Programming Model', Econometrica 31, 181-196.
14. Roy, B.: 1969, Al~ebre moderne et th~orie des graphes orient~es vers les sciences econ-
omiques et speciales, Paris.
15. Marschak, J. and Redner, R.: 1972, Economic Theory of Teams, Yale Univ. Press, New
Haven.
16. Prrkopa, A.: 1974, 'Programming under Probabilistic Constraint with a RandomTech-
nology Matrix', Math. Operations-forschung und Stat. 5, 109-116.
17. Pr~kopa, A. and Szfintai, T.: 1976, 'On Multi-Stage Stochastic Programming', in
A. Prrkopa (ed.), Progress in Operations Research, North Holland Publ. Co., Vol. II,
pp. 733 756.
18. Carlsson, Ch., Khaynish, S. V., and Vlasov, A. G.: 1984, 'Decision Support Systems
for Ill Structured Problems', paper presented at EURO 6, Wien.
19. Simon, H. A.: 1978, 'Information-Processing Theory of Human Problem Solving', in
W. K. Estes (ed.), Handbook of Learing and Cognitive Processes, v.s. Human Infor-
mation Processing, pp. 271~95.
20. Keeney, R. L. and Raiffa, H.: 1976, Decisions and Multiple Objectives, J. Wiley, New
York.
21. Fishburn, P. C.: 1970, Utility Theory for Decision Making, J. Wiley, New York.
22. Raiffa, H.: 1968, Decision Analysis, Addison-Wesley, Mass.
23. Keeney, R. L.: 1973, 'A Decision Analysis with Multiple Objectives: The Mexico City
Airport', Bell J. Econ. Mngmt. Sci. 4.
24. Keeney, R. L.: 1974, 'Multiplicative Utility Functions', Oper. Res. 22, 22 34.
242 J A N O S ACS
25. Viliums, E. R. and Sukur, L. Ya.: 1984, 'Practical Aspects of Alternatives Evaluating
and Decision Making under Uncertainty and Multiple Objectives', in Cybernetics and
Systems Research 2, 165-171.
26. Keefer, D. L. and Pollock, S. M.: 1980, 'Approximation and Sensitivity in Multi-
objective R~source Allocation', Operations Research 28, 114-128.
27. Carter, R. L. and Doherty, N. A.: 1974, 'The Development and Scope of Risk Manage-
ment', in Handbook of Risk Management, Carter-Doherty, London.
28. Helten, E.: 1984, 'Strategische Unternehmensplanung und Risk Management, in
E. Gangler, O. H. Jacobs and A. Kieser (eds.), Strategische UnternehmensJ~hrung and
Rechnungslegung, C.E. Poeschel Verlag, Stuttgart, pp. 15-30.
29. Gallagher, R. B.: 1964, 'Position of the Risk Manager in a Business Organization
Structure', in Risk Management, H. W. Snider, Homewood, pp. 1-32.
30. Cristy, J. C.: 1965, 'Fundamentals of Risk Management', in Property and Liability
Insurance Handbook, J. D. Long and D. W. Gregg, Homewood, pp. 1085-1100.
31. Risk Management Manuals: 1971, The Merrit Co., Santa Monica.
32. Handbook of Risk Management: 1974, R. L. Carter and N. A. Doherty, London.
33. Parkinson, J. R.: 1976, The Role of Risk Manager in Industry and Commerce, London.
34. Williams, C. A. and Heins, R. M.: Risk Management and Insurance, 2nd edn., New
York.
35. Denenberg, H. S., Eilers, R. D., Melone, J. J., and Zelten, R. A.: 1974, Risk and
Insurance, Englewood Cliffs.
36. Baglini, N.: 1976, Risk Management in International Corporations, New York.
37. Acs, J.: 1980, 'Zu einigen Problemen der kollektiven Entscheidungen aus der Sicht der
Informationstheorie und -technologie', in Proc. 4th Int. Wittgenstein Symposium 1979,
Kirchberg (Austria) Wien (H61der-Pichler-Tempsky).
McGraw-Hill Book Company and Elsevier Science Publishing Company have granted
permission for the reprinting of certain tables and figures from the book Managerial
Economics - Corporate Economics and Strategy, Naylor et al. and from the article "Market-
ing Oriented Strategic Planning Models", by Yoram Wind, in "Marketing Decision
Models", edited by R. L. Schulz and A. A. Zolthers, North Holland, New York, 1981.
Institut J~r Arbeits und Betriebs-wissenschaften,

Theresianumgasse 27,
1040 Wien Austria
t~
4~
oo
A N N E X 2 - continued
Model Degree of Specific Allocation Comments

adaptability dimensions rules
7. Analytic Fully adaptable to As with conjoint Optimal allocation among all Limited applications.
hierarchy management needs analysis, items of the portfolio (e.g., Conceptually and
process determined by products, market segments) mathematically very appealing.
management determined algorithmically Allows assumptions and
judgment allocate resources across
products,market segments, and
distribution networks
optimally under different Z
scenarios of market and O
competitive conditions. ;}
Weighting of dimensions
r~
explicitly considered
8. Risk/return None. A theory 1. Expected return Determination of optimal Conceptually the most
model derived model (mean) portfolio defensible, yet, difficult to
2. Risk (variance) operationalize for the product
portfolio decision. Limited
real-world applicatins
9. Stochastic Same as The entire Same as risk/return Same as risk/return

dominance risk/return model distribution of
return
244 JANOS ACS
PRODUCT PORTFOLIO MODELS [
1
t prod els I
I
Standardized Models
f
Univariate dimensions: Composite dimensions:
9 Boston Consulting Group's 9 The McKinsey/GI business
growth share matrix assessment array
Relative M/S Industry attractiveness
H~ [ =L High I Medium Low
H "Star" Problem Investment ] Selective

Market ~ child High and growth growth Selectivity
growth Cash Dog (c) (G) (Y)
L cow
Business Selective
strengths Medium growth Selectivity Harvest
(G) (Y) (S)
Low Selectivity Harvest Harvest

(Y) (R) (R)
9 A.D. Little business

profile matrix
Stage of industry maturity
=mbryoni~ Growth Mature Aging

1
Dominant
Strong
Competitive Favorable
position
Tentative
Weak
9 Shell international directional

policy matrix
Prospects for sector profitability

Unattractive Average [ Attractive
Phased
Weak Disinvest withdrawal Double
custodial or quit
Company's Phased Growth Try harder

compet!tive Average withdrawal
capabilities
Strong Cash Growth

generation leader Leader
I
Customized Models
Risk return model
Expected
9 The product performance matrix return
tX-~,ae Sab~ c~,o.lh
Management trade-off
a~ TIrWt ~ ~ t ~1o~ h,~l
TItle[ A~IarF Abo~ betwcen risk and return
t~,nR
fl~ciegcy
G.owlh A~F ontler
M.,~n.l
Risk
S,a~ A~r~w
M.,l,n.i OStochastic dominance ]
J-r
OA conjoint analysis based approach ]
o The analytic hierachy process j
ANNEX 1
t,~
.gu
o~
ANNEX 2
Degree of Specific Allocation

Model adaptability dimensions rules Comments
1. BCG growth/ None. A rigid 1. Relative market 1. Allocation of resources Widely used but conceptually
share matrix framework share (cash among the four categories questionable given the forcing
generation) (move "cash" to "problem of two dimensions, the unique Z
2. Market growth child," etc. operational definition, and 9
(cash use) 2. Consideration for product lack of rules for determining a
deletion (e.g., "dogs") portfolio of "drogs," "stars,"
3. No explicit portfolio etc. No consideration of risk,
recommendation except no weighting of dimensions.
with respect to the balance
of cash flows
2. McKinley/G.E. Limited through 1. Industry In its simplistic use, it offers a Forcing of two dimensions
business the selection of attractiveness slightly greater precision than which might not be the
assessment variables used to 2. Business BCG (nine cells vs four and appropriate ones. The
array determine the two strengths better definition of empirical determination of the
composite dimensions). In its more correlates of the two
dimensions sophisticated uses (as by dimensions is superior to the
G.E.), the classification of BCG approach, yet, given the
products on these two tailoring of factors to each
dimensions is used only as industry, comparability across
input to an explicit resource the industries is ditficult. No
allocation model. consideration of risk
3. A.D. Little Same as 1. Competitive Same as McKinsey/G.E. Same as McKinsey/G.E.
business profile McKinsey/G.E. market position
matrix 2. Industry O']
maturity -]
4. Shell Same as 1. Profitability of Same as McKinsey/G.E. Same as McKinsey/G.E. -]

International McKinsey/G.E. market segment rn
directional 2. Competitive
policy matrix position in the
segment r"
5. Product Consierable. The 1. Industry sales Same as BCG but based on Limited applications (major Z
performance specific dimensions 2. Product sales projects results in response to user: International Harvester), Z
matrix are selected by 3. Market share alternative marketing yet it offers the conceptual
management 4. Profitability all strategies advantage of management-
by market determined performance
segment dimension and allocation of
resources based on projected
rather than historical
performance. No weighting of Z
dimensions. r"
6. Conjoint Fully adaptable to No general Based on computer simulation Limited applications. Very
analysis based management needs dimensions. The which incorporates manage- demanding of management
approach dimensions ment utility functions (for the time Z
determined by dimensions of the portfolio),
management and product performance data
judgment (supplemented to the extent
needed by management Z
perceptions of current and
new products and businesses)
Z
-]
bo
t~
4~
oo
A N N E X 2 - continued
Model Degree of Specific Allocation Comments

adaptability dimensions rules
7. Analytic Fully adaptable to As with conjoint Optimal allocation among all Limited applications.
hierarchy management needs analysis, items of the portfolio (e.g., Conceptually and
process determined by products, market segments) mathematically very appealing.
management determined algorithmically Allows assumptions and
judgment allocate resources across
products,market segments, and
distribution networks
optimally under different Z
scenarios of market and O
competitive conditions. ;}
Weighting of dimensions
r~
explicitly considered
8. Risk/return None. A theory 1. Expected return Determination of optimal Conceptually the most
model derived model (mean) portfolio defensible, yet, difficult to
2. Risk (variance) operationalize for the product
portfolio decision. Limited
real-world applicatins
9. Stochastic Same as The entire Same as risk/return Same as risk/return

dominance risk/return model distribution of
return

Comparation 4 Strategic Plann and Risk MGMT

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JANOS ACS

A COMPARISON OF MODELS FOR STRATEGIC

Growing risks, uncertainties in business firms and their environments

Theory and Decision 19 (1985) 205-248. 0040-5833/85.10

enthusiasts go even further and equate risk management with corporate

2. RISK AND UNCERTAINTY IN STRATEGIC

2.2. The Capital Asset Pricing Model

j=l j=l k=l

in division j, and in division k respectively, aj is the variance of return for

2.3. Capital Asset Pricing Model as a Possible Tool for

by the management, rm should be as close to zero as possible or maybe

2.4. Critical R e m a r k s on the Capital Asset Pricing M o d e l

The application of the CAPM as a strategic planning tool is strongly

5. Strategic decisions deal with dynamic problems, whereas the CAPM

2.5. The Index Method of Ahlers

The difficulties of estimating variances, covariances got the simpler and

planner's idea about output expectation and risk limitation. It is evident

3. APPLICATION OF STOCHASTIC PROGRAMMING IN

(4) maximized subjectto P(jX=~ Wj[ Rj~> d ) ~ > p ,

In this model special attention has to be paid to the probabilistic con-

the probabilistic constraint has the form of

It can be expressed by the inverse function F-1 of F in

(8) d.< ~ R ~ + . F l(1 - p).

(9) maximize Ij~Rj~+ aF-l(l-p) 1

If the random rates of return Rj (j = 1. . . . . n) have a non-degenerated

3.2. Connection of the Capital Asset Pricing Model and the

(10) maximize (j~=~RjWj-Ormtr)

--or,,, ----- F - I ( 1 - p), that is p = 1-F(-Qrm).

3.3. Safety First Principleand StochasticDependentReturns

(11) maximize P(j~= WjRj>>.d)

Here we can derive an equivalent nonlinear programming model similar

subject to the same constraints as in (11). Here we cannot see the

(13) maximize i , ..... m)

3.4. The Safety First Principle in Multiobjective Optimization

(14) maximize (jX=l 5~ i= 1. . . . m )

has no meaning; not even if the objective is a weighted average (7~,

i=1 j=l i=1

(16) maximize P(jX=,f0Wj>>. di, i = 1. . . . . n)

subject to X Wj = l, ~ -N< 0, j - - 1. . . . ,m.

The transformation of models (13) and (16) into deterministic problems is

3.5. Critical Remarks on the Stochastic Programming Methods

The application of the stochastic programming methods has some serious

distribution function is of a special structure. This is especially valid for

4. THE ROLE OF DECISION SUPPORT SYSTEMS IN STRATEGIC

4.1. The Necessity of Decision Support Systems in Strategic

of these efforts various software packages have been elaborated for

the information postulated is effectively available to the processes - i.e.,

4.2. Multiobjective Optimization of Investment Using

R1 . . . . . Rj,...,Rm, considering the uncertainty.

(17) E(u(x)) = ~R u(r)f(rlx) dr

where R = {R~} is an appropriate set of attributes, j = 1. . . . . m. r =

(18) f(rlx) = fl(rllYq)f2(r2lYc2)...fm(rmlSCm).

(19) u(r) = X kiui(ri)

(20) 1 + Ku(r) = 11 [1 + Kk, ui(ri)],

(22) E[u(rlx)] = X k~u~+(5ci)

(23) E[u(rlx)] = ~, [1 + Kkiu~(YQ] - --

(24) u+(Yci) = ~[R~ u'(ri)fi(rilYO dri' i = l, 2 9 m.

4.3. Approximate Solution o f the Multiobjective Optimization

One implementation of the solution algorithm in an interactive system was

_1 2. Choice of feasible set of alternatives ]

3. Determining the set of attributes [

4. Construction of the attributes scales [

5. Verification of the structural independence assumptions [