Underestimating Uncertainty

The art (or is it science?) of forecasting has failed the electronics market numerous times. As the year ends and forecasters roll out their predictions for 2012, there are no reasons to expect these outlooks for the year ahead will prove any more reliable than previous ones. So, how should the industry approach the turbulence everyone now sees in their crystal balls for this quarter and parts of 2012?

Researchers at McKinsey & Co. have a solution. Rather than suggest we hedge with scenario planning alone, they are taking a deeper look at the reasons behind forecast inaccuracies and offering solutions that may help electronics industry players reduce the gap between predicted sales and actual shipment. In fact, they suggest we don't even expect "precise predictions," because this can lead "executives to underestimate uncertainty." Failure to assign a higher significance to uncertainty in the business environment "can be downright dangerous," the research firm says. I agree.

In a report titled "Strategy under uncertainty" three McKinsey researchers focus on the problems of uncertainty in the economy and try to chart a course for executives seeking greater clarity in their operations even as they struggle to determine the usability of the tools and forecasts provided by industry pundits.

Before expanding further on the McKinsey solutions, I would like to bring this issue closer to home for the electronics industry. Inaccurate forecasts have in the past wreaked havoc on the industry, showing up in devastating demand-supply imbalances that have upended manufacturing, inventory, employment, and capital equipment expenditure planning. It's extremely difficult for companies to even determine the amount of raw materials to order when a reasonably reliable forecast cannot be used to determine consumption and sale.

Further, aside from the related issues of missed sales and distorted gross profit and operating margins, the other byproducts of unreliable forecasts have included severe pressure on market valuations and loss of credibility in relationship with customers and suppliers. In the semiconductor market, for instance, projections are used to determine the optimal level of installed manufacturing capacity, next-generation technology investment, engineering resources, and raw material procurement. Even for companies that are fabless and rely on foundries, sales projections are critical to orders, which the wafer supplier may insist the IC designer accept regardless of actual demand.

The situation has become even more complicated as the global economy lurches from one crisis to another and as the electronics market becomes closely entwined with the larger system. In previous electronics cycles, companies have missed forecasts for reasons that were easier to determine and most of which arose from events within the industry. That's no longer the case. The old era was marked by self-destructive action on the part of electronics companies -- for instance, previously unaccounted-for inventories derailing production plans or insane fights for market share that resulted in corrosive price wars.

It is different today. High unemployment and high national debts as well as fears about future prospects among consumers in the West plus rising inflationary pressure in developing economies are eroding confidence worldwide. For McKinsey researchers, these all add up to a higher level than usual of uncertainty for manufacturers who in the best of times were unable to decide how to measure the impact of unknown factors on their operations. They write:

At the heart of the traditional approach to strategy lies the assumption that executives, by applying a set of powerful analytic tools, can predict the future of any business accurately enough to choose a clear strategic direction for it. The process often involves underestimating uncertainty in order to lay out a vision of future events sufficiently precise to be captured in a discounted-cash-flow (DCF) analysis. When the future is truly uncertain, this approach is at best marginally helpful and at worst downright dangerous: underestimating uncertainty can lead to strategies that neither defend a company against the threats nor take advantage of the opportunities that higher levels of uncertainty provide.

What's the solution to the uncertainty conundrum? McKinsey suggests managers try to understand the four levels of uncertainty: a clear enough future; alternative futures; a range of futures; and true ambiguity. "Level four situations are quite rare, and they tend to migrate toward one of the others over time. Nevertheless, they do exist," the McKinsey researchers say. I agree, and we may actually be in one right now.