Finance teams serve as the most important informants for their organizations, hence shouldering the critical responsibility of preventing bad outcomes. They need to carefully consider the various what-ifs that can occur with different business decisions, accurately predict what setbacks could occur with different paths, and strategize how to evade negative results. This sort of prediction in business is referred to as scenario planning.
Scenario planning is arguably the most important responsibility of a finance professional. Executing this task at the highest standard possible requires an understanding of the specific objectives of scenario planning, the different approaches to it, and knowing the best practices and most common mistakes. This post will flesh out all these aspects of scenario planning.
What is Scenario Planning & Its Purpose?
Scenario planning is a method of strategic financial planning that enables finance leaders to mitigate risk and prepare for volatility.
This method accounts for inherent future uncertainties by quantifying the financial and operational implications of change, and analyzing a range of possible outcomes. The process involves identifying the key drivers of change for an organization, calculating an array of projections based on scenario modeling for potential variations in performance for one or more of those drivers, analyzing the results, and then concluding how to best apply such results to the business’s long-term financial and strategic plans.
Scenario planning may be done across an organization, or at the unit or initiative level. With initiative planning, finance leaders use scenario planning to analyze the potential financial effects of critical business decisions, such as closing a specific department or business unit, or launching a new service line.
Scenario planning helps finance leaders better understand the influence of various factors driving fluctuations in an organization’s performance and overall financial health. It enables them to evaluate the possible financial impacts of different external forces, such as shifting market demand or increasing expenses, or internal forces, such as variations in staffing levels or organizational investments. Equipped with these powerful insights, the c-suite can better mitigate risks and prepare for change through informed decision-making.
3 Types of Scenario Planning
1. Multi-Level Driver-Based Analysis:
This specific strategy starts with “What-if analysis,” and includes both independent and dependent drivers. This scenario planning example incorporates a series of independent drivers, like volume and growth assumptions, which then cascade down to affect downstream dependent drivers, such as departmental workload or supply needs. Multi-level driver-based analysis is an important tool for effective contingency planning and offers insights to the “cause and effect” of multiple assumptions.
2. Single Variable Sensitivity Analysis:
This involves changing one variable at a time while holding others constant and quantifying the impact of that singular change. These types of scenarios can help identify the drivers or model inputs that have the greatest impact on the organization and thus merit the greatest attention.
3. Initiative-Based Scenario Planning:
Incorporation of different sets of initiatives together into a composite plan or strategy. Finance leaders can layer different initiatives or combinations of initiatives on top of a baseline to gauge their combined impacts.
Yielding The Best Results in 5 Steps
The following are the five main steps required to best execute scenario planning:
1. Establish driver assumptions: Well-constructed scenario planning models identify an organization’s key business drivers. In a standard cause-and-effect relationship, these are the independent or causal variables.
2. Define the business logic: The interplay between driver variables and financial outcomes is the heart of any scenario planning model. In this step, finance leaders must define algorithms that best emulate the dynamics of the organization.
3. Collaborate with key stakeholders to review inputs: Once finance leaders have identified key drivers and defined the business logic, they should work with stakeholders or subject matter experts to review those assumptions and make adjustments based on their feedback.
4. Execute scenario analysis: Finance leaders use a variety of tools to conduct scenario modeling, from simple spreadsheets that require manual calculations to more advanced scenario planning software solutions that allow for automated calculations.
5. Store and present scenarios: After the scenario mapping is complete, finance leaders should save their scenario analysis in an accessible format for future reference and recalibration. The core findings then should be translated into easy-to-understand presentations for stakeholders, with side-by-side comparisons that include key drivers, financial information, and narrative around the contents of the scenario.
Evading The Worst Mistakes
The following list includes strategies regarding some of the most common mishaps finance teams encounter in their scenario planning processes.
1. Don’t let scenarios muddy communications:
Leaders can use scenarios without abdicating their leadership responsibilities but should not communicate with the organization via scenarios. You cannot stand up in front of an organization and say, “Things will be good, bad, or terrible, but I am not sure which.”
Anyone in an executive position in an organization must provide clear and inspiring leadership. That doesn’t mean that corporate leaders should not study and prepare for a number of possibilities. Understanding the range of likely events will embolden corporate leaders to feel prepared against most eventualities and allow those leaders to communicate a single, bold goal convincingly.
One additional point about communication and scenarios is worth noting. Scenarios can help leaders avoid looking stupid. A wide range of scenarios, even if not publicly discussed, can help prevent leaders from making statements that can be proven wrong if one of the more extreme scenarios unfolds. For instance, one financial regulator boldly announced, early in the financial crisis, that its banking system was, at the time, capitalized to a level that made it bulletproof under all reasonable scenarios—only to announce, a few months later, that a further recapitalization was required.
Similarly, the head of a large bank confidently suggested that the downturn was in its final phases shortly before the major indexes plummeted by 25% and we entered a new and even more dangerous phase of the crisis. Many CEOs have given hostages to fortune; scenarios would have helped them avoid doing so.
2. Don’t become a deer in the headlights:
You should create a range of scenarios that is appropriately broad. In today’s uncertain climate, excessive breadth can easily paralyze a company’s leadership. The tendency to think we know what is going to happen is in some ways a survival strategy: at least it makes us confident in our choices (however misplaced such confidence may be). In the face of a wide range of possible outcomes, there is a risk of paralysis: the organization becomes confused and lacking in direction, and it changes nothing in its behavior as an uncertain future bears down upon it.
The solution is to choose the scenario whose outcome seems most likely and to base a plan upon that scenario. It should be buttressed with clear contingencies if another scenario, or one that hasn’t been imagined, begins to emerge instead. Ascertain the “no regrets” moves that are sound under all scenarios or as many as possible. Ultimately, the existence of multiple possibilities should not distract a company from having a clear plan.
3. Don’t rely on an excessively narrow set of outcomes:
The astute reader will have noticed that the above-mentioned financial regulator managed to embarrass itself even though it was using scenarios. One of the more dangerous traps of using them is that they can induce a sense of complacency, of having all your bets covered. In this regard at least, they are not so different from the value-at-risk models that left bankers feeling that all was well with their businesses, and for the same reason. Those models typically gave bankers probabilistic projections of what would happen 99% of the time. This induced a false sense of security about the potentially catastrophic effects of an event with a 1% probability. Creating scenarios that do not cover the full range of possibilities can leave you exposed exactly when scenarios provide most comfort.
One investment bank in 2001, for instance, modeled a 5 percent revenue decline as its worst case, which proved far too optimistic given the downturn that followed. Even when constructing scenarios, it is easy to be trapped by the past. We are typically too optimistic going into a downturn and too pessimistic on the way out. No one is immune to this trap, including professional builders of scenarios and the companies that use them. When the economy is heading into a downturn, pessimistic scenarios should always be pushed beyond what feels comfortable. When the economy has entered the downturn, there is a need for scenarios that may seem unreasonably optimistic.
The breadth of a scenario set can be tested by identifying extreme events, low-probability, high-impact outcomes, from the past 30 or 40 years and seeing whether the scenario set contains anything comparable. Obviously, such an event would never be a core scenario. But businesses ought to know what they would do, say, if some more virulent strain of avian flu were to emerge or if an unexpected geopolitical conflict exploded. Remember too that it would not take a pandemic or a terrorist attack to threaten the survival of many businesses. Sudden spikes in raw-material costs, unexpected price drops, major technological breakthroughs—any of these might take down many large businesses. Companies can’t build all possible events into their scenarios and should not spend too much time on the low-probability ones. But they must be sure of surviving high-severity outcomes, so such possibilities must be identified and kept on a watch list.
4. Don’t discard scenarios too quickly:
Sometimes the most interesting and insightful scenarios are the ones that initially seem the most unlikely. This raises the question of how long companies should hold on to a scenario. Scenarios ought to be treated dynamically. Depending on the level of detail they aspire to, some might have a shelf life numbered only in months. Others may be kept and reused over a period of years. To retain some relevance, a scenario must be a living thing. Companies don’t get a scenario “right”—they keep it useful. Scenarios get better if revised over time. It is useful to add one scenario for each that is discarded; a suite of roughly the same number of scenarios should be maintained at all times.
5. Don’t use one single variable:
The future is multivariate, and there are elements strategists will miss. They should therefore avoid scenarios that fall on a single spectrum (“very good,” “good,” “not so good,” “very bad”). At least two variables should be used to construct scenarios—and the variables must not be dependent, or in reality there will be just one spectrum.