As a finance professional or business owner, scenario planning plays a big part in the future success and well-being of your organization. For this reason, it’s critical to understand the ins and outs of scenario planning, ranging from why it’s important to the tools you can use to complete the process.
What Is Scenario Planning?
Scenario planning is a method of financial planning with which you mitigate future risk by identifying assumptions and determining in advance how your company will respond.
For example, projecting estimated future cash flow allows you to plan for all scenarios, including both an increase and decrease.
Scenario planning can be completed across your entire company or within individual departments. For example, finance departments often run scenario planning on their own. However, there are times when they’ll collaborate with other departments to better understand the potential impact of business decisions, such as expanding a product line.
The Importance of Scenario Planning
There’s no denying the fact that scenario planning is time consuming. And depending on the approach you take, it can also turn into a large expense. Even so, you must consider what your organization gets in return.
Here are some of the primary benefits of scenario planning:
- Gives you the confidence that you’re prepared for anything and everything that could happen
- Helps you understand the key components of organizational performance
- Reduces bias
- Helps you manage uncertainty more effectively
- Produces more accurate budgets, forecasts and strategic plans
- Enables collaboration between departments
- Creates new (and potentially better) ways of doing things
Also, scenario planning provides an advantage over the competition as you’re able to react quickly, concisely and decisively because you already have a plan. You’ve thought through your options and documented them accordingly. This reduces panic and poor decision making should a crisis move to the forefront.
Are There Any Disadvantages of Scenario Planning?
This is a legitimate question that you need to address before getting started. The biggest drawback is that scenario planning can eat up a lot of company resources. It’s a lengthy process that generally involves a large number of people. You can expect it to take several months from start to completion.
Also, scenario planning isn’t something you do once and forget about until you need to take action. Constant reviews and updates are required.
Even with these potential drawbacks, the benefits of scenario planning far outweigh the disadvantages.
Types of Scenario Planning
There’s no one-size-fits-all solution to scenario planning, but there are four distinct types to consider:
Normative Scenario Planning
Normative scenarios focus primarily on the statement of goals, as opposed to objective planning. These goals don’t have to correspond with your company’s vision. Instead, they’re based more on how you want to operate over the short and long term. On its own, normative scenario planning isn’t as powerful as some of the other types. However, when combined with other scenarios, it’s a solid choice.
Operational Scenario Planning
Operational scenario planning is one of the most common types of scenario planning, as it touches on the direct impact of a specific future event. It allows you to better understand strategic implications and to plan accordingly.
Quantitative Scenario Planning
It often helps to look at future situations from a best and worst-case point of view. And that’s exactly what you get with quantitative scenario planning. It also allows you to make quick adjustments by altering a variety of variables. This form of scenario planning is most common when creating budget forecasts.
Strategic Management Scenario Planning
This type of scenario management focuses less on the company itself and more on the manner in which products and/or services are used. This is among the most challenging types of scenario planning as you must have comprehensive knowledge of your industry, local and national economics and the global landscape.
Sensitivity Analysis vs. Scenario Analysis
It’s a common misconception that scenario analysis and sensitivity analysis are one and the same. We’ve talked about scenario analysis and planning to this point, so let’s dive deeper into sensitivity analysis. Here’s a definition shared by Paro:
“Sensitivity analysis can also be helpful to quantify and analyze different outcomes. However, it differs from scenario analysis because sensitivity analysis only alters one input. It then shows how sensitive the projections are to that variable.”
There are times when scenario analysis is all you need. The same holds true of sensitivity analysis. However, there are also situations in which it makes sense to use them both.
Best Practices for Scenario Modeling
Don’t go into scenario modeling with the mindset that you have to do things a certain way. This can back you into a corner, making it a challenge to maximize your efforts.
A better approach is to rely on best practices, all while taking your company’s individual needs into consideration. Here are four best practices to guide you:
1. Use Data to Your Advantage
Without the right data, executing on agile planning is an impossibility. Sure, you could make educated assumptions, but that’s not what scenario planning is about. Every decision you make should be backed by accurate data.
Some examples of data include sales volume data from your customer relationship management (CRM) software, headcount data, sales pipeline health and historical data.
You won’t use every data point at your disposal, but it doesn’t hurt to closely review it to determine what you can employ.
2. Choose the Right Variables
There are two things to remember here. First and foremost, you have to choose the right variables. Secondly, you don’t want to overdo it.
For example, here’s an excerpt from our best practices blog post:
“Identify your levers from all of the metrics at your disposal. Then start with the plan and execute with the budget or forecast. When making decisions about financing, operational changes and more, consider your values and strategic priorities. Then work to remodel your KPIs, business assumptions and expected business performance accordingly.”
Just because you have a particular metric at your disposal doesn’t mean you need to work with it. You need to choose the right variables at the right time.
3. Run Three Basic Scenarios
This is based largely on the old saying “hope for the best, but plan for the worst.” The only difference is that you’re adding another scenario: status quo.
Your three basic scenarios should include:
- Low: Consider this the worst-case scenario. It shows that sales and revenue are dipping and you need to examine your business model to improve the likelihood of turning things around in the future.
- Medium: This is “business as usual”, such as if your growth remains the same as the last quarter. Identify what business as usual entails so you know how to run this scenario.
- High: This scenario is based on sales and demand increasing, resulting in additional revenue. Of course, it also has the potential to bring challenges to your organization, such as those with staffing.
4. Use a Break-Even Analysis
The goal of break-even analysis is to determine what you need from each variable to continue performing at the same level. You can use it to answer questions such as:
- What sales volume is required to continue operating in the same capacity?
- Do you have variable costs that are likely to change in the near future? What about fixed costs?
- What steps can you take to lower your break-even point?
Break-even analysis is a useful tool for scenario modeling as it can help you better understand your company’s required performance in relation to the three basic scenarios as detailed in #3 above.
4 Steps of Scenario Planning
It’s been said multiple times in this guide, but it’s worth mentioning again: the scenario planning steps that one company takes won’t be identical to the next company. Don’t make decisions based on what your competitors are doing. Make decisions based on what’s best for your organization.
Here’s a four-step scenario planning structure to help guide the process:
1. Identify the Questions You Want To Answer
This varies from company to company and from model to model. Identifying the questions you want to answer sets the table for the steps to come. Common questions include:
- What technology is needed to remain relevant in three years, five years or 10 years?
- What’s the best way to plan against a changing economic climate?
- How can your company prepare financially for another pandemic?
Even if you start with a list of defined questions, your approach could change as you get started. You may find that there are additional questions to address.
2. Determine Who To Involve
The first question to answer is this: Does scenario planning involve your entire company or only one (or several) departments?
Once you answer that question, you can more easily determine who to involve. Even in the smallest of companies, scenario planning isn’t generally a one-person task. It takes several individuals—or more—to manage and carry out this process.
3. Make Note of External Factors
Scenario planning isn’t all about what’s happening internally. Sure, this is a big part of the process, but you should also consider external factors. These can include details such as:
While you have control over what happens internally, external factors are likely to come into play over the long run.
4. Choose the Right Type of Scenario Planning
As noted above, there are four general types of scenario planning:
- Normative scenario planning
- Operational scenario planning
- Quantitative scenario planning
- Strategic management scenario planning
You can’t get started with the actual scenario planning process until you know which type you’re using.
Tip: don’t force yourself to take steps that don’t align with your company, its goals and/or the resources available to you. These four steps can act as a framework, but make adjustments as necessary.
Common Questions Associated With Scenario Planning
It doesn’t matter if you’re new to scenario planning or have gone through this process several times in the past, you may have questions. It’s best to address any questions and concerns as they arise, to avoid future complications.
Here are 10 common questions associated with scenario planning:
- Who needs to be involved with scenario planning?
- What’s the best way to plan for external factors over which you have no control?
- How much will scenario planning cost?
- How long will it take to complete your scenario planning?
- What’s the best way to measure scenario planning success?
- How will scenario planning change your company’s day-to-day approach to business?
- How will you know if a particular scenario that you planned for is playing out?
- How will you know which plan of attack to roll out to deal with a specific scenario?
- How often should you review your scenario plan?
- What are your primary objectives?
Maybe some of these questions have been bogging you down. Or perhaps all of them have been on your mind. Even if you only have one or two questions to answer, address them as quickly as you can.
By now, it’s our hope that you have a thorough understanding of all things related to scenario planning. With this knowledge, you can take the steps necessary to plan for any situation your company could face in the future. After all, if it’s good enough for the U.S. Military, it should be good enough for your organization.
And remember, there’s no “exact science” to scenario planning. A lot of what you do comes down to the specific requirements of your organization. The more time you spend on scenario planning the more comfortable you’ll become.
If you’re ready to get started with scenario planning, contact us online to request a free demo. We’ll walk you through our scenario planning and analysis software to help you better understand the way it can positively impact your business.