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Scenario Modeling: 4 Best Practices for Preparing for the Future—Whatever it Might Be

April 9, 2020 |

Unless you’re Nostradamus, there’s no predicting what the future holds: whether new market needs are about to put your company on an upwards trajectory, or a worldwide crisis will have you facing fresh uncertainties. In finance—as in life—change is the only constant. While there may be nothing you can do to keep the future—good or bad—at bay, you can make sure you have a plan ready when it arrives. By constantly testing your assumptions, you can equip your company with a strategy that lets you move forward confidently and with agility. That’s where scenario modeling comes in. 

Strategic finance teams use scenario modeling as part of their daily, monthly or annual practice, keeping their finger on the pulse of future scenarios to ensure they know which levers they can pull to adjust course. But in times of uncertainty, it’s even more valuable. Whether you’re encountering seismic market shifts, entering a new geographic market or making changes to a line of business (LOB), scenario modeling can help you build agile models that allow you to assess the impact of your business plans on revenue, costs and cash flow. 

Four best practices can help you get the most out of your scenario modeling efforts.

1. Draw on all kinds of data

As a strategic finance team, you won’t be able to execute on agile planning with any degree of confidence without the right data, and that means going beyond the general ledger (GL). Having ready access to company-wide data will give you a holistic picture of your business today and better inputs, drivers, and outputs for the scenarios you model. 

The right metrics bring together real-time, company-wide data from typically siloed systems, including:

Ultimately, effective scenario modeling under any condition means linking business drivers to key performance indicators (KPIs), monitoring those KPIs and being able to factor in external modeling inputs. That means combining traditional financial metrics with non-financial data (from sales, marketing, HR and operations) as well as external data from public sources (e.g., tariffs and exchange rates).

2. Be selective in the variables you model

As with your budgeting process or dashboard reporting, effective scenario modeling should be based on a select number of levers and performance indicators. 

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.

For scenario modeling, select a manageable number of levers to model. As much as possible, you want to make choices that are either within your control (levers) and then predict a variable range of outcomes with confidence. 

Given the challenges facing businesses today, the most common levers to test against your business model are:

3. Hope for the best, plan for the worst (and the best too)

For each variable you want to model you should consider three basic scenarios: high, low and medium, the latter referring to continuing business as usual. 

The trick to coming up with those scenarios is to make them very different. Make the high scenario a true, blue sky best case—your business is firing on all cylinders. Conversely, the low scenario should mean your business is facing significant challenges. The medium scenario should be something in between: business continuing along the planned status quo, without any drastic market changes. 

To illustrate the high, medium and low scenarios against the levers most likely to be top of mind for today’s finance teams, consider the following examples:

4. Use a break-even analysis to show what’s needed from each variable to keep it performing as is

There’s no shortage of tools and decision-making models available to you and your finance team in times of uncertainty, but the simplest method of determining your financial health in any situation is a breakeven analysis. Whether you use Excel or a more advanced FP&A solution, breakeven analysis identifies what decisions you need to make to continue operating at a cash flow break-even level, including:

When time is of the essence, breakeven analysis is a way to confront hard truths about the feasibility of a product line or business. 

Scenario Modeling in Action

While scenario modeling may not give you the power to predict the future, it will empower you with a plan to face that future head on, and inform the solutions you develop for good times and bad. Ultimately, in a mature FP&A process, scenario modeling can help fuel your strategic portfolio planning, and give you a sense of the investments or innovations you should embrace—and which you shouldn’t—to build towards your business goals. It can also play a part in identifying your company’s key drivers and areas where you need to improve measurement.

How you use scenario modeling at your company will depend on the maturity of your financial team and the tools you have in your toolset, as well as your people, process and company culture. But wherever you sit on that spectrum, scenario modeling has the power to help you put your company on the best track—no matter the future ahead.

Learn more about how you can quickly get started with best practices for scenario modeling or talk to an Vena FP&A expert 1:1 with no obligation to help you plan for today and tomorrow.

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