Scenario planning is one way to reduce risk and overcome uncertainty
In an uncertain business environment, staying on top of future cash needs is challenging… but essential.
What is scenario planning?
A scenario is what we think might happen in the future based on certain assumptions. For example, we may ASSUME it will rain tomorrow and the game will be cancelled – that’s Scenario 1. However, the game may still go ahead but with a delayed start - that’s Scenario 2. We can measure the probability and impact of these scenarios and then make plans.
The concept of scenario planning is simple and humans do it all the time.
Some advantages of scenario planning
- Business leaders are encouraged to consider MULTIPLE FUTURE CIRCUMSTANCES, not just those which are most likely or those that have prevailed in the past. This invites comparison and a healthy debate on the preferred strategy for the business. There is no limit to the number of scenarios which can be considered.
- Business leaders are encouraged to make assumptions on BOTH INTERNAL AND EXTERNAL FACTORS. Internal factors include those that the business can (mostly) control (like expenses) while external factors are (mostly) out of the control of the business (such as interest rates, currency fluctuations, the ability to borrow, policy changes and so on).
- Business leaders are encouraged to think about the SHORT, MEDIUM and LONG-TERM (whereas many budgets are made for the short term e.g. one quarter or one year)
Here are some Best Practices to make scenario-planning even more productive.
1. Think broadly when making assumptions
Be imaginative about the assumptions you make. Nothing is ‘off the table’. Consider all future possibilities as well as past events.
Example: An operator of corporate travel agencies may consider scenarios in which:
- corporate travel only recovers to 20% of its former value
- the business is forced to target leisure travellers
- the government offers incentives to encourage corporate travel
- staff is more difficult to hire and retain etc.
2. Develop a wide range of scenarios (not scenarios which are substantially similar)
Part of the process is to generate meaningful debate on different strategies and this will occur if your scenarios are materially different.
Example: An operator of schools for plumbers and electricians is considering:
- Terminating leases on their 12 physical locations and offering only online education
- Retaining their current model, raising capital and aggressively marketing to new members of these trades
- Selling their client base and intellectual property to a competitor and liquidating the business
3. Don’t over-complicate the models
Focus on a few key external and internal variables. There is always an opportunity to go deeper if required.
Example: The financial performance of an importer of car accessories is heavily influenced by import duties which are under review by the federal government. Management considered three scenarios for their one year budget and profitability forecast:
- Scenario 1: No change in duties (the ‘Current Case’)
- Scenario 2: A 2% increase in duties (the ‘Expected Case’) and
- Scenario 3: A 4% increase of duties (the ‘Extreme Case’)
4. Determine what actions you will take in each scenario
There is no point scenario planning unless you consider what actions will need to be taken in each case.
Example: An operator of mid-size hotels in business districts developed scenarios based on the speed of recovery in their sector. Even in the ‘best case’, they expect a cash deficit within 12 months and are implementing plans to:
- Cut costs of personnel and procurement while halting capital intensive projects
- Seek alternative sources of capital through debt or equity
- Develop reports to track progress against their forecasts and change course as appropriate
5. Consider outside facilitation
Scenario-planning can be complex and require specialist expertise. An experienced independent facilitator can add a lot of value by challenging management on their assumptions and approach.
While humans are not necessarily good at predicting the future, scenario-planning provides a useful guide and assists in business decision-making. To see how this can apply in your business, please get in touch with Alliott NZ Chartered Accountants and Business Advisors in Auckland on 09 520 9200.