Scenario planning can help visualize the future, plan for multiple scenarios and assess how to respond.
By Marc Seewald, Vice President of Product Management, Oracle
Amid COVID-19, every underlying driver of and assumption about “business as usual” is being challenged. We lack the historical data we’d normally look to in a crisis, and we also lack the trends that would help forecast what things might look like once we come out the other side.
This is where scenario planning comes into play. It can help us visualize the future, plan for multiple scenarios and assess how to respond to each one.
The COVID-19 crisis has demonstrated that companies can’t place all their bets on one outcome. After the crisis passes, some things may go back to normal while others may not. You should ask yourself, “Will we return to business as usual? Or will we see fundamental changes in our business model, how we serve customers or gain market share? Will there be new opportunities that arise, and how do we best position ourselves in a post-COVID environment?”
Best practices for scenario planning
One of the biggest advantages of scenario planning is that it can clearly demonstrate cause-and-effect relationships about how potential scenarios could play out in terms of plans, budgets, and forecasts. Before you begin, here are a few best practices to consider:
Scenario planning should be from the top down. Scenario planning should involve fewer people and be more strategic than traditional budgeting and forecasting, with key stakeholders across the enterprise working together.
Focus on high-level drivers. Focus on summaries instead of line items. Critical assumptions and variables should drive the strategy. Importantly, don’t over-rely on traditional drivers. Put thought into the best drivers that will capture the essence of the new normal.
Apply a full trial balance. Think across your full income statement, balance sheet, and cash flow. Overly focusing on just 2-3 key areas, such as cash or revenue in isolation, will not give you enough transparency into cause-and-effect relationships.
Limit the number of scenarios. Don’t try to model every possible outcome. Instead, model no more than four. Examples might be, “fast recovery,” “moderate recovery,” “moderate recovery but disrupted supply chain,” or “slow recovery.” Spend equal time examining each scenario – even if you think 1-2 scenarios are far more likely. The value of scenario planning is to be as ready as possible when the unlikely happens. Having thoroughly evaluated all options ensures that you are best-prepared, even for unlikely scenarios.
It may be tempting to just re-use your strategic long range plan (LRP) for planning in a crisis. While the LRP will be a good foundation to start from, there are some key differences. Let’s take a closer look at the six steps involved in the process of scenario planning.
- Define scope, issues, and time horizon: Unlike the LRP, you’ll be focusing more on the next six to 12 months. One to two years out may still be relevant, depending on your industry, but your focus will definitely shift to more immediate needs.
- Define key drivers: What’s important right now? For example, an agribusiness in normal times might focus mostly on commodity price as a key driver. Today, assumptions around the supply chain are likely equally as important. (More on this below.)
- Collect and analyze data: Scenario planning requires collecting quantitative and qualitative data to develop key assumptions. Combine information from both internal and external sources. For example, there’s currently a lot of free data available from sources like Harvard Business Review about the macro-economics of past pandemics.
- Develop scenarios: The number of scenarios you model will depend upon your organization’s data and patterns, but it’s important to identify which ones are most important to you. And, as noted above, keep the scenarios to a manageable number.
- Apply scenarios: Test the chosen scenarios by identifying what the downstream impacts will be on sales, cash flow, capex, etc. Identify metrics and KPIs you want to monitor. Consider the thresholds that would require action for each metric that you choose to monitor. Ultimately, you are creating a company-wide plan. It must be actionable and pushed-out to all parts of the enterprise.
- Maintain and update: Monitor the plan regularly and consider if you need more frequent reporting so you can respond quickly to changes in metrics. Augmenting your current bottom-up forecasting may be necessary to ensure that the enterprise is tracking towards key assumptions.
Defining key drivers
Traditional strategic plans use key business drivers (such as market share) to model sales. In a crisis, assumptions by customer segment or industry might be more appropriate. Relevant variables for managing through crisis might include access to capital, productivity of the workforce, or impacts from government stimulus. Size and timing of government stimulus will likely impact workforce retention, capex, as well as corporate income tax strategy. Isolating the most important drivers for your business will be key to successful scenario planning.
Your model should let you easily compare scenarios side-by-side. Select an approach that makes sense for your industry and your organization. For some, it might make sense to model across geographies, while for others it might be better to model across sales channels or product lines. And you can evaluate risk and perform stress testing across each scenario using a type of data modeling known as Monte Carlo simulation. This technique allows you to quickly explore a range of outcomes across multiple variables. It can be hugely valuable when there is a high degree of uncertainty in assumptions.
Cash is king
In a crisis, it’s critical to focus on your balance sheet. Consider impacts such as funding the business, customer payment delays, and bank covenant ratios. You can also complement top-down scenario planning with bottom-up re-forecasts. For example, if you are not already doing it, collecting a bottoms-up short-term weekly forecast on uses and sources of cash can help you validate your more strategic top-down assumptions on liquidity. All of these capabilities are available in Oracle EPM Cloud.
The value of scenario planning
The point of all this isn’t to obsess over possible outcomes. It’s to help prepare your organization for whatever might happen. When you have a plan for multiple outcomes, you can communicate those plans to employees, customers, investors and other stakeholders, instilling confidence in your organization and its finance leadership.
In this way, your finance team can play a critical role for C-suite leaders seeking better decision-making processes, insights, and relevant information to drive strategic choices.