Executing Effective Scenario Planning During COVID-19
Updated: Oct 14, 2021
In light of the world having been turned upside down for the past year and a half, scenario planning has been the most critical aspect of an FP&A professional’s work. In the face of such a watershed crisis like the pandemic, nothing has been as important as the processes of guiding companies through considerable uncertainty, and thoroughly considering various paths of possibilities. Despite our best attempts, our forecasts will have inherent errors; actual results deviating from the figures we had anticipated hitting.
Rather than marry our plans to one set of forecast figures, companies may employ a varied approach, contemplating optimistic and low-cases and assigning probabilities to each. With such an approach, organizations remain more forward-thinking and agile for change. Circumstances change.
How to Effectively Conduct Scenario Planning in Strategic Management
Instead of simply crafting possible scenarios, finance professionals should attempt to simulate how changing assumptions and drivers may impact certain results. This allows the company to more or less create a future reality before a future reality can occur. While planning for scenarios is wise, allowing an organization to contemplate how the direction of the business may change, and actual tracking is extremely important.
Through tracking ongoing performance, whether given cases become more likely to come to fruition or if a more normalized case is to be realized. When the company knows how it is faring, versus its expectation, can it pivot and refresh its scenarios. In fact, the most capable companies can recalibrate their scenario planning model in real-time when circumstances trigger a change. Such companies are enabled to do this when they effectively adopt and integrate the latest technology that can assist in scenario planning with real time data displays.
Scenario Planning Contexts
The essence of the scenario planning process is consistent whether considering enterprise-type planning or even personal financial planning. In the context of personal finance, scenario planning is often employed to estimate our future retirement balance. Rather than sensitizing just one input, such as the average annual rate of return, scenario planning allows us to manage the forecast across all key elements.
For instance, we may designate an aggressive scenario with an average annual rate of return of 16%, a standard deviation of 0.21, an annual investment of $30,000, and a years-to-retirement of 30 years. Alternatively, we may designate a conservative scenario with an average annual rate of return of 8%, a standard deviation of 0.10, an annual investment of $35,000, and a years-to-retirement of 35 years.
We should be intentional about creating an ability to easily toggle between scenarios and plan accordingly for the future. If we, as a personal investor, determine that the conservative case is our preferred investment strategy to achieve our objectives, we can operate in line with those parameters. As time progresses, and our reality changes, we can develop new scenarios that help guide us accordingly.
Enterprise Scenario Planning
Scenario planning for enterprises is very similar to that of personal contexts. An excellent use for an organization’s scenario planning process is in the analysis of capital expenditures. Capex forecasting is notoriously difficult, as it contemplates how near-term investment in assets will translate into long-term benefit, yet to be realized.
Scenario planning enables a business to assess not just how potential projects will be planned, but how such projects will affect financial metrics such as return on assets and liquidity. Various forecasts should be conducted allowing the comparison of what-if scenarios, creating the visualization of the potential result before dedicating large sums to investment.
For example, an organization may consider the maintenance and development of an ERP system at a cost of $1.75 million and annual incremental expenses for hiring, marketing, customer service, and other administration. These expenses, depending on the scenario contemplated, range in total from $223,000 to $556,000. Incremental gross profit, depending on the scenario contemplated, ranges from $302,000 to $688,000. Your decision to invest in the ERP system is largely justified by which scenario you believe is most realistic.
Like sensitivity analysis, an organization’s scenario planning process should consider probabilities assigned to each pathway. If you contemplate three scenarios in the above ERP business case – best case, base case, and worst case – diligence should be conducted to determine which of the cases is most and least likely and to what extent.
For example, if you determine the best case to be 50% probable, the base-case to be 30% probable, and the worst-case to be 20% probable, you can conclude an outcome more heavily weighted toward the upside. Knowing these scenario probabilities allows us to plan with a heightened degree of confidence in our forecast and, ultimately, our decisions. Similar to a sensitivity analysis, you should contemplate how we can more effectively manage risk across the scenario by focusing on the key individual drivers.
How FP&A Professionals Play a Role in Scenario Planning
It’s not the role of a finance team to predict the potential futures in a changing corporate landscape. However, FP&A professionals do need to play a role in scenario planning via preparation for a range of possible outcomes, the likelihood of each outcome, and developing corresponding strategies to maximize the long-term benefit. Additionally, learning how to communicate it to business stakeholders and partners has shown itself to be vital for FP&A in the “New Normal” the world over has had to embrace since 2020, and will likely continue to deal with for the months to come.
FP&A teams should be helping their business leaders consider a wide range of scenarios. The pandemic has highlighted an opportunity to have a range-based plan based on scenario analysis rather than a set plan. While planning for multiple scenarios undoubtedly makes the planning process more complex, it does give management a better chance to look at what could possibly happen and develop action plans in response. When the unexpected occurs, businesses that have planned for a multitude of scenarios will be more prepared than those that did not. Of course, there is a cost associated with producing a more in-depth, robust, wider-ranging scenario planning regiment, but as history has taught us repeatedly, reacting in a crisis is costly.
Scenario Planning in a High Tech Era
Given the incredible advances that cloud-based technologies have provided us with, we have never been in a stronger position to leverage the enormous amounts of data we currently have access to. We are talking about internal/external and structured/unstructured data in the scope of brontobytes (1027th power). Not to mention eventually leveraging the 70% – 80% of data that is considered “dark”. (According to Gartner, dark data is the information assets organizations collect, process, and store during regular business activities, but generally fail to use for other purposes).
By leveraging the technology that is currently available, by preparing and training our people to utilize these new technologies, by having the processes in place (both from a data and decision-making governance perspective), and by having a culture that embraces all of these components, organizations can run robust scenario planning platforms to maximize the opportunities and minimize the risks that our highly uncertain world continues to throw in our path.