Are You Using Scenario Planning To Improve Decision Making?

As the business and macro-economic environment continue to change at rapid paces and increasingly getting complex, the pressure on the finance organization to support the core business by strategically addressing volatility, uncertainty and risk is also intensifying.

This fast changing environment is making it extremely difficult for organizations to forecast business performance with a greater degree of certainty. What we used to consider extraordinary is now the ordinary and the previously unthinkable is now reality. In this environment, organizations need to become more proactive, flexible, adaptable and not reactive. Traditional planning cycles such as the static annual budget are no longer ideal for this dynamic economy.

Past Performance is Not a Predictor of Future Performance

Despite significant evidence indicating this rapid change, many organizations are still relying on the annual budget for planning and evaluation purposes. What we tend to forget is the fact that the annual budget gives a false view of a stable future. By the time the annual budgeting process is over, the majority of the assumptions used to compile the budget are outdated. Additionally, most budgets solely use historical performance as a baseline for predicting future performance. Again, this ignores the fact that past performance cannot be used to mirror future performance.

Most budgets prepared by companies only have a financial focus, normally adding or deducting a percentage to previous year’s numbers. They lack specific consideration of the forces driving the business and value creation. The link between the strategy, planning, resource allocation and performance reporting processes is broken.

With the current volatility, uncertainty and complexity in today’s environment, companies need to adopt an agile mindset and new ways of planning. Working together with the other business functions, Finance can drive this process and lead its success. Taking advantage of the function’s analytical and risk management strengths, finance executives can use scenario planning to help decision makers identify and understand possible future events and their impact on strategy execution and business performance.

Scenario Planning

Instead of taking a static view of the future and basing key decisions on gut feel, scenario planning helps business leaders understand their business environment (any significant emerging threats and opportunities), identify the critical drivers of value and correlate their impact on performance, both operationally and strategically. It achieves this by enabling decision makers frame a number of questions on the strategic intent of the organization.

Regardless of your business’s industry sector, scenario planning is useful for getting different views of the future that reflect volatility, uncertainty, and complexity thereby helping you identify gaps in your organization’s ability to respond to threats and opportunities. Once you have identified the blind spots and gaps in your company’s response capabilities, you can then start building a dynamic risk management framework and gain knowledge of the risks you have direct control of or influence and those that you do not have.

When conducting a scenario planning exercise, organizations must:

• Define the purpose and scope of the exercise.
• Examine the internal and external environment for emerging trends and issues.
• Identify possible realistic future scenarios and evaluate their impact on the business.
• Formulate strategic and operational responses to each scenario.
• Monitor performance related triggers and regularly challenge assumptions

Scenario Planning is Not About Predicting the Future Accurately

Instead, it is about understanding the environments in which your business operates, discovering new insights, and increasing adaptability to changes in these environments. By constantly taking uncertainty into account when making decisions and also encouraging alternative thinking, you will be able test and evaluate the robustness of your company’s strategies against a range of possible futures. This in turn will assist you broaden your perspective and develop robust response plans.

Critical to note is that scenario planning is a continuous process rather than a once-off exercise and must be incorporated into processes for managing the business on an ongoing basis. The macro-economic environment is constantly changing and as such, an ongoing review of the drivers of performance and trigger points is necessary.

You need to constantly ask questions on the social, technological, economic, environmental, political and legal influencing factors and indicators.

Examples of questions that you might ask include:

• If you are an automaker, what is the impact of autonomous and electrical vehicles on our current business model? Are self-driving cars the future and how should we respond?
• If you are consumer company, how would the organization respond to growing emerging markets and the rise of the middle class workers?
• How would the organization respond to unexpected loss of a major contract that has sustained the company for a long time to a competitor?
• What are the short-term and long-term implications of a major product recall on your market position, reputation and the organization’s ability to meet strategic performance?
• What is the range of likely impacts on our brand, customers and supply chain, if one of our key suppliers files for bankruptcy?
• What competing products or disruptive forces will have the potential of threatening and forcing us out of business?
• What is the impact on our quarterly and annual performance targets of material short term changes in key external variables such as commodity prices, inflation rates, interest and exchange rates, GDP and consumer spending?
• How would the organization respond to unexpected external events such as a major natural disaster, political or regulatory actions, or occurrence of a pandemic?
• What are the likely advantages and disadvantages of moving our enterprise systems to a cloud-based platform versus retaining them in-house?
• What are the global business implications of UK leaving the European Union, and how would our organization react to such a move?
• What are the implications to the business of a data breach on key account information?

By systemically monitoring a series of performance related triggers, the organization will be able to anticipate major trends and changes in the industry or broader business environment, respond dynamically, gain competitive advantage and seize growth opportunities in both developed and emerging markets.

Scenario planning is more than a business threat analysis tool. It also helps you identify emerging opportunities, improve your business model and proactively address industrial and environmental uncertainties.

7 Steps to Scenario-Based EPM

BusinessFinance published an Axiom EPM sponsored paper on scenario modelling and driver based planning. The paper is great read and I highly recommend it. Below are my picks from the publication:

Extraordinary is now the ordinary. Today’s global business operating environment is characterized by ongoing uncertainty and volatility. Businesses are operating under extraordinary circumstances and what we previously regarded as unthinkable is now a reality.

Much of the uncertainty and volatility confronting organizations is result of shift in economic powers, an increased demand for commodities, rapid demographic changes, increased environmental concerns, global interdependence and technological innovation.

Because of these new and unforeseen challenges, companies need to transform their planning, budgeting and forecasting. The past is no longer a good predictor of the future.

Instead of basing strategies, plans and targets on a single static view of the future, derived from an extrapolation of past performance, companies should consider moving to scenario based enterprise performance management (EPM). This helps management to regularly consider different scenarios when running the business on an ongoing process.

In an environment of growing uncertainty and volatility, it is no secret that traditional forms of analytical planning are inadequate. What is required from managers is open-minded thought and imagination that spirals around possibilities and scenarios.

Therefore, forecasts and budgets made on fixed assumptions are inappropriate. In fact, understanding and monitoring a company’s value drivers requires a rolling, nearly real-time approach to planning and forecasting, as opposed to an annual exercise.

Scenario-based EPM  can assist, not just in strategic planning, but also in business planning, forecasting, reporting and analysis, providing the foundation for risk mitigation strategies, integration of early warning measures into performance management and, perhaps most valuable of all, for managing the unexpected nature of day to day business.

Incorporating scenario planning into strategic planning, budgeting and forecasting processes enables the organization to become more proactive as opposed to being reactive.

Scenario planning helps managers to ask the right questions, anticipate changes in the environment, identify scenario triggers and make course corrections more rapidly and efficiently.

Ultimately, this also helps the company to avoid paths that lead into negative territories if the company is currently in positive territory; and if it is currently in negative territory, to choose paths that will lead it put and avoid paths that will cause further value destruction.

Incorporating a scenario capability into an organization’s EPM processes requires seven steps:

• Identify the key factors that can have a material impact on the organization. For example, consumer products companies may look at GDP growth and consumer spending, airlines at oil prices, global manufacturing companies at exchange rates and freight costs, and financial services companies at consumer credit quality, interest rates and asset prices.
• Define relevant scenarios (typically three to four) that describe a range of future operating environments. For example: What if oil prices average $75 a barrel, $110 a barrel or $200 a barrel?
• Agree on a baseline scenario that will be used to develop/review strategy, set targets and develop operational plans and budgets.
• Develop strategic plans, targets, action plans and budgets using the baseline scenario.
• Develop alternative views of targets, plans and budgets under each scenario. Identify the major impacts and changes under each scenario. For example:
  • What will be the positive or negative impact on key financial metrics such as sales, margins and earnings under each scenario?
  • How will investments and projects be reprioritized under each scenario?
  • What will the impact be on product mix, pricing and promotional spending under each scenario?
• Identify relevant triggers and corresponding tolerance ranges for each scenario that should be monitored on an ongoing basis in order to provide management with advance warning of material changes in the operating environment.
• Whenever established triggers or tolerances are exceeded, meaning a new scenario becomes effective, adjust tactics using the previously developed plans and generate a new forecast reflecting the change in the scenario and the changes in tactics.

Thus if the company is to achieve any form of control over its future and outperform its competitors, then the identification of the pivotal uncertainties shaping future scenarios is critical. In addition to avoiding and mitigating risk, scenario-based EPM can also be used to identify and seize growth opportunities in developed and emerging markets.