In business as in life, the only thing that’s certain is uncertainty. Scenario analysis is a powerful process for navigating the uncertainty of the future by analyzing the potential business impacts of future events and considering alternative possible outcomes. Companies can use scenario analysis to explore a broad range of possible future situations, from economic slowdowns and natural disasters to expanding a product line or opening new offices.
What is Scenario Analysis?
Scenario analysis is a technique that provides a rational and structured way to analyze the future. Businesses can use it to examine different potential impacts of negative and positive events, such as:
- What are the possible impacts on the business of an economic slowdown?
- What happens to revenue and profitability if the cost of various raw materials rises?
- What revenues might be generated by a new product line?
- How would the business be impacted by the unexpected market entry of new competitors?
Scenario analysis doesn’t attempt to predict a single outcome from any of these events. Instead, it examines a spectrum of different potential situations and outcomes, typically ranging from a best-case to worst-case scenario. Businesses can then conduct scenario planning to better prepare for these events and their potential impacts.
Scenario analysis is not new. It was pioneered by the U.S. military during the mid-1900s, and Shell Oil started using it during the 1970s to analyze and respond to fluctuations in global oil supplies. It’s now widely used by businesses, thanks in part to financial modeling tools that eliminate much of the manual effort and make the process much faster. It may be even more important for small businesses than for larger ones, since smaller companies may be more heavily impacted by a single event. Scenario analysis is employed by financial services companies to analyze risks and make investment decisions, and it can even be used to analyze household finances.
- Scenario analysis helps businesses plan for the future by analyzing the business impact of potential events and strategic decisions.
- Scenario analysis is valuable for businesses of any size and can be used to analyze a wide variety of situations, from the impact of economic slowdowns and disasters to new product launches.
- Modern software tools allow finance teams to leverage financial intelligence and built-in features to rapidly model multiple scenarios to deal with change and give them confidence in decision making.
Why Businesses Need Scenario Analysis
Changes that impact the business environment can happen unexpectedly and suddenly—as demonstrated in magnified ways by the global pandemic in 2020. Scenario analysis allows organizations to analyze and quantify potential business impacts of such events, so they can plan accordingly. It can also be used to assess the benefit and risks of different business decisions, such as the potential impact on revenue and profitability of building new facilities. It helps businesses avoid diving blindly into a risky investment or project.
How Scenario Analysis Works
A scenario analysis considers a potential event and the business scenarios that may result—the potential future states or, as they’re sometimes called, alternative worlds. Generally, a range of scenarios are considered, from best to worst. For each scenario, the company makes assumptions about its effect on different factors that are important to the business, such as interest rates or the cost of raw materials. These assumptions are then used as input variables to model the impact of each scenario on the business.
Scenario analysis may consider many different factors. Analysis of the potential financial impact of constructing a new facility might consider labor, rent, utilities, taxes and other costs, for example.
Let’s take the imaginary example of Kooky Cooks Inc., a maker of innovative kitchen equipment. The company comes up with an idea for a new appliance that not only cooks food but also cleans itself afterwards. However, it will take at least a year to get the product to market and financial analysts are predicting worsening economic conditions over that period.
The company could use scenario analysis to examine the potential impacts of economic conditions on the revenues and profits generated by the new product. Economic conditions may affect a variety of factors, from customer demand to the cost of raw materials. The company could consider a range of scenarios, each generating a different set of assumptions.In one scenario, sales might fall by 20% because customer demand declines due to the economic conditions, while the cost of raw materials rises because some suppliers go out of business and there’s less competition among the remaining providers. However, rent on manufacturing facilities could fall by 10% and the company might be able to borrow money at a lower interest rate to fund manufacturing start-up costs. Scenario analysis could consider the impact of all these factors.
Types of Scenarios
One key benefit of effective scenario analysis is that it drives decision-makers to consider a range of potential cases, each with its own set of assumptions. This can help prevent businesses from becoming fixated on a single, over-optimistic view of the future and developing business plans that assume ideal conditions and outcomes.
Cases in Scenario Analysis
A scenario analysis generally considers at least three types of scenarios:
- Base-case scenario: A baseline scenario based on current, commonly accepted assumptions.
- Worst-case scenario: The most negative set of assumptions.
- Best-case scenario: The ideal projected scenario to achieve goals and objectives.
For example, in Kooky Cooks’ best-case scenario, revenues might actually rise because people stay at home and do more cooking instead of eating out. In the worst-case scenario, demand falls while all costs rise. In the base case, current trends continue into the future. Each of these scenarios has a different impact on revenue and profit.
Examining a range of scenarios provides the company with a range of possible outcomes for planning purposes. For example, the best-case scenario might result in a net profit margin of 20%, while the worst-case scenario results in a margin of 5%. The company uses the range of 5%-20% to guide its decisions about investing in the manufacture of new products.
A company may also assign probabilities to each scenario, based on its assessment of the likelihood that it will occur. This can help to guide the company’s subsequent planning and decisions about how to allocate resources.
Multiple scenario analysis: Scenario analysis doesn’t have to be restricted to just three possible cases. A company may consider many different scenarios, each using a different set of assumptions. The tradeoff is more scenarios require more effort to analyze them.
Benefits of Scenario Analysis
Key benefits of scenario analysis include:
- It helps companies manage risks more proactively by assessing the impact of potential future events and situations.
- It can help businesses make better decisions by investigating the risks and benefits of different options.
- The methodical approach to analyzing the future may enable companies to spot opportunities or risks that might otherwise be overlooked.
Challenges of Scenario Analysis
- Scenario analysis can be a time-consuming process that requires specific skills and expertise, although modeling tools can help.
- It can be difficult to envision all possible scenarios, make realistic assumptions and assign probabilities to them.
Scenario Analysis vs. Sensitivity Analysis
Scenario analysis is sometimes confused with sensitivity analysis. But there’s a key difference. Scenario analysis makes assumptions about multiple variables and factors for possible future scenarios and looks at how each would affect the business. Sensitivity analysis, in contrast, examines the effect of changing a single input variable while keeping all the other variables constant. For example, a company might examine how a change in the lending interest rate could affect the company’s profitability or cash flow.
6 Steps to Perform a Scenario Analysis
Taking a methodical approach to scenario analysis can help to ensure that the company focuses on the most important scenarios, considers the most relevant factors, and gets the most benefit from the process. Here are six key steps:
- Define the issue and the decisions that you need to make.
- Gather data and identify key factors, trends and uncertainties that may affect the plan. This may include external factors such as market shifts, political changes, competitive threats and trends in customer behavior. It may also include internal factors such as the company’s key strengths and development capabilities.
- Develop a scenario planning template. This is generally a financial model (see below) that enables the company to plug in various assumptions and examine the impact on key metrics such as revenue or net income.
- Develop scenarios. Develop base-, worst- and best-case scenarios, plus others if desired. To get the broadest view of potential scenarios and assumptions it’s important to involve people with relevant knowledge across the organization. This can also help avoid unconscious bias and potential blind spots.
- Evaluate the scenarios. Analyze the potential impact of each scenario.
- Plan accordingly. Use the scenarios you have developed in your planning, weighing the most likely risks and rewards.
What is Scenario Modeling?
Scenario analysis generally captures a range of possible outcomes that will help ensure agility, business continuity and growth. In times of uncertainty, scenario modeling helps businesses build models that allow them to assess the impact of their business plans on revenue, expenses and cash flow.
Originally, the calculations were performed manually. Now, companies can use a variety of tools, from spreadsheets to sophisticated modeling software that is integrated with financial and operational source systems.
Scenario Analysis and Financial Modeling
Scenario analysis imagines a range of scenarios, each with its own assumptions. Once the company describes each scenario and the associated assumptions, it can perform the analysis by entering those assumptions into a financial model. The model turns the assumptions into quantifiable impacts, such as a 10% increase in revenue. The value of the analysis depends on the accuracy of the model and the data on which it is built. Realistic assumptions and an in-depth knowledge of the company’s business are key to creating an accurate model.
Using Financial Modeling Tools for Scenario Analysis
In the past, scenario analysis was an extremely labor-intensive manual process. Typically, it involved manually gathering data from disparate sources inside and outside the company and entering the data into custom-built spreadsheet-based financial models. The value of these models was limited by a variety of factors, including the staff’s spreadsheet expertise and the ability to gather information that was both comprehensive and up to date. Also, when the financial modeling process is static, it’s difficult to run what-if scenarios for exploring multiple options.
Modern financial modeling tools make scenario analysis much faster and easier for companies of any size. For example, tools that are integrated with enterprise resource planning (ERP) systems can pull in current and historical financial and operational data which increases data integrity by eliminating the need to transfer data manually. Preconfigured scenario analysis templates make it much easier to build models. These tools greatly reduce the effort required for analysis, making it feasible to conduct scenario analysis on a regular basis and apply it to more situations, including smaller day-to-day operational decisions and issues.