Scenario Planning: Strategy, Steps and Practical Examples

• Scenario planning helps decision-makers identify ranges of potential outcomes and impacts, evaluate responses and manage for both positive and negative possibilities
• By visualizing potential risks and opportunities, businesses can become proactive versus simply reacting to events
• There are a number of templates and formalized frameworks for scenario planning, as we’ll discuss. What’s important is choosing a method that works for your team
• We’ll look at two fictional firms, a software company and a wholesale distributor, to illustrate the planning process

If anything magnifies the value of scenario planning, it’s a pandemic — even if most companies didn’t have “economy grinds to a halt” in their modeling. In the context of a business, scenario planning is a way to assert control over an uncertain world by identifying assumptions about the future and determining how your organization will respond.

By building organizational awareness of what could happen, leaders may spot warning signs of brewing challenges and respond accordingly. When a worst-case event arises, scenario planning documents add tremendous value by playing out multiple outcomes and listing immediate steps to contain damage. Plans are also valuable for best-case scenarios — say a product goes viral and demand spikes 300% overnight? What if an acquisition opportunity lands unexpectedly? Are you prepared?

Scenario plans, ultimately, tell a story with many possible endings. Crafting the narrative requires a clear set of assumptions about potential business realities and ensuing outcomes.

What Is Scenario Planning?

For businesses, scenario planning enables decision-makers to identify ranges of potential outcomes and estimated impacts, evaluate responses and manage for both positive and negative possibilities. From projecting financial earnings and estimating cash flow to developing mitigating actions, scenario planning is more than just a financial planning tool — it’s an integrated approach to dealing with uncertainty.

But it’s more than just a way to recognize and mitigate risk or plan for growth situations. Scenario planning is also about visualizing different representations of an organization’s future, based on assumptions about the forces driving the market — some good, some bad.

Scenario planning is a process pioneered by the U.S. military, which today runs exercises looking up to 20 years out to guide R&D efforts.

Why Is Scenario Planning Important?

Scenario planning can provide a competitive advantage by enabling leaders to react quickly and decisively — because a situation has been thought through and actions documented, no one has to scramble when in the midst of a crisis.

Scenario planning also gives executives and boards of directors a framework to make nonemergency decisions more effectively by providing insight into plans, budgets and forecasts and painting a clearer picture of key drivers for business growth and the potential impact of future events.

Scenario Planning Advantages and Disadvantages

A comprehensive scenario planning exercise takes time, effort and money. Should you commit?

Advantages:

• Scenario planning will help executives understand the effects of various plausible events.
• Finance, operations and other teams can prepare initial responses.
• There’s an element of knowledge management; by having key personnel take part, the company captures their insights and recommendations.
• If these stakeholders are unavailable during an actual extreme event, the company has documentation to fall back on.

Disadvantages:

• Scenario planning is a potentially enormous undertaking. It can be a lengthy process to collect data and driving factors; for large enterprises, plans can take months to create.
• Factors that impact plans can change quickly. That means scenario planning must be a living process, with constant updates as conditions and assumptions evolve.

We recommend that all companies perform at least rudimentary scenario planning, even if it’s in the context of a business continuity exercise. The process itself has real value.

Once you’ve decided to get started, you need to settle on a format.

Types of Scenario Planning

• Quantitative scenariosFinancial models that allow for the presentation of best- and worst-case versions of the model outputs. These models can be quickly changed by altering a limited number of variables/factors. Quantitative scenarios are also used to develop annual business forecasts. These models assume key variables are known and that relationships among them are fixed.
• Operational scenariosOne of the most common types of scenario planning an organization will undertake internally. Operational scenarios specifically explore the immediate impact of an event. The scenario then provides short-term strategic implications.
• Normative scenariosThese describe a preferred or achievable end state. These scenarios are less objective planning and more geared toward statements of goals. These goals are not necessarily about an organizational vision, but more about how the company would like to operate in the future. Normative scenarios are often combined with other types of scenario planning as they provide a summation of changes and a targeted list of activities.
• Strategic management scenariosEssentially stories that say little about the company or industry, but more about the environment in which products and services are consumed. These are often the most challenging scenarios for company leaders to put together because they require a broad industry, economic and world view. On the plus side, they give planners freedom to brainstorm decisions and a broad storytelling mandate. In some cases, companies bring in analysts or even so-called futurists.

How to Use Scenario Planning

Typically, macroeconomic expectations are used in conjunction with scenario planning to help the CFO frame near-term expectations for the company and to level-set expectations in departments.

The fundamentals of scenario planning are the same, even if the particulars across industries and within businesses vary. To illustrate this, consider how two fictional companies, a software provider and a wholesale distributor, would approach scenario planning during the COVID-19 pandemic.

Company 1: Gimbloo Software is a young business software company that had been experiencing steady growth until the pandemic. The leadership team hadn’t undertaken any scenario planning, but its CFO had lived through both the dot-com bubble and the Great Recession and was ready to act quickly to protect Gimbloo’s runway.

Company 2: Before the pandemic, the CFO at established wholesale distributor Tar Heel Direct had prepared three scenarios based on order volume: green, yellow and red. Each scenario encompassed a new set of mitigating actions, using order volume as a metric to trigger when it was time to enact each action sequence. However, the retail freefall meant that Tar Heel Direct found itself operating in the worst-case scenario — red — within a matter of weeks.

Questions both companies considered:

• What is the issue that we are trying to assess?
• How far out are we trying to predict?
• What are the major external factors likely to impact on our scenarios?
• What are the key internal drivers that we need to address?
• What are the risks to the scenario?
• Do we have the right data, technology, bandwidth and skills to develop and maintain scenario plans?

Tar Heel Direct’s scenarios are based on order volume and ability to fulfill orders efficiently. Because the negative effects of the pandemic were so sudden, the company decided to set milestones for every 30 days in anticipation of delayed accounts receivable as well as reduced ability of retailers to accept products.

It quickly lost orders from most customers with physical retail locations — infection rates and lockdown orders have a direct impact on sales. Internally, Tar Heel Direct has taken safety precautions for its workers. Social distancing and increased sanitization measures mean that warehouse teams are operating at about 60% capacity. Suppliers and customers are in roughly the same boat, with suppliers being affected too — though not as dramatically as retail outlets. Some incoming product shipments will be delayed, or suppliers may be able to provide only fractions of their normal output.

Tar Heel’s leaders are in close communication with suppliers and customers, and the firm monitors government data and industry reports to try to stay ahead of trends; however, the future of retail is uncertain, and it may need to explore new sources of revenue.

Scenario Planning vs. Business Continuity Planning

Scenario planning is often conflated with business continuity planning. While both are structured processes for helping a company navigate the future, scenario planning plays a longer game that considers revenue over time. Business continuity planning is about how your business will react to a disaster, such as a warehouse fire or earthquake.

In both processes, the journey may be as valuable as the final work product. By bringing leaders together to think through what could affect your business, you may head off potential risk.

Meanwhile, Gimbloo’s challenges are less dependent on outside stakeholders. Its management and private equity partners met early in the crisis to establish a plan. They came to an agreement that new business and additional sources of funding aren’t likely in the next few months, so the key focus is extending runway by cutting discretionary costs and being prepared to adjust headcount. The company’s PE partners aren’t likely to sit by and watch Gimbloo run out of money, but before providing additional funds, they will want to see that the company has cut wherever possible.

Leadership made the assumptions that recurring revenue would stay largely the same and new deals would surge when the economy reopens. If both hold true, they’d begin scaling back the cost-saving measures. They also added a cushion for churn, down-sells and, in the event of an extreme and protracted downturn, some mid-contract cancellations.

Any significant changes in metrics would trigger another scenario with further cuts.

Scenario Planning Work Approach

Actions to take

1. Secure commitments from senior management, select team members and organize scenarios around key issues to be addressed and evaluated.
2. Define assumptions clearly, establish relationships between drivers and limit the number of scenarios created.
3. Make sure each scenario presents a logical view of the future.
4. Focus on material differences between scenarios.
5. Indicate KPIs, and refresh scenarios and update assumptions on a regular basis.

Actions to avoid

1. Avoid developing scenarios without defining the issues first.
2. Don’t develop too many scenarios – three is a good starting point. Beginning with your best guess at how business will go, add one scenario for things going better and another for things going worse. A good starting point is 50% for best guess, then 25% for things going better and 25% for things going worse.
3. Do not attempt to develop the perfect scenario – more detail does not mean more accuracy.
4. Avoid becoming fixated on any one scenario.
5. Don’t hold on to a scenario after it has ceased to be relevant.

3 Steps to Better Scenario Planning

1. Identify critical triggers even in the midst of uncertainty:

When faced with a crisis, finance leaders quickly establish guidelines for how the organization should respond by developing multiple scenarios. These scenarios are built on a set of assumptions around events that affect the survival of the organization and should trigger a series of actions.

In times of crisis, companies need to combine historical data with plausible outcomes to determine ramifications for each part of the organization. Scenario plans can give leaders breathing room to slow down and assess economic, political and environmental factors. These prioritized factors are a critical part of crisis scenarios.

2. Develop multiple scenarios, but keep it simple:

When building multiple scenarios, it’s easy for finance teams to feel overwhelmed by the range of potential outcomes. How can anyone properly plan for so many possibilities? Simply put, you can’t. That’s why it’s best to keep it simple. Focus on two to three major uncertainties and build scenarios from there. Finance leaders need to prioritize and develop perspectives about each of the scenarios to help the company navigate.

3. Build a nimble response strategy:

Each scenario should contain enough detail to assess the likelihood of the success or failure of different strategic options. Once this is all in place, finance leaders can create a framework that helps the executive team make decisions. Any decisions made need to be monitored in real-time so the team can be nimble in its ongoing response.

Scenario Planning Matrix

Strategies to Manage Scenario Planning Projects

As has probably become clear, the scope of scenario planning is limited only by leaders’ time and imaginations. There must be guardrails on the project to keep the time investment in line with expectations. Here are some key issues in managing scenario planning scope creep:

• Recognize the importance of the team’s time.
• Spend more time on creation and analysis of problems/questions, less on “what if” tangents.
• Define important outcomes.
• Decide how you will put your scenarios to use; that will inform scope.
• How will you assess success?
• Recognize an evolving context and narrative.

Tar Heel Direct’s models were based on assumptions that didn’t work during the pandemic, but the mitigating actions planned in its original scenarios still applied, even with different conditions.

For example, pre-pandemic scenarios used fuel costs as a trigger, anticipating higher prices in a crisis. After spending a few weeks assessing key metrics for the business, the company realized that because diesel fuel is cheap, it can be more competitive on rates and pay truckers better than Amazon — the opposite of what it expected in its original scenario planning. Fuel is so inexpensive, in fact, that sending out partly filled trucks is a more reasonable proposition than it was just a few months ago. Because the company had already planned mitigating steps for scenarios that relied on high fuel costs as a trigger, it was able to work them backwards without additional planning.

Operating at 60% of regular revenue, management assessed what its existing customers needed and got the sales team working on acquiring new customers by thinking out-of-the-box. Tar Heel Direct’s next move is to identify small and niche businesses that are operating at reduced capacity and have the sales team contact those that may be having trouble moving partial loads. The projection is that taking these steps will bring revenues up to 80%, which would move the company into a better scenario.

For Gimbloo’s part, leaders began running weekly cash forecast scenarios using a variety of inputs, focusing first on collections and hoping for a week-to-week decline in delinquent payments. Next, they examined new bookings, customer churn and customers reducing licenses. The company’s forecasts are based on recurring revenue, and factors that affect MRR will trigger new actions.

The company decided to focus on its core value: the service it offers. Leaders decided to take on fewer new customers before making cuts to customer service, cloud services or customer success. It eliminated discretionary expenses, paused hiring and cancelled future marketing events to make up the difference.

If things go poorly and Gimbloo sees a spike of non-renewals and cancellations, leaders plan to seek additional capital from current investors and cut employee costs, such as by furloughs and reducing discretionary bonuses, versus delaying product launches. If it wins new business, the company will begin hiring again and expand its digital marketing footprint.

Scenario Planning and Modeling: Best Practices

1. Assemble the right team:

In large companies, financial planning and analysis groups should be included. But while finance professionals can certainly lead the scenario planning process, they won’t be successful alone. This effort needs to connect leaders from across the organization, including business units and HR.

2. Get the right data:

For finance teams to execute with confidence, they need the right data, going well beyond the general ledger. To create better, more accurate models, finance needs historical and comparative sales data, headcount and expected growth, and of course actuals from the general ledger. They’ll also need to understand the costs of producing products and services, which products are foundational and which are additive.

3. Model with basic scenarios:

Finance teams should consider developing basic low, medium and high models. A low scenario is where costs and revenues are challenging. The goal here will be finding cost savings while still delivering quality products in a timely manner. A medium scenario assumes that sales will continue to grow based on last period actuals. This scenario will show how the last period’s sales figures compare with forecasts, and what adjustments you need to make on headcount and other departmental spending to maintain trajectory. The high scenario is usually based on demand increasing and sales accelerating due to big changes in the market. The goal is to ramp up capacity without incurring costs that eat into margins.

4. Provide break-even analysis:

This analysis will support, with data, decision-making regarding your cash-flow break-even level. It looks at the minimum sales volume your company needs to keep operating normally and sales compensation plans to see if you need to adjust commissions or bonuses.

Source:
https://www.netsuite.com/portal/resource/articles/financial-management/scenario-planning.shtml#:~:text=Scenario%20planning%20helps%20decision%2Dmakers,versus%20simply%20reacting%20to%20events