Scenario planning in FP&A
Financial planning entails effectively defining and timing future resource deployments. Scenario planning is a technique used in FP&A to help guide companies through considerable uncertainty, contemplating 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.
Rather than simply crafting possible scenarios, it’s wise to simulate how changing assumptions and drivers may impact certain results. This allows the company to almost create a future reality before future reality occurs. While planning for scenarios is wise, allowing an organization to contemplate how the direction of the business may change, actual tracking is extremely important. By tracking ongoing performance, it is evident if either these 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 in real-time when circumstances trigger a change.
Scenario Planning can be used for different purposes
The essence of scenario planning is consistent whether considering enterprise-type planning or even personal financial planning. In the context of personal finance, many of us may employ scenario planning to estimate our future retirement balance. Rather than sensitize just one input, such as 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.
Scenario planning for enterprises is very similar. An excellent use for scenario planning 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 allows an organization to assess not just how potential projects will be planned, but how they will affect financial metrics such as liquidity and return on assets. Various forecasts should be created allowing the comparison of what-if scenarios, allowing the visualization of the potential result before dedicating large sums to investment.
For example, our company may contemplate development and maintenance 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. Our decision to invest in the ERP system is largely justified by which scenario we believe is most realistic.
Like sensitivity analysis, scenario planning should consider probabilities assigned to each pathway. If we contemplate three scenarios in the above ERP business case – best case, base case, and worst case – we should conduct diligence to determine which of the cases is most and least likely and to what extent. For example, if we determine the best case to be 50% probable, base case to be 30% probable, and the worst case to be 20% probable, we can arrive at 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, we should contemplate how we can more effectively manage risk across the scenario by focusing on the key individual drivers.
A company that makes decisions without scenario planning is tying itself to a limited number of assumptions and exposing itself to unnecessary risk. Yet, a company that utilizes scenarios in its planning efforts is positioned to move quickly. Public and PE-funded companies, in particular should be wary of the pressures of earnings expectations, which often require the company to back into targeted figures rather than arrive at them through the development of possible scenarios. Despite external pressures, companies should identify earnings estimates as just one of the many outputs and objectives that scenario planning can help reach. Finally, as organizations grow more confident in their scenario forecasting, they increase their ability to reduce their planning cycles – an unforeseen benefit of this technique.