Scenario analysis to manage risks and find opportunities for success

Scenario analysis effectively manages and prepares for possible outcomes by examining the potential impacts of future events and anticipating alternative scenarios, such as economic downturns or expanding a product line within a budget model.

With a dynamic economic landscape, it's essential to understand the scenario analysis process and how to implement it for business planning and to align with your strategies.

What is scenario analysis, and how does it work?

Scenario analysis is a strategic planning technique used to analyze business obstacles and alternatives in the event of possible future impacts. This practice helps businesses plan and make strategic decisions, decide what is best for their operations, and be more prepared for sudden occurrences.

Businesses can use scenario analysis to examine the potential impacts of negative and positive events, such as:

• Dramatic increase in raw materials or cost of goods — Raw material price increases and decreases can affect production expenses, influencing the total cost of goods or services. Therefore, prices can significantly impact the profitability and pricing of products.
• Disruption in the supply chain – Developing a contingency plan is ideal for establishing communication protocols, diversifying a supplier base and conducting a comprehensive risk management assessment.
• Increase in market demand – If product demand increases over time while the supply is low, businesses can charge a higher price to increase revenue during the current year.

Scenario analysis is not intended to forecast what will happen from these events. It focuses on a wide range of likely situations and results based on best-case to worst-case scenarios. Businesses can follow up scenario analysis with more detailed planning to prepare for such incidents and potential outcomes.

Why companies use scenario analysis

Companies often use scenario analysis to understand a range of possible outcomes based on different situations. The analysis can help stakeholders identify and work to avoid high-risk situations or implement a business strategy that may increase revenue.

It enables them to act based on assumptions or potential circumstances that can compromise their investment, such as an inflation shift.

Scenario analysis is ideal to use for several reasons, including:

• Teaching businesses how to manage risks and vulnerabilities: By considering future scenarios and different outcomes, companies can understand the potential impact of risks on their operating environment. Therefore, risk management helps companies identify uncertainties and determine the best ways to overcome them.
• Creating an effective plan based on strategic goals: When opportunities and threats happen, strategic planning is essential for businesses to adapt to specific situations. This also involves preparing for possible outcomes by capitalizing on an effective plan.
• Implementing practical decision-making: Decision-makers with reasonable input about possible future scenarios understand the potential consequences of different investment decisions. Scenario analysis can help them face challenges, develop financial planning strategies, and identify potential risks common in their industry.
• Dividing resources wisely: Scenario analysis helps companies allocate resources according to various potential future circumstances. Therefore, by considering possible scenarios, you can maximize your flexibility and ability to adjust to changing environments within your budget model.
• Testing resilience and endurance: Stress testing is essential for recognizing weak points and liabilities. This is why businesses also rely on a sensitivity analysis of the effectiveness of their financial model, budget plans, and active strategies to address any issues that could put them at risk.

The difference between scenario analysis vs. sensitivity analysis

Using scenario and sensitivity analysis, stakeholders determine risk levels and possible benefits. One key difference between both approaches is that sensitivity analysis is a process of testing individual drivers in a budget or forecast to find the levers that have the most effect on a business. On the other hand, scenario analysis addresses the impact of altering variable inputs and outputs all at once.

Scenario analysis allows all business partners to consider and analyze possible cases. While it can help businesses avoid focusing on only one scenario, whether negative or positive, it also allows them to acknowledge assumptions, economic conditions, and possible outcomes.

Being realistic about various cases is ideal, especially for making informed decisions about adapting to the situation and finding the best solution.

Scenario analysis and sensitivity analysis considers at least three case types:

• Best-case scenario — In the best-case scenario, businesses implement a positive set of assumptions to forecast the best possible outcomes of a case. This could help them prepare and get the financial backing needed while focusing on business planning and achieving their goals.
• Worst-case scenario — When forecasting the most severe result of a scenario, businesses focus on the most negative assumptions in a worst-case scenario. This may condition them to be more alert and ready to anticipate possible outcomes or potential risks.
• Base-case scenario—In a base-case scenario, businesses develop a set of assumptions for a prediction without considering the most positive or negative scenarios and potential risks.

Fortunately, finance teams can organize their business affairs and manage their financial models using effective techniques for the best results.

Headcount planning can help businesses determine if they have the right number of employees and avoid offering existing employees false expectations about pay rises or establishing unrealistic employment requirements.  

Businesses need proficient employees to thrive and continue to grow. However, they also must ensure needs and expectations are met and set a positive example for others, which may influence them to work hard and succeed.

When using a business planning and analytics platform like Phocas, you can easily plan your people’s needs with the built-in headcount planning tool. Creating a headcount tab allows you to budget, enter salary adjustments, bonuses, and commissions, and update each team member's benefit plans.

Since finance and business partners are joint decision-makers and rely on the analysis for economic and staff planning, they must explore multiple cases. It is essential to consider the potential impact, external factors, and multiple scenarios and how to address the situation.

Additionally, scenario analysis is also helpful for reviewing inventory purchases to match demand planning. It helps businesses track and manage inventory data, improve inventory management methods, and examine usage patterns effectively so they don’t have stockouts.

Benefits of scenario analysis

Key factors and benefits of scenario analysis include the following:

Ability to make better decisions: Businesses can improve their decision-making by considering possible outcomes in the future. They can also get a better understanding of the potential consequences as a result of specific actions and have the opportunity to find valuable solutions.

Knowledge to implement strategic planning: Scenario analysis can ease the development of more flexible and adaptive strategic plans and budget. Businesses can identify tactical options that influence resilience and an adaptive mentality by considering future outcomes and performing a sensitivity analysis.

Learn to recognize opportunities and vulnerabilities: Companies can use scenario analysis to anticipate issues that may occur in the future. This allows them to position themselves to capitalize on developing trends, make strategic decisions for a financial model, make smart investment decisions, and use marketplace volatility to their advantage.

Gain the resilience to overcome challenges: Performing a scenario analysis allows a company the flexibility to create more adaptable strategies and make smart business decisions for resilience and growth. Finance teams and stakeholders discover practical options that can help them adjust and react according to unpredictability, future outcomes, and changing economic circumstances.

Perform resource allocation more effectively: Scenario analysis enables companies to distribute resources by evaluating many possible scenarios at once. This emphasizes assets and the effort to be adaptable to numerous circumstances, boosting resource allocation, accuracy, productivity, and scenario modeling.

How to use scenario analysis for supply chain disruption

Supply chain disruption is any event that slows down or stops the flow of goods or the production, sale, or shipment of products. Several tips can help you determine ways to assess disruption and how planning can help you overcome severe impacts.

1. Identify potential disruption — Several internal or external factors could cause supply chain disruption for many businesses, such as natural disasters or extreme weather (hurricanes, blizzards, fires, floods, earthquakes, and tornadoes), product fluctuations, limited inventory, fluctuating freight prices, wars and pandemics  
2. Quantify effects of the disruption — When analyzing the impact of disruption in a specific industry, it’s crucial to assess various metrics such as revenue fluctuations that can affect cash flow, and market share changes.
3. Consider creating new plans or revising current planning strategies — Supply chain planning can help update and modernize operational strategies, improve productivity, avoid delays, and reduce operating costs.

Flexible scenario analysis and planning starts with detailed, organized financial data, dynamic financial analysis, reporting tools, and resourceful planning tools. For example, Phocas provides FP&A software that lets you quickly and easily access data to carry out sensitivity analysis and quickly decide which scenarios to further analyse.  

Instead spending days and weeks gathering data from every corner of the business to manually to build numerous scenarios, Phocas allows you to quickly identify which factors have the biggest impact on business growth, to then develop into more detailed worst-case, best-case, and base-case scenarios.

While it's necessary to consider many scenarios, one important key is to identify and focus on the business driver that have the most impact on your business and spend more more time analysing and planning for the scenarios that can effect these business variables.