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What is Scenario Planning?
Scenario planning is a method of forecasting and analysis that takes a variety of assumptions to drive different outcomes in the future. This method of planning can be traced back to the days of the Cold War, where analysts used existing information to predict how nuclear war could play out to better manage the uncertainties. Though nuclear war could be considered an extreme scenario, a global pandemic has done just that, reminding finance and business leaders of the importance of planning for the unknown.
Best Practices in Scenario Analysis & Planning
Scenario analysis is most commonly used to run various outcomes in a single budget or plan, which we will cover today.
The most common example is drawing various outcomes from an annual operating budget to make better business decisions around resource allocation and adjustment. After hundreds of budget cycles, we’ve come up with a best practice around building various scenarios in annual planning:
1. Start With the Major Goals
These are typically the targets that the business would like to achieve, often set by the CEO and the board (example: grow x% this year while maintaining the same operating expenses). The goal plan is also referred to as “top down” and can be used to back into the major line items of a plan, such as revenue, gross margins, operating expenses, and cash.
It is critically important to assess whether these goals are achievable by building a bottoms-up plan that matches the key drivers and metrics in the goal plan. Finance leaders should do this assessment, and any dissonance in achievability should be called out to management by citing KPIs from other companies in the industry. See To Grow or to Profit: The Rule of 40 Question.
2. Follow Up with the Base Plan
While the Goal plan details what the business hopes and expects to achieve, a best practice is to build a robust “bottoms up” plan called the Base Plan or Base Case. The “Base Case” should be the most realistic version of the plan that still gets the business closest to its most important goals, typically revenue and/or profitability.
This is the time to cross check the plan with KPIs. It’s also an opportunity to evaluate that the plan has achievable goals that are neither too easy to hit nor too efficient. Make sure to assess the need to build in commonly missed assumptions such as employee turnover.
3. Build a Best and/or Worst Case Scenario
When considering the worst case scenario, it’s important to build this plan as a “realistically worst case” scenario. A realistic question that a company may wonder is “what if we miss revenue by 15%”? If this happens, what is the one metric that the business hopes to optimize? Is it cash flow? Profitability?
As an example, if the company misses revenue but wishes to achieve profitability over increased cash, it will drive different decisions around how to build out the plan. To increase profitability, they may focus on cutting costs. However, if cash is the goal, the business may be drawing down on a line of credit.
A “best case” scenario might mean that the business has exceeded their goal and can invest in more areas of the business that support this growth. For high growth companies, planning out a “best case” can support the business with scaling challenges that arise when the business grows too quickly but doesn’t have the right resources to support the growth. It’s a highly underutilized practice that can mean the difference between success and failure.
Using the Plans to Optimize Performance
Once the major versions of the plan have been developed, it’s time to put them to work. Communicating the right plan to the business is often more art than science, but we’ve had good results by using the plans in various ways:
1. Plan to have enough cash to support the worst case scenario.
Cash is the lifeblood of the business, so it’s worth taking extra precautions around cash flow management. That may mean looking for additional debt or equity before it’s needed, when it’s easier to access.
2. Use the Base plan as the operating plan for the business.
Using the goldilocks method, make sure that the base plan is neither “too hot” or “too cold.” Keep in mind that the Budget and the Forecast could vary over time as the business evolves
3. Communicate a revenue range to stakeholders and investors.
Aim for the range to hedge from 10-15% below plan through the base plan. For example, revenue could be $20-22M for the quarter and the operating expenses and cash plans are tied to the base case.
The Best Practices: Implemented
As the company approaches its next scenario planning session (or its first-ever!), be sure to consider these strategies. Utilize the industry KPIs to set realistic major goals before crafting the perfect Base Plan. From there, it’s easy to build out best and worst case scenarios to understand how the business plan should be sculpted for the coming periods. These scenarios, combined with the goals for the organization, can be used to develop a strategic plan for the future.