The COVID-19 pandemic has forced many companies to revise carefully crafted strategies and budgets in preparation for the “next normal.” One key question and challenge for top executives and strategic planners alike is how to best plan for an unclear future, and the answer is scenario based planning.
We have observed a sharp increase in the number of organisations applying scenario based planning approaches to manage the uncertainty of the current situation and ensure they have sufficient cash reserves, as we have discussed in previous blogs. In a recent McKinsey survey with CFOs of leading companies, 90 percent of respondents indicated using at least three scenarios to support their planning. In pre-crisis times, scenario based planning was often perceived as a stimulating, intellectual, and thought-provoking exercise—describing alternative future states and defining the best strategy for each one—but not one with a clear business impact. That notion has changed with the arrival of COVID-19.
Compared with pre-crisis levels, the number of scenarios under active consideration has increased, enabling companies to react swiftly to changing economic conditions as the crisis continues to unfold. In the recent CFO survey, more than 40 percent of respondents said they dedicated a significant share of their crisis management efforts to scenario based cash planning. More than 70 percent claim they will hold back a reasonable amount of cash, based on scenario planning.
At the same time, many finance organisations, which rely on longer-term scenarios, have not yet been able to develop the agility required to plan for a COVID-19 world. Cash-constrained companies typically use 13-week cash forecast models to navigate a crisis. These models are poorly suited in the long run for strategic cash management. They are focused on the short term and include granular detail, such as single-purchase orders or billings, rather than alternative economic scenarios. This misalignment highlights the challenge companies face in applying lessons from the crisis and adopting dynamic scenario planning as part of the next normal operating playbook.
In our experience, the most successful businesses are those who connect their internal finance systems with digital tools in the boardroom for agile impact modelling. Getting the scenario approach right is fundamental in these models. To help you get this right, below we list five best practices guidelines for you to follow
Scenarios should be relatively far apart from one another to foster a meaningful debate on different courses of action.
There is always uncertainty around individual scenarios, so running multiple scenarios that are very similar may result in significant overlap. Instead you should focus on a varied set of scenarios, from best to worst case. This will help you understand where the risks are, to prepare you should they eventuate, and ensure your decisions allow for these.
Scenario models should not be too complex. Ideally, companies will identify a few key variables that describe both the external macroeconomic environment, such as sectorial GDP growth, and company-specific parameters, such as fixed operating cost. To limit redundancy, only the financial line items required for decision making should be simulated.
There are two reasons for this, complexity can slow down the process which in uncertain times is paramount. It can also lead to overconfidence in the results. No one can predict the future, despite what they say. We may be lucky and predict (guess) 1 or 2 things correctly, but the more ‘things’ we try to predict the more likely we are not to get them all correct. The more variables, the more combinations, the less likely we are to cover them all in our scenarios, yet with all the variables included the more we are likely to think we have every possibility covered.
Variables should be linked to specific, well-defined outcomes. For instance, simulated cost-reduction initiatives should have direct impact on planned fixed or variable cost lines.
With scenario based planning being about making better decisions with more confidence, it is important to make the decision associated with the scenario as un-ambiguous as we can. Whilst there is always an element of unknown and uncertainty in any scenario based planning, ensuring the linking of variables and outcomes above helps to limit this.
The chosen modeling granularity for each level of the business structure (such as business units, product lines, and regions) should be sufficient to show specific effects and suggest specific actions. For multinational companies modeling COVID-19 scenarios, for instance, a regional segmentation is fundamental to account for the different timing of the pandemic waves across geographies.
In the deterministic approach to scenario based planning, at least three to four scenarios should be modeled to sufficiently cover the range of possible outcomes. Alternatively, stochastic models, which are based on a Monte Carlo simulation model using thousands of scenarios, can provide the additional probabilistic lens of expected outcomes.
Some companies have created stress scenarios—essentially a hybrid approach of deterministic and stochastic scenario modelling—based on the worst possible outcomes for each macroeconomic driver. These scenarios are generated from a stochastic “uncertainty cube” that captures thousands of coherent stochastic scenarios for such macroeconomic variables over time. If a balance sheet withstands such a stress scenario, it will also hold up under scenarios that are more likely to materialize, considering the correlation between variables.
The COVID-19 pandemic has created a dynamic and difficult-to-predict environment with many uncertainties that challenge organizations and executives each day. Navigating through the crisis is a formidable task and scenario-based planning can be a valuable tool in preparing and planning for the next normal.