BUDGETING - 07.09.2011

Scenario analysis

Planning in difficult times

Predicting the future is never easy, and that’s particularly the case when developing business plans. In the current economic climate, business conditions can change unexpectedly - customers go bust, raw material costs rise significantly and exchange rates fluctuate. As a result, budgets can become outdated or even an impediment to financial decision-making.

Key variables

Sidestep this problem by identifying the key variables, or drivers, that affect financial performance and using scenario analysis to evaluate how changes to these key drivers could affect your business.

Identify the key drivers

Step 1. Start your scenario analysis by listing what you know based on the past. For example, for sales budgets, review historic sales data and analyse by product, customer, geography or distributor.

Step 2. From your analysis, identify the key issues that have affected past financial performance. For example, if sales have fallen/increased for a particular product, what was the cause?

Step 3. Use your analysis of the root causes to help identify the key drivers (the risks and uncertainties) that could affect future results. It could be a full range of variables.

Tip. Rank the key drivers by giving each a score out of ten for the potential range of variation and a score out of ten for the size of the potential impact on your business. Multiply the two together and select the two or three most important ones, i.e. those with the highest scores.

Example. You consider that overseas demand for your products is difficult to predict but has a big impact on your sales so you give it a variability score of 8 and an impact score of 9 - total 72. The price of raw materials may have the second highest score of, say, 70.

Constructing the scenarios

Step 1. Set valuesfor the key drivers. For example, you may consider overseas demand may have a range from a decline of 20% to growth of 30%. Price increases for raw materials might have a range from 20% to 80%.

Step 2. Create scenarios using a matrix which will identify the best and worst case scenarios. If you have two key drivers, the matrix will generate four scenarios (2x2). If you have three drivers, the matrix will have nine scenarios. It’s an exercise that’s really worthwhile undertaking.

Step 3. Write up each of the scenarios to bring them to life. For example, if overseas demand falls by 20% and raw material costs rise by 40%, tell the story of how, why and when this could happen.

Step 4. Examine each of the scenarios with your department managers to quantify the impact on the business and develop appropriate strategies or tactics that you would employ for each scenario.

For an example scenario matrix, visit http://financialcontroller.indicator.co.uk (FC 03.11.03).