Major setbacks like the pandemic can pave the way for organizational maturation if handled properly. A good method to gauge a company's maturity is the extent to which finance leaders embrace the discipline of financial planning and analysis (FP&A). A critical tenet of FP&A is that instead of relying on past performance to prepare their companies for the future, finance leaders must plan for multiple possible outcomes.
Yet despite recognizing the inherent benefits of scenario planning, such as replacing groupthink with critical thinking and proactive collaboration, finance leaders continue to struggle with a fundamental question: How does a company determine in advance which scenarios to prepare for? The following will outline several of the best methods finance leaders can use to improve their scenario planning.
4 of the Best Scenario Planning Improvement Methods
1. Model the data to understand business behavior in different scenarios
Once the CFO has nailed down relevant data inputs, the inputs can be run through various forecasting models, including decision trees and Monte Carlo simulations, to determine how changes in the data under different scenarios will affect the business.
This process can incorporate information from different functions across the business, but there may be a need for the CFO to be empowered to challenge the assumptions going into the models.
This flexible, dynamic scenario–planning can not only focus on the company’s own business, but it can also stress–test suppliers and customers to see how they will be impacted by, for example, a reclosing of certain borders or a rise in COVID-19 cases in key manufacturing centers.
It is essential to build “black swan” events into scenario planning, as we have seen that these events may not be as rare as executives assume. In recent years, massive fires on an entire continent, a pandemic, and geopolitical shocks all have affected business. Scenario planning not only identifies likely impacts on the P&L, balance sheet, and liquidity, it also empowers organizations in identifying market opportunities.
In one case, we have seen how the pandemic forced a change in how some consumer products, such as beer, are packaged. Bar owners learned that kegs caused too much inventory risk, and some news media reports chronicled how shuttered bars got stuck with stale beer during the lockdowns. There has been more of a focus on single-serving containers since and even some anecdotal evidence of an aluminum can shortage. That type of shift could impact how companies invest in their product mix in the future, which, in turn, could affect their entire supply chain.
2. Identify New Data Inputs
It is often not easy to forecast and plan for various scenarios without the right data. But typical metrics, such as revenue and foot traffic, are now less available or relevant for future planning. Businesses are just beginning to reopen (or shut down again) and some revenue has been propped up by government stimulus programs that may not continue. Other data does not necessarily have the same implication as it did in a normal economy. For example, low gasoline prices would normally correlate with increased restaurant traffic, but that relationship is no longer linear.
One consumer company we worked with reconsidered which data it needed to augment its typical syndicated sales data and other inputs to develop a more accurate, timely forecast. Among the inputs it chose were weather data, cell phone tower data, social media mentions of its products, and ZIP code–level unemployment data. The finance team then performed a regression analysis to see which metrics would show causation. The result was more accurate forecasts that are now updated in hours, rather than weeks.
The CFO can take the lead in determining which inputs are most relevant and predictive for the business, with the finance team performing a regression analysis to see which metrics show correlation and determine which represent actual causation.
3. Proactivity to enable flexibility under different scenarios
Proper scenario planning can help companies gain better transparency into the risks they face in different situations. The CFO can then use the various scenarios to help guide decisions around the company’s cost structure, working capital policies, dividend policy, backup sources of liquidity, and other near-term measures.
Planning for the true worst-case scenarios can also help guide whether long-term investment needs to be made into a more flexible supply chain, different manufacturing facilities in different geographies, or other measures. For example, if a company forecasts that a key supplier might fail in X% of scenarios, the company could increase inventory levels while it finds more suppliers, or could even acquire the key supplier.
4. Base your playbook on the crisis
One lasting project the CFO can lead is to use information and lessons learned from the current crisis to develop a crisis playbook. This playbook may include specific actions to take in response to specific shocks to the business. These can be demand shocks, supply shocks, or both, and may impact specific geographies or the entire ecosystem. For example, an X% drop in sales may trigger a drawdown of funds under a line of credit, whereas a 2x decline in sales may further trigger the suspension of a dividend and the furlough of certain workers. The crisis playbook can also clearly define the crisis response team and its roles and responsibilities, as preparedness is the key to a quick response.
By improving forecasting and scenario–planning now, and preparing a plan for the next crisis, CFOs can help improve their company’s resilience, position it to weather market disruptions, and take advantage of the opportunities that come with any crisis.
Data-Modeling and Insights in the Age of High Tech
The first two actions mentioned above are difficult to get good at if you and your organization are stuck with an outdated mindset and corporate toolbox. Many finance teams are unfortunately not aware of the best software solutions at their disposal; specifically, the ones that are designed to maximize your data modeling capabilities, and in-turn the potential for quality insights. Software like DataRails and Vena Solutions can help you with your data modeling and processing, and lay the best foundation possible for your organization’s approach to scenario planning.
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