Turn What-if to What-Now: The Importance of Scenario Analysis

We used to call it “what-if” but today it’s known as “scenario analysis.” It’s been a favorite management tool of mine since my time as VP for a market research firm, and it’s a method I used for decades growing a software company from zero to well over $10 million in annual sales. Today, with the COVID-19 crisis upon us, it’s the best way to move forward through rising uncertainty.

What is a scenario analysis?

Scenario analysis is about looking at what might happen and then coming up with a plan for how you might act in that situation. If your business is facing uncertainty, considering several different “what-if” scenarios and coming up with a plan will be critical to business survival. Here are just a few what-if scenario questions to ask yourself as you develop different scenarios:

• Time to recovery: Think about how the world will recover from the current economic crisis. Will businesses open slowly? Or will it take time?
• Impact on sales: If sales go down 30%? What do we do with payroll and expenses? What if they go down 50%, or 70%? What then?
• Length of crisis: What if the downturn lasts two months? What if it lasts six months? A year?
• Impact of social distancing: How long will social distancing have an impact and how long will it last? Does that impact your business?
• Financing options: Can I get an emergency payroll loan? How does that impact the numbers?
• Scarcity: Will key inputs (such as raw materials for assembly) be scarce? What if their price goes way up and availability way down.
• Retaining your workforce: How long can I keep my people without having to let people go. What will be the cost of letting somebody go when it includes recruiting and retaining a replacement later when the economy recovers? Would an overall cut in payroll be an acceptable compromise? Should the executive team take a cut first?
• Cutting expenses: Which of my expenses are truly discretionary? How much damage does each cut do? 

For each of these questions, and all the other important questions that come up in a time like this, you need to work with a scenario. Each scenario combines the key numbers in the hypothetical case and explores the impact on the bottom line, and helps you define your cash burn rate and runway. Most people think through the contingency plans better when they are laid out into numbers – it helps connect all the dots and assures you’re on the right track toward actual change. 

Why is scenario planning important?

Simply put it’s a better method of accurately looking forward and business owners know better than mathematicians. Before I started my own business I was a market researcher, doing forecasts. I’ve got a fancy business education and I can do sophisticated business modeling, econometrics, variations of smoothing and weighted averages, and all of that. 

However, I discovered when I was in the front lines of it, that all of the mathematical approaches depend on the basic dynamic of the past predicting the future. And in contrast, most business owners do a far better job of seeing the future when they combine numbers and the past with their own experience and human intuition.

Scenario analysis optimizes the combination of numbers and intuition. For example, you take an original pre-crisis sales forecast and use it to develop a new scenario in which sales plummet (ouch, by the way … hard to talk about this). Then you go back to your original expense budget and see what you’d cut if you had to make do with lower sales over 3, 6, or even 12-months. The connection of the numbers helps you think it through and allows you to look ahead in varying increments.

The main benefit is the scenario is not set in stone. You can revisit the analysis at any time and make adjustments based on your updated budgets and revenue numbers, as well as the changing economic landscape. Your intuition intersects with your numbers as you make adjustments based on actual performance and make predictions as to how the market will change.

How to conduct a scenario analysis

You have to have good numbers to optimize your management. Maybe you, the business owner are responsible for this or maybe you entrust it to somebody on your team. Especially in a crisis, you can’t run a business well without projected future numbers for sales, cost of sales, expenses, profit (or loss), and cash flow. Here are a few ways to conduct the analysis, including steps for each process.

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Build scenarios using spreadsheets

Start with a spreadsheet that includes worksheets for sales, expenses, P&L, balance sheet, and cash flow. The magic of the spreadsheet allows you (or someone on your team) to link the numbers up so that when you change a number in one sheet, related numbers in other sheets also change. For example, lowering sales will automatically produce fewer profits or a bigger loss, and less cash. If your budgeting spreadsheets don’t do that, it’s worth the effort to connect them with a handful of Excel formulas. It will allow you to make adjustments without having to manually track and change every value, making scenario planning substantially easier and quicker.

Tips for developing scenarios with a spreadsheet

1. Back up your main workbook file. Confusing file names and overwriting are the most common errors in doing spreadsheet scenarios. If my main business plan projections workbook is named — just an example — business plan projections.xlsx — then before I start exploring a new scenario, I want to make at least one copy of that file with a useful name such as business plan projections-4-20-20-backup.xlsx.
   
2. Use the Save As command in the File menu to save that workbook as a new scenario, with its file name corresponding to the scenario. For example, 20-pc-drop.xlsx or 50-pc-drop.xlsx.
   
3. Work on that scenario as a potential plan, with contingencies. For example, for a 20% sales decline scenario, change the sales forecast to reflect that, using your experience and judgment (there are no magic algorithms; you look to the recent past for help but expect this to be educated guessing). Then you look at what to change in expenses to keep the business going during the downturn. Look how that affects the all-important cash flow projection. Adjust as you have to.

Building scenarios using a business planning tool

If the idea of developing and maintaining an active spreadsheet sounds like too much of a hassle, you might want to consider using a tool like LivePlan. The LivePlan forecast automatically includes sales, direct costs, personnel, expenses, cash assumptions, and even the three main financial statements (Profit & Loss, Balance Sheet, and Cash Flow). And it includes different scenarios as an option in the top menu which makes developing and adapting scenarios much easier, even when planning for the impact of potential loan funds.

When you are in the forecast section of your plan, you can click on the top menu to create a new scenario. In the example, we are in the 40 percent drop forecast and we have the option to create a new forecast to add another scenario. This preserves the integrity of the original and the modified scenarios, each with its own financial forecast including all the components.

Use your scenarios to help soften the impact of the crisis

Ultimately, this is fundamentally sound management that is useful in any scenario. But in a crisis filled with uncertainty, it’s absolutely vital. Create forecasts that reflect each potential scenario and continue to ask yourself questions that should be addressed. 

What do sales look like and how long do they take to recover? How will social distancing affect sales when things return to “normal?” Ask anything and everything and develop potential best, worst, and average scenarios to help you prepare.

Within each of these scenarios, explore the responses in how you expect to spend money. Define decision points for each scenario as to how you will approach spending, overhead, variable costs, etc. What will make it your new normal?

To optimize management during a crisis, review, and revise these scenarios often. Things are changing quickly and you can use your scenarios to keep your working plan always up to date to plan for how things might continue to change. Good planning is a process, not just one static plan. You keep it lean and use a continuous review-and-revise mentality to steer your business through the crisis.