What Is Scenario Analysis? (With Benefits And FAQs)
Updated 23 September 2022
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Companies often evaluate scenarios that may or may not occur before making decisions for the future, like opening a new branch office. This activity is important as it may help companies predict the possible outcomes of their plans and act accordingly. Understanding how to analyse scenarios and how this process works can help you avoid potential losses and attract more clients and investors. In this article, we define what scenario analysis is, explain its benefits and challenges, discuss who can use this analysis, review its cases and provide some examples of this activity along with some FAQs.
What Is Scenario Analysis?
Scenario analysis, or scenario planning, is the process of evaluating various scenarios that may occur in the future and understanding the possible outcome of those scenarios. In business terms, this refers to evaluating scenarios that may affect the valuation of a company or its cash flow. Companies often perform this analysis to understand the possible outcomes of their plans on the basis of different scenarios. This can help in identifying high-risk situations to avoid potential losses and perform activities that may increase profits for the company.
Related: What Is Financial Modelling? (With Benefits And Types)
Benefits Of Scenario Planning
Here are some reasons why scenario planning is important and may prove beneficial for a company:
Enables future planning
Scenario planning can be beneficial for both the business and its investors. Analysing all the possible outcomes of the decisions the business takes can help predict scenarios where it can gain profit for itself and the investors as well. On the basis of this, the company can plan or replan its operations so that it can potentially fulfil its goals.
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Allows companies to be proactive
Analysing the scenarios that may occur in the future can help companies prepare for them and adapt better. For example, a company identifies that lowering the price of its product may result in higher sales, which in turn may cause a supply shortage. The company can then start manufacturing more units of the product to ensure that when the demand increases, it has enough stock to fulfil it.
Helps avoid potential risks
Scenario planning can help businesses and investors minimise or completely avoid potential investment risks. Analysing the best and worst case scenarios can help them understand what action they may take to increase their return on investment and minimise or avoid potential loss. It may also help them analyse the impact of the loss if it occurs and develop plans to recover from it.
Related: 10 Types Of Risks In Finance And Tips For Mitigating Impact
Helps attract investors
A company may use scenario planning to onboard investors by showing them the positive growth results of the analysis, which may offer investors financial benefits. Investors may also be able to make an informed decision after looking and the best and the worst case scenarios and their outcomes. This may also help them remain informed on the potential benefits and the risks of investing in that particular company.
Related: Learn How To Become An Investor (With Essential Skills)
Challenges Of Scenario Analysis
Along with the benefits, there are some challenges companies may experience while performing scenario planning. These include:
Requires a high skill level: Scenario planning can be a time-consuming process and often requires high-skilled professionals to perform it with accuracy. Inefficient analysis may cause errors in predictions.
May not be accurate: The analysis can only predict what may or may not happen in the future. The actual event can be somewhat or entirely different from the results of the analysis.
May not analyse every scenario: It may not always be possible to analyse all the possible outcomes of a scenario. This may limit the business' ability to prepare for adverse or unprecedented outcomes.
Who Can Use Scenario Planning?
Most businesses use scenario planning to understand the outcome of their business plans on the basis of different scenarios. In a company, it is the leadership that involves in this activity. Some companies may invite investors to be a part of the analysis to maintain transparency on the progress of the company. This allows investors to gauge the profits they may make in the future. It may also help them determine if they may invest more in the business. Finance professionals like accountants or financial analysts are the ones who typically perform this analysis for a company.
Related: How To Become A Financial Analyst (With Skills And Salary)
Cases In Scenario Planning
Here are the three main scenarios under which businesses can categorise their analysis:
Base-case scenario: This type of scenario is the most realistic one of all three. It refers to businesses using the actual assumptions for a prediction without considering the most positive or negative inputs.
Worst-case scenario: In the worst-case scenario, businesses use the most negative assumptions to predict the most severe outcome of a scenario. This can help them stay aware and prepare for such events in advance.
Best-case scenario: In the best-case scenario, businesses use the most positive set of assumptions to predict the most favourable outcome of a scenario. This can help them proactively determine the efforts and resources they may require to achieve that.
Here are some examples of scenario planning:
Pupper Technologies just created an automatic pet feeder that sends notifications to users' phones and smartwatches when they require to add more food to the feeder. The company wants to determine if the market might like its product and decides to conduct scenario planning. They examine a variety of independent variables to see how they might change the outcome.
One factor Pupper Technologies looks at is whether its competitors offer a similar product. When reviewing this, they see if other technology companies offer similar products, their number of products sold may decrease. This allows Pupper Technologies to come up with a strategy for how they can attract more consumers to their product instead of their competitor's product.
Sharma Enterprises is considering whether to open a new office building in the city next year. They conduct scenario planning to see what may occur if the cost of raw materials went up. They also examine the business demand for more office space in the city.
In one of their scenarios, the demand for office space decreases due to more people working from home, which would be a worst-case scenario. In a best-case scenario, the price for raw materials may decrease due to a partnership with a supplier. After reviewing some more scenarios, Sharma Enterprises decides to build a new office.
Frequently Asked Questions About Scenario Planning
Here are the answers to some FAQs about scenario planning:
How does scenario planning work?
Scenario planning involves considering a potential event to predict the business situations that may result from it. Organisations using this method develop a range of scenarios and determine how they may affect different factors related to their business. For instance, if the price for their raw materials goes up, this may impact the number of raw materials they can purchase.
Related: What Is Resource Planning? (With Benefits And Techniques)
What is the difference between scenario planning and sensitivity analysis?
While scenario planning and sensitivity analysis are both tools that help companies see how variables create different impacts, there are some differences between the two. Scenario planning examines a wider range of potential outcomes and analyses the impact of changing the variables. Sensitivity analysis looks at the effects of one variable at a time. Another difference between these two methods is their uses. Companies conduct a sensitivity analysis to determine what variables may have the greatest impact on their business. Scenario planning is helpful when creating an overview and looking at multiple cases.
What are some characteristics of scenario planning?
Scenario planning consists of multiple inputs. Companies examine many factors to help them predict possible outcomes. For instance, an organisation may consider how a decrease in available fuel can impact their delivery turnaround time and the number of goods sold. This also involves looking at several business cases when forecasting. Often this includes a base case or current state, an upside case or best-case scenario and a downside case or worst-case scenario. Another characteristic of scenario planning is that it tries to tell a story about the future and explain why certain events may occur.
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