Imagine you are sitting at your desk in September 2007. The Dow is close to 13,900; U.S. unemployment is 4.5%; and oil is $45 a barrel. You are in the middle of developing your organization’s plans and budgets for 2008. How likely is it that the assumptions in your 2008 plan accurately forecast that in September 2008 the Dow will be below 9,000; U.S. unemployment will have risen to 6.5%, on its way to more than 10%; and oil prices will have risen to more than $140 a barrel before falling below $40 a few months later?
An aberration? Unlikely, not with a European sovereign debt crisis, a massive oil spill in the Gulf of Mexico and major health care reform in the United States. Uncertainty, volatility and risk are here to stay. The world has been transformed from a series of loosely connected, reasonably predictable economies to a complex web of relationships where the global impact of local events is felt almost instantaneously.
In this climate the past is not a good predictor of the future. In response to such uncertainty, scenario planning has been used by organizations as diverse as the Australian government, AutoNation, British Airways, Corning, Disney, General Electric, the U.S. Federal Highway Administration, JDS Uniphase, KinderCare (a large U.S. chain of day care centers), Mercedes, Royal Dutch Shell, UPS and the World Bank. Today, scenario planning is being widely used by many small and midsize organizations operating in uncertain or volatile markets.
WHAT IS SCENARIO PLANNING?
Scenario planning is a way of understanding the forces at work today, such as demographics, globalization, technological change and environmental sustainability that will shape the future. While the origins of scenario planning were in the world of strategic planning, many organizations now apply scenario planning techniques to the operational planning, budgeting and forecasting processes as a means of evaluating their effectiveness under different sets of assumptions about the future.
Two forces are fueling the increased popularity and use of scenario planning. The first is the rapid and broad global impact of unpredictable events such as 9/11, or the global credit crisis. The second is the accelerated pace at which new trends become material. For example, the rapid growth of China and India, the rise of social media, and smart phone adoption have occurred in a decade or less.
BUILDING SCENARIO PLANS
Scenario planning is largely focused on answering three questions:
What would be the impact on our strategies, plans and budgets?
Although there are numerous methodologies for building scenario plans, they all follow the same basic approach (see Exhibit 1).
Before embarking on a scenario planning exercise, it is essential to be clear about the issue you want to address, and then to define the appropriate scope and time horizon for the scenarios to be constructed. There are four broad types of scenarios:
Social. For example, what are the implications of increasing obesity?
Economic. For example, how will the rapid economic growth of China and India change global markets?
Political. For example, how will changes in U.S. health care policy affect the economics of small businesses?
Technological. For example, how will the increasing use of smart phones impact desktop and laptop computer use?
Answering the following questions will help determine whether a scenario planning project makes sense and how to define the objectives and scope:
What issues or decisions are we trying to evaluate?
Is there a high degree of uncertainty about the future? If yes, can scenario planning be an effective tool?
What is the time horizon for making decisions and then executing them?
After the organization has agreed on the issue(s) to be studied and defined the scope and time horizon for the project, they should be documented, confirmed with senior management, and clearly communicated to everyone who will be involved in the project.
At the end of this step, the project team should have developed a project charter that clearly states the objectives, scope, issues to be addressed, deliverables, and have secured approval from senior management.
ROLE OF THE CPA IN SCENARIO PLANNING
Finance and accounting professionals are being asked to help managers better understand the threats and opportunities in today’s world. As many organizations integrate aspects of scenario planning into financial planning, budgeting and forecasting processes, they are looking to their CPA partners for support in conducting rigorous and insightful analysis.
Applied judiciously, scenario planning can provide valuable insights as to how the future may unfold, thereby equipping organizations to react with speed, agility and confidence.
Scenario planning is often used as an input to an organization’s overall risk management process and can aid in areas of interest to CPAs such as risk appetite evaluation, capital planning, credit quality, cash flow forecasting and hedging strategies.
An understanding of scenario planning equips CPAs with tools that can help advance their careers into more senior finance or general management roles through a richer understanding of how to effectively manage in a volatile and uncertain world.
CPAs can effectively support a scenario planning process in their organizations by:
Analyzing the financial implications of alternative strategies under different future scenarios;
Testing the sensitivity of key assumptions, financial measures and variables under different scenarios;
Developing alternative financial plans and forecasts under different scenarios;
Defining key performance measures and leading indicators to track potential triggers of key drivers of alternate scenarios; and
Monitoring and reporting on internal performance and external indicators likely to impact the current strategy.
SCENARIO PLANNING IN ACTION
Let’s see how scenario planning can work in practice by following the progress of ElectricIQ, a software company that develops smart systems for managing electricity use. This case study is based upon a real organization. Some details have been changed to maintain client confidentiality.
ElectricIQ was founded in 2005, and by 2009 sales had reached $25 million a year, primarily from the installation of electricity management systems in new office buildings in Western Europe. Management believed that ElectricIQ had reached a tipping point.
With environmental sustainability becoming a hot public policy issue, the company believed it was time to enter the emerging smart grid market for digital environmental management systems. Management wanted to gain insights as to the relative attractiveness/risk of the market.
The company decided to embark upon a scenario planning project to help understand the alternatives as an input to R&D, marketing and product development plans. A project team led by the CFO and including the vice president of marketing, the head of research and a financial analyst was formed, and after initial discussions with the management team, the project’s objectives were defined as “Developing a better understanding of the markets for smart grid, the risk profiles of each market and the ease of market access.”
The first step for the ElectricIQ team was to identify the likely drivers of the future environment. This is the most important step in scenario planning since the ability to define the correct drivers and then understand the impact of changes in drivers is at the heart of effective scenario planning. Through discussions with the management team, customers, investors and external thought leaders from the Organisation for Economic Co-operation and Development (OECD), General Electric, IBM and Shell, the team developed a simple driver model around the issue of the Demand for Renewable Energy Sources. Two level 1 drivers, Social Opinion and Political Action, were identified, and each level 1 driver was then mapped to three level 2 drivers. For social opinion, these were the credibility of climate change data, the technical viability of potential renewable energy sources and the price of such options. For political action, they were the availability of government subsidies, the regulatory framework and the role of tax policy in energy use (see Exhibit 2). The team then used this framework to identify the types of data it would collect.
This included data about economic growth; forecasts of construction activity; likely government actions to encourage adoption of environmental control systems; and the likely players in the market for environmental control systems. Not all the data was quantitative; some of the most interesting inputs were the opinions of experts who specialize in conceptualizing alternative futures. The key is to collect a broad range of data with a view to developing credible scenarios of how the future may look.
The team then prioritized the drivers by mapping them against two axes. The first axis was an assessment of each driver’s impact on the issue being analyzed, and the second looked at the predictability of future trends for each driver (see Exhibit 3). Drivers that were both material and predictable (top-right circle) formed the basis for all scenarios that were developed. Those that were material but difficult to predict (top-left circle) defined the differences between the scenarios.
The team isolated those drivers that were most likely to shape future demand. It then developed four scenarios across two dimensions (see Exhibit 4). The dimensions were public opinion, which describes the level of consumer demand for environmentally friendly solutions, and public policy, which describes the extent to which government policy mandates “green” standards.
The team then developed narrative descriptions for each scenario:
Necessity. “Do It or Die”: Public opinion swings rapidly to green solutions and dramatically changes customer buying patterns. Products not seen as being green are shunned in the marketplace. Governments mandate adoption of environmentally friendly technologies.
Market driven. “Competitive Advantage”: Public opinion moves to green, and consumers will pay extra for the best products. Adoption is balanced between market innovation and tax-based incentives. Being green is a source of competitive advantage.
Mandate. “Cost of Doing Business”: Governments mandate adoption without incentives. Adoption is a “cost of doing business.” Consumers will not pay more for green solutions unless forced to do so.
The “S” curve. “Steady as She Goes”: Demand follows a traditional cycle of early adopters leading the way at high prices; as the market scales and prices drop, mass market adoption takes off before flattening out as maturity is reached.
ElectricIQ used these scenarios to frame strategies and make decisions affecting key elements of the business (see Exhibit 5).
Using the scenarios as a baseline, ElectricIQ’s finance team recast the company’s five-year plan and annual budget under each scenario to assess the financial implications and identify key performance metrics that could provide the organization with an early warning as to which scenario is actually playing out. The CFO also added metrics that tracked the key drivers to the company’s balanced scorecard, ensuring their constant visibility to the management team.
But the work was not done—scenario planning is not a one-off exercise. For example, what if just six months after the initial scenarios were completed, oil reached $200 a barrel and the G-20 imposed strict mandates on CO2 emissions to be met within five years? ElectricIQ would have had to revisit its plans and may have decided to focus on only two of the original four scenarios: “Do It or Die” and the “Cost of Doing Business.” After more detailed modeling of these two scenarios, it could decide to focus on delivering solutions that far exceed the mandated minimums while keeping prices reasonable.
The scenario plans allow them to make fast, confident decisions by providing a sound basis for evaluating the impact of changing market conditions. As the CFO commented, “We constantly review our actual and forecasted results against the scenarios so we can act quickly when we see any changes in the marketplace that will impact our performance.”
As organizations struggle to deal with an increasingly uncertain world, they are looking to their finance teams to assist in helping them understand the choices, opportunities and implications that uncertainty presents.
The past is not a good predictor of the future. To respond to uncertainty, finance and accounting professionals can use scenario planning to help managers better understand the threats and opportunities in today’s world.
Scenario planning is not just a strategic planning tool. Many organizations now apply it to operational planning, budgeting and forecasting processes to evaluate their effectiveness under different assumptions.
There are four broad types of scenarios: (1) Social, (2) Economic, (3) Political and (4) Technological.
Scenario planning is largely focused on answering three questions: (1) What could happen? (2) What would be the impact on our strategies, plans and budgets? And (3) How should we respond?
Scenario planning equips CPAs with tools for career advancement. It enables CPAs to effectively support the strategic planning process; provides a frame of reference for developing alternative financial plans and forecasts; tests the sensitivity of key assumptions, financial measures and variables under different scenarios; and helps define key performance measures.
It is essential to be clear about the issue you want to address before embarking on a scenario planning exercise, and then to define the appropriate scope and time horizon for the scenarios to be constructed.
David A.J. Axson (firstname.lastname@example.org) is the author of the Management Accounting Guideline Scenario Planning: Plotting a Course Through an Uncertain World, published July 2010 by the AICPA, CMA Canada and CIMA, from which this article has been adapted.
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