Use scenario analysis to anticipate challenges and strengthen business decisions
By Angela Civitella
Previously published in WestmountMag.ca
In scenario analysis, or “what if” analysis, you ask a series of “what if” questions to predict potential complications and their impact on company operations. For example, a store owner could ask, “What if another luxury clothing store opens on the same street?” and “What if my main supplier goes out of business?” These questions could help decide whether there is adequate safeguards in place to protect the business if these risks and complications actually happen.
In scenario analysis, you ask a series of “what if” questions to predict potential complications and the impact they’ll have on company operations.
If another luxury store opens in the same area, what impact can be expected on sales? How will these revised sales figures change the bottom line? Likewise, if a main supplier goes out of business, how will that affect sales and customer service? Are there other suppliers, and how long will it take to set up properly functioning relationships? How long can operations be sustained given the cash flow needs? You can ask and answer many questions with “what if” analysis. These could be high-level risk-management planning questions, or they could be questions with very specific, measurable impacts. You choose the scope and depth of analysis. You could have a purely qualitative analysis or a purely quantitative one. A typical “what if” analysis is somewhere in the middle, with elements of both.
Qualitative “what if”
As a risk management tool for decision-making, “what if” analysis helps you brainstorm risks and then explore solutions. The store owner’s “what if” questions might include the following:
- What if a competitor opens across the street?
- What if my supply line is suddenly limited?
- What if currency exchange rates change?
- What if the sales tax increases?
The store owner would respond to each question and make sure the business plan includes sufficient contingencies. Thinking further about the first question, “What if a competitor opens across the street?” there are a number of strategic options to investigate, including these:
- Reducing prices
- Defining and marketing to a niche market
- Offering a complementary line of products
- Improving customer service
The store owner can then investigate each option and adjust the business plan or model accordingly.
Quantitative “what if” analysis (sensitivity analysis)
A specific form of “what if” analysis, called sensitivity analysis, looks at the effect of changes in the value of estimates or assumptions within an existing model. This asks, “If this value changes, how does that affect the rest of the model?” As such, decision makers typically do this type of analysis in a spreadsheet. In this situation, the store owner might want to know the impact on the bottom line of reducing prices. Using this analysis, you can adjust sales figures to see how much room there is to decrease prices. Likewise, you can examine changes in currency spreads to ensure margins can withstand projected changes.
A specific form of “what if” analysis, called sensitivity analysis, looks at the effect of changes in the value of estimates or assumptions within an existing model.
By combining sensitivity analysis with the flexibility of a spreadsheet, the store owner can quickly see how sales, margins, and net income change when other inputs change. From there, the owner can determine which changes are significant and which require further investigation and planning. An increase in the cost of goods sold may seem more significant than an increase in rent. However, a quick sensitivity analysis lets the owner test that assumption.
Step-by-step “what if” analysis
Step one: Define the scope of the analysis
Identify and clearly define the boundaries for the risk-related information you need. Are you interested in the impact of potential sales-related risks? Maybe you want to make decisions related to your investment activity? Or perhaps you want to focus on issues related to staff retention?
Step two: Identify the significant problems to analyze further
The scope of your analysis will be determined by the problems you will want to investigate. For sales issues, you’d likely start with questions related to supply, competition, costs, and demand. For investment activity, focus on changes in interest rates, market conditions, and economic forecasts. Retention questions might cover your ability to offer a competitive wage, the cost of providing training opportunities, and organizational culture.
Step three: Generate “what if” questions for each problem area
Brainstorm hypothetical situations that you believe could impact each issue. What might affect your sales, your investments, or your retention?
- What if costs increase by 5 percent, 10 percent, and so on?
- What if interest rates rise by 1/4 percent, 1/2 percent, and so on?
- What if training costs rise by 2 percent, 4 percent, and so on?
Because your “what if” questions are mostly based on assumptions, it’s also a good idea to test your assumptions. This helps you generate valid questions worth investigating.
Step four: Respond to the “what if” questions
Respond to the “what if” questions by investigating further, testing your assumptions, and using sensitivity analysis where appropriate. If the impact is significant in a certain area, you may want to explore that in more detail. Other times, you may decide the impact isn’t significant enough to justify more planning and assessment. It’s also a good idea to analyze the risks you’ve identified for probability and potential impact.
Step five: Use the results in decision-making
After your analysis, adjust your plan appropriately or implement new actions accordingly.
Featured image: StartupStockPhotos – Pexels
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Angela Civitella, a certified management business coach, negotiator, strategist, and problem-solver, creates strong synergies with those seeking to improve their leadership and team-building skills. You can reach Angela at linkedin.com/in/angelacivitella/ • intinde.com
