What is Scenario Analysis? 

Scenario Analysis is the process of evaluating probable scenarios that might take place in the coming future and forecasting the many viable outcomes. Scenario Analysis helps business managers to make decisions after analyzing the best case and the worst-case scenario. This process helps determine changes in the business value during potential favorable or unfavorable impact on the company. It helps anticipate profits or losses and is useful to base decisions involving big investments like setting up a business or buying a property.   

Scenario Planning in everyday life 

We make use of Scenario planning and analysis in our everyday personal lives. We analyze various situations before making decisions like ‘Which college should I opt for?’, ‘Should I quit my job?’, ‘Should I invest in a house?’ and so on. The difference between analyzing a business scenario and analyzing a personal life scenario is the number of variables that should be considered and the impending ramifications.  

Scenario Analysis Process 

 A business manager evaluates the potential state of a business, the encompassing industry, and finally, the economy while performing the analysis. The manager will initiate the process of the analysis by making assumptions like the price of a product, operating costs, customer metrics, interest rates, inflation, and other factors that drive a business. A manager will start by evaluating three basic scenarios. 

Base Case Scenario  

This is an average scenario based on the manager’s assumptions. For example, while calculating NPV or the net present value, the manager will consider the most likely rates to be used, such as the discount rate, tax rate, or the cash flow growth rate. 

Worst Case Scenario 

The manager will consider the worst possible outcome of a given situation at hand. For example, while calculating the net present value, the manager will assume the highest discount rate possible, the lowest possible cash flow growth rate, and the highest possible tax rate. 

Best Case Scenario 

This is the ideal scenario that can be projected and generally relied on by the managers to achieve the company goals. For example, while calculating net present value, the manager will consider the lowest discount rates possible, the highest growth rate possible, and the lowest tax rate possible.  

Scenario analysis is a strategic tool that a manager uses to evaluate a large range of possible situations. The manager tries to identify basic trends and define a series of scenarios that will help him/her to reduce the margin of error that can occur while taking a decision.  

Scenario analysis helps to expand the scope of opportunities without over or under predicting. The available knowledge is separated into things that are known about and uncertain information. Changes in the political face of the country and increase in prices are things we know will happen for sure. Uncertain information includes things that we anticipate might take place in the future but cannot be absolutely sure about. Scenario analysis encourages strategic thinking to gauge and be prepared for opportunities. 

 How to use Scenario Analysis 

The first step is to define the issue and set goals of what the company wants to achieve.  The next step is to gather data and identify factors, uncertainties, and trends that may affect and alter the course of the plan. Depending on the vastness of the plan, the manager might choose to do a PEST analysis to understand the Political, Economic, Socio-Cultural, and Technological context of the plan. Once the manager has collated information, an important step is to separate certain information from uncertain information. Some assumptions identified can be confidently predicted. However, the dynamic and volatile market conditions lead to a lot of assumptions to be based on uncertain data. The most important and impactful uncertainties should appear at the very top of the list. The fourth step is to start with the top-most uncertainty and analyze the worst and the best outcome for it. A scenario is developed for each certainty and the chosen outcome.  The final step is to use the scenarios as a part of the plan and make decisions based on probable risks and rewards. 

 Why Organizations Need Scenario Analysis 

Technology has created rapid change in customer demands, demographics, and the way businesses operate. The market is competitive and in an ever-changing environment. 

Scenario analysis allows organizations to evaluate the unexpected impact changes in the business environment will have on investment and other decisions. It helps them test the robustness of future decisions to understand the potential impact of unexpected influences and identify potential opportunities and threats. And also in the following: 

•         The ability to test decisions 
•         Understand the potential impact of external influences 
•         Identify potential threats and opportunities 

Example 

John wants to start a business and implement software to help his corporate clients manage their financial activities. He charts down his business plan for the next five years and sets goals. John relies on Scenario opportunities and threats. John knows that he can set up a suitably equipped team, and his research tells him that updated software will hugely benefit his clients. He, however, anticipates new competition that might render his software obsolete. He is also uncertain if a recession will disrupt the market situation. John develops the following scenarios –  

•         If everything goes as per plans: the next five sees a steady growth in the economy, and the software company attains leadership in the market. 
•         A slowdown in the Economy: The economy faces a sudden price shock and slips into recession. Though the software implementation might still be carried out, many clients opt out and wait for the recession to blow over. 
•         Intense Competition: A new competitor disrupts the market by introducing the latest version of the software and makes John’s company lose its current footing in the market. 

Once John has all the scenarios before him, he understands that there will be mid-term risks involved in the business. John sets up his full-time team and outsources contractors to scale up the business at the earliest. This way, he gains the first mover’s advantage. John also keeps a sharp eye on the market to sniff out the competition. This makes him prepared for uncertain conditions.    

Scenario Analysis does not lay an emphasis on predicting the end result or the outcome accurately. It helps generate various future scenarios, which might be valid but uncertain. Scenario Analysis helps improve strategic thinking and pushes the manager to consider positive as well as negative outcomes. It also helps effectively allocate resources and cut down the negative consequences.  

Glossary  

Business Environment – is the sum of all internal and external factors like workforce, customer purchase behaviors, suppliers, demand & supply, client, owners, technological advancements, changes in government regulations, etc. 

Independent Variable – An independent variable is an assumption, a driver, or an input that is changed to evaluate its effect on a dependent variable. Where the independent variable is an input, the dependent variable is output. 

Sensitivity Analysis – Sensitivity Analysis predicts how a percentage increase in prices will cause a percentage decrease in the number of units/products. Sensitivity analysis helps gauge the sensitivity of the dependent variable. 

Common Mistake 

Students confuse scenario analysis with stress testing, though these two are very different exercises. Scenario Analysis is a process that can help predict the value of a future investment that depends upon anticipated changes to the existing variables. Scenario Analysis studies the impact of various factors which occur within a short span of time, while Stress Testing assesses the impact of a single risk or factor in isolation.  

 Context and Applications 

This topic is significant in the professional exams for both undergraduate and postgraduate courses, especially for: 

• B.com (Honors) 
• M.com 
• Chartered Accountants (CA) 
• Company Secretary (CS) 
• MBA (Finance) 
• CMA (Certified Management Accountant)