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Scenario analysis
What is it?
Scenario analysis, also known as horizon analysis or total return analysis, is a method of projection. It is an analytic process that allows you to analyse a variety of possible future events or ‘scenarios’ by considering alternative possible outcomes.
By planning out the detail required to implement a particular decision or course of action you can observe not only the final potential outcome but also the viability of the path leading to that outcome. Often it’s only when you really consider what would be involved in the actual implementation of an idea that you fully appreciate the scope of that idea. Scenario analysis therefore allows you to improve decision making by fully considering the outcomes you expect and their implementation implications without the cost and time involved in actual real-world implementation.
Scenario analysis does not rely on historical data and doesn’t expect the future to be the same as the past or seek to extrapolate the past into the future, rather it tries to consider possible future developments and turning points.
When do I use it?
Use scenario analysis when you are unsure which decision to take or which course of action to pursue. It can be especially useful if the implications of the decision are significant. For example, if the decision would cost a great deal of time or money to implement or if the ramifications of getting the decision wrong could be fatal for the business then scenario analysis can be a very powerful tool.
It can be used to assess the possible likely future of different strategic choices or it can be used to generate a combination of different scenarios that look at the same scenario but from three different perspectives – the optimistic version of events, the pessimistic version of events and the most likely scenario.
It is also a very useful tool if you are unclear about what is going to be involved in the execution of a strategy or decision as the process required pushes you to really engage with the scenario you are testing. This amplified engagement can help to anticipate more of the pros and cons of each scenario therefore reducing risk and directing you to the best choice.
What business questions is it helping me to answer?
Scenario analysis can help the decision-making process by looking at the likely implications of that decision and how it might or could pan out in the future. It can help you to answer:
- Which strategic direction do we take?
- What are the best countries to expand our business into?
- Do I open in a new location or upgrade or expand the retail stores I currently have?
- Do I invest in a new market or seek to increase market share in the one I’m already in?
Scenario analysis can help to prevent errors of judgement and direct strategy.
How do I use it?
Essentially, what you are doing in scenario analysis is attempting to work out if the world would turn out a certain way if certain conditions were met. The process usually consists of a five-stage process:
- Define the problem.
- Gather the data.
- Separate certainties from uncertainties.
- Develop scenarios.
- Use the outcome in your planning.
Define the problem
Obviously the only reason you would use scenario analysis is if you were trying to gain insight into a particular challenge. The first step is therefore to define the problem you are trying to solve or gain greater understanding of it so that you can make the best decision.
It is also important to think about the time horizon. Most decisions need to be made within a timeline so make sure you have enough time to conduct the scenario analysis before the decision needs to be made.
Gather the data
So what is going to affect or influence the scenario you are considering? Identify what data and information you need to make the analysis as realistic as possible. You may, for example, consider trends and what uncertainties exist around your scenario.
You could use PESTLE analysis as a guide in gathering data – what could affect the outcome when you consider politics, economy, social, technical, legal and environmental issues? Also seek to identify the key assumptions on which the plan might depend.
Separate the certainties from the uncertainties
You will invariably come into the analysis process with a host of assumptions and preconceptions about how the analysis will turn out. It is important that you become aware of what those assumptions are so you can really shine a light of enquiry on to those assumptions and separate the certainties from the uncertainties.
Take a moment to challenge all your current assumptions and decide if they are certainties or uncertainties. It is always best to err on the side of caution; that way if the outcome is better than expected it’s a bonus, whereas an outcome worse than expected could be a disaster and would negate the whole purpose of running the analysis in the first place.
List the uncertainties in order of priority with the largest, most significant uncertainties at the top.
Develop scenarios
Starting with the top uncertainty – what would you consider to be a good outcome for that uncertainty? What would be a bad outcome? Once you’ve done this develop a story of the future around each that marries the certainties with the outcome you’ve chosen.
Do the same with each of the major uncertainties you’ve listed.
Use the scenarios in your planning
This process will give you much more knowledge and clarity around the situation you face and you can use the scenarios to influence and guide your planning.
There are commercially available scenario analysis tools on the market that can make scenario planning much easier.
Practical example
Scenario analysis is essentially a planning tool that can allow you to identify various factors that could affect a proposed plan and assess how those factors may play out in the future so you can see which alternative is most likely to work out well.
Say you are planning to start a new business that helps clients implement a specific new software program. You want the business to be turning over £1 million within five years. But is that feasible? A friend suggests that you run some scenario analysis to help you get a clear picture of that challenge and how likely that outcome really is.
You gather data on trends and current realities. Among other things, you discover that people tend to hold off on buying new hardware and software during a recession and you are currently in a recession. That said, economic pressure also increases potential customers’ desire to increase productivity and your software can meet that need. The software vendor is also working on an upgrade that is already at beta testing, so your clients could potentially reap even greater rewards. The only possible challenge is that your software is quite new and innovative so you are unsure how quickly you could recruit consultants to implement the software.
Next stage is to separate certainties from uncertainties. The current economy is an uncertainty, but the recession has definitely increased the number of people looking for work so you can feel more confident that you can find the necessary employees to make this work. You realise you haven’t actually seen the beta version of the upgrade so you visit the vendor to see what’s in the pipeline and are certain that the new version will be even more beneficial to your clients. What is uncertain, however, is whether or not any other software company is working on anything similar or better that could seriously undermine your planning and potential outcome.
Based on what you’ve discovered you create three scenarios to test:
- Best-case scenario assumes that the economy pulls out of recession and grows steadily over the next five years. It also assumes that you’ve chosen the right software and that no big company swoops in and surpasses your software.
- No great scenario assumes the recession continues for at least another two years, which would probably mean that at least 25 per cent of your clients would choose to defer their investment.
- Worst-case scenario assumes that a global software giant does enter your market and establishes itself within two years. This would definitely put pressure on your new business.
Having looked at the scenarios and considered their planning implications you realise that most of the risk is in the short term. While the economy is a challenge, you could take advantage of this by educating clients in the productivity improvements that software will deliver. The bigger issue is the possibility of another player entering the market with better software, so you decide to make the business flexible by hiring a mix of full-time and contract workers so you can scale up and scale down quickly depending on what actually happens. Plus you need to keep a very keen eye on what rival software companies are doing so you can cross-train personnel if necessary.
By appreciating the very real threat a rival software company poses to your business you can anticipate that challenge, and are well positioned to monitor it closely so that it does not have the chance to de-rail your plans.
Tips and traps
While the outcome of scenario analysis can greatly facilitate better decision making and help to reduce the risk of big decisions, the process of the analysis is probably more important. By creating a few scenarios – even the out of left-field scenario – you can end up uncovering new information or insights that were previously unknown that can not only assist the outcome but what’s happening in the business right now.
That said, it’s easy to assume that what you think you know about the current situation is true and jump to conclusions, or automatically assume that you are certain about some of the influencing factors. Scenario analysis will always yield the best results when you challenge all your assumptions in the process.
Further reading and references
A lot of the information in this section is based on the great information provided on the Mind Tools website:
Other useful sites include: