By Greg Silverman, Oct 05, 2020
Every day, businesses are utilizing different types of analyses to assist in their decision making. While, broadly speaking, analysis is the process used to break down complex data to gain insights into historic trends and forecasting, there are many different ways for businesses to reach a desired conclusion from their information.
In this post, we are specifically focusing on the purpose of scenario analysis. While typically used for corporate financial modeling (think base case scenarios using cash flow rates), this kind of analysis is especially beneficial for businesses wanting to optimize their investment strategy and plan for the changes in the market. With advancements in technology and simulation capabilities, scenario analysis has only become more effective at helping organizations plan for different scenarios - both good and bad.
Using a simulation that represents an accurate twin of the marketplace, businesses are able to run scenarios and understand how their actions have the power to change outcomes without experiencing true consequences. Let’s uncover how else performing scenario analysis benefits businesses in the current marketplace.
Scenario analysis is utilized across a variety of departments, from IT to marketing and finance, to help decision makers create strategies that are resilient and ready for unexpected circumstances. It’s typically used in one of two applications:
1. Retroactive Response: This is similar to how businesses use historical data to uncover trends. It’s a look back to consider “What if we didn’t do X, Y or Z?”. By changing the model retroactively through pulling different strategic levers, businesses gain insight into what the alternative outcomes are and run more counter-factual scenarios.
This is not to be confused with predictive analytics, but rather understood as a jumping off point for these forecasting capabilities. Scenario analysis started with “What if we did not do this in the past?” and with advanced computational power transformed into “What if we do this in the future?” - or predictive analysis as we know it today.
2. Knowledge Hub: As a business grows, expertise becomes dispersed across departments. Scenario analysis involves bringing together this specialized knowledge and employees' singular ideas into one platform the entire business benefits from. This cumulation of knowledge pulls from the idea James Surowiecki presented in his 2004 book, “The Wisdom of Crowds.” Surowiecki described the three principles of wisdom: decentralized, independent and diverse. Through this trifecta, it makes sense that crowds are collectively more knowledgeable (or wise) than a single person, which makes for more efficient and effective problem solving. Scenario analysis aggregates the knowledge from across an organization in one place for the ultimate platform to assist in the decision-making process.
Often, scenario analysis is confused with sensitivity analysis, and while the two processes are similar, they are used to accomplish different goals. As discussed at length in our previous post about sensitivity analysis, this form of analytics aggregation takes a range of input factors that drive performance and determines the spread and volatility of the range of outcomes. This effectively helps businesses determine how a single variable has the power to change the outcome of a decision.
Scenario analysis, on the other hand, helps businesses understand the future value of their investment depending on their actions and market conditions. While both analyses help organizations brace for uncertainty and optimize their investments, they work at different levels. Ultimately, scenario analysis has the power to test changes to multiple independent variables at the same time, while sensitivity analysis is done with single inputs. Each analysis is useful for businesses, but scenario planning provides quick insights into variables on a larger scale.
Scenario analysis has immense organizational value, but Gartner summarized the overarching benefits of the process best. When businesses adopt a scenario-based approach to planning, their strategies become more resilient to unforeseen changes, allowing them to create a response to best and worst-case future scenarios.
With disjointed processes and information spread throughout an organization, businesses may have a difficult time identifying the amount of risk and opportunities for growth. Scenario analysis brings this idea of the wisdom of crowds to the forefront so businesses are able to find and investigate compelling ideas with thousands of sensitive variables. Some scenarios will be near-perfect, others costly. But, in a safe, simulated environment businesses will identify how and why these scenarios happen to begin estimating the likelihood a wanted outcome will occur.
For instance, a company uses scenario analysis to determine its marketing strategy for high-speed online trading. After developing segments, identifying distribution channels and additional customer touchpoints, it runs its scenario with these multiple variables at play. From this model, the business identifies two segments that are more valuable than the others. This helps the company's leadership determine the kind of customer they want to attract to their brand and how to do it.
By constantly stress testing different components of the scenario, businesses become aware of the actions they need to take to enhance their investments and mitigate risk. With the insight gained from the modeled scenario, leaders and organizational decision makers optimize asset allocation to achieve their goals and expected return on their investment. The proven results help them be confident that when they sign off or deny a choice, they are doing so in the best interest of the company.
At this point, sensitivity analysis also comes in handy. By understanding which single variable (or more) has the power to make a scenario better or worse, businesses focus on these areas to ensure everything goes smoothly in the actual market. The seamless blend of technology and human action drives ideation - teams with intuition about future trends and transition risks are able to test their theories to see what occurs.
The next step in the process of scenario analysis is prescription - which Concentric excels in. Our platform puts the power of what-if analysis in the hands of the everyday business user to help organizations receive a path to their desired outcomes. Contact us today to learn more about optimizing your business’s investment decisions.