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Scenario Analysis: Why is it so important?

What Is Scenario Analysis?

Scenario analysis is a tool used to evaluate organizational decisions. Initially, a base case scenario is created for the organization that uses current and assumed future conditions. Three scenarios are prepared: best-case, worst-case, and base case.

The best-case scenario considers what will happen if everything goes the organization's way, while the worst-case scenario considers the negative impact of factors that depreciate returns, such as an economic recession, higher interest rates, global disruption and poor sales.

Why does my business need Scenario Planning?

This strategy is used by organizations to assess the effects of future changes on their investment and other decisions. Scenario analysis helps them test the robustness of their decision-making in anticipation of unexpected influences, identify potential opportunities, and identify potential challenges.

The main advantages of Scenario Planning:

Identify potential threats and opportunities your business may face:

By identifying potential threats, organizations can change the scope of their decisions to minimize the impact of potential threats.  Scenario Planning also helps in identifying emerging trends. By analyzing the probable impact of potential opportunities, organizations can make informed decisions and adjust their strategies to leverage the benefits of new developments.

By examining a range of scenarios, you can test your business's ability to cope with uncertain or unexpected circumstances.

Understanding the effector potential external factors and their effects:

Identifying the external factors that influence decisions will help projects evaluate their projected profit and return. If there are no changes in the economy or surrounding environment, then it does not have to affect predictions.

The ability to test decisions

Managers advocating organizational investment are naturally optimistic, but research shows that many investments don't realize the benefits that were predicted. Scenarios analyze outcomes to project and understand how decisions will react in a range of circumstances. Best and worst-case scenarios are explored, resulting in the ability to determine the potential effects of an implemented plan on all possible instances where that decision may be utilized.

How to perform use scenario analysis:

1) Define the problem

First, you need to compile detailed information about the problem at hand. This includes time frame, scope and decision variables. From here you can form a greater understanding of all possible outcomes of the issue at hand.

2) Define the key variables in your analysis.

A common way to perform scenario analysis is via a technique called "SWOT" analysis, which involves identifying the "strengths" and "weaknesses," as well as the "opportunities" and "threats," associated with your businesses issue at hand. In the next step, the organization must create a list of known and unknown variables that could affect their organization. Known variables, such as unit pricing and sales volumes overtime data, are collected from historical business records. Unknown variables would include any affected by trade disputes, higher tariffs, foreign currency exchange rates or recessionary trends.

3) Run a what-if scenario analysis

After identifying which variables could impact the organization, it used the what-if scenario analysis to evaluate best and worst-case scenarios, then address any vulnerabilities. This is in contrast to sensitivity analysis that evaluates each variable separately rather than change all at once.

4) Establish these key features to aid you in your decision making

Base case scenario – It is the average scenario, based on management assumptions.

Best-case scenario - what will happen if everything goes the organization's way,

Worst-case scenario - the negative impact of factors that depreciate returns, such as an economic recession, higher interest rates, global disruption and poor sales.

5) Takeaways Scenario Analysis

Implement the changes you need, to make your plan more realistic and implement what can be done to minimize the effect of the changes.  

Use Scenario analysis to help you make better decisions for your business by looking at a variety of factors that are likely to affect them all in different ways.

Be sure to use extreme caution when using any kind of financial prediction or forecasting, as if the scenarios are even slightly off, it can be very misleading.  You want to remain as flexible and adaptable as possible when attempting to predict the future of your business so it can prepare for whatever curveballs life may throw at it. All in all, proper planning gives you a better chance of success.

What are the Drawbacks of Scenario Analysis?

Usually requires a high level of skill

Scenario analysis tends to be a demanding and time-consuming process that requires high-level skills and expertise, however with futrli we've made it simple. Making a detailed scenario analysis often involves making hundreds of small but time-consuming choices. This is why using the futrli system to run your scenarios, can save you up to 50% hassles and 25% time.

Unforeseen outcomes

Due to the difficulty in forecasting what may occur in the future, the actual outcome may be fully unexpected and not foreseen in the financial modeling.

Cannot model every scenario

Predicting all possible scenarios for a given investment is difficult, and investors must be aware that there’s always some amount of risk associated with your choice.

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