Scenario Planning

Many companies are struggling to get the most out of planning – too often it is monovalent and does not support the dynamic steering of a company which is essential, especially in volatile and unpredictable times like right now. One of the most common short fallings is that many companies plan only one realistic business-scenario. Either the company has not planned more than one scenario, or the other scenarios are not plausible, because they are not built on realistic risk-evaluations. However, to support corporate management as best as possible, companies should reevaluate how they can integrate structured risk management with planning and how insightful scenarios are built. In this article, we examine how scenarios are built properly, how risk management can be integrated in the planning process and how companies can implement scenario planning in their SAP-ERP-landscape.

Thinking in only best- and worst-case scenarios is flawed

One setup we often see in planning is the creation of a “real case” scenario in combination with both a maximum-positive (best case) and maximum-negative (worst case) scenario. However, the creation of these individual scenarios has its flaws. Usually, these extreme scenarios are based on the premise that either all positive or all negative risks occur to full extent. However, the probability of these scenarios to occur is extremely low – usually they are off to an extent that even the scenario itself becomes implausible and therefore irrelevant to corporate management. Especially in the worst-case scenario, oftentimes all negative risks are added up. If these were the case, however, the scenario would always predict that the company goes bankrupt. As tough as it may sound – there are always enough negative risks around to threaten a company in its existence. If the worst-case scenario says that the company goes bankrupt, in most cases it does not really help the management to steer properly. If, on the other hand, the worst case scenario says something different, one can assume that it is mostly randomly drawn up and some risks are included while others are not – therefore, it is not really a worst case scenario.

The same logic applies for the best-case scenario. If all positive risks and opportunities would be included, managements would most likely have to pivot to other business models or constantly pursue change in an unhealthy manner. The best-case scenario oftentimes only includes a certain selection of positive risks, therefore, again is not a true best-case scenario.

This short evaluation of the three-scenario technique in planning offers two insights: Firstly, every scenario should be accompanied by the assumptions, which risks are included, and which are not. Secondly, this requires a comprehensive identification and documentation of all risks possible. This is usually a task of risk management.

Linking controlling and risk management to improve the planning quality

A better approach is to methodically link planning with risk management. Risk management and controlling show considerable interdependencies. If risk is defined as a deviation from a planned result, a direct link to planning is established. Analyses of the potential causes of plan deviations (risk identification), their evaluation (risk measurement), categorization (preventable risk, strategic risk, external risk), (risk) management as well as control are important for both areas at the same time. The most important take-away for organizations should be to have one structured and unified way of identifying risks, evaluating them for their likelihood and damage-level at entry and linking them to corporate steering tools. By combining risk management with controlling, companies can build a shared platform for risk identification and evaluation across the entire organization and create a transparent information-basis for decision-making. Also, it becomes much easier to quickly initiate risk-mitigating measures.

Sometimes that can mean bringing risk management and controlling organizationally closer together. A missing link between both areas is often the reason companies are not in the position to derive the aggregated overall risk volume in a transparent and well-founded manner.

After identifying and evaluating the risks, it is essential for controlling to link them to the balance sheet, P&L and Cash Flow statement to assess how they are linked to the different positions in these financial statements. This step is necessary to make sure that the impact of a risk is disclosed in its entirety. On top of that, linking the risks to financial statements is oftentimes the key to creating management attention. Thereby, the risk and its impacts become tangible and it is more likely that appropriate measures are initiated. Of course, risks can consist of internal and external factors, and oftentimes they are interdependent. Therefore, almost any risk has an impact on several positions in the financial statements.

Identifying risks, evaluating risks in a common and structured way and linking them to the financial statements are oftentimes the most important steps towards a qualitatively good planning process with well-founded scenarios. Linking controlling with risk management and equipping them with the rights techniques can therefore already improve the planning quality and ensure the definition of appropriate measures. This can also include to identify plan assumptions that are uncertain and should therefore be formulated not in terms of monovalent plan numbers but instead as risks with a certain probability-distribution.

Bandwidth planning over several years provides valuable input for corporate steering

If organizations build their planning scenarios on these foundations and make transparent which risks are included or excluded in each scenario, they are already one big step ahead. However, organisations which want to actively act on the premise of volatility and anticipate future outcomes take it one step further than scenario planning and establish what is called “bandwidth planning”. Bandwidth planning pursues the goal of risk- and value-oriented corporate management and assumes that every deviation from the plan represents a risk – either a positive or a negative risk. To create true bandwidth simulation and/or bandwidth planning, it is not enough to create a best-case and a worst-case scenario. Instead, a large number of scenarios are built, consisting of different combinations of included and excluded risks. Especially, since risks can be interdependent and therefore cannot be simply added up, in contrast to e.g. cost or revenue.

Naturally, the more scenarios are built and calculated the more accurate the distribution curve of future company performance is. Companies that take this principle all the way use the so called “Monte-Carlo-Simulation”. In the Monte-Carlo-Simulation, many thousands of different scenarios are calculated based on all possible combinations of risks being included and excluded. These scenarios are then analyzed regarding their outcome and impact on financial statements. This can lead to the situation that different combinations of risk can result in common outcomes, especially on an aggregated P&L, balance sheet or cash flow view. Therefore, an even more comprehensive distribution curve of outcomes is created. Management can take away which business scenarios are most like and can also find out, which combination of risks can be existentially problematic for a company. Based on this, precautionary measures can be initiated.

This multiplicity of scenarios then creates a true “bandwidth” of possible outcomes. To create a realistic funnel of scenarios and not end up with the already discussed best- and worst-case scenarios again, many organizations “cut off” scenarios that fall below a certain threshold of probability. Thus, the corridor of possible outcomes is narrowed, and the boarders of this corridor are justified by stochastic probability instead of arbitrariness.

Another aspect of meaningful bandwidth planning is to plan in different time-horizons: from an operational short-term planning that creates budgets via a mid-term planning that links strategy to operations to true long-term strategic planning. Thinking in bandwidths should be part of every planning activity, irrespective of its time horizon. Naturally, a long-term strategic perspective can have a much wider range of outcomes, as more and more risks can occur over time compared to a short-term perspective. There, the range of possible outcomes should be much narrower, as the likelihood of risks to occur in a shorter period is also lower. However, it is important for every company to make bandwidth analysis and planning for at least 3-5 years ahead. This helps to grasp the real risk-position the company is exposed to and it helps to identify possible need for action early on – and is also legally mandatory for public companies in many countries.

Identifying, storing, and working with a multiplicity of risks should, however, not be done manually, as it can create unnecessary labor as well as be a source of error and confusion. Instead, the SAP-landscape of many companies offers everything that is required for the implementation of bandwidth planning.

Bandwidth planning with SAP

If companies want to establish a complete Monte-Carlo-Simulation, special tools that are solely designed for this purpose are recommended. Risks and their evaluation as well as financial statements can be entered, linked and the possible outcomes and distribution curves are calculated by the tool.

However, if companies want to establish bandwidth planning (or multiple scenario planning) without going to the extremes, many demands can be met by the SAP-landscape, by SAP BW. Various scenarios can be represented using plan versions, while BW-facilitates the recording of both plan values and risk weighting. SAP enables companies to link actual and plan values in an integrated environment without generating redundant data and having to manage it in various tools. In addition to the display and preparation of actual figures, planning data can be entered directly via SAP BW and thus be made available immediately and reported in an integrated manner. For example, a template-sheet for all risks can be created where the risk is defined, evaluated and the impact on P&L-positions is entered. Every risk gets assigned an ID and by selecting different risk IDs, scenarios are created.

The data in SAP BW-IP is stored in real-time capable “InfoProviders”. In custom-made user interfaces the data can be entered or changed and logical characteristic relationships between the data (e.g. hierarchical structures, interdependencies, or predefined impacts on plan-positions) can be determined. In addition, complex planning formulas can be defined, and comprehensive forecasting functions can be used.

With SAP BW, Excel-based input tools do not have to be prepared, sent, collected, quality-assured and processed in a time-consuming and costly manner. Instead, all the necessary data is available in the central ERP-system which considerably reduces the workload for all involved departments.

If you want to get more information on how to implement scenario or bandwidth planning in your organisation, feel free to contact Andy Draxinger (andy.draxinger@www.draxingerlentz.de) or Fabian Winckler (fabian.winckler@www.draxingerlentz.de)