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Scenario Analysis Explained

Rami Ali | Senior Product Marketing Manager
October 28, 2020

In business as in life, the only thing that’s certain is uncertainty.

Scenario analysis is a powerful process for navigating the
uncertainty of the future by analyzing the potential business
impacts of future events and considering alternative possible
outcomes. Companies can use scenario analysis to explore a Top

broad range of possible future situations, from economic

slowdowns and natural disasters to expanding a product line or
opening new offices.

What Is Scenario Analysis?

Scenario analysis is a technique that provides a rational and
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structured way to analyze the future. Businesses can use it to
examine different potential impacts ofHow
negative and positive
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change?
events, such as:

What are the possible impacts on the business of an

economic slowdown?
What happens to revenue and profitability if the cost of
various raw materials rises?
What revenues might be generated by a new product line?
 How would the business be impacted by the unexpected
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market entry of new competitors?

Scenario analysis doesn’t attempt to predict a single outcome

from any of these events. Instead, it examines a spectrum of
different potential situations and outcomes, typically ranging
from a best-case to worst-case scenario. Businesses can then
conduct scenario planning to better prepare for these events
and their potential impacts.

Scenario analysis is not new. It was pioneered by the U.S. military

during the mid-1900s, and Shell Oil started using it during the
1970s to analyze and respond to fluctuations in global oil
supplies. It’s now widely used by businesses, thanks in part to
financial modeling tools that eliminate much of the manual
effort and make the process much faster. It may be even more
important for small businesses than for larger ones, since smaller
companies may be more heavily impacted by a single event.
Scenario analysis is employed by financial services companies to
analyze risks and make investment decisions, and it can even be
used to analyze household finances.

Key Takeaways
Scenario analysis helps businesses plan for the future by
analyzing the business impact of potential events and
strategic decisions.
Scenario analysis is valuable for businesses of any size and
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can be used to analyze a wide variety Chat from the
of situations,
impact of economic slowdowns and
Howdisasters to new
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change?
product launches.
Modern software tools allow finance teams to leverage
financial intelligence and built-in features to rapidly model
multiple scenarios to deal with change and give them
confidence in decision making.
Why Businesses Need Scenario
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Analysis
Changes that impact the business environment can happen
unexpectedly and suddenly—as demonstrated in magnified
ways by the global pandemic in 2020. Scenario analysis allows
organizations to analyze and quantify potential business impacts
of such events, so they can plan accordingly. It can also be used
to assess the benefit and risks of different business decisions,
such as the potential impact on revenue and profitability of
building new facilities. It helps businesses avoid diving blindly
into a risky investment or project.

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and long-term success. Whether you’re newly tasked with establishing
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How Scenario Analysis Works

A scenario analysis considers a potential event and the business
scenarios that may result—the potential future states or, as
SalesGenerally,
they’re sometimes called, alternative worlds. Chat a range of
scenarios are considered, from best toHow
worst. Forbusiness
is your each scenario,
adapting to
change?
the company makes assumptions about its effect on different
factors that are important to the business, such as interest rates
or the cost of raw materials. These assumptions are then used as
input variables to model the impact of each scenario on the
business.

Scenario analysis may consider many different factors. Analysis

of the potential financial impact of constructing a new facility
might consider labor, rent, utilities, taxes and other costs, for
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example.

Let’s take the imaginary example of Kooky Cooks Inc., a maker of

innovative kitchen equipment. The company comes up with an
idea for a new appliance that not only cooks food but also cleans
itself afterwards. However, it will take at least a year to get the
product to market and financial analysts are predicting
worsening economic conditions over that period.

The company could use scenario analysis to examine the

potential impacts of economic conditions on the revenues and
profits generated by the new product. Economic conditions may
affect a variety of factors, from customer demand to the cost of
raw materials. The company could consider a range of scenarios,
each generating a different set of assumptions.

In one scenario, sales might fall by 20% because customer

demand declines due to the economic conditions, while the cost
of raw materials rises because some suppliers go out of business
and there’s less competition among the remaining providers.
However, rent on manufacturing facilities could fall by 10% and
the company might be able to borrow money at a lower interest
rate to fund manufacturing start-up costs. Scenario analysis
could consider the impact of all these factors.

Types of Scenarios
One key benefit of effective scenario analysis is that it drives
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decision-makers to consider a range of potential cases, each with
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its own set of assumptions. This can help prevent businesses
change?
from becoming fixated on a single, over-optimistic view of the
future and developing business plans that assume ideal
conditions and outcomes.

Cases in Scenario Analysis

A scenario analysis generally considers at least three types of
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scenarios:

Base-case scenario: A baseline scenario based on current,

commonly accepted assumptions.
Worst-case scenario: The most negative set of
assumptions.
Best-case scenario: The ideal projected scenario to achieve
goals and objectives.

For example, in Kooky Cooks’ best-case scenario, revenues

might actually rise because people stay at home and do more
cooking instead of eating out. In the worst-case scenario,
demand falls while all costs rise. In the base case, current trends
continue into the future. Each of these scenarios has a different
impact on revenue and profit.

Examining a range of scenarios provides the company with a

range of possible outcomes for planning purposes. For
example, the best-case scenario might result in a net profit
margin of 20%, while the worst-case scenario results in a margin
of 5%. The company uses the range of 5%-20% to guide its
decisions about investing in the manufacture of new products.

A company may also assign probabilities to each scenario, based

on its assessment of the likelihood that it will occur. This can help
to guide the company’s subsequent planning and decisions
about how to allocate resources.

Multiple scenario analysis: Scenario analysis doesn’t have to

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be restricted to just three possible cases. Chat may
A company
How is your business adapting to
consider many different scenarios, each using a different set of
change?
assumptions. The tradeoff is more scenarios require more effort
to analyze them.

Benefits of Scenario Analysis

Key benefits of scenario analysis include:
 It helps companies manage risks more proactively by
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assessing the impact of potential future events and
situations.
It can help businesses make better decisions by investigating
the risks and benefits of different options.
The methodical approach to analyzing the future may
enable companies to spot opportunities or risks that might
otherwise be overlooked.

Challenges of Scenario Analysis

Scenario analysis can be a time-consuming process that
requires specific skills and expertise, although modeling
tools can help.
It can be difficult to envision all possible scenarios, make
realistic assumptions and assign probabilities to them.

Scenario Analysis vs. Sensitivity

Analysis
Scenario analysis is sometimes confused with sensitivity analysis.
But there’s a key difference. Scenario analysis makes
assumptions about multiple variables and factors for possible
future scenarios and looks at how each would affect the
business. Sensitivity analysis, in contrast, examines the effect of
changing a single input variable while keeping all the other
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variables constant. For example, a company might examine how
How is your business adapting to
a change in the lending interest rate could affect the company’s
change?
profitability or cash flow.

6 Steps to Perform a Scenario

Analysis
Taking a methodical approach to scenario analysis can help to
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ensure that the company focuses on the most important
scenarios, considers the most relevant factors, and gets the most
benefit from the process. Here are six key steps:

1. Define the issue and the decisions that you need to make.
2. Gather data and identify key factors, trends and
uncertainties that may affect the plan. This may include
external factors such as market shifts, political changes,
competitive threats and trends in customer behavior. It may
also include internal factors such as the company’s key
strengths and development capabilities.
3. Develop a scenario planning template. This is generally a
financial model (see below) that enables the company to
plug in various assumptions and examine the impact on key
metrics such as revenue or net income.
4. Develop scenarios. Develop base-, worst- and best-case
scenarios, plus others if desired. To get the broadest view of
potential scenarios and assumptions it’s important to involve
people with relevant knowledge across the organization.
This can also help avoid unconscious bias and potential
blind spots.
5. Evaluate the scenarios. Analyze the potential impact of
each scenario.
6. Plan accordingly. Use the scenarios you have developed in
your planning, weighing the most likely risks and rewards.

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What is Scenario Modeling?
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change?
Scenario analysis generally captures a range of possible
outcomes that will help ensure agility, business continuity and
growth. In times of uncertainty, scenario modeling helps
businesses build models that allow them to assess the impact of
their business plans on revenue, expenses and cash flow.

Originally, the calculations were performed manually. Now,

companies can use a variety of tools, from spreadsheets to
sophisticated modeling software that is integrated with financial
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and operational source systems.

Plan & Forecast

More Accurately
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Scenario Analysis and Financial

Modeling
Scenario analysis imagines a range of scenarios, each with its
own assumptions. Once the company describes each scenario
and the associated assumptions, it can perform the analysis by
entering those assumptions into a financial model. The model
turns the assumptions into quantifiable impacts, such as a 10%
increase in revenue. The value of the analysis depends on the
accuracy of the model and the data on which it is built. Realistic
assumptions and an in-depth knowledge of the company’s
business are key to creating an accurate model.

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Using Financial Modeling Tools for
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Scenario Analysis change?

In the past, scenario analysis was an extremely labor-intensive

manual process. Typically, it involved manually gathering data
from disparate sources inside and outside the company and
entering the data into custom-built spreadsheet-based financial
models. The value of these models was limited by a variety of
factors, including the staff’s spreadsheet expertise and the ability
to gather information that was both comprehensive and up to
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date. Also, when the financial modeling process is static, it’s 
difficult to run what-if scenarios for exploring multiple options.

Modern financial modeling tools make scenario analysis much

faster and easier for companies of any size. For example, tools
that are integrated with enterprise resource planning (ERP)
systems can pull in current and historical financial and
operational data which increases data integrity by eliminating the
need to transfer data manually. Preconfigured scenario analysis
templates make it much easier to build models. These tools
greatly reduce the effort required for analysis, making it feasible
to conduct scenario analysis on a regular basis and apply it to
more situations, including smaller day-to-day operational
decisions and issues.

Learn about the unique solutions NetSuite offers

businesses to accelerate growth with a unified suite for
financials, operations, and commerce.

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