Scenario analysis is a very powerful tool for SMEs. Unfortunately, most business owners are unaware of what it is, how it can be used, or think it only applies to large corporates.
Those people are missing out.
What is Scenario Analysis?
As the name would suggest, you analyse a scenario to work out the financial impact on your business. And you start by asking a question.
What would happen if I lost my biggest customer? What would happen if I started producing this new product? Should I lease this new piece of machinery or buy it outright?
Scenario analysis can be applied to pretty much any scenario you can think of that will affect your business.
The next step is to highlight the items in your cash flow and profit and loss statement that will be impacted by your chosen scenarios and adjust them to fit. You also gather all know figures for factors that aren’t currently part of your P&L statement or are external or intangible factors. An example would be your anticipated growth projections for a new product.
Except in very simple examples, you are unlikely to know all the exact figures. But research and knowing your business and your industry will allow you to use a combination of known facts and figures, and educated assumptions to frame your analysis.
Then you bring it all together and filter it through to see what the impact is for your business.
Why is it so powerful?
Scenario analysis is about as close to a crystal ball as you are likely to find. You can analyse the impacts of a decision or plan before you commit resources.
It can be applied to almost any scenario. You can apply multiple changes as part of a single scenario, compare multiple scenarios to determine which gives the optimum result, use it to analyse the ‘sum-of-the-parts’ for a scenario, or to analyse flow-on effects.
You can also either work forward and see “what happens if?”, or work backward from a desired outcome to see what would be necessary to make it happen.
It can be as simple or complex as you like. Scenario analysis is a very flexible, very powerful tool.
Whats the benefit?
In business, “give it a go and see” can be a very costly exercise.
Business owners continually lament their costly mistakes, “Well we tried X, but we didn’t take into account the impact of Y, and it just ended up costing money.”
Using scenario analysis to evaluate an idea before you commit to it will do one of two things:
1. It will show you in black and white figures that your plan has merit and is worth pursuing further.
2. It will highlight that you are about to make a potentially large and costly mistake.
So, either you get confidence in your idea, with the figures to back it up and an idea of the risk/margins involved, OR you save yourself time, money and heartache.
Either way: Very. Valuable. Exercise.
In terms of future planning, the results of changes you make to your business can take twelve months or more to flow through to your bottom line and show you in real terms the impact of your decision. And during that time, you are likely to have implemented more than just one change.
This can make it very difficult to determine which of the changes you’ve made is having the impact and to what extent. With scenario analysis, you can exclude or isolate individual changes to determine their impact.
While you can never have 100% certainty about a plan, running the numbers before starting a project can save you big.
Simple vs. complex scenarios
As I mentioned before, scenario analysis begins with a question. And your analysis can be as simple or complex as you need it to be. The main deciding factor is how far down the rabbit hole you want to go.
Simple scenarios tend to have only one or two impacting factors and be based mostly on known figures, and/or highly reliable assumptions. Things like:
- Roster optimisation based on cost of labor.
- The face-value impact to your profit and loss statement if you lose your biggest customer.
- The viability of outsourcing certain tasks to achieve better work-life balance.
These are all examples of relatively simple scenarios where most, if not all the actual figures are known, and you could be highly confident of any small assumptions you may need to make.
The results from analysis like this provide a business with highly useful information, but they are also relatively superficial.
For example, it would be very useful to know that losing your biggest customer would, all other factors remaining the same, reduce your gross profit by 20% due to loss of sales. However, there are many, many more factors at play that can be investigated in this scenario.
Going down the rabbit hole
Say you have a manufacturing operation. As well as identifying this potential 20% loss in gross profit you could expand the scenario to look at:
- Should you scale back production short term?
- Impacts to purchasing including meeting thresholds for purchasing discounts.
- Impact to warehousing, stock handling and distribution strategies and costs.
- Direct and indirect staff costs (do you now have a relationship manager with nothing to do, impact on workload of admin and accounts staff, etc.).
- Viability of product lines (is this product line viable anymore).
- Does this open up an opportunity to focus on more profitable products?
- Impacts to cash flow, debt servicing, and timeframes for replacement revenue streams.
- Impacts on viability of financing arrangements for plant and machinery.
The list could go on and on. You might discover by the end of your analysis that losing your biggest client could really be an opportunity for your business.
You can also apply this sort of analysis before taking on a large client or contract to determine if it will actually benefit your business. It can help you avoid a situation where you just end up working harder for less, or worse. Ask any business banker and they will have stories of how winning a big contract was the beginning of the end for more than one business.
Can I do it myself?
Absolutely. While more complex scenarios can, as the name suggests, become very involved, simple scenario analysis is something that all business owners can and should consider doing to improve their business. Even simple analysis will provide you with very valuable information.
Scenario analysis gives you the data you need to make a really informed decision about what’s best for your circumstance and your business.
Unless you really love crunching numbers, complex scenario analysis is probably something you’ll want help with. When you start looking at multiple impacting factors, scenarios that rely heavily on assumptions, or require extensive research, the analysis does become involved. That’s why there are people who specialise in this field.
There are a couple of main points to keep in mind if you decide to DIY:
- Try a simple scenario first. Don’t set yourself up for a headache by starting with a scenario that has multiple impacting factors, or relies heavily on assumptions.
- Do your research and try to get as many ‘solid’ figures as you can. Limit the use of assumptions where you can.
- Where you need to rely on assumptions, ensure they are well researched and feasible.
- Make sure you understand the limitations of any assumptions you are relying on and take this into account when making any decisions based on your analysis.
Of course, if you are the sort of person who hates spreadsheets, or would rather pull teeth than analyse numbers, there is always the option to “pay the man to do the thing”.
The main point to take away is that scenario analysis exists. It is available to SMEs. And it can have incredible benefits for your business.
What “what if” questions have you been pondering lately in relation to your business?