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Friday, February 27, 2009

So What's Wrong with Scenario Analysis Anyway?

When I meet with CFO's, I like to ask if they are doing scenario analysis. Because they all went to good MBA programs, they universally say "yes". I don't think that is a good idea. Let's explore what happens.

First, your team meets for a planning offsite at a nice location. So far, so good. Then among the SWOTs and whiteboarding session you come up with a list of key drivers for your business. There are always at least 4 or 5. Each driver has two or more possible values (either we are in a high regulatory environmnet or lax; competitive issues are increasing or decreasing; pricing power is high or low; channel effectiveness etc). With that many variables in play there are 20+ possible scenarios to consider.

Next, the group narrows the list of scenarios to a 'plausible' 3-4. (uh oh). The plausible few get the full integrated operational and financial planning process applied to them.

Then, reality hits. One of the implausible scenarios plays out. At a recent meeting with an airline CFO, he said when we were doing our planning the main concern was fuel cost -- we never considered a scenario where the price of oil is under $40.

Another way to approach this situation is to not try to guess as to which scenarios are plausible. In eliminating all but a few scenarios, you have just thrown out the most valuable part of the analysis: the rare, but highly-impactful events in the scenarios in the 'tails' of your expectations.

By keeping all scenarios, and using simulation to model the uncertainty in your key drivers, you can get a more realistic view of your entire assessment of the future. While no one can predict the future, with simulation you can better anticipate it so that you can be prepared for when the scenarios in the 'tails' play out.

Thursday, February 26, 2009

Scenarios v. Strategies v. Simulation v. Sensitivity

In speaking with a variety of CFOs and risk professionals recently, it seems that there is come confusion over these terms. So before we go any further, let me clarify how I think about these terms. In any business decision, there are things you control (decision variables) and things you cannot control (assumptions).

Scenarios: A comprehensive set of assumptions that tell a consistent story. For example, Obama gets elected, price of oil is under $50, dollar is weak, demand is soft, labor is cheap, etc. would be one scenario. McCain is elected, oil is at $150+, strong dollar, etc. would be another scenario and so on. Scenarios show one possible outcome at a time.

Strategies: A comprehensive set of decisions that tell a consistent story. For example, we will be the low-cost, hi-volume provider in our market using a fast-follower product strategy. Another strategy may be to conserve cash, reduce capicity, protect margine etc. A third may be to spend agressively to gain share.

Sensitivity: This is the worst-best-most-likely scenarios.

Simulations: Simulations simultaneously test all assumptions across a broad range of possibilities. A simulation yields the probability of any particular outcome. This is what Crystal Ball does.

Thursday, February 12, 2009

So once you start 'Thinking in Ranges'; the next key step is to understand what is driving that variability. If you are an executive making decisions based on numbers, then you should always:
1. Know the range around the number, and
2. Know the key drivers of that range.

A sensitivity chart shows you those drivers. It much more realistic than a tornado chart because it is varying all of the assumptions simultaneously and each assumptions varies according to its own distribution.

Sensitivity charts are also handy for negotiation and expense cutting. When negotiating, you know which dimensions you can compromise on and how much while still preserving your overall objective. With expense cutting, you can trim expense in low impact areas to preserve your upside.

I like to think of these as "Know What Matters" or "Where to Focus" charts. And every organization needs help in understanding where to focus its energies.

Tuesday, February 10, 2009

So this is where it all began. I first saw a Crystal Ball forecast chart in the summer of '94 and it changed how I thought about the world.

Thinking in Ranges. No longer could I just see a number, but rather I could see the range around the number. How different would it have to be for me to make a different decision?

When I received an MBA, I especially liked spreadsheets and NPV calcs. Of course, the whole point of NPV is what is the probability that NPV>0? With just Excel, you can only see Possibilities, not Probabilities. With Crystal Ball you can see that left, red tail. That is the key to understanding a project's risk and uncertainty.

Uncertainty Management

Having been involved with UM since 1994, I thought I'd share some thoughts on the recent focus on these 'uncertain' times.