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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.

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