The COVID-19 pandemic has forced many companies to revise carefully crafted strategies and budgets in preparation for the “next normal.” One key question and challenge for top executives and strategic planners alike is how to best plan for an unclear future.
We have observed a sharp increase in the number of organizations applying scenario-based planning approaches to manage the uncertainty of the current situation and ensure they have sufficient cash reserves. In a recent McKinsey survey with CFOs of leading companies, 90 percent of respondents indicated using at least three scenarios to support their planning.
In precrisis times, scenario planning was often perceived as a stimulating, intellectual, and thought-provoking exercise—describing alternative future states and defining the best strategy for each one—but not one with a clear business impact. That notion has changed with the arrival of COVID-19.
We have observed a sharp increase in the number of organizations applying scenario-based planning approaches to manage the uncertainty of the current situation and ensure they have sufficient cash reserves.
Scenario-based planning has increased during the pandemic
Compared with precrisis levels, the number of scenarios under active consideration has increased, enabling companies to react swiftly to changing economic conditions as the crisis continues to unfold. In the recent CFO survey, more than 40 percent of respondents said they dedicated a significant share of their crisis management efforts to scenario-based cash planning. More than 70 percent claim they will hold back a reasonable amount of cash, based on scenario planning.
At the same time, many finance organizations, which rely on longer-term scenarios, have not yet been able to develop the agility required to plan for a COVID-19 world. Cash-constrained companies typically use 13-week cash forecast models to navigate a crisis. These models are poorly suited in the long run for strategic cash management. They are focused on the short term and include granular detail, such as single-purchase orders or billings, rather than alternative economic scenarios. This misalignment highlights the challenge companies face in applying lessons from the crisis and adopting dynamic scenario planning as part of the next normal operating playbook.
Five best practices have emerged
In our experience, leading players connect their internal finance systems with digital tools in the boardroom for agile impact modeling (Exhibit 1). Getting the scenario approach right is fundamental in these models, and five best practices have emerged.
Describe alternative future states—not just variations of today
Scenarios should be relatively far apart from one another to foster a meaningful debate on different courses of action.
Scenario models should not be too complex. Ideally, companies will identify a few key variables that describe both the external macroeconomic environment, such as sectorial GDP growth, and company-specific parameters, such as fixed operating cost. To limit redundancy, only the financial line items required for decision making should be simulated.
Connect scenario planning to action
Variables should be linked to specific, well-defined outcomes. For instance, simulated cost-reduction initiatives should have direct impact on planned fixed- or variable-cost lines.
Have the right granularity to steer your business
The chosen modeling granularity for each level of the business structure (such as business units, product lines, and regions) should be sufficient to show specific effects and suggest specific actions. For multinational companies modeling COVID-19 scenarios, for instance, a regional segmentation is fundamental to account for the different timing of the pandemic waves across geographies.
Select the modeling approach that is best for your company
In the deterministic approach to scenario modeling, at least three to four scenarios should be modeled to sufficiently cover the range of possible outcomes. Alternatively, stochastic models, which are based on a Monte Carlo simulation model using thousands of scenarios, can provide the additional probabilistic lens of expected outcomes.
Some companies have created stress scenarios—essentially a hybrid approach of deterministic and stochastic scenario modeling—based on the worst-possible outcomes for each macroeconomic driver. These scenarios are generated from a stochastic “uncertainty cube” that captures thousands of coherent stochastic scenarios for such macroeconomic variables over time (Exhibit 2). If a balance sheet withstands such a stress scenario, it will also hold up under scenarios that are more likely to materialize, taking into account the correlation between variables.
The COVID-19 pandemic has created a dynamic and difficult-to-predict environment with many uncertainties that challenge organizations and executives each day. Navigating through the crisis is a formidable task and scenario-based planning can be a valuable tool in preparing and planning for the next normal.