Introduction

The gist of the market, industry and environmental analysis should be the impact on the planned or existing business in the longer term which is typically 5-10 years of the horizon.

One of the formal ways to incorporate the elements of environmental analysis – to assess the impact on a particular business – is called Scenario Analysis. As the name suggests, Scenario analysis is a method of forecasting future events or conditions by considering multiple potentially high impact and uncertain outcomes. It is used  to evaluate the potential impacts of different events on the business environment a company is operating in.

In scenario analysis, several different scenarios are developed and analysed to consider the range of possible outcomes. For example, a company might consider several different economic scenarios, such as strong growth, moderate growth, and recession, and evaluate the potential impact of each scenario on its sales, expenses, and profits.

By considering multiple scenarios, companies can prepare for different opportunities and threats and be better equipped to handle unexpected events or changes in the business environment.

Scenario analysis is a useful tool for businesses, investors, and policy-makers because it helps to incorporate uncertainty and unpredictability into planning and decision-making processes, and provides a framework for assessing risk and opportunity.

Conducting Scenario Analysis

Scenario analysis can be conducted formally by following these steps:

Define the objectives of the analysis

Clearly state the purpose of the scenario analysis and what decisions or questions it is meant to inform. The narrower the scope of the decision or strategy, the more useful scenario analysis will be. For example, a focused strategic objective for an e-commerce player can be a decision to open brick-and-mortar shops to increase profitability by defraying the cost through supply chain synergies. Another example of the objective can be how a business will perform in a 5-10 year time horizon given different environmental factors.

Identify key variables

Determine the key variables or drivers that will impact the objective of the scenario analysis. The impact could be positive or negative and it is important to assess the impact to not only look into the downsides but also the opportunities that may be presented by the changing scenarios.  This could include wars, pandemics, economic indicators, industry trends, regulatory changes, or other factors.  Practitioners should note that scenario analysis is an analysis of external factors with little or no control by the businesses. Thus the chosen variables are, by definition, external to the organisation undertaking the scenario analysis.

When identifying the variables, the focus should also be on the novel risk events which are defined as the risks that arise from[1] :

• Unforeseen events – by definition they are difficult to envisage and it should be a creative exercise. A common way is to look back in the industry and think of the events which have been rare occurrences. Spanish flu between 1918-20 and COVID-2020 are the typical very rare and unforeseen events
• Complex combinations of apparently routine events. For example, supply side constraints imposed by oil exporting nation and high interest rates can together wreak havoc directly or indirectly on the businesses.
• Events that may appear familiar but occur at an unprecedented scale and speed, we can gain valuable insights. Natural disasters, like tsunamis, are known to occur regularly in many parts of the world. However, there are instances when the magnitude and swiftness of such events can render existing preparations inadequate. Take, for instance, the tsunami that struck Japan, India, and many other nations bordering the Indian Ocean. Japan is no stranger to tsunamis, experiencing them fairly regularly. Nevertheless, the 2004 tsunami event resulted in immense damage, even in Japan.

[1] Novel Risks by Robert S. Kaplan, Harvard Business School, Herman B. “Dutch” Leonard, Harvard Business School, Harvard Kennedy School, Anette Mikes, Oxford University

Develop scenarios

Based on the key variables, create a set of scenarios that represent various combinations of variables. Each scenario should be based on a different set of assumptions about the key variables and describe a different potential future state. As a start, a scenario analysis may consider all combinations of variables i.e. a practitioner should take the MECE ( Mutually Exclusive and Collectively Exhaustive ) approach in developing scenarios. Care must be exercised while developing scenarios as the scenarios should be structurally different[1] i.e. each scenario should not be a minor variant of the other scenario or scenarios. Some other caution while selecting scenarios include:

• Any scenario which is high-impact and possible must be included regardless of the probability of the scenario. Practitioners tend to ignore low-probability events despite their impact hence the caution.
• The combination of variables or logic should be consistent. For example,
• Every scenario should allow practitioners to make decisions
• A litmus test for the selection of scenarios is that it must challenge the accepted organisational wisdom

It should be borne in mind that scenarios, in strategic exercises undertaken by the businesses, are not analysed for academic purposes but to sharpen management’s decision-making & introduce rigour in the decision-making process.

[1] Analysing Environments and Developing Scenarios in Uncertain Times , By James L. Morrison and Ian Wilson

Analyse the impact and uncertainty of each scenario

Each scenario thus selected should be analysed concerning the impact on the objective identified in Step I.  This could include visualizing the results, calculating metrics such as expected value or value at risk[1] of the target metrics.

Use mathematical or simulation models to estimate the impact of each scenario on the target variable such as expected value,  sales, expenses, profits, or investment returns.  There are many ways in which quantification of the target variable may be undertaken. They include Discounted Cash Flow(DCF), Real Options, Replacement Value, Depreciated Value and Monte Carlo analysis to name a few.

An introduction to Monte Carlo simulation is provided in the APPENDIX D :. It is fairly easy and can be implemented by using commonly available tools such as Microsoft Excel. The simulation could be undertaken with fairly basic knowledge of concepts in probability with industry knowledge. I would again like to emphasize that the purpose is to introduce enhanced robustness in the decision-making process by laying out most,  if not all, possible outcomes quantitively.

For example, the decision to open  brick-and-mortar stores by the ecommerce company may be analysed with respect to the decision’s  expected present value in the scenario concerning high interest rate and emergence of new technology such as Metaverse.

In the above example:

1. The variables selected are interest rate and impact of Metaverse on the footfalls in brick and mortar store
2. The variables are high impact irrespective of the probability
3. The variables are independent
4. The scenario is the combination of high impact and independent variable
5. The objective is to assess expected present value of the decision and associated probability

It may also be possible to do the Scenario Analysis utilizing inbuilt tools in MS Excel.  However, it is difficult to simulate with multiple variables. Also, the scenarios are dependent on discrete values of input variables which are decided by the practitioners. Lastly, with the in-built tool in MS Excel judgement on the likelihood of different outcomes cannot be visualized. However, these limitations are compensated by its ease of use. The in-built tool can be a very handy way to put out the scenarios in a fairly quick manner.

Pruning scenarios

To keep the number of scenarios manageable, it is imperative to develop an objective criteria to remove scenarios which don’t impact the business meaningfully. One of the ways for shortlisting the scenarios may involve the likely impact and the uncertainty involved in the occurrence of each scenario. High-impact scenarios should be chosen for further analysis. While low impact scenarios can be left out.

Evaluate  the results

The above exercise should be employed to identify the shared strategic elements among all scenarios. These common elements can then be integrated into the core strategy. For instance, when deciding on the brick-and-mortar store, a common element could be identifying real estate and securing it without additional investment until there is greater clarity on the variables. Another approach might involve establishing distribution centres to serve online customers, with the foresight that these centres could later evolve into physical stores as uncertainty diminishes. Decisions may be made qualitatively by leveraging the practitioner’s experience. Alternatively, they can be approached quantitatively by weighing the costs of undertaking the initiatives against the expected value of the benefits.

The following diagram depicts the treatment of scenarios and how they are integrated into strategy development :

Note: Please remember that the core strategy is common denominator in all scenarios whether low or high probability

In addition to the core strategic elements, specific elements pertaining to individual scenarios should be outlined for implementation when the variables defining those scenarios become certain or less uncertain. For instance, in the case of a decision about physical (brick-and-mortar) stores, the choice to invest in the infrastructure may depend on the prevailing interest rate regime and the adoption rate of Metaverse technology.

Make decisions

Use the results of the scenario analysis to make informed decisions about the future. The results could be used in multiple ways. One of the ways could be to compare the outcomes of the scenario analysis with the existing strategy of the organisation. The outcomes can be utilised for adjusting plans and strategies. Practitioners should also evaluate the readiness to take advantage of the opportunities presented and to minimise or eliminate the risks posed by the threats.

The strategic options developed during this stage may also form the part of adjunct strategy. The exercising of these options may be dependent on the leading indicators i.e variables constituting the scenarios.

This is one of the most crucial parts of the scenario analysis and should be done with care by a practitioner. The practitioner is advised to run the analysis and discuss it with a well-informed group such as industry veterans and experts before concluding

[1] Value at Risk (VaR) is a statistical measure used to assess the potential loss in value of an investment or portfolio over a specified time horizon and at a given confidence level. It provides an estimate of the maximum loss an investment is likely to incur under normal market conditions, making it a crucial risk management tool for investors and financial institutions