Since 2008 the business community has been operating in an environment of extreme volatility, with new risk demands often placed on corporate treasurers. What was once extraordinary has become ordinary and the previously unthinkable has become reality. Companies that once prepared detailed, long-range plans – with budgets based on a stable view of the future – now operate in an environment that presents new and unforeseen challenges nearly every day.
We have seen a remarkable series of material trends reshaping our world in recent years, including:
- The rise of new economies such as China, India and Brazil, with attendant wealth creation and rising consumer demand. This has led to new areas of regional responsibility for multinational corporate (MNC) treasurers and, indeed, new treasurers joining the industry.
- Demand for commodities creating boom and bust cycles in everything from oil to corn to copper, making commodities risk a major issue for treasurers.
- Demographic change, with rapid population growth in some countries and an aging, shrinking population in others leading to shifting patterns of demand.
- Environmental concerns including climate change, water scarcity and resource depletion; not to mention resulting threats to the corporate’s supply chain.
- Global interdependence, with companies sourcing talent and resources from multiple countries while opening up new markets for their own products and services.
- Technological innovation, as inexpensive cloud computing, telecommunications and social media increase global interconnectedness while accelerating the pace of change.
As a result, treasurers and senior managers have come to realise that the past is no longer a good predictor of the future. Management and boards of directors, as well as investors and other stakeholders to whom they are ultimately accountable, are questioning the wisdom of basing strategies, plans and budgets on a single, static view of the future derived from an extrapolation of past performance.
Finance professionals, and corporate treasurers in particular, are under more pressure than ever to find better ways to support the core business by managing uncertainty, volatility and risk. The challenges for those in the sector include setting long-term capital investment priorities; establishing credible targets and annual plans; analysing the impact of material events on strategies and plans; and effectively managing cash and capital.
Against this backdrop traditional planning processes are largely obsolete. A single view of the future – typically very detailed, trend-based and financially-oriented – can be both time-consuming to prepare and rapidly made irrelevant by events. Organisations can respond to these dynamics by changing their planning capabilities in three areas:
- Pace: Organisations can shorten development cycles, with less emphasis on detail and more attention to predictive ability. They also can update plans more frequently in response to events, to support faster decision-making and more effective cash management.
- Certainty: Planning processes can be used to isolate factors that affect an organisation, and can assist in identifying and balancing financial and non-financial factors.
- Agility: Processes can be designed to address multiple scenarios and identify triggers or leading indicators of scenario change. They can also suggest appropriate actions when such triggers are identified.
Such a capability, based upon scenario-based enterprise performance management, can explicitly address risk, uncertainty and volatility, and lead to faster, more confident business decisions.
As the complexity of the environment increases, so can the advantages of scenarios over other commonly-used uncertainty management techniques such as sensitivity analysis, which can analyse changes one variable at a time. Scenarios, however, typically consider combinations of uncertainties and their significant interactions. By late 2009 two in three companies were using scenario planning – compared with just 35% in early 2008, according to ‘Financial Planning and Budgeting’, a report published that year by Aberdeen Group. According to an earlier article by Julie Verity, ‘Scenario planning as a strategy technique’, published by European Business Journal, the figure was less than 20% back in 1979.
Three out of four firms that use scenario planning indicated that they are using it more extensively in response to the increased uncertainty and volatility of the business environment, reported Accenture in its 2009 ‘Planning, Budgeting, Forecasting Global Survey’.
Scenario-based enterprise performance management (EPM) can be used to assist, not just in strategic planning, but also with business planning, forecasting, reporting and analysis, providing the foundation for risk mitigation strategies, integration of early warning measures into performance management and – perhaps most valuable of all – to manage the unexpected nature of day-to-day business.
It also can help firms transform planning and reporting processes from a reactive, accounting-based activity into a value-centric capability focused on shaping and managing optimal outcomes.
Building Scenario-Based Plans
Incorporation of a scenario capability into an organisation’s EPM processes involves multiple steps, including:
- Identify key factors that can have a material impact on the organisation. For example, consumer products companies may look at gross domestic product (GDP) growth and consumer spending, airlines at oil prices, global manufacturing companies at exchange rates and freight costs, and financial services companies at consumer credit quality, interest rates and asset prices.
- Define relevant scenarios (typically three to four) that describe a range of future operating environments. For example, what if oil prices average US$75 a barrel, US$120 a barrel or US$200 a barrel? How does this impact on the business and can the treasurer mitigate the risk?
- Agree on a baseline scenario for reviewing strategy; setting targets and developing operational plans and budgets is good practice.
- Develop strategic plans, targets, action plans and budgets using this scenario. For example, the company may agree a target of growing revenues by 8%. Strategies to reach this target might include selling more to existing customers and acquiring new customers. Plans for implementing the strategies might, in turn, include expanding emerging market sales by 15% while increasing marketing spend in core markets by 7%. A treasurer might, say, reduce foreign exchange (FX) exposure and introduce a programme to achieve this.
- Develop alternative views of targets, plans and budgets under each scenario, and identify the major impacts and changes under each of them. For example:
a. What will be the positive/negative impact on key financial metrics such as sales, margins, costs and earnings under each scenario?
b. How will investments/projects be re-prioritised under each scenario?
c. What will be the impact on product mix, pricing risk and promotional spending under each scenario?
Assumptions under each scenario can be tested under various market conditions.
- Identify relevant triggers and corresponding tolerance ranges for each scenario to be monitored on an ongoing basis in an effort to provide management with advance warning of material changes in the operating environment.
- Whenever established triggers or tolerances are exceeded – meaning a new scenario becomes effective – adjust tactics using previously-developed plans and generate a new forecast reflecting the change in scenario and the changes in tactics.
Integrating Scenarios into Core EPM Processes
The commercial application of scenario planning has its origins in strategic planning. A 2012 Accenture study, entitled ‘Managing the Unthinkable: Scenario-Based Enterprise Performance Management (EPM)’, reported that nearly 85% of companies that use scenarios extensively employ them in the strategic planning process.
Using scenarios to provide insight into the choices and trade-offs to be made in strategic planning can increase flexibility and provide access to a broader range of growth and finance options.
Typically, organisations set targets on an annual basis to guide the annual planning and budgeting process. Those targets are often set based upon two or three inputs: past performance, strategic plan objectives and external market expectations (for public companies).
A scenario-based EPM capability uses scenarios as a fourth input. For example, a large global transportation company built its targets for 2011 using a baseline assumption for oil prices of US$79 per barrel; a realistic assumption at that time based upon oil price trends during the second half of 2010. However, as part of the planning process they developed alternative sets of targets under both a US$110 per barrel scenario and a US$140 per barrel scenario. The business modeled the impact on volumes, revenues, operating expenses and earnings under each scenario. The value of this scenario planning became clear as oil prices moved up rapidly from the US$79 baseline to average more than $110 per barrel during the first quarter of 2011.
The target setting process in a scenario-based EPM environment often involves a shift from setting absolute targets. As the expected rate of industry growth would change depending on a scenario, for example, so would the targets.
Tactical Planning, Budgeting and Resource Allocation
The 2012 Accenture study also found that more than four out of five companies employing scenarios extensively use them in their budgeting and resource allocation processes. As with target setting, moving to scenario-based EPM for tactical planning, budgeting and resource allocation processes typically includes new approaches and a different orientation.
Once targets have been set, an organisation can develop a set of tactics and resource allocation plans to meet them. The budget is simply a financial representation of the tactics and resource allocation plans, and can serve to validate the adequacy of plans.
Moving to a scenario-based EPM approach adds one more step. Once the baseline plans are complete, an organisation can identify changes to the tactical, resource allocation and financial plans that would take place under each scenario. For example, a pharmaceuticals company could show how the delay in regulatory approval of a new drug could impact its merchandise assortments and promotional spending should the economy tip into recession. It can be beneficial for there to be a resource allocation plan or budget for each scenario that explains the impact on the organisation’s ability to meet targets that have been set. Treasury could be in charge of overseeing this plan.
Evaluating the Business Case for Investment
The case for investment – entering new markets, building new plants, making acquisitions, launching new products and adopting new technology – can be evaluated under a range of scenarios to identify circumstances under which specific projects might no longer be attractive. For example, a consumer products company that wants to enter new markets may look at the likely market demand for its products under multiple scenarios based upon forecasts of gross domestic product (GDP) growth and consumer spending levels. Treasury could look at which country(ies) to invest in and which to avoid.
Before making an investment It is important to understand the key assumptions upon which it is based, and to define clear ‘abandonment criteria’, which identify scenarios under which an investment or project no longer makes sense. Abandonment criteria can be tracked closely and be monitored, along with the investments themselves, for continued validity.
Monitoring and Performance Measurement
While 78% of companies using scenario planning claim that they monitor leading indicators for key internal and external factors affecting their business, less than two-thirds of those companies have established tolerance thresholds for these indicators and connected them to scenarios in order to detect when the current baseline has lost its validity and an alternative scenario become material.
In scenario-based EPM, monitoring of indicators designated as scenario triggers takes place on an ongoing basis. Monitoring frequency can vary depending on the volatility of different indicators and the business environment in general. What often stays the same is a structured, consistent approach.
In general, forecasts can be developed using a ‘best prediction’ principle, based on the most reliable information available at the time of preparation. Many companies, however, base their forecasts on the ambitions and expectations of the board of directors and top management, which can mask the need to develop rational action plans that help the organisation achieve agreed-upon performance targets.
As a part of an effort to avoid this problem, forecasts prepared under scenario-based EPM can explain both the predicted impact of a specific scenario on business performance and the expected result of executing agreed-upon corrective actions to close gaps in reaching both short and long term targets. If there is a remaining gap, additional potential corrective actions may be needed.
In scenario-based EPM, it is important to have pre-defined action plans ready for each scenario. The organisation can then act immediately to implement such an action plan when it is clear that a particular scenario is unfolding. Scenario changes can require changes in pricing, promotion, production scheduling, inventory management and other operational components. Business continuity planning, in place to respond to any threat to the supply chain, is also a good idea.
Clearly, companies that have established scenario triggers and associated thresholds may be in a much better position to maximise the benefits from early detection of scenario changes and execution of their pre-determined action plans.
Companies can obtain significant benefits by developing a scenario-based EPM capability. A primary benefit is that it can lead to better formulation of strategic plans, tactical plans, budgets and forecasts by helping them think more broadly. Management teams can then look at a wider range of possible outcomes, identifying new opportunities as well as potential problems. The dialogue and debate that is inherent in effective scenario planning often leads to new insights about the interaction of external and internal factors in the business environment and their impact on plans and actions.
At a time of intense market uncertainty, we are seeing broader use of scenario-based EPM as a valuable tool for determining how businesses will respond to a wide range of potentially difficult situations. We believe that it could become the basis not just for avoiding risk, but for identifying and seizing growth opportunities in both developed and emerging markets, despite the uncertain business environment.
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