The Four Phases of Building a Scenario-based Planning Model with Econometrics

Scenario-based planning is a tool CFOs can use to develop strategies for operating in any of several contrasting business and economic environments. Each scenario is a plausible sequence of future events that affect an organization’s strategy and operations.

The outcomes of the scenario-based planning process can be used to establish a number of plans, from fundamental changes in strategy caused by global paradigm shifts to tactical contingency planning for shorter-term developments. “A robust scenario-based planning effort using econometric analysis can enhance the competitive advantage of a business,” says Dwight Allen, director, Strategy Development, Deloitte LLP. “When done correctly, these techniques can position an organization to be better able to adapt to an ever-changing business environment,” he adds.

Following is an overview of the key phases of scenario-based planning and how econometrics—the application of statistical techniques to analyze economic data—can be used to help CFOs and their finance teams establish effective action-oriented processes.

Phase I—Define the Purpose, Scenarios and Associated Strategic Implications

As an example of how econometrics can be used in connection with a scenario-based planning initiative, consider a U.S.-based multinational manufacturing company with manufacturing operations in Asia. Most of the company’s sales are generated in the U.S. and in markets across Europe. The company’s executives are concerned about the implications of changes in the eurozone and want to build scenarios to evaluate the effects of the euro crisis over the next year.

The first step in developing scenarios for any situation is to ensure that the process is properly linked to the objective. In this case, that is to determine the effects of potential near-term developments involving credit and currency markets on the execution of an existing strategy. The next step is to formulate a set of scenarios. The number can vary; typically two to four are the most manageable. The scenarios reflect “what-ifs” concerning aspects of the business environment that are of greatest interest to the company. For example, assume in Scenario 1 that fiscal reforms and emergency measures prevent any national defaults, but the value of the euro falls substantially. In Scenario 2, Greece defaults and it, along with several other countries, leave the eurozone, resulting in two or more sets of monetary and economic repercussions (inside and outside the eurozone). In Scenario 3, internal dissension causes a break-up of the eurozone altogether, with a wider range of aftereffects.

Phase II—Conduct the Financial Impact Analysis

In this phase, econometric modeling is used to estimate the financial impact of each scenario. In the first scenario, a weakened European economy would have a direct impact on European sales, as well as a potential indirect impact on U.S. sales. At the same time, the euro would be weakened compared to the U.S. dollar and Asian currencies. As this happens, the relative cost of manufacturing products in Asia becomes more expensive, coupled with weakening demand in Europe. Moreover, the weakened euro would make the European operations less profitable. In the second and third scenarios, there would be national currencies to consider as well. Which national and product markets are affected and to what extent will be different in each scenario.

By analyzing the ripple effects of the different versions of a weakened European economy, executives can identify contingency plans and tactical, operational solutions, which are discussed in Phase III. “CFOs should continue to work with all levels of management involved in, and impacted by, the scenario-based planning to identify issues that may arise and impact the execution of strategies,” notes Carl Steidtmann, chief economist at Deloitte Research and a director with Deloitte Services LP.

Projecting Financial Impact

To project the potential financial impact of scenarios, the first step is to identify the economic indicators that impact the business. The manufacturing company in the example may find that European revenue is correlated to three economic indicators: European sovereign state GDP, the exchange rate between the U.S. dollar and the euro, and durable goods orders. Other examples of indicators could include currency values, inflation rates, consumer spending or investment in a particular sector.

Two of the most challenging parts of this process are defining the future states of the economic indicators and obtaining historical data extracts. Another challenging aspect can sometimes come as somewhat of a surprise—getting historical data from a company’s systems. Taxonomy and system changes throughout the years, as well as data quality issues, can often complicate a seemingly simple task.

Developing an Econometric Model

After the appropriate data have been obtained, an econometric model can be developed to establish a relationship between historic performance and economic indicators. Multiple regression is a common technique used to make predictions and projections. In essence, revenue is projected by applying the historical relationship to the state of the indicators in the scenarios. Before building an econometric model, various aspects of both the data and business that could impact results should be considered. Common considerations include seasonality, mergers, performance lags, business diversity and one-time events.

Establishing a Monitoring Process

After initial projections are established, a monitoring process should be built to identify trending and changes in the indicators. By maintaining ongoing commentary surrounding changes in the forecasts, CFOs can gauge whether their scenarios and corresponding actions remain appropriate. Staying current with economic developments will also make it easier to act on scenarios for shorter-term tactical operations, or perhaps identify a new scenario.

Phase III—Analyze Scenario Impacts and Define Responses

After potential financial impacts are identified in Phase II, the next step is to draw inferences and consider what the company would do in each scenario.

In the example, the multinational manufacturing company can develop plans to mitigate potential revenue loss incurred in each of the eurozone distress scenarios. It may identify strategies ranging from increasing global integration to diversifying its product portfolio and/or customer base, and from reducing cost structure through headcount or process improvements to changing its marketing strategy. Thinking through each scenario provides insights as to how to deal with any of the potential outcomes.

Through monitoring the environment, the company can also determine the appropriate time to implement the plans and will be well positioned to change course to help mitigate any negative effects. In the process of thinking through scenarios and responses, the company may also identify changes that would be beneficial regardless of which scenario should come to fruition. Putting such “no-regrets” changes into effect allows a company to improve its ability to deal with a range of potential business conditions without reducing its current competitiveness and without discounting any particular prediction of what lies ahead.

Once strategies have been identified, company executives can work with key stakeholders to develop an integration plan and socialize any required changes to current practices that may be needed to deal with scenario conditions. Business managers who have helped to develop the models can help integrate the models into their day-to-day efforts as organically as possible. Success can depend on how well the plans are received and how much ownership the managers feel they have had in the process.

Phase IV—Adapt and Refine the Econometric Model

“Perhaps the biggest key to success is to ensure that the model evolves,” says Mr. Steidtmann. “It is important to manage everyone’s expectations as it can take several business cycles to develop a sound working model. Gaining decision-makers’ confidence in the credibility of the model is crucial to success,” he adds.

After the initial model has been socialized and key stakeholders feel comfortable with the model and the process itself, the process and its four phases can be restarted. Monitoring events to determine when the future has become reality relative to the scenarios, including establishing benchmarks to prompt action relative to real-world developments, will drive the process back through the four phases. Continuous evaluation of the base model, including the ongoing relevance of economic indicators, is critical in order to expand and hone it until the model reaches its full functionality.

Meanwhile, additional feedback can be obtained from the business managers, which will help in enhancing the model as well as building relationships and gaining trust. “Feedback from the business managers on each model’s results is crucial for further refinement,” notes Mr. Steidtmann. Finally, it’s important to be realistic about the timeline. Don’t expect to deliver a “final” model in a few months. Although the process can take time to develop, over the long term the effort will likely be worthwhile.

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September 11, 2012, 12:01am

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