Scenario Modeling: What You Need to Know
Scenario modeling has become a valuable tool for businesses, governments, educational institutions, investment firms, and other organizations to evaluate possible future events.
If done correctly, scenario modeling enables organizations to better plan for the future, mitigate risks, and capitalize on opportunities.
When analysts, modelers, or CFOs perform scenario modeling, they examine all feasible outcomes and test decisions before they happen. The best scenario models test a variety of assumptions at once, ensuring stakeholders understand the full scope of possibilities
For example, an agricultural company may use scenario modeling to see how their business would perform if corn prices declined, a natural disaster hit, or land policy changes were implemented.
Scenario modeling would clearly show how such situations could affect revenue and cash flow, and even the overall value of the operation. The agricultural company can then prepare for those risks while identifying where future opportunities lie.
In this guide, we’ll take a deeper dive into what scenario modeling is and how your company can best leverage it.
What is Scenario Modeling?
Scenario modeling examines a range of potential futures, instead of attempting to predict just one future. While you don’t have structured data on future performance, like you do with the past, you can use inputs and scenarios to see possible trends that you may encounter in the next few years or decades.
Scenario modeling explores the differences between these possible futures and facilitates investigations into how decisions around those situations would directly and indirectly impact the organization. It’s more about answering “what-if” than “what”.
Scenario modeling differs from conventional forecasting because:
- Conventional forecasting analyzes the undertaking of specific projects to identify the ‘best-case’ scenario or ‘most likely’ future. You predict the impact of executing a plan versus not executing a plan.
- Scenario modeling doesn’t just look at the ‘best-case’ scenario or ‘most likely’ future. Rather, you produce a multitude of possible futures and compare them against some common basis.
For a bit more clarity, look at the image below. By changing inputs (those blue, yellow, green, and red bars at the back of the device), you change the outcome. With each variation, you see where you land in relation to the ideal financial outcome.
Scenario modeling offers a distinct advantage over traditional forecasting: You can future-proof your business by developing scenario-specific plans. This way, you know nothing will surprise you.
An Example of Scenario Modeling
A small liberal arts college wants to enhance the student experience while improving financial sustainability. This requires that they examine a variety of pricing models, including:
- A tuition price reset: Simply lower or raise the tuition.
- Inflation price model: Adjust the tuition for inflation each year.
- Tuition promise model: Keep tuition the same for all four years for each new class of students.
- Three-year degree: Offer the chance to graduate earlier by taking extra classes (and therefore pay less overall).
- Continuing student scholarships: Students get financial aid, or a tuition discount, if they get a good GPA.
For the college, this goes beyond simple tuition model adjustments. The college wants to combine one of these tuition models with marketable initiatives that would improve the student experience. These initiatives include:
- Providing financial counseling to students and boost transparency in college pricing
- A graduation guarantee for students who meet academic expectations
- A high-impact stipend for high-performing students to study abroad, do research, etc.
- A subsidy for an interim experience
- More affordable study-abroad options
To perform a compelling scenario analysis, the college would first determine their baseline, so they can contrast different choices and outcomes. After that, they need to calculate all possible scenarios to determine the best possible course of action.
This involves calculating a lot of combinations and permutations, which is much easier said than done. But running through all possible scenarios ensures that the college will make the best decision possible—the one that increases student enrollment and retention rates.
Scenario modeling illustrates that increasing tuition by 10% in the first year and then reducing to a 3.3% increase in the following years is the best tuition model to follow. It also shows this tuition model works best when paired with student scholarships, stipends, a graduation guarantee, and financial counseling.
This example comes from a real-life usage of Synario by Wofford College. You can find the full Wofford College case study here or contact us about higher education scenario modeling for your unique institution.
How to Do Scenario Modeling
Generally, a company will include assumptions such as pricing, operating costs, inflation, customer data, interest rates, and other metrics that could impact the business.
As a guide from the NYU Stern School of Business states, organizations typically begin scenario modeling with three scenarios:
- Best-case scenario: If you were flipping a coin 100 times, and tails meant you win, 100 tails would be the best-case scenario.
- Most likely scenario: If you were flipping a coin 100 times, 50 heads and 50 tails would be the most likely outcome. This is also called the base case scenario.
- Worst-case scenario: If you were flipping a coin 100 times, and tails meant you win, 100 heads would be the worst-case scenario.
That’s a bit oversimplified, but you get the point. These three scenarios form the foundation for generating all your future scenarios.
But how do you actually do scenario modeling?
1. List all the assumptions for each scenario:
For instance, if you run a manufacturing business, you can make assumptions for the following:
- Revenue growth
- Cost of goods
- Salaries and benefits
- Rent and overhead, including inventory levels
- Depreciation and amortization
- Net margins
These assumptions all can vary. How they change can impact your business and your decision-making.
2. Put all the assumptions into a spreadsheet:
Copy and paste for each scenario. You may have five scenarios or more. It depends on your organization, all the variables at play, and all the potential decisions you could make.
3. Build a section on the spreadsheet for a live scenario:
This is for real-time updates of data. You can reference your scenario models to see how to respond to the ever-changing situation on the ground.
4. Test various scenarios and create scenario-based plans:
This will enable you to answer high-level questions, such as:
- Should we take a business loan at a 6% APR?
- Should we invest the capital to enter a new market?
- What do we do if sales come in lower than expected?
- Does it make sense to raise the price of our services by 5%?
- How can we make up revenue if customer retention rates drop by 10%?
5. Test, implement, analyze, and adapt:
Scenario modeling and financial modeling should never be static. It should be a dynamic model that allows you to test a wide range of scenarios in real time.
This way, you can adapt to what’s happening and move forward in the best possible manner.
The Lasting Benefits of Scenario Modeling
External factors change daily. That means you don’t know exactly what’s coming tomorrow.
How do you prepare for a future you can’t predict?
Enter scenario modeling—your tool to future-proof your organization. With adaptable, advanced scenario analysis, you can:
- Make realistic goals for the future.
- For example, if you run a beauty company, you can find out what goals are achievable based on changes in pricing, sales, cost of goods, and more.
- Take a proactive approach to factors outside your control.
- For instance, you can’t stop a bad rainy season if you run a resort, but you can plan for it.
- Project profits and losses more accurately.
- Imagine you handle finances for a university. With concrete data for a range of scenarios for enrollment, expenses, tuition revenue, and more, stakeholders have a clear picture of what to expect with your university’s bottom line.
To summarize, scenario modeling gets you ready for tomorrow, today.
The Lasting Benefits of Scenario Modeling
How do you feel when you look at the image below?
Panicky, right? We all have horror stories working in spreadsheets that never quite behaved the way we wanted, or where we edited formulas and cells so much it became hard to keep track of what was interconnected.
Simply put, spreadsheets are difficult and unwieldy, which is one of the biggest problems with scenario modeling today. Too many analysts—even at the Fortune 500 level—continue to rely on spreadsheets. This has the following drawbacks:
- Mistakes: Close to 90% of spreadsheets have a mistake in them.
- Time Wasted: European businesses waste $55 billion per year on spreadsheets.
- Static Analysis: Spreadsheets don’t update themselves. You have to update constantly and give new recommendations to stakeholders over and over again. This leaves your organization playing catch up at all times.
- Two Dimensional: With spreadsheets, analysts simply can’t test an unlimited number of assumptions all at once. Traditional scenario modeling only allows you to answer a few questions at one time.
Simply put, building competent, accurate financial models and running scenarios through them is a Herculean feat with traditional spreadsheet-based solutions. Fortunately, there’s a better way.
Intelligent Scenario Modeling for Your Organization
As analysts ourselves, we struggled with spreadsheets for decades. Until we realized we didn’t have to anymore and got to work on a better solution. We’ve built a scenario modeling software that allows you to test an unlimited number of assumptions at once, with a click of your mouse.
Just like you can toggle different layers on and off with Photoshop, you can easily customize Synario with preprogrammed sliders and levers that allow you to “turn on or off” various combinations of assumptions, choices, and outcomes.
Even better, you don’t have to change the underlying math, like you would with a spreadsheet-based model. That ensures you can save time and focus on what matters: Making the big decisions alongside your stakeholders.
In other words, unlike spreadsheets, which are two dimensional, Scenario gives you a multidimensional, multiverse model at your fingertips. You can test every scenario possible and take control of your organization’s future by being ready for anything
With a tool like Synario, you put yourself in the best possible position to succeed not only this year or next year, but for many years to come.