On 19th February 2020 the world seemed like a fairly predictable place.
Brexit had been “done”, the general election was over and a clear majority government had won the vote, the stock market was performing well, austerity was coming to an end, Trump’s trade wars with China were calming down, oil prices were strong and spring was in the air.
But between 20th February and “Black Thursday” – 12th March 2020 – the entire world was turned upside down in what most analysts and observers are agreeing will be the single most devasting socio-economic event since World War 2: the coronavirus pandemic. Stock markets saw the biggest crash in over 30 years, interest rates were slashed to zero, football leagues were shut down, pubs and restaurants closed, borders closed and the world went into lockdown as daily death rates from Covid-19 became the grim statistic which told the tale of the unraveling pandemic.
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2020 is, without doubt, the year of uncertainty.
How do organisations, and we as accountants within organisations, respond to such uncertainty? Does this uncertainty mean bad news for all concerned? What, for an accountant, does “uncertainty” mean?
Frank Knight, one of the most eminent economists of the 20th century wrote in 1921 (8 years before one of the biggest stock market crashes of all time): “Profit arises out of the decisions made under the conditions of uncertainty” – in other words, it is uncertainty which provides the very foundations out of which profit can emerge and grow.
The uncertainty presented by the coronavirus pandemic undoubtedly presents a terrible situation for many organisations – think P&O Cruises, TUI Travel, Wagamama restaurants, PureGym, Virgin Airways, cafes, football clubs, concert venues, hairdressers, festivals etc.
An opportunity to flourish
But for others, it has presented a situation where their business model has flourished and grown – Netflix, Amazon, Ocado, Dominos, Zoom, Fedex, Deliveroo and many more have seen unprecedented demand for their products and services and share prices are UP by well over 30% in some cases. Socially, medically, physically, emotionally – the pandemic is a and situation, that goes without saying.
But we are accountants and this article is looking at the pandemic from a commercial perspective, through the lens of scenario planning/forecasting, and from this perspective, the present uncertainty provides the basis for both downside AND upside performance. The concepts of scenario planning and forecasting cannot be properly understood without appreciating this fact.
A scenario, in this context, is a potential future set of circumstances which can be imagined and rehearsed for today. It is a “vision” of one possible future which might emerge out of the current uncertainty. Maybe, after the pandemic, people will never want to mingle in public to the degree they wanted to before and social distancing will become a permanent feature of human life – that’s one possible scenario.
On the other hand, maybe people cannot wait to get back to mingling freely and maybe public places will be completely packed out once people, hungry for social intraction, are released from lockdown – that’s another possible scenario.
Maybe after the pandemic people will feel so financially insecure they won’t go on another holiday until 2023 or later; or, maybe, as soon as lockdown is over everybody will rush out to take advantage of 0% interest rates and go on the biggest holiday they can find. Nobody knows what the “true” scenario will be now, here in the present – that’s what makes it a scenario – but if we try to imagine all possible scenarios then we can begin to imagine how we would need to operate within each one.
2. Scenario planning
Scenario planning is the method used for “seeing” the different scenarios which may become reality. This is sometimes described as a “macro” activity as it is looking at the big picture, trying to look from the present into the future to see what a range of possible futures might look like. These scenarios are then “rehearsed” for effects, impacts and implications.
3. Scenario forecasting
Scenario forecasting refers to the specific commercial activities (all of them inevitably bearing financial consequences and therefore of specific interest to us) which the business will undertake in each of the scenarios which have been “seen” and rehearsed. This is sometimes described as a “micro” activity level as it looks at detailed, tangible actions and financial impacts rather than “big picture” stuff.
Scenario planning looks at potential futures – but how many futures is enough futures? Experts say two is always a bad number (it leads to an “either/or” mentality which is often unhelpful) and three is even worse (it’s too tempting to just go for the “middle ground” scenario) so the technique involves thinking of four future scenarios based on two “uncertainty pairs”. Overall, the process involves 5 steps:
- Identify the driving force of uncertainty (eg. Brexit, trade wars, 9/11 or ….. Coronavirus)
- Identify two critical uncertainty factors affected by the driving force: eg
- “Hardness of Brexit”/“Strength of the Pound” (Brexit uncertainty)
- “Customer demand”/“Lockdown period” (Coronavirus uncertainty)
- Draw a 2 x 2 matrix with 4 scenarios based on your uncertainty factors
- Define/understand the implications for your business based on all 4 scenarios
- Perform Scenario Forecasting for all 4 scenarios
Assuming we are looking at Coronavirus, let’s start with Step 3:
Step Three: Construct the scenario matrix:
First, we draw a 2×2 matrix and we label the axes based on our uncertainty factors from Step 2 – these are derived through discussion within the organisation, based on the two most uncertain factors of the driving force. For coronavirus these could be “How quickly will the lockdown end to enable markets recover and get back to normal?” and “What will happen to customer demand when the lockdown does end?” (there are no ‘right’ answers to choosing these factors – each organisation will be different and must choose the factors most relevant to them).
Once the matrix is complete, we then think of appropriate names for our 4 scenarios – again there is no “right” answer to this and many practitioners choose quirky names like mine below:
Step 5: Scenario forecasting (appropriate actions are rehearsed)
Scenario 1: Jungle Survival:
In this scenario we imagine a future where the return to normality is slow, perhaps there is a second wave of infections, lockdown continues, social distancing is a long-term norm and, as a result, customer demand for our products is very weak. This is a crisis situation where demand for what we sell is low and there is no sign of an upturn in the market. The industry may enter temporary or even permanent decline and many organisations will cease trading. What is the accountant’s role in relation to the relevant appropriate actions in this scenario? Well, consider the following:
- Identify breakeven point for all product lines and cut those which cannot breakeven
- Review aged debtor reports, tighten up on credit control
- Consider debt factoring/invoice discounting to liquidate receivables
- Direct product profitability analysis – cut loss-making / low-profit products
- Customer profitability analysis – cull loss-making customers based on Activity-based Costing
- Supplier relations – analyse lower cost suppliers or lower cost supply chain solutions
Scenario 2: Cloudy Day:
This is where the general recovery from the pandemic is quick, there is a “V” shaped return to normality across the stock market, lockdown ends, there is a very effective cure which comes along quickly, no further outbreaks and society shows a willingness and an ability to get back to normal straightaway; however, demand for our products does not follow this trend and sales remain in the doldrums. The accountant’s role here would include:
- Identify cost cutting opportunities to enable us to drop the price to stimulate demand
- Tighten budgets on existing cost centres to consolidate liquidity
- Exploit data for lower cost marketing to drive traffic to our business
- Identify low cost sources of finance for investment in product relaunch/innovation
- Revise hurdle rates for projects – invest only in projects with immediate/quick payback
Scenario 3: Conquest:
This is a positive scenario in which the world is slow to return to normal (therefore many organisations will be in the Jungle Survival scenario) but demand for our products is really strong. We are in an atypical situation – thriving within an overall situation of gloom and slow growth. As the pandemic continues and lockdowns are extended with no sign of a vaccine on the horizon, demand for what we are offering is growing and revenues are strong. In this scenario we as accountants should be focused on:
- Setting KPIs for monitoring customer satisfaction
- Pricing strategies – increase prices where demand will accept it and assess elasticity
- Acquisitions – conduct benchmarking analysis to identify targets for takeover
- Headhunting – cost/benefit analysis of recruiting extra staff from rivals
- Raise finance, balance gearing and invest for growth
Scenario 4: Rushing Bulls:
This double whammy of good news (very quick recovery from the pandemic plus strong demand for our products) may look like the perfect scenario but it brings with it dangers of over-trading: allowing the organisation to grow too quickly in terms of sales and profit without the underlying balance sheet structure or cashflow to sustain it. Having been locked down for weeks/months, society charges ahead in a spending spree and we get carried along for the ride – but the challenge is to manage that ride and not be thrown off onto the horns. Relevant activities here could include:
- Ensure receivables days ratios are always lower than payables days ratios
- Raise appropriate long-term finance for growth (low cost, fixed rate, long-term debt)
- Build barriers to entry to secure consistent sales (loyalty schemes, invest in brand)
- Lock in customers with multi-year contracts
- Recruitment with flexibility – zero-hours, casual work, short-term contracts
- Monitor cashflow regularly, maintain cash buffers, review liquidity ratios and margins
Benefits and Drawbacks
The benefits of performing scenario planning/forecasting now are plentiful. Firstly, most obviously, it will reduce the element of surprise in the future as you will have effectively rehearsed the future before it happens, so managing the actual events facing you down the road will not be as bad as if they hit you unawares.
Secondly, it allows you to communicate your situation and potential outlook with relevant stakeholders (such as banks or employees or shareholders, for example) who may appreciate knowing a “worst-case” and “best-case” scenario at the very least. Finally, it can assist greatly with financial planning as steps can be taken now to ensure finances are in place to exploit scenarios with upside uncertainty, and also to mitigate the damage of scenarios with downside uncertainty.
However, there are some problems with this whole activity too. Obviously, there is the time (and cost) of actually constructing the scenarios in the first place – especially difficult to justify sometimes given that in reality there will only be ONE future which transpires and all other imagined scenarios will come to nothing.
But there are also question marks over how many scenarios to consider – we have looked at a model which produces 4 scenarios but maybe an organisation could imagine 6 or 8 or 20 scenarios, all different enough to justify a “rehearsal”. Or, even if you stick with 4 scenarios in the method described above, how do you decide on the two uncertainty factors around which your scenarios will be built.
Scenario planning and scenario forecasting is not an exact science, nor is it an attempt to perform magic by seeing the future. It is, at heart, a risk management tool for dealing with uncertainty. It is a widely used technique with many merits but, like any tool, the output which it yields will only be as good as the human input which guides it.
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Andy Booth is a trainer for AAT Mastercourses on Financial Performance, Management Reporting, and Budgeting topics.