What is Scenario Modeling?
Scenario modeling is essentially identifying assumptions about the future financial profitability of your business and determining how your company will respond in various potential scenarios. It helps you determine the profitability of each possible scenario for your company and is an integral skill of a high-quality financial modeler.
Being able to model profitability under various scenarios—and being able to conduct sensitivities around the scenario you have modeled—is essential for the success of your business.
Profit Frog offers a scenario modeling solution that is tailored to owners of small businesses. We make scenario planning easy.
Scenario Modeling: an Example
Scenario modeling is confusing, so let’s take a practical look at it with a scenario planning example.
Say you are asked to build a scenario model for the launch of a new subscription product for Netflix around video games. No matter how much information you have about video games, your model is going to be off, as you have no way of knowing how many customers will sign up.
However, based on your research, you can get an idea of how many customers will sign up by using available data (such as video game market size, number of current subscribers, number of video games available on the platform, etc).
You can then adjust the estimate based on this data to develop a potential range of new customers. For example, your modeling could predict a range of 1 to 3 million new customers per month over the first six months of launch. This range helps you see what profitability will look like under each scenario before you decide whether launching this new product makes sense.
Why is Scenario Planning Important?
The need for scenario planning has never been greater than it is today. Just look at everything that has happened in the last 3 years:
- Global pandemic (COVID-19)
- Global conflicts
- Health crisis (monkeypox)
- Energy crisis
- Record inflation
- Supply chain issues
- Climate change
With the increased uncertainty comes the need to look at opportunities based on different scenarios, as opposed to just taking a point estimate and moving forward.
As Winston Churchill famously said, “He who fails to plan is planning to fail.” Planning what to do when different scenarios instills confidence that we can manage the changes and adjust the way we operate.
What is a Scenario: an Example
A scenario is a situation or sequence of events. We are modeling different sequences or series of events to see what will happen to a business, based on a set of assumptions in each scenario.
Say, for example, you sell nutritional snack bars, smoothies, and other wellness snacks through various ecommerce channels. You are deciding what the next step for our business will be, and you want to model three different scenarios before deciding how to proceed forward. The scenarios are:
- Expanding from ecommerce to selling in retail stores such as Costco, Kroger, and Whole Foods
- Adding a new product line of nutritional gummies to be sold within existing e-commerce channels
- Opening your own retail store to sell your current products
A good scenario planning template–or scenario planning tool such as Profit Frog–will allow you to model all three of these decisions. Not only will you be able to model all three decisions, but you’ll be able to model each under a variety of potential scenarios:
- Which has the better outcome if labor costs increase significantly? Or if there is a labor shortage?
- Which has the better outcome if prices of raw materials increase significantly?
- Which has the better outcome if commercial real estate prices drop?
- And so forth: there are hundreds of variables that one could model for each potential decision.
What is a Scenario Planning Template?
A scenario planning template is a form that allows you to input your assumptions, run your calculations, and generate a model. There are many different approaches to creating scenario templates.
With an abundance of scenario planning template options available online, many business owners try to conduct scenario planning on their own with Excel. They then get discouraged by the complexity.
Scenario planning software brings the power of scenario planning within reach of the average business owner. You don’t need a degree in finance, or wizard-level Excel proficiency.
Profit Frog, for example, is built for owners of small businesses. Our software is designed to let you model different scenarios, easily and intuitively. You don’t even need a template; just plug in the numbers for your business and the software does the rest.
Financial Scenario Planning Template: a Profit Frog Example
Scenario planning examples can help you understand the integral parts of scenario planning, so let’s examine one.
The following scenario planning exercise involves a fictional baseball shop. Below is a screenshot of a pessimistic scenario. Here, we can see the baseball shop’s profit over the last year and what happens to profit over the next year based on our worst-case scenario.
Here, we can see the baseball shop’s profit over the last year and what happens to profit over the next year based on our most likely or base-case scenario assumptions.
We have also entered assumptions for what we expect will happen in an optimistic environment. Here, we can see the baseball team’s profit over the last year and what happens to profit over the next year based on our best-case scenario assumptions.
Scenario Planning in Excel: an Example
Below is a screenshot of what a scenario model might look like in Excel. In the previous example, we have created three scenarios:
- Base case scenarios
- Best case scenarios
- Worst case Scenarios
Under each scenario, we specify the number of customers we expect each year, as well as the order value. We can then select what scenario we want to analyze, and all the data in the model will update based on the scenario. This allows us to see how revenue and profits are impacted as a result of each scenario.
How Do You Write a Scenario Plan?
The first step of writing a scenario plan is brainstorming the different scenarios. Then, write down what information you’ll need to develop a model for each scenario. This requires an understanding of what assumptions (inputs), calculations, and outputs will be needed for your scenario.
For example, if you are writing a plan for a scenario that involves opening a new retail location for your clothing store, you would need to make assumptions about:
- The cost of rent for the location
- The cost and number of employees you need for the store
- What inventory you will need in the store
- How much revenue you can assume to make each month
- How much will you spend on marketing and advertising
In addition to the inputs above, you also need to think about factors that you cannot assign a financial input to and how they impact the decision. For example, whether the management has the necessary experience to successfully open a retail store, or how the floor plans of potential locations may influence your sales.
The key to doing scenario planning is to spend time thinking about what scenarios make sense to model. Once you lay out the inputs, calculations, and outputs, you’ll be able to compare different scenarios to each other and understand what the appropriate business strategy for each scenario is.
Scenario Planning Templates Made Easy with Profit Frog
Even a good scenario planning template can cause a headache, and the internet is filled with poor-quality ones that will just confuse you. Luckily, Profit Frog is here to help you map out different scenarios and optimize the future performance of your company.
We focus on the most important metric, profit, when mapping out scenarios. Rather than overwhelm you with extraneous information, we help you drill down to model what would happen to your profitability under various scenarios.
Get started now and prepare for the future of your business with the help of our data-driven predictions.
Scenario Planning FAQ:
What are the five steps of the scenario planning process?
The five steps of the scenario planning process are:
- Discuss multiple scenarios: a good way to come up with different scenarios is to brainstorm different positive and negative possibilities. At a minimum, you should consider a best case, base case, and worst case scenario and what that means to your model.
- Choose which scenarios to model: after discussing multiple potential scenarios, choose which ones you want to build on. One way to do this is to rank the scenarios that you think will be most likely or most valuable for you to model.
- Develop the model for each scenario: once you have selected the scenarios, you will need to build a model for each of them, so you can compare the different scenarios against each other and see how key elements of the model change.
Profit Frog makes this step easy and intuitive. Get started today with your free trial.
- Evaluate scenarios and develop a game plan: after creating and comparing the different models, evaluate the scenarios and develop a game plan how you will adjust and what actions you will take in each scenario.
- Implement your game plan and continually review: follow the action plan associated with the scenario that is currently unfolding. Continually assess the reality of the situation and adjust as needed. For example, if indicators point to a looming recession, you might decide to implement the scenario you developed related to the recession. If the recession ends up being minor, and the economy rebounds, you can pivot to the plan related to your “good economy” scenario.
What are the four approaches in scenario planning?
The four approaches to scenario planning are
- exploratory scenarios
- target-seeking scenarios
- policy-screening scenarios
- retrospective policy evaluations
These approaches are typically used in larger enterprises and serve different functions in the budget planning process, with retrospective evaluations being particularly useful in determining the driving forces of the sales cycle.
Smaller businesses don’t need the complexity of these different approaches, which is why Profit Frog simplifies the scenario planning process to make it understandable and actionable for average business owners.
What is scenario analysis?
Scenario analysis is the process of comparing different scenarios against each other. It allows you to plan, in a dynamic world full of critical uncertainty, what you will do based on different potentialities.
How do you create a scenario matrix?
A scenario matrix is a method of comparing different scenarios against each other. For example, the following matrix include three scenarios and the variables for rating each:
A scenario matrix allows one to assess potential outcomes in table form.
Some additional common financial modeling metrics used to compare scenarios include (definitions come from Investopedia.com):
- Internal Rate of Return (IRR)
The IRR is a metric used in financial analysis to estimate the profitability of potential investments. IRR is a discount rate that makes the Net Present Value (NPV) of all cash flows equal to zero in a discounted cash flow analysis.
- Net Present Value (NPV)
NPV is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is the result of calculations used to find the current value of a future stream of payments from a company project or investment.
- Payback Period Analysis
The payback period analysis divides the total cash outlay for the project by the average annual cash flows to determine how long it will take to pay back your initial investment. A modified payback period analysis considers the time value of money in calculating your payback period. This is because a dollar today is worth more than a dollar tomorrow and it is important to consider the time value of money when comparing different opportunities.
- Accounting Rate of Return (ARR)
The ARR is a formula that reflects the percentage rate of turn expensed on an investment or asset, compared to the initial investment’s cost. The ARR formula divides an asset’s average revenue by the company’s initial investment to derive the ratio or return that one may expect over the lifetime of an asset or project.
The above four methods are the most common methods used to analyze different investment projects/scenarios before deciding on which ones to pursue. These methods provide different ways to compare projects against each other to see what return will be generated.
If this sounds overly complicated, don’t worry: Profit Frog can help you make sense of all the mess. Our financial planning software does all the hard work for you—all you need to do is put in the necessary numbers, and let the software do the heavy lifting.
What is an ER diagram?
The entity relationship diagram, also known as an ER diagram or an ERD, is a type of flowchart that uses the Venn diagram to illustrate how certain entities (concepts, people, objects) relate to each other within the company. Scenario plan diagram software offers a diagramming tool to determine how entity relationships may influence future events of the company.
ERDs are typically used in advanced enterprise applications and are not as applicable to smaller businesses.
What is a Gantt chart?
The Gantt chart is a work chart that helps teams plan and work around deadlines. Many project management software solutions use some version of the Gantt chart. In business, this chart is mainly used by project managers and heads of departments.
What is an organizational chart?
An organizational chart, also known as an org chart is a mind map of sorts that shows the internal structure of your company or organization. In this chart, different departments, such as the digital marketing department, the social media department, and the human resources department, are represented by boxes or other shapes. An org chart is integral for your business process to run smoothly, as it shows how different employees and departments are connected.
What is business continuity planning?
Business continuity planning is a form of scenario planning that consists of critical information a business needs to operate during an unplanned event. The main goal of continuity planning is to ensure that critical business processes can continue. Scenario planning, including continuity planning, can help you identify threats to your business’s continuity and address the key issue involved.
What is operations planning?
Operations planning is the process of turning a strategic plan into a map that outlines actions of your team that are needed on a weekly (or daily) basis to achieve the desired goals. This process comes after a successful scenario mapping process and is only successful if your scenarios are rooted in data.
Further Reading on Small Business Finance
What Is the Cost of Goods Sold?
How to Determine if Your Product is Profitable
Is Cost of Goods Sold Considered an Expense?
How to Calculate Your Year-Over-Year Growth
How to Optimize Your Profits Today
Profit and Loss vs Cash Flow—What Are the Differences?