SCENARIO PLANNING:

LINKING

FINANCE & STRATEGY

PERPECTIVES

EXPLORE HOW SCENARIO PLANNING

CAN BE LEVERAGED TO ENHANCE

FINANCIAL AND STRATEGIC PLANNING

Y V E S - B E R N A R D B R I C E M E T A L O

P A R I S B U S I N E S S C O L L E G E

F R A N C E , 2 0 1 5

2

THEORETICAL FRAMEWORK

This memoir has been written in the context of my Bachelor of Business

Administration.

Please accept my sincere apologies if the referencing is not perfect. In such cases, I

did not wish to attribute to myself only the fruit of work from any researcher. Note

that there were no supervisor that helped or conducted me in my researches and

writings.

If any issues to be raised, please get in contact with me for modifications and update

to this body of work.

Advice to contact me: ybmetalo@gmail.com or LinkedIn Yves-Bernard METALO.

I have condensed many approaches to formulate a Strategy and Finance perspective in

same research. In fact, it is not possible to dissociate both, simply because: in

“business reality”, they both go hand-to-hand in order to make the company move

forward!

Within this memoir, researches sources are various: it ranges from consulting

companies white paper (expert and practitioners); researcher’s own memoir’s; and

classic book abstracts.

The ground foundations for the writing of it are:

“Econometric Analysis for Scenario Based Planning” by Deloitte Consulting;

“A Scenario-based Approach to Strategic Planning” by Prof. Dr. Wulf, Meissner,

Stubner; “Scenario Analysis: A Tool for Task Managers” Jonathan N. Maack (World

Bank);

“Fundamentals of Corporate Finance” Brealey, Meyers and Marcus;

“Introduction to scenario planning” Thinking Futures, Maree Conway

The depiction of these sources relays mainly on the understanding and transcription of

methodologies and processes. In fact, there is many ways scenario planning is used,

and each one is adaptable depending on the company conditions. Therefore, a

condensed view of the most common and pertinent elements across scenario planning

approaches is presented, in my view.

Also, in scenario analysis, there is no right or wrong. Therefore, when applicable, we

will take the case of Delphi, multinational automotive part supplier, to illustrate major

steps.

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PAGE INTENTIONALLY L EFT BLANK

THANK YOU MUM: YVETTE MBIAKOP METALO!

4

SUMMARY

Theoretical framework ............................................ 1

Page intentionally left blank .................................... 3

thesis statement ........................................................ 5

I. Scenario planning: what is it? ............... 6

1) a diversity of definitions ........................ 6

2) Strategic implications of scenario planning 7

2.1) where does it sits? ............................................ 7

2.2) the characteristics of effectiveness ................... 7

3) the finance nterlink ................................ 8

3.1) scenario vs forecast .......................................... 8

3.2) The business environment ................................ 9

3.3) scenario planning as an input to strategy & finance10

II. scenario planning within finance: exploration of a two-fold process 12

the scenario planning process ............................. 13

1) Definition of scope ........................................... 13

2) Environmental scanning ................................. 15

2.1) Defining meaningful indicators ...................... 15

2.2) Determining key drivers of change ................ 16

3) Scenario building ............................... 18

3.1) developing the scenarios ................................ 18

3.2) Build the econometric model .......................... 19

4) strategic and finanical implications . 21

4.1) developing and considering options ............... 21

5) implement & monitor ........................ 22

5.1) business unit level of implementation ............. 22

5.2) monitoring ...................................................... 23

III. Limitations of scenario planning ......... 25

1) the matter of subjectivitty .................... 25

2) corporate capabilities ........................... 25

3) Implementation .................................... 26

final thoughts ......................................................... 27

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THESIS STATEMENT

Today’s world is more uncertain than ever. Industries grow so fast that they are

ending up exploding as the sub-primes; countries evolve so much that they change the

economic landscape like China; and certain products enters the market and totally

disrupt it as the first iPhone did. Within that landscape of uncertainty, companies are

left-out wondering, walking by rules of thumbs, and eventually end-up living for

today… Only!

At a recent position, as a Business Strategy Analyst, I had the possibility to do some

research work on Risk Management. The intent was to come up with a best practice

guidelines for Corporate Risk Management. After extensive information gathering,

the practice of scenario analysis came into light as a risk assessment and mitigation

planning practice.

Later on, I have established that “Scenario” methods are used across various

disciplines, essentially: Risk Management, Strategy and Finance. For the purposes of

this Research Paper, we are going to concentrate on the two latest aspects of it.

The practice of scenario planning have been popularized by the need for companies to

plan their strategies and investments accordingly to an ever-evolving environment.

Considering that, strategic and financial planning are increasingly in the need for pro-

activity, flexibility and adaptability.

While several companies have employed those practices, for several reasons, it

remains an un-common practice within both private and public sectors.

Why should you read this paper? The main reason is in within the intent itself:

bringing the light on the uses and practices of scenario planning in order to strengthen

long-term financial planning.

Within this memoir, we will initially cover what scenario planning is; then a how can

it be unfolded within the financial long-term financial planning; and finally the

limitations of such practice.

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I. SCENARIO PLANNING: WHAT IS IT?

1) A DIVERSITY OF DEFINITIONS

That is the very first question to be asked. Many version of that definition have come

to the surface since the 1960’s.

Initially originating from World War II US Air Force, it was initially used to

“imagine what opponents might do and to prepare alternative strategies”.1

The scope then expanded to the overall corporate environment when Shell, in the

70’s, started to popularize those practices by employing it for corporate strategy

planning.

As a result, they eventually succeeded to anticipate, adapt and respond to 1973 and

1979 oil crisis.

We can retain 3 main definitions of scenario planning:

“A planning method used to deal with uncertainties in the future

business environment”2

“Identify some significant events, the main actors and their

motivations and it conveys how the world functions”3

“Scenario is a tool for ordering one’s perceptions about alternative

future environments in which one’s decisions might be played out”4

In all cases, it will always ask “Are our proposed strategic actions ‘wise’ when

considered from a ‘future’ perspective?”5

There scenario can also be looked at diverse perspective from different disciplines.

Within finance, according to Brealey, Meyers and Marcus; scenario analysis helps

managers to look at testing project performances under different scenarios. It focuses

on a diverse but consistent combination of variables that constitute scenarios as a

whole. In most cases, it is used within the forecast process as well as project NPV and

risk evaluation.

In the Strategy world, the focus is more about the development of a plausible future

for which adjusted strategies will be developed. They are rich data-driven, stories

about tomorrow that enables organization to make better decisions in the now. It thus

provide an organized framework that helps to make sense of market signals.

Within the Corporate or IT Risk Management area, according to the ICASA

Organization, it emphasis on the contingency planning aspect.

1 The art of long view: planning for the future in an uncertain world, Peter Schwartz 2 Scenario planning: the link between future and strategy, Mats Lindgren & Hans Bandhold 3 Shell. Scenarios: An explorer’s guide 4 Scenario planning: the link between future and strategy, Mats Lindgren & Hans Bandhold 5 Inspired « Introduction to scenario planning » Thinking Futures, Maree Conway

7

In fact, it is about raising the right questions that will help managers to prepare for the

unexpected by allowing for better risk analysis, assessment and response.

All things considered, in order to have a better understanding of scenario planning,

there is a need to look how it fits within the environment of Strategy.

2) STRATEGIC IMPLICATIONS OF SCENARIO PLANNING

2.1) WHERE DOES IT SITS?

First of all, it is important to understand and locate where scenario planning sits does

as an approach to strategy.

In fact, within strategy; we distinguish three inter-dependent elements:

Strategic Thinking: an intuitive, synthetized and creative activity intended to generate

options;

Strategy Development: assessment of options to examine choices and make decisions

that will set a goal;

Strategic Planning: concerns the pragmatic steps to be taken and implementation of

the actions required to reach these goals.

At the end, scenario planning resides within Strategic Thinking. The reason being that

it is a thinking process that intend to consider plausible alternative futures; not to

predict the unpredictable.

2.2) THE CHARACTERISTICS OF EFFECTIVENESS

In general, scenario planning will deliver a whole new perspective about the most

important forces that influence the business environment.

Scenario planning can be used and adapted to many types of situations and

organizations.

Although, according to Johnson, Scholes and Whittington6, there is some

organizational characteristics and/or strategic positions that will make the scenario

planning truly valuable.

1) Limited number of drivers influencing the success of strategy: not everything that

can be counted, counts;

2) High level of uncertainty about such influences: estimating what’s plausible is the

purpose;

3) Outcomes could be radically different: it is not a best/worse/realistic case type;

4) Organization have to make substantial commitments into the future that may be

highly inflexible and hard to reverse in adverse circumstances: the need to make

large and long-term capital investment such as oil/automotive companies.

6 Adapted from “Exploring Corporate Strategy” 8th edition.

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Obviously, companies into which scenario is planned to be undertaken might not have

all these characteristics; but the ones who does shall leverage the most on the benefits

of this practice.

3) THE FINANCE NTERLINK

3.1) SCENARIO VS FORECAST

Scenarios differs from simple pro-forma forecasts. In fact, forecasting usually uses

historic data in order to project future revenues and costs. While subject matter

expertise is involved, it only considers what is known to the organization from both a

trend and risk perspective.

Taking on this graphic from Thinking Futures Consulting, we can explain that idea.7

Forecasting is often a process intended to predict what might happen, but founded on

elements for which uncertainty is low.

This result in the high predictability of elements that are analyzed in order to perform

projections and sensitivity analysis (see layers of environment later on). Thus, the

perspective of the forecast are within a limited time frame because of these short-term

variables and assumptions.

Scenario planning on the other hand, rely more on a long-term approach that can

support financial planning for the long-run (5 years +). The indicators that are

analyzed during the scenario methodology solely focuses on what is less predictable

nor certain, but still are drivers of business environment.

That mixture of uncertainty and predictability is what makes that method relevant.

As well as it is senseless to produce scenarios for next week, it wouldn’t make any

sense to forecast the next decade using the traditional methods.

7 « Introduction to scenario planning » Thinking Futures, Maree Conway

9

8

3.2) The business environment9

The challenge to capture the macro-economic events and translate them into

measurable potential business impacts. The aim will be to leverage on econometric

models in order to build long-term financial planning with sets of hypothesis.

Due to his long-term horizon, financial planning focuses on the big picture: too much

detail isn’t relevant, especially as many event can occur that might completely shift

the plan.

8 Adapted from GBN Consulting’s introduction to scenario planning 9 Adapted from « Exploring Corporate Strategy » 8th edition, & « Introduction to scenario planning » GBN Consulting

Organization level comprises of assets,

product or services, costs etc. Most forecasts

will consider this level of environment,

explaining their short-term nature.

Industry environment is including

competition, customers and market

dynamics. In this space resides some more

mid-term elements that can be leveraged for

scenario planning purposes.

The contextual environment is what is

considered the most for scenario planning,

and the less in traditional forecasting. It

focuses on macro events that can range from

all elements of a PESTEL analysis.

Scenarios also considers past data, but emphasize

on issues that might emerge Also, it will provide a

modelling that represent multiple outcomes for each

of these uncertainties.

Most forecasting processes are based on facts that

happened in the past, without really considering

plausible future outcomes. The sensitivity analysis

will only allow for business impact analysis based on

+ or – estimations.

10

3.3) SCENARIO PLANNING AS AN INPUT TO STRATEGY & FINANCE

Draw the line: scenarios are not strategies! The value lies in the process of exploration

and contingency planning elicited by the Foresight work.

Below, I have built an integration of the components of Foresight Process10 at

Swinburne University, and Financial Planning based on Brealey, Meyers and Marcus.

We will depict this “graphic/framework” from Foresight to Financials.11

The inputs are originating from the scanning of the strategic environment. By

encompassing elements that are within a near-future and long-term context, it helps to

understand “what is currently happening” as well as what might happen.

In the meantime, financial statements as inputs to financial planning, financial

planners need to worry about unlikely events. And they also have to prepare (if they

don’t already use external specialists) macro-economic and industry forecast.

The Foresight segments:

Analysis comprises the trends issues and themes that are being identified which are

related to the company (more on the levels of business environments later on);

Interpretation will allow the focus to be zoomed on “deep drivers of change” that

are the most directly linked to the business environment;

Prospection itself will then be the process of developing the scenarios using a

framework.

10 Can be defined as « an approach of thinking of alternative plausible futures”, Maree Conway 11 Quotations based on both « Introduction to Scenario Planning » and « Fundamentals of Corporate Finance.

11

Planning model segment: calculate the implications of the manager’s forecasts for

profits, new investment, and financing.

Key value drivers will be determined through the foresight work of scanning the

contextual environment;

Hypothesis are drawn-out in forms equations specifying the key relationships

between events implications on business performance and financial results;

Estimates will be made to project financial results under each scenarios that have

been built.

Contingency planning will be developed based on scenario’s new found real options.

Therefore, it is a clear need of financial statements in order to provide practical

translation of macro-economic events and scenarios impact on the P&L;

The outputs is an expanded perception of the Strategic options of the company (i.e

new markets, products or contingency strategies could be explored).

The financial managers will need to evaluate whether there are opportunities for the

company to exploit its existing strengths by moving into a wholly new area”. Strategy

development phase will assess these new options found during the foresight work.

From there, financial managers have to consider these options and justify them as

potentially profitable growth options.

Financial planning must also reflect the strategic plans made by senior

management.12

Forcing Consistency will be necessary at the strategic planning phase to provide the

necessary steps needed to reach these new goals.

Financial planning will therefore play a go/no go role in terms of evaluating the NPV

of these goals based on the financial requirements of the proposed strategy.

The projected financial statements shall be supported with financial ratios that will

evaluate the health of the company under these various scenarios.

This demonstration shows that complementing Scenario and Financial planning

provides the link between strategy and operations by intervening at all the main steps

of thinking, developing and planning the strategy.

12 “Fundamentals of Corporate Finance”, Chapter 18, Brealey, Meyers & Marcus, 7th editions

12

II. SCENARIO PLANNING WITHIN FINANCE:

EXPLORATION OF A TWO-FOLD PROCESS

During this chapter, we are going through scenario planning as a two-fold process,

involving both the strategy and finance perspective. The late has been extracted and

adapted from several sources in order to form a logic that is common between most

scenario planning methods.

In “Scenario-based strategic planning”, Schwenker and Wulf they explain about the

conflict between the planning and the process school of strategy.

The outcome of the research is to prove that scenario planning can link the opposed

approaches by: offering a systematic process to scenario creation that is built on

specific management tools and thus easy to implement.13

Within this book, they succeeded to demonstrate that scenario-planning is not a side

activity to be done by strategist in their own world. It is rather an approach that can be

specifically framed, and can result in an enhanced strategic planning by involving

various type of stakeholders to get insights.

From a finance perspective, elements of “Econometric analysis for scenario-based

planning” by Deloitte is setting the ground for the “concrete”. They greatly illustrate

the overarching intent of this research paper, which is exploiting strategic methods in

order to enhance a finance practice.

The whole question is “Suppose your boss, the CFO or CSO (Chief Strategy Officer),

asked you how your company’s revenue would be impacted by a changing economic

climate […] how you would quantify the potential impact of specific events or

variables?”14… A challenge!

13 « Scenario-based Strategic Planning : – Integrating planning and process perspective of Strategy », Bukhard Schwenker, Torsten Wulf 14 « Econometric analysis for scenario-based planning », Deloitte, Jeanne Wood, Mike Dougherty

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THE SCENARIO PLANNING PROCESS

1) DEFINITION OF SCOPE

The first and most important step of this process is to determine the framework of this

scenario planning process.

According to GBN Consulting15, scenario planning have these main applications:

Creating a more sustainable long-term strategy;

Taking strategic decisions under conditions of uncertainty;

Develop the ability for the organization to think flexibly and creatively;

Aligning key stakeholders in support of a shared vision.

This sets the tone for using the first tool fit-for-purpose of this process: the Framing

check-list.

15 Adapted from GBN Consulting’s « introduction to scenario planning »

Definition of Scope

Environmental scanning

Scenario buildingStrategic & Financial

implications

Implement & Monitor

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Tool n°1: the Framing checklist.16

Goal of scenario project: this is the focal question or issue that the organization

intends to explore. It allows to maintain the focus to the project team as well as

determining what will be the final output-like of the planning process.

It can be such as: “How would the prolonged economic downturn or economic

uncertainty of the European region can affect our business and cause us to require

additional sources of financing?”17 In this case, the application of scenario planning

will mainly be about taking strategic decisions under uncertain conditions, be it

economic in this case.

Strategic level: at which level the organization wished to conduct the scenario

planning process? Remember the three layers of business environment: organizational

(short-term), industry (medium-term), macro-environment (long-term).

It is key to determine this, in the sense that it will shift all other components of the

framing check-list. If we continue on our first example with Delphi, it is concentrated

on a macro-economic level, by looking at current negative trends and their potential

implications on the business performances, be it the sales.

Participants: it has to be decided who is going to be running the workshops. They

shall represent all the areas as well as levels of the organization, in order to counter

the traditional top-down approach to strategy planning.

From a finance perspective, it shall include mainly controllers, treasurer, financial

analyst and economist (or external specialist on that field), and of course run by the

CFO when he is available. A broader audience shall be consulted (key customers and

suppliers, industry experts etc) in order to obtain the more valuable and objective

input possible. That alone will play a major role in the following steps.

Time horizon: how far shall the project plan for? This is more or less conditioned by

the focal question and strategic level: 1, 2, and 5, 10 years or longer. This will also

indicate the expected time sustainability of the strategic and investment choices that

shall be made. In the case of Delphi that we have cited earlier, it should be a 5-10 year

exercise due to the fact we are looking at economic growth (GD) in Europe.

16 Adapted from « Scenario-based Strategic Planning », Bukhard Schwenker, Torsten Wulf 17 Adapted from Delphi Corporate 10K SEC Annual report, 2012

15

2) ENVIRONMENTAL SCANNING

Here we will take on a two phase approach of “Identifying basic trends” and then

“Identify key uncertainties” which have been brought P Schoemaker.18

2.1) DEFINING MEANINGFUL INDICATORS

After the scope has been defined and agreed, the first necessity is to understand the

current environment into which the organization is playing in. The purpose is to

capture and understand the forces or factors that plays a major role for the success or

failure of the current strategies.

Those can be captured by the extended participant’s lists, which includes outsiders, in

forms of a questionnaire or brainstorming.

Depending on the level of environment that has to be analyzed, could be used:

PESTEL framework at the macro-environment level, for long-term

perspectives

5 Forces or Diamond framework for industry level analysis of trends

SWOT analysis or organizational level analysis

For our purpose, we will focus on the macro level. Below, an example of PESTEL19

applied to Delphi Corp, 2012.

At this point, the finance team should arm himself with the current financial

statements which will be used down the line to produce the pro-forma.

18 « Scenario planning : a tool for strategic thinking », P Schoemaker 19 « Competitive advantage : Techniques for analyzing Industries and Competitors

16

The next step then, which can be run in conjunction with economists, financial

analysts and CFO, is to:

1) Determine the macro indicators that might impact the business. On this case, it can be: currency values across EMEA and North America,

GDP growth in European countries; macroeconomic impacts of natural

disasters on aggregate economic variables like GDP 20etc…

Those would be used later on in order to “translate” those events into financial

impacts;

Those are more or less known on a general basis for such finance teams.

However, the involvement of the external participants often brings new

perspectives as to what can be dangerous.

2) Collect historic data on multiple variables.

Those are ranging both from the historical economic data on these defined

indicators and the historical revenue data from the company. Those data are

recommended to be extracted from 30 data points (i.e: 30 quarters of company

revenue data) for statistical significance which enables relevant econometric

modelling.

In the Delphi case, it can be: USD, EUR, GBP, RUB, LIR currency values

evolution from the last 7 years, GDP growth for the main markets such as

France, UK and Spain; estimated impact on GDP of 2008 Sichuan earthquake

in China etc.

2.2) DETERMINING KEY DRIVERS OF CHANGE

Later on, we should end up with an extensive list of factors and indicators. Now, is

time to define what factors will be your “key drivers of change”. Those are the forces

that are most likely to affect the structure of an industry, sector or market21. The

challenge here is to assess each factor to determine the most important trends and

critical uncertainties that can potentially impact the future of the company22.

A meaningful tool has been developed for this purpose: the Impact/Uncertainty matrix

which have been developed in the 1970’s by K.v.d. Heijden.23 The method, which

have been greatly used in Royal Deutsch Shell for their scenario planning.

20 According to a study by the World Bank, most disaster estimations are measured against GDP growths evaluations, « Macroeconomic Impacts of Natural Disasters”, Reinhard Mechler 21 From “Exploring Corporate Strategy”, 7th edition, Johnson, Scholes, Whittington 22 Adapted from “« Scenario-based Strategic Planning», Bukhard Schwenker, Torsten Wulf 23 « The Art of Strategic Conversation » K V D heidjen.

17

Here, a presentation and application of it by the Chair of Strategic Management and

Organization in Lupzig school22 a German photovoltaic company and industry.

The matrix allows for classifying the factors based on a potential low/medium/high

impact and/or uncertainty to the business. This simplifying ranking approach will

determine if:

-factor is determined as a “secondary element”; meaning that it will remain important

issues to the strategy or potential scenario drivers to monitor;

-factor is a “trend/predetermined element”; in other words, uncertainty is low

therefore it is what we already know that might happen.

Those one can become critical planning issues when reaching certain levels of impact.

Referring to our Delphi case, it could be the sustained economic downturn and slow

recovery of the European downturn.

Due to all the lights on that subject in the financial news, there is awareness is huge,

and the impact on the car demand of the European market can greatly decrease for

Delphi’s customer, therefore causing a sales decline.

-factor is a “Critical uncertainty” when it can have a huge impact but there is an

opacity that cause high uncertainty of the event to happen in the time-frame of the

analysis.

If we consider that Delphi has some manufacturing plants in Asia Pacific to serve the

market, it is never away from a natural disaster that could cause spike to operating

costs, if not interrupting it. And even, if it is not him, it could be the increase of

commodity prices that increase overall COGS and reduce its bottom line.

The key for finance is to assess the impacts of those factors on business

performances. In fact, they shall work with business units in order to pre-estimate

how those events could impact the business performances based on current

investments and cost commitments.

These evaluations shall be made by financial analysts in conjunction with business

planning and the business units heads. Subject matter expertise will be required as

well as an understanding of macro trend forces.

The historical revenue and macro data that has been gathered previously shall enable

to pre-assess how past events have behaved jointly with past performance

performances.

18

By doing so, it would allow for building a high level relationship between the events

and the company performance24. It will seed the ground for the econometric model

that has to be built all through the process (more on that on the following phase,

scenario building).

3) SCENARIO BUILDING

3.1) DEVELOPING THE SCENARIOS

As a result to the last step, we have successfully identified the uncertainties the

organization might be faced with. Now, it is time to prioritize: the Critical

Uncertainties (high impact and probability factors) will be considered for developing

the scenarios. Other trends or secondary elements might be briefly taken into

consideration.

With the factors defined, refined and categorized, the scenario building can start.

The main tool used for this purpose, is the Scenario Matrix25 which have also been

employed at Royal Dutch Shell.

It provides a visual representation of the scenarios that will be developed by the team.

But in the meantime, it provides guidelines as to how to build them, see below26.

The first step is to select two key uncertainties from the previous step. They will form

the end-point of Critical uncertainty 1 and 2; those will be called the scenario

dimensions27. Those will then extended to their own positive and negative outcomes

in order to sketch-out four distinct scenarios.

On the Delphi case, say we established that one critical uncertainty is: “customer’s

credit availability may be affected due to slow economic recovery in Europe”. On the

positive state we may have “European credit availability driving sales increase” at the

24 « Econometric analysis for scenario-based planning », Deloitte, Jeanne Wood, Mike Dougherty 25 « The Art of Strategic Conversation » K V D heidjen. 26 « Introduction to scenario planning », Thinking Futures, Maree Conway 27 « The Art of Strategic Conversation » K V D heidjen.

19

top of the arrow of Critical Uncertainty 1; and negative “European credit availability

creates losses in sales” at the other hand.

Those are defined as world as they would depict different future state of the

corporation and especially the environment it plays in. The context will be defined

and explained during the creation of the scenarios.

Shell scenario planning approach estimated that: two scenarios are often limited to

just polarizing; three scenarios that to bias them into the forecast logic of

best/worst/realistic case; making four scenarios a general principle.

Next, in order to have more accurate description of the scenarios, is often used

influence diagrams. Those will allow to elicit the influence of the trends we

previously identified on the critical uncertainties28. This allows to understand the

inter-relationship of several events in order to build a more accurate picture of the

future state/world that will be depicted for each scenarios.

Below an example adapted from the German Photovoltaic Industry Scanning from the

earlier mentioned Leipzig research project.

Hence, it produces more detailed scenarios that emphasis on the critical uncertainties

while still considering other trends that may even change the direction of those.

3.2) BUILD THE ECONOMETRI C MODEL

Now armed with detailed scenarios, key indicators, factors, and historical macro and

revenue data, we shall be able to build an econometric model for financial planning

purposes.

In fact, with the potential impact performance estimated with business units as well as

meaningful macro indicators, we can look at two aspects:

-Key Risk Indicators29 arising from the analysis and scoping of business relevant

macro-events;

28 Adapted from “« Scenario-based Strategic Planning», Bukhard Schwenker, Torsten Wulf 29 « KRI are metrics used by organizations to provide an early signal of increasing risk exposures in various areas of the enterprise” from “Developping KRI to streghten ERM”, COSO ERM

20

-Key Performance Indicators that may be affected from an operational and financial

perspective if these events were to occur.

Provided with those valuable information, we shall:

Build an econometric model based on historical data.

The intent here will be to define a relationship between the KRI’s and KPI’s

over time based on the collected historical data. A perfect correlation isn’t

possible, although, co-jointly with financial analysts, economists and Business

Unit’s SME will allow for estimating financial impact based on the high

impact and uncertainty KRI’s with the KPI’s affected over the time of the

historical data analysis.

Here, the key is the use of econometrics into financial modelling. Multiple

linear regression may be used in this case in order to establish correlations

accross multiple variables.

Testing and validating the model.

This type of modelling can of course build a certain number of

inconsistencies.

Firstly, while using multiple regression, it can be difficult to interpret the

relationship between each variable and the resulting factor. In fact, if

Delphi’s KRI are customer credit availability, interest rates and GDP, it

becomes harder to establish the strongest correlation; hence explaining the

need for multiple regression.

Secondly however, the focus shall be on the business logic rather than the

statistics. For example, the probability might show that strongest KRI happens

to be the fall of government spending in military arming, including heavy duty

vehicles.

But if those represent, and it represent only 2% of Delphi’s business units, it

will not be logical to rank it as high from a business correlation perspective.

Adjustments have to be made while building the econometric model and establishing

the KRI/KPI relationship.

On historical revenue data:

Seasonality; in order to really compare “apples to apples” from one period with

another;

M&A; because comparing with as-is state won’t be relevant as company valuation

and attributes are now drastically different.

Business diversity; diversified companies such as Bouygues cannot use on

econometric model for all, because they have completely disparate business segment

from construction to telecommunications and network. The reason being that business

segments will react differently with macro-events, therefore making the KRI/KPI

different. In fact, it can even be totally different Key Drivers of Change.

On macro-event data:

Lags; some event might show an impact on the business but with a n+1 timing,

therefore expressing variances later on in the quarter or year;

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Onetime events; for example a sudden favorable interest rate for 1month to

customer that boost car spending and increase Delphi shall not be confused with

steady KRI/KPI relationship.

4) STRATEGIC AND FINANICAL IMPLICATIONS

4.1) DEVELOPING AND CONSI DERING OPTIONS

At this point, all inputs are in readiness to be exploited for strategy development.

Remember as we stated in part one, scenario planning in an input and doesn’t

substitute the strategy.

In fact, we know have a knowledge, quantifiable understanding of what might happen

and how it could impact us.

At this point, it is about developing strategic options available for each of the new

built scenarios. The real options and decision three approach can be taken. It shall be

the option to expand, to abandon, to wait or to be flexible.

For example, Delphi might have the option to close a manufacturing plant in China in

the event that natural disaster happen, option to abandon. As a contingency, they

might decide to move that production to Taiwan, if it meets requirement, and still

serve the South Asian market.

The finance team is not twisting fingers in the meantime. Referring back still to 3.3)

scenario planning as an input to strategy: we have the key value drivers (macro

trends), the assumptions (KPI/KRI econometric model) and the estimations

(scenarios).

That combined allows to build and exploit the long-term financial planning model.

Financial Impact Analysis of each scenario.

Evaluate the financial impact of the scenarios on the most relevant areas such

as sales, profit, costs etc.

To do so, sensitivity analysis might be used based on a list of assumptions that

have built based on the scenarios story lines. Though, as we are on the long-

term financial planning, it should remain a high level view on key financial

elements.

It shall prove how sensitive the high level financial statement is to those

macro-events. In the meantime, it shall allow for testing the econometric

model.

Revenue projections under each scenario.

Firstly project the historical macroeconomic indicators, on the timeframe of

the analysis that have been set at the first step of scenario planning (framing

checklist).

Once those made, you may now use the initial financial statement in order to

make revenue projections using the econometric model that has been built.30

30 Inspired from « Econometric Analysis for Scenario Planning » Deloitte, B. Schwenker, T. Wulf

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Assess current vs future state of financial health.

In fact, financial ratios are still a good way to assess the companies’ high level

financial health. Here, it would be a practical look at what the company is

looking like today on the financial statement vs. how it looked like under our

initial forecast (without going through the scenario planning process) vs how it

is under each scenarios.

With those information in hand, the CFO shall now be in position to make informed

decisions based on multiple plausible futures and how they will impact the business.

On the other hand, the CSO or strategy team have indicators in hand and strategic

options.

Therefore, it comes to the end-point strategic planning: what will the company do

under each scenario? Failure to adjust to those new found parameters may result in

strategic drift for the organization31.

Under this new paradigm, financial strategies have to be developed for each strategic

goals set under the four distinct scenarios. Those would be, as a result, pro-forma that

have been developed all through this process so far, based on an econometric

enhanced financial model.

5) IMPLEMENT & MONITOR

5.1) BUSINESS UNIT LEVEL OF IMPLEMENTATION

Like any strategy, the challenge always lays into the implementation of it. In this

approach, one of the main element to consider is actually the management of

stakeholders: key stakeholders needs to be involved from day one.

During the buildup of the econometric model, it is essential for financial managers

and analysts to obtain insights from SME’s with the assistance of Business Unit’s

managers.

For the simple reason they are the one executing the strategy on a day-to-day basis.

Thus in better position to evaluate the impact of a particular event on them: it needs to

be incorporated in the strategic and financial planning processes.

By consulting all key stakeholders in all business segments and at all level, it facilitate

an organic integration of the planning model into the processes32.

That element is the key to scenario planning, therefore an educational process of the

benefits of the practice also have to be conducted gradually. If the approach is not

embraced by business unit heads it will be harder to make them commit to the

practice of it; and nearly impossible to enforce the implementation of the contingency

strategy.

31 « where strategies progressively fail to address the strategic position of the organiwation and performance deteriorates », from « Exploring Corporate Strategy », Johson, Scholes, whitthington 32 Adapted from « Econometric Analysis for Scenario Planning » Deloitte, B. Schwenker, T. Wulf

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5.2) MONITORING

Within this research paper, the scenario planning has been approached as a process, as

the intent is to reiterate it.

For this purpose, a three step approach has been proposed by the searchers of the

University of Lupzig: the scenario cockpit33.

Step one: defining indicators. In fact, by involving stakeholders, you would

be able to determine what are the indicators of the risks/even to happen. Those

signposts will be crucial in the sense that it will provide a guidance as to the

progress of the key risks indicators. This would also allow business unit to

warn for early signals.

Those can also be derived from the influence diagram that we have mentioned

in the scenario building part. Remember they are trend that affect the high

Impact/Uncertainty macro-indicators that we chose to build the scenarios.

I.e. for Delphi the interest rate of private customers on personal line of credit

in Europe.

Such indicators may also be included in the financial planning model as new

input after the initial scenario planning process.

Step two: evaluate value ranges for these indicators. As our proposed

approach suggest, there is a need for quantification at each step of the scenario

planning process. Here, it is about determining a valuable threshold on the

evolution of a particular indicator.

On the previous example, it may be a trigger point for a financial analyst if

personal credit rate is higher than 8% for five consecutive quarters.

Step three: monitor the indicators. In fact, KRI’s such as KPI’s have to be

monitored over time. This comes to the heart of scenario planning practice

itself in a sense that it will allow to assess the evolutions of the contextual

environment. These evolutions might or might not be the ones expected within

the scenarios, hence requiring even more attention. Key stakeholders,

especially CFO and CSO or divisional management, shall then be presented

these reports on a periodical basis in order to re-assess and improve the

scenarios and strategic plans.

The stakeholders might also provide necessary input in order to improve the

econometric model.

Below, a graphic from COSO34 Strategic Risk Management which illustrate the

relationship between the goal (increase revenues/reduce costs), the strategic initiative

and the KRI’s.

33 Adapted from “« Scenario-based Strategic Planning», Bukhard Schwenker, Torsten Wulf 34“Developping KRI to strengthen Enterprise Risk Management”, COSO ERM

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To add on this graphic, we can consider that a successful strategic planning will allow

to determine KPI’s of each strategic initiatives. Furthermore, the potential risks and

KRI’s are elicited through the scenario planning process. Therefore, there will be a

quantified (thanks to econometric modelling) link between the initiatives and the

KPI/KRI relation.

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III. LIMITATIONS OF SCENARIO PLANNING

Like all processes and methodologies, it is not absolute. Here are the key points I have

denoted within this approach that may discredit some if not all of its benefits.

1) THE MATTER OF SUBJECTIVITTY

There is a lot of perception involved within this process. In fact, it starts right from the

focal question of the framing checklist: “is it really the most important question that

the company has to ask itself right now?”

How many times leadership teams prefer to neglect the actual painful issues that the

company faces? It could be both because they do not see the blind spots, and also that

if some of them were to come at the surface shareholders may make them exit!

Then, all through the process there is “bias opportunities”. In conditions where a

company is resulting from a Merger, the financial rules could be completely disparate.

Thus creating a revenue projection that is incorrect in a sense that the recognition of

sales isn’t the same between those units.

Even econometric modelling, after all, is based on the assumptions of these scenarios.

Macro level data such as natural disaster, even though are available, are still in

development for possible exploitation in economic fields. Therefore, we might end-up

with pro-forma that are not so far-off from traditional forecasting, whose are meeting

immediate business needs.

2) CORPORATE CAPABILITIES

Although considered that it could, this method is hardly adaptable by any type of

companies.

Subject matter expertise in various disciplines (finance, strategy, economy,

operational…) which may not all be available, requiring consultant and expert

involvement. In fact, the approach could possibly efficient if all expertise can

be leveraged over a certain amount of time;

Information systems structured from which we can extract historical company

data (may therefore pre-requisite investments in IT infrastructure and/or

Business Intelligence);

The culture of the company itself has to be in readiness of such practice. For

some corporations, it is not even in the habits to think beyond 2 years,

although they might be affected by 10 years ahead environmental policy

changes for example. Hence, that culture impact the strategic thinking

capabilities of a leadership or management team might be limited to it, not

enabling for foresight work.

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All in all, the success of it highly depends on the resource available to the company,

be it human, financial, infrastructural and even time…!

3) IMPLEMENTATION

Compared to traditional approach, scenario planning can be considerate as quite

cumbersome. In fact, if it is not 100% embedded into the strategic development and

planning process, I doubt if it would work. The reason being that it will be seen as an

additional work by business unit managers, more than a valuable input: it is a hard

sell!

Also, once indicators have turned into red, how well and quickly the organization can

react will play a major key. If the strategies haven’t been taken for ownership at

business unit level, that reaction could be very slow.

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FINAL THOUGHTS

Within this research paper, we have approached Scenario Planning from a Strategy

and Finance perspective. As the result of this two-dimensional view, we have been

able to go through all necessary steps and overview what has to be done for both

disciplines.

The first part gave us the necessary understanding of what scenario planning is about.

There is a diversity of definitions and approaches to it, which calls for a

benchmarking of the diverse methods.

Then, we had to understand what the strategic implications of such practice are. Clear

distinction between thinking, developing and planning a strategy is essential.

But also, the finance interlink is what is making the improvement to long-term

financial planning. In fact, idea is that a CFO get closer to a CSO thinking in order to

understand that traditional forecasting may not be sufficient for real long-term

financial planning purposes.

Although, they both goes hand-to-hand in order to make a successful, practical and

actionable scenario planning process.

That partnership is then illustrated during the overall scenario planning process.

It is important to scope what is the purpose and outcomes of the process. That will

define how we will scan the environment the business is playing it.

Outcome of these, macroeconomic indicators that enables to prioritize uncertainties

and build detailed scenarios. Not only that, it is an econometric model which will

improve financial modelling while engaging key members of an organization into

thinking and measuring its plausible future.

The key identified benefits of scenario planning for CFO is therefore:

1) discovering a whole set of new plausible long-term real options;

2) methodic approach for capture and analyzing macroeconomic events impacts on

the business by using econometric modelling;

3) improved long-term financial planning thanks to the model and continuous

monitoring of indicators.

This research paper was more intended to open new perspective that providing a

perfect solution. There is many more extension possible to the scenario planning

process.

Nowadays, the use of Business Intelligence and Predictive Analytics will play a major

role into the process as well as its implementation.

In fact, with a correct IT infrastructure as well as business process owners, it can

greatly simplify the collection of the business’s historical performance using

QlikView for example.

By getting economic indicators data from the World Bank, Central Banks of

specialized consulting or even rating agencies, sufficient macroeconomic indicators

can be found.

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In the meantime, SAP and SAAS provide top-notch solutions in order to produce

statistical projections using econometrics or Monte Carlo simulations.

Then once indicators determined, it is now easier with technologies such as Tableau

to build Dashboard of the evolution of these indicators, as long as a reliable data

source is provided.

To put it in a nutshell, with today’s science, financial modelling and technology,

scenario planning can be erected to the top of strategic and finance planning practices.

But it will require the democratization of these technologies first, thus will make it

100% effective for only a selected few Fortune 100 companies.

But as anything, the dimension that is often forgotten is the Human. Yet, that is what

will make or fail any scenarios and financial plan.

Therefore, there is an opportunity for Financial Planning with the inclusion of

Scenario Planning, Strategic Risk Management, Business Intelligence & Analytics…

and Change Management!

At least, that is where I see its future going…

7 147 words

Y-BM

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R E F E R E N C E S

1. “The art of long view: planning for the future in an uncertain world”, Peter Schwartz

2. “Scenario planning: the link between future and strategy”, Mats Lindgren & Hans

Bandhold

3. “Shell. Scenarios: An explorer’s guide” Shell corporation

4. “Scenario planning: the link between future and strategy”, Mats Lindgren & Hans

Bandhold

5. « Introduction to scenario planning » Thinking Futures, Maree Conway

6. “Introduction to scenario planning” GBN Consulting

7. « Scenario-based Strategic Planning : – Integrating planning and process perspective

of Strategy », Bukhard Schwenker, Torsten Wulf

8. « Econometric analysis for scenario-based planning », Deloitte, Jeanne Wood, Mike

Dougherty

9. Delphi Corporate 10K SEC Annual report, 2012

10. « Scenario planning : a tool for strategic thinking », P Schoemaker

11. « Competitive advantage : Techniques for analyzing Industries and Competitors »,

Miichael Porter

12. « Macroeconomic Impacts of Natural Disasters”, Reinhard Mechler

13. “Exploring Corporate Strategy”, 7th edition, Johnson, Scholes, Whittington

14. “Exploring Corporate Strategy”, 8th edition, Johnson, Scholes, Whittington

15. « The Art of Strategic Conversation » K V D heidjen.

16. « Macroeconomic Impacts of Natural Disasters”, Reinhard Mechler

17. Developping KRI to strengthen Enterprise Risk Management”, COSO ERM