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Econometric Analysis for Scenario-Based Planning

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Econometric Analysis for Scenario-Based Planning Econometric analysis for scenario-based planning Introduction based planning using econometric analysis may be the next Companies have become well aware of how challenging best thing and can assist you in being better prepared for it can be to compete in the current rapidly changing future uncertainties. marketplace. Couple this increasing pace of doing business with economic and political uncertainty and it is clear Scenario-based planning is a tool designed to assist the that the ability to react to change is more important development of strategies for operating in any of several than ever. Companies that are well prepared and able to contrasting business and economic environments that quickly execute strategically thought-out plans are better could lie ahead. Scenarios can run the gamut of plausible positioned to thrive during uncertainty. outcomes and can be used to develop a wide range of plans from tactical contingency planning for near-term Suppose your boss, the chief financial officer or chief economic developments to fundamental changes in strategy officer, asked you how your company’s revenue strategy caused by global paradigm shifts. Here we provide would be impacted by a changing economic climate in an introduction to using the statistical techniques of coming years. How would you quantify the potential econometric modeling and multiple regression to project impact of specific events or variables? Unfortunately, there financial performance within scenario-based planning. is not a crystal ball to create a revenue forecast. Scenario- External influences on business performance What will my customers value Materialistic in the future? vs. How and when will new quality technologies affect of life Will stable growth markets and production processes? return or are difficult Economic Technology days ahead? momentum shifts vs. vs. game volatility changers Business performance How would a population Markets More vs. less shift impact sales? To what extent will vs. immigration government government regulation impact corporate activity? Resources vs. environment How will the world balance the need for resources with sustainability? Business uncertainties health through turbulent times, but adequately positioning Business uncertainties can be driven by various factors. for growth once the new developments have been taken Using scenario-based planning and econometric modeling into account. The following sections focus on the process to identify the potential impact of changes in market of developing an econometric model to project revenue conditions can enable your company to adapt quickly to based on various economic indicators within worlds new threats and opportunities. At the corporate level, depicted by scenarios. Considerations required when the scenarios can help a company establish an overall performing scenario-based planning, as well as tips and frame of reference for its strategic planning processes. suggestions are also discussed. In summary, we highlight The corporate development group can use results of the the opportunities to use econometric modeling as a tool to models as input to make limited, expandable investments enhance both strategic and tactical decision making. in assets that would facilitate adaptation to a scenario. At the business-unit level, planners can develop scenarios Distinguishing between shorter- and longer-term and models to test and refine how these scenarios would initiatives impact their existing strategies. On an ongoing basis, Econometric models can be used in a variety of forward- business units can use scenarios to make tactical decisions thinking situations. Models can be developed to illustrate on how to cope with near-term uncertainties that threaten how the conditions prevailing within the longer term, the execution of their current strategy. macro-scenarios used in developing strategic plans would affect selected key market and business indicators. This Definition of econometrics provides a more detailed, quantitative understanding of a The term “econometric” can be defined as the application scenario’s impacts than is typically possible when relying of statistical techniques to analyze economic data. solely on a qualitative, narrative description. Models Econometric models can be used to determine the can also be developed for shorter-term scenarios when relationship between a set of economic factors and executing the strategy a business has adopted. It can be organizational performance. These models can help you helpful to group these different applications into three make decisions to better prepare not only for sustaining tiers. Econometric analysis for scenario-based planning 2 First tier: Longer-term macro-scenarios — These Third tier: Ongoing, lower-level analyses — Once high-level scenarios are developed to provide context strategies have been identified and implemented by the for corporate-level strategic planning. They are “broad business units, additional, more tactical scenarios and brush” and overarching scenarios. While these scenarios analyses will need to be developed periodically as new are at a higher level, they may be the most important uncertainties emerge. These scenarios help to analyze the scenarios as their input sets the direction and tone of the significance of changes that have already emerged and to corporate strategy. For example, modeling out shifts in experiment with different theories as to what additional consumer behavior may prompt an increased research and developments might be on the way. It is important to development investment in specific product segments that assess what situations may impact the business unit’s the scenarios highlight as particularly variable. ability to execute against the strategy. Second tier: Impact of macro-scenarios on business Sensitivity analysis and contingency planning can both be units — After the longer-term scenarios have been used in conjunction with existing scenarios as an input developed, you then want to dive into how each would for decision making. The purpose of sensitivity analysis impact the various business units, markets, industries, is to test the impact of specific variables or indicators etc. Once the potential impacts of each scenario have used in the scenarios. This can be beneficial in evaluating been identified and the appropriate strategic responses the criticality of indicators being used, as well as the are defined, each business unit determines what future subsequent impact on the business. Contingency planning market conditions it will assume and strategy it will adopt. can be used to assess plausible outcomes and impacts of Competitive strategy will vary and should be tailored based new developments that raise questions about how best to on the intricacies of each business unit and its market. execute the strategy that is in effect. This type of planning In a company with many lines of business, the array of focuses on tactical approaches to financial or operational strategies will be correspondingly diverse. risks identified during the scenario-based planning process. Econometric analysis for scenario-based planning 3 Scenario-based planning process A scenario is a plausible sequence of future events that can affect an organization’s strategy and operations. As stated above, the underlying principles used to create the models across all tiers are very similar. The following section provides an overview of the phases involved in developing these scenarios. Throughout the development life cycle, the scenario- based planning process can be divided into four phases. Phase I Phase II Define purpose and scenarios Financial impact analysis • Determine the purpose of the scenario- • Evaluate the financial impact of each based planning exercise scenario on relevant areas, including • Develop and define how the scenarios are revenue, earnings, and expenses going to unfold • Collect data and develop a financial model • Determine the strategic direction of the (e.g., econometric model) business and potential impact of the • For each scenario, project financials for the scenarios established time frame Phase IV Phase III Adaptation and refinement Analyze impacts and identify responses • Finalize preparatory measures • Identify comprehensive issues and • Develop guidelines for integrating changes determine mitigating actions into planning and budgeting processes that • Review financial impact of current are in line with strategic initiatives investments and cost commitments • Work with business owners to socialize and • Develop plans based on potential issues integrate the plan • Develop integration plan to incorporate mitigating actions into the planning process Phase I — Define the purpose, scenarios, and “what-ifs” concerning events within the eurozone and associated strategic implications the changes that occur. For example, in Scenario 1, fiscal As an example of how econometrics can be used in reforms and a series of emergency measures prevent connection with a scenario-based planning initiative, any national defaults, but the value of the euro falls consider a U.S.-based multinational manufacturing substantially. In Scenario 2, Greece defaults and it, along company that is concerned about the implications of with one or several other countries, leave the eurozone, changes in the eurozone. This particular company has resulting in multiple sets of monetary and economic manufacturing operations in Asia, while most of the sales repercussions (inside and outside the smaller eurozone). are
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