A Decision Range Instead of a Single Plan: The Place of Scenario Work in Strategic Financial Management

The document that emerges at the end of annual planning processes is usually a single set of figures. The sales target is defined, cost assumptions are set out, and the investment amount and financing need are calculated. This document is useful for internal communication; it ensures everyone looks at the same numbers and makes budget approval processes easier.

However, when conditions during the year move away from the assumptions on which the plan was built, a plan resting on a single set of figures may offer limited guidance. Falling a certain percentage short of the sales target, movements on the currency or interest side, lengthening collection periods or an unexpected cost increase — each of these invalidates parts of the plan. In the time until the plan is updated, decisions are often taken not against current data but against a framework that has lost its validity.

In practice this often ends with the plan being abandoned altogether. When the deviation becomes clear in the first half of the year, the plan is set aside and decisions begin to be taken on the basis of day-to-day data. This approach can work in the short term; but when the link between resource allocation decisions and strategic priorities weakens, the picture that emerges at year-end may move away from the intended structure.

Scenario work comes into play at this point. Its purpose is not to predict the future more accurately; it is to define in advance how a decision will change under which conditions. The plan thus ceases to be a single target point and becomes a decision range within which movement is possible.

In terms of strategic financial management, the equivalent of this approach is defining the plan's flexibility in advance. In a plan where it has been determined which item will be reviewed under which conditions, changes during the year are treated not as deviations from the plan but as steps the plan anticipated. This distinction can help preserve the link between resource decisions and strategic priorities throughout the year.

Why Scenario Work Comes Up in Strategic Financial Management

Strategic financial management covers the linking of a company's long-term priorities to budget, investment sequencing, maturity and cash decisions. The main instrument through which this link is established is the plan; yet the plan itself rests on a set of assumptions. When the assumptions are not stated explicitly, the conditions under which the plan is valid also remain unclear.

The first contribution of scenario work is that it makes these assumptions visible. When it is set down in writing which price and volume combination underlies the sales growth, which items the cost increase has been calculated on, and what collection period has been assumed, the discussion of the plan also rests on defined ground. Different units interpreting the same target through different assumptions may thereby diminish.

The second contribution is identifying the points at which the decision is sensitive. Not every assumption has the same effect on the outcome. In some companies a short extension in the collection period noticeably affects the cash balance, while a similar proportional deviation in sales volume may produce a more limited result. Knowing which variable changes the outcome and to what extent also allows the monitoring routine to be built around those variables.

The result of the sensitivity analysis may also affect resource allocation decisions. In a company where the determining variable is the collection period, the management agenda and the resources allocated would be expected to concentrate on that area. This view also determines which part of the plan will be monitored more closely.

The third contribution is a shortening of decision time. The discussion to be held when conditions change has already been held once. When it has been agreed in advance whether an investment will be deferred once a certain threshold is passed, which expenditure item will be reviewed first, or at what level an additional financing need will arise, the decision process during the year can move more quickly. Speed here does not mean hasty decisions; it means continuing the discussion from where it was left rather than from the beginning.

The fourth contribution is that the plan is shared with a realistic confidence range. A plan resting on a single set of figures may be perceived, both internally and externally, as more certain than it is. Work showing three different courses, by contrast, provides both the board and financing institutions with information indicating that the company has anticipated conditions and is prepared for them.

The fifth contribution is that the discussion is taken out of the realm of personal expectations. Expectations of different units in planning meetings often differ; the sales side may foresee a more optimistic and the finance side a more cautious picture. Defining this difference not as a disagreement but as two separate scenarios moves the discussion away from the question of who is right and allows the consequences of both situations to be seen together.

Another function of scenario work is classifying decisions according to their reversibility. Some decisions can be revised during the year, while others produce consequences that are difficult to undo once implemented. Capacity investment, long-term lease commitments or permanent headcount increases may fall into this second group. Handling decisions that are difficult to reverse under more cautious assumptions, and flexible decisions according to the base course, creates a balanced approach across the plan as a whole.

The board-level equivalent of scenario work also becomes clear at this point. When a single set of figures is presented to the board, the discussion often concentrates on whether the target is realistic. Presenting different courses together with the steps attached to them moves the discussion from the target itself to the question of what will be done if the target is not met. This second discussion usually produces more useful results for the board's monitoring function.

The scope of scenario work varies according to the size and operating structure of the company. Comprehensive work in which numerous variables are modelled together may not be necessary for every company. Simple work built on a limited number of variables and updated at regular intervals often yields more useful results; work that is sustainable contributes more to decisions than work carried out once and archived.

Which Variables Form the Basis of Scenarios

The usefulness of scenario work depends on the selected variables overlapping with the company's actual areas of decision. Work built on general economic indicators may be informative, yet it is often not connected directly to a decision. When variables that arise from the company's own operations and over which management has influence are preferred, the result of the work also becomes applicable:

→ Volume and price combination: meeting the same revenue target through different volume–price balances produces different results on the margin and cash sides.

→ Collection and payment periods: how a change of a few days on the maturity side is reflected in the working capital requirement.

→ Variability in the cost structure: to what extent the balance of fixed and variable costs preserves the result when volume contracts.

→ Financing terms: the effect on debt service of changes in interest rates, maturities and collateral structures.

→ Investment schedule: the equivalent, in cash balance and capacity terms, of bringing expenditure forward or deferring it.

→ Currency sensitivity: the effect on margin, under exchange rate movements, of the currency distribution of income and expense items.

Each of these variables produces meaningful results when handled together rather than separately. The effect of a contraction in volume alone may appear limited; the picture may differ if a lengthening collection period and a cost increase are added in the same period. For this reason scenarios are generally built not on a single variable but on internally consistent sets of assumptions.

The company's revenue structure is also determining in the selection of variables. In structures where revenue comes from a limited number of customers or a single product group, scenarios need to take this concentration into account. A limited contraction in total sales may, in a company with high concentration, stem from a change in a single customer's orders, and its effect may exceed what an average-based calculation suggests. Similarly, in companies where contracted recurring revenue accounts for a large share, the band of the base course may be kept narrower, and wider in project-based companies.

In practice, three courses form a sufficient framework for most companies: the base course on which the plan is built, a course in which conditions develop less favourably than anticipated, and one more favourable than expected. Working through the favourable course is frequently omitted; yet accelerating growth can also create additional working capital and capacity requirements. Seeing this requirement in advance can make it easier to manage the pressure growth places on the cash side; in this context it is useful to consider working capital management together with the planning work.

It is also useful for each of these three courses to have a written rationale. When it is recorded which assumption was selected and why, what has changed can readily be seen in the update carried out during the year. Timing as well as figures needs to be defined when scenarios are prepared. Two different courses producing the same annual result may produce different outcomes in cash terms. Between a course in which sales concentrate in the first half of the year and one in which they concentrate in the final quarter, the period in which the working capital requirement arises and the timing of the financing need both change. Building scenarios on a periodic distribution rather than an annual total therefore increases the decision value of the work.

Limiting the number of variables also matters for the sustainability of the work. Modelling many variables at once can make results harder to interpret and make regular updating more difficult. Selecting the three or four variables most determining for the company's result makes the work both understandable and repeatable.

The degree to which scenarios diverge from one another also determines the function of the work. Courses built on very similar assumptions may not contribute to decisions, since they produce no meaningful difference in the outcome. Courses built on very distant assumptions may be disregarded because they appear unlikely. Taking as a reference the actual range of fluctuation the company has experienced in past periods can provide both divergence and credibility.

The reliability of the data on which scenarios rest also determines the outcome. Where estimates coming from different units are not produced under a common set of definitions, the output of the work may create a new subject of debate instead of easing discussion. Clarifying which system produced the data and under which definition is therefore a precondition of the work; the structure of accounting and reporting systems directly affects the quality of scenario work. Whether the existing financial structure provides a sound starting point for the work can become visible through an independent financial check up assessment.

From Scenario to Decision: Thresholds and the Monitoring Routine

Scenario work turns into decisions through thresholds defined in advance for each course and the steps attached to those thresholds. Where the work is limited to showing different pictures, the discussion begins again when conditions change and the time saving the work provided disappears.

Defining the responsibility side of thresholds is also part of the routine. When it is determined which unit will calculate which metric, to whom and how often the result will be conveyed, and which meeting's agenda the matter will enter as a threshold is approached, monitoring ceases to be a reporting exercise and becomes part of the decision process.

Measurability is essential in setting thresholds. The phrase "sales falling below expectations" is not a metric that can be monitored; "cumulative quarterly sales falling below a certain percentage of plan" is a threshold that can. In the same way, a minimum balance level on the cash side, the average collection period on the receivables side, and the share of debt falling due within the total on the financing side can be defined as thresholds.

It is also useful for thresholds not to be defined only in the unfavourable direction. When it is determined in advance which investment may be brought forward, which capacity decision will arise or which debt may be repaid early where conditions develop more favourably than anticipated, the favourable course is also tied to a decision. Where this definition is not made, the additional funds that arise often go towards unplanned expenditure.

Sequencing the steps attached to thresholds in advance also allows the work to turn into decisions. When it is determined beforehand which expenditure item will be reviewed first, which investment can be deferred, which item's deferral will produce long-term consequences and at what stage an additional financing need will arise, the number of options to be assessed at the moment of decision remains manageable. Carrying out this sequencing at the start of the year usually yields sounder results than doing so in a period in which conditions are creating pressure.

Another heading in setting thresholds is keeping the number of metrics limited. In routines where many metrics are monitored at once, a metric approaching its threshold may lose visibility among the others. A monitoring routine built on a limited number of metrics that directly affect the company's cash and debt structure both eases follow-up and ensures the decision process operates as a threshold is approached.

The frequency of the monitoring routine is determined by the company's operating pace. Monthly monitoring is suitable for many companies; weekly monitoring may be needed in structures with a fast cash cycle. What is determining is less the frequency itself than the calculation of the same metrics under the same definitions in every period. When definitions change, comparability between periods weakens and the reason for a deviation may become contested.

Updating the scenario work is also part of the routine. As actual data accumulates during the year, some of the initial assumptions lose their validity. Reviewing the work at defined intervals, for example quarterly, shows which assumption has been confirmed, which needs revising, and whether the decision range has narrowed. Including this review as a defined item on the

management agenda prevents the work from remaining in the plan file.

Separating out the reason for a deviation during the update is also useful. When it is established whether the difference between plan and actual stems from the assumption, from implementation or from external conditions, the step to be taken differs as well. A deviation arising from an assumption may require the plan to be revised, whereas one arising from implementation may point more towards an adjustment on the process side. Where this distinction is not made, the same difference may recur over successive periods.

The work retaining its usability during the year depends largely on its simplicity. Comprehensive models provide detailed information in the period in which they are first prepared; but because updating them takes time, they may fall out of use after a few periods. Work built on a limited number of variables and thresholds, by contrast, can be updated quickly each period. What contributes to decision processes is usually not the most detailed work but the work that can be updated regularly.

Finally, the way the output of the scenario work is shared also affects the outcome. Detailed model files are often read only by the finance unit. Conveying the same work to the board and the relevant units in simplified form, through a limited number of metrics and thresholds, contributes to decisions being taken on shared ground. On how strategic priorities are reflected in budget and investment decisions, the article "Strategy and Financial Management: How Resource Allocation Decisions Make Priorities Visible" offers a complementary framework; for details on the corporate structure of the planning process, our planning and management services may also be considered.

At NT Finans Partners, we turn your annual plan into a decision range that is not confined to a single set of figures; we establish together, within a defined framework, the scenario assumptions, the thresholds to be monitored and the steps attached to those thresholds. To strengthen your strategic financial management processes with this routine, you can contact us.