Visibility and the Practice of Scenario Creation: Analytic Methods Focus on Core Uncertainies, Enviornmental Shifts
Signals, Autumn 2001
Without a crystal ball you may not know which scenario will play out, but you can know what the impact will be for each... and have an action plan in place. It began with a spate of technology sector earnings warnings earlier this year. The new buzzword in stock analyst circles became 'visibility'—or more pointedly, the lack of it. The term describes the uncertainty in estimating the length of the downturn in the business cycle that slows sales and swells inventories. Visibility shortfalls are being used to explain the element of surprise—and as such brought little confidence to investors looking for predictable business performance.
Few portfolio managers or CFOs can cite a lack of visibility as an excuse for lagging performance—and get away with it. Yet environmental uncertainty abounds. How can one accurately enhance visibility of key portfolio drivers and their impact on portfolio results in the near future?
The answer lies in building competence in the development of business scenarios. Scenarios are credible instances of what the future could look like. Without a crystal ball you may not know which scenario will play out, but you can know what the impact will be for each. And you can have an action plan in place when it becomes clear that one of your scenarios is starting to become history. Scenarios have three main parts: origination, policy, and environment. Marketing plans (including how many new accounts and their demographics) will alter the portfolio mix being simulated. Changes in policy for existing customers and changes in external factors (legal, regulatory, or economic) shift the environment that affects consumers.
PA technology begins with the decomposition of the historical data for the key portfolio drivers into its maturation and exogenous impact components. From the maturation curve, we project the intrinsic behavior of new and existing customers. Examination of the exogenous impact curves quantifies past environmental changes and provides the basis for creating a scenario for the future environment.
What characterizes good scenario building? Collaboration is essential. Rarely does a key portfolio driver behave in isolation without impact on other drivers. Therefore, contributions from various disciplines (marketing, collections, risk management, finance) enhance the validity and credibility of the scenarios.
Second, good scenarios learn from the past without blindly repeating it. By quantifying the components of past behavior, PA's technology enables informed judgments about which impacts will recur and which will not. Third, good scenarios 'bound the problem' in a reasonable way. While the number of possible scenarios can grow geometrically with each possible permutation, good scenario management focuses on a reasonable number of scenarios that represent best, worst and most likely cases.
Today's uncertainty regarding the impact of bankruptcy reform presents an illustrative challenge: the best case may anticipate a modest spike in bankruptcies and then a drop as legislation takes hold. The worst case may anticipate a larger spike and a sustained higher level before a decline. In both cases, assumptions as to when the legislation takes hold are implicit. A middle ground can then be crafted which balances optimism and pessimism. For all three, the portfolio impacts are measured and used to develop contingency and mitigation strategies.
Finally, good scenario management involves monitoring and continuous revision. Internal scenarios should reflect the latest in business trends, changes in sourcing strategies and acquisition of new customers. Even without major changes in these areas, knowing which path one is going down is critical to activating new management strategies. Further, feedback on the accuracy of scenarios provides the lessons for more accurate scenario development in the future.
With experience, scenario development and management can become not only a key competence of the organization but a competitive weapon. Those businesses with visibility are and will continue to be more effective in executing their business strategies, and are more highly valued as a result. Clients of PA's forecasting and simulation tools are empowered not only with the finest tools to measure the impact of future trends—they have the full support of PA in the scenario development process as well. We look forward to helping you make it an ongoing and successful process for your organization. |
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