Scenario Planning or Stress Testing
Scenario Planning is the act of simulating how a model will react to a set of variables, caused by a discrete event.
Stress Testing is the act of simulating how a model will react to a single variable in a range of situations.
A common mistake that I see is building out scenario plans with an executive and they propose changing a single variable in the entire model. Usually, this comes after we’ve built a nuanced model, full of KPIs for different departments. After spending hours on the base model, we change one variable and record the change to growth or cash at the end. The problem is that it’s not scenario planning, it’s stress testing. Stress-testing is rarely discussed but an important process for founder confidence. As a founder, you need to know the difference between when something is going well, going wrong and going so wrong that you need a code red. Stress-testing illuminates your businesses operating ranges.
Scenario Planning is different and even more important. When one or two variables are wrong in a forecast, it’s an execution error. However, that’s not usually how things go wrong. Normally obstacles are large and not small, so they affect a number of different variables, not one singular variable. Take the tariffs this year as an example. If you’re an American goods seller, the tariffs may have made importing your goods more expensive. But what some people missed was how the tariffs hit the trucking companies, so logistics providers within the US also increased prices. At the same time, your end customer is feeling the sting of increased inflation and is more price sensitive than ever. Taking into account the entire tariffs scenario means analyzing the event piece-by-piece to understand what the specific implications are for your business. Some of the ripples will be big, some will be small, but its hard to know what to focus on until you’ve done the work of mapping out different scenarios.
The goal here is not to predict Covid or the tariffs. The point of scenario planning is to think through all of the variables of your business, not just as inputs that you can effect but as variables woven together by a coherent narrative. As you understand how each variable moves together, you will develop the ability to move faster in the face of novel obstacles because you will understand when and how your model of reality breaks. Put a different way, scenario planning allows you to build flexibility into your model. If you do not do this, there is a much higher likelihood that an exogenous shock could render your model useless. (Scenario) Planning ahead will allow for flexibility and quick reaction.
