Global supply chain breakdowns, international conflicts, labor shortages, surging input prices, abandoned business districts and shopping malls, and more have drawn renewed attention to corporate risk management. This has been a practice of interest since the 2008 financial crisis forced executives and entrepreneurs to think differently about how to prepare for extreme disruptions, also known as black swan events.
Traditionally, companies have focused their risk management efforts on the disruptions most likely to occur. A black swan event, however, is by definition low-probability—and that’s precisely what makes it so potentially devastating. After an exceptionally volatile decade and a half, today’s risk managers recognize that they need more robust approaches to contingency planning. Enter: scenario analysis.
A More Dynamic Way to Manage Risk
Traditional risk planning models fall short of the new economic reality, which presents more distributed, long-tail risks. This demands “fresh thinking,” says Erik Stettler, Toptal’s chief economist. “The modeling required today should focus more on dynamic processes, inflection points, and even how to model an external event that has never previously occurred.”
Scenario analysis has become a prominent framework during the pandemic. While it uses the same statistical methods as traditional risk management, it shifts the focus from events to impacts. Instead of focusing exclusively on historical data to predict disruptions and develop contingency plans, scenario analysis simulates the financial impact of a series of events and uses the results to test the sensitivities of a company’s financial operating data against these perceived risks. For example, it can help a company understand how a change in demand for its products or services could affect the price. Traditional risk management plans focus on responses to predicted events; scenario analysis focuses on operational impacts—and opportunities.
The result is more comprehensive contingency planning that produces more resilient and flexible responses to unexpected events, says Stettler, a data scientist and founding partner of the venture firm Firstrock Capital. It also encourages firms to focus less on crisis management and think proactively about how they can use disruptions to their advantage, he says.
Case Study: A Contingency Plan That Launched a New Product
Jason Goldstein, who joined Toptal’s consulting network in 2021, was hired to provide CFO services for a fast-growing US soft drink distributor that was feeling the impact of COVID-19 on its business. Although Goldstein wasn’t hired explicitly for risk management, he helped his client establish a disruption response framework that not only eased the pandemic pinch, but also helped the company grow.
The client, which distributes soft drinks to convenience stores, was struggling to keep its customers’ shelves stocked in the face of supply chain problems and surging wholesale costs. Goldstein first sought to get a handle on inventory control, analyzing sales data to develop scenarios in which the distributor could substitute alternate products while not hurting a store’s sales.
After analyzing the company’s financial data, Goldstein created an interactive electronic dashboard for salespeople so stores could review the effect of trying different product mixes. He then studied how much flexibility the company might have to pass along rising wholesale costs, again analyzing sales data to come up with strategies. In addition, he developed a plan for cutting costs by optimizing delivery driver routes.
“Data-driven financial analyses helped the business make better decisions,” says Goldstein. “By upping the analytical capabilities with even more data, we were able to work more strategically.”
As a result of this analysis, not only did the distributor maintain gross margins and increase its bottom line, it is now also forecasting a 100% sales increase for 2022 and is moving forward with a plan to release its own branded soft drink, working with one of its overseas suppliers.
Identifying the Building Blocks for a Risk Framework
To lay the groundwork for scenario analysis, a company needs to articulate the assumptions that underlie its business, since understanding these will help highlight potential weaknesses. For example, the soft drink distributor needed to examine foundational questions, such as: In view of rising input costs, should we absorb rising shipping and wholesale costs in order to maintain relationships? How much flexibility do we have to pass along higher costs to the consumer? What are the ideal product mixes for our largest clients? Can we gain efficiencies by altering how we distribute our products?
To develop and respond to questions like these, a company must fully grasp the array of risks that threaten the ability to achieve goals, including:
- Financial risk: cash flow and other liquidity issues that compromise the ability to meet obligations, obtain credit, and more
- Operational risk: internal and external hazards that could disrupt day-to-day business activities
- Economic risk: macroeconomic events like changes in stock markets or monetary policy that could affect a company
- Security and fraud risk: data breaches, cyberattacks, identity theft, embezzlement, and intellectual property theft, for example
- Reputational risk: often ambiguous but certainly quantifiable when considering how negative publicity can damage credibility
- Compliance risks: changes in laws or policies that affect how a company does business or the cost of doing business
Additionally, a company has to recognize that these risks can compound one another. For example, a data breach that results in identity theft can damage a company’s reputation.
Once the threats have been identified, a company can turn to calculating their potential costs.
Analyzing the Impacts
The next step is where scenario analysis departs most radically from traditional risk management: moving away from responding to predicted events, and instead focusing on impacts and opportunities. This could mean analyzing a firm’s financial structure to find actions it might take to improve its cash position or measures that could help diversify key suppliers. The newer technique also entails more mathematical analysis than conventional risk management, with steps such as the following:
- Break down the factors that could lead to a disruption like a price shock, perhaps due to a geopolitical event or a natural disaster. Attach probabilities to those factors where possible.
- Evaluate these probabilities against relevant data from a company’s operations. Look for both first-order and second-order effects, such as how a surge or plunge in prices might not only affect sales but also bleed into areas like research and development.
- Map out the mathematical relationships between risks and corporate data with a spreadsheet or algorithmic program. Use this information to understand how elements of the business respond to disruptions and where there are areas of concern.
Based on this analysis, a company can develop contingency plans that prepare it for the most significant scenarios, not just the most probable ones. This helps a company gain a clearer understanding of all the forces that shape its business, both good and bad, and provides a solid, objective foundation for making emotionally difficult decisions.
Case Study: Powering Negotiations With Data
Michael Yarmo, a turnaround consultant working in distressed situations, performed scenario analysis for a farm that packages and sells fresh herbs through major US grocery store chains. As a result of the pandemic, the farm was struggling to balance rising input costs while facing growing demands from retail buyers, such as more frequent deliveries.
To survive, the farm needed to find ways to either absorb or pass along the higher costs. Since the farm was already distressed, absorbing costs could have compromised its ability to stay in business. But passing along costs was risky, too, because the farm didn’t know how much customers would be willing to pay or how amenable stores would be to raising prices. So Yarmo used a scenario planning approach to model the elasticity of demand for his client’s products, which revealed how high prices could rise before consumers would balk. He then helped the farm develop a compelling explanation it could present to its buyers, so it could make a convincing case for passing along at least some of the higher wholesale prices for its products to consumers.
“[The stakeholders] were nervous about having the price increase discussion, but they had to have that conversation,” says Yarmo, who joined the Toptal network in 2017. Having the data helped the farm build a persuasive narrative that it could present to the buyers at grocery store chains with more confidence.
Shaking Up the Bureaucracy
Planning for the most significant scenarios instead of the most likely ones can invigorate a firm’s risk management process—which for larger organizations is usually institutionalized through multidepartment committees representing different corporate functions, says Paul Ainsworth, a former finance executive at General Electric. “The danger with the functional approach is you tend to focus on the risk you know about,” says Ainsworth, who joined the Toptal network in 2018 and specializes as an interim CFO. “You become experts on things like safety and commercial terms, and become almost too comfortable with the risks you’re regularly managing, [while failing to] focus on things that could blindside you.”
Instead of managing risk in silos, companies should approach scenario analysis by pooling data as well as brainstorming what-ifs that tap into the experiences of employees across the company—from front-line workers to middle managers to executives. It can also mean looking outside the firm to consultants or experts such as white-hat hackers, who can test cybersecurity.
Looking Beyond Crisis Management
The goal of scenario analysis is to develop more flexibility and optionality in a business’s operations. For example, the analysis could reveal ways to replace fixed labor costs with variable ones by using digital platforms like Toptal to hire skilled contingent labor, or renting desks for employees in co-working spaces instead of leasing an entire office suite, or shifting enterprise information technology from on-premises facilities to the cloud in third-party data centers.
“You’re weaving flexibility into the fabric of your business,” says Jeffrey Fidelman, a management consultant who focuses on growth, go-to-market strategy, and fundraising for early to mid-stage companies and joined the Toptal network in 2016. “This is the best form of risk management.”
Ultimately, scenario analysis should enable a company to look beyond impact and understand how it can use its core technologies, capabilities, and partnerships to not only withstand a disruption but to leverage it toward new opportunities and innovations. These hinge capabilities are strengths a firm may not have realized it had, or may never have fully articulated before.
A global internship company that Stettler advised found such hinge capabilities at the beginning of the pandemic, when international travel shut down. If the company had used a conventional risk management approach, it might have responded to the shock by emphasizing where to cut spending and personnel, or how to shift operations geographically. Instead, scenario analysis led them to facilitate virtual internships, partnering with universities to launch training programs for employers adapting to a globally distributed remote workforce.
A more prominent example from the pandemic was when a number of liquor distilleries in the US started producing alcohol-based hand sanitizer as demand soared because of COVID-19.
Using Scenario Analysis to Build Resilience and Opportunity
The 2008 financial crisis and the COVID-19 pandemic have made it clear that a new approach to risk management is necessary. A keen understanding of the types of black swan events that could rock a company and a dedication to data analysis will help businesses withstand these disruptions while also identifying greater efficiencies.
Making scenario analysis central to ongoing operations also helps build a more robust approach to managing risk, introducing more voices into a process that could otherwise get hamstrung by internal politics and bureaucracy. In addition to including employees, this framework can help elevate some of the ideas and insights from the board of directors, which provides an outside, more skeptical perspective to executives, says Ainsworth.
The result is a risk management approach that makes an organization more resilient to unexpected events and more prepared to capture new opportunities. A company that uses scenario analysis will no longer need to be overly concerned with predicting the next catastrophe, but it will be better prepared to weather it.