Simulation and scenario modelling: an important controlling instrument in times of crisis and beyond
Simulation and scenario modelling are valuable not only in times of crisis. Their use increases business understanding and allows efficient and comprehensive preparation of decisions. Michael Kappes and Dominik Klehr explain the application, advantages and IT technical requirements for a successful use of these controlling tools of the future.
Proactively shaping the future instead of reacting to changes in the status quo
During the corona crisis, many companies recognized the necessity of simulations and scenarios in the context of corporate planning and set up appropriate models at short notice. However, the modelling of scenarios is not only essential in times of high uncertainty. The creation of different future concepts forces to think in alternatives and thus forms the ideal basis for proactive corporate steering.
Although the importance of simulation and scenario modelling is widely recognized, experience shows that most companies use this tool only sporadically and especially ad-hoc in crises. There are two main reasons:
On the one hand, scenario modelling usually has a project nature and is not integrated into the regular performance management processes. Accordingly, it is usually abandoned after a crisis.
On the other hand, there is sometimes a diffuse understanding of "scenario planning" in the sense of an exclusively long-term and qualitative ("strategic") view of the future. Such attempts, which often appear academic, can only convince management to a limited extent due to their limited added value.
Modern understanding of scenario modelling as base for a continuous application
Many companies use pure financial models for their simulations in crisis mode. Such models do not go far enough and are decoupled from operative business. In contrast, we recommend a modern interpretation of scenario modelling that focuses on business drivers and measures.
Base scenario as starting point for driver model
The starting point for modelling is a base case or basic scenario derived as automatically as possible. This is based on an existing planning or is generated like a forecast using update logic such as predictive analytics or basic projection drivers.
This basic scenario is then adapted using a driver model to create alternative scenarios. Such a change-based approach ensures efficiency and avoids extensive re-planning. Central input variables are various operational drivers or parameters (e.g. changes in quantities and productivity), which are translated into financial variables. The drivers must always be integrated so that a driver change affects all associated variables: For example, a change in sales volume must result in a change in both revenue and variable costs.
Designing business cases for operational measures
Besides the drivers, measures form the second, essential modeling component for the simulation. These can be larger projects or organizational changes, for example. For each measure, the financial effect for the relevant horizon must be available in the form of a "business case". In this way, a kind of “measure backlog” is built up for the company. The modeling is then carried out by flexibly assigning the effects of individual measures to the scenarios ("on-off"). Where it makes sense, threshold values for central control parameters (sales, profitability and liquidity) can be defined for each scenario. If these threshold values are exceeded, the corresponding measures are triggered in stages.
In order to develop its full effect, the modelling and consideration of scenarios must become a continuous accompanying instrument of management and controlling and must be integrated into the controlling processes. Different occasions can be distinguished here:
Within the framework of top-down planning, possible alternative developments are discussed, with a focus on the relevant measures. If there are indications of changes in the environment during the year (e.g. an unregulated Brexit, the loss of a strategic supplier or the entry of a competitor), the defined scenarios should be updated and, if necessary, extended to include adjusted or new action plans.
Scenario modelling should also be part of risk management in the sense of stress testing. Here, we consider how different negative scenarios ("downside") affect the financial stability of the company.
Scenarios should also be considered as standard for important investment decisions (e.g. automation of parts of production), make-or-buy decisions and M&A decisions.
Modern cloud platforms instead of Excel as required technological basis
In order to establish a comprehensive simulation model, professional tool support is required. Most companies - at least so far - carry out their simulations based on MS Excel. This is basically possible, but proves to be difficult for a consistent, long-term use. What is perfectly justifiable for simple ad-hoc modelling quickly becomes costly and error-prone in more complex business contexts and the need for flexible adjustments.
Modern cloud tools such as Anaplan or SAP Analytics Cloud, on the other hand, supplement Excel with central capabilities (see Fig. 3) and allow both complex and flexible simulations. In this way, the focus of controlling shifts from model creation to model usage, i.e. to decision support in the sense of business partnering.
Scenario modelling as the crucial instrument for corporate management in the future
The use of scenario modelling offers clear competitive advantages for the company: Better and faster decisions as well as a generally stronger forward orientation. Scenario-based corporate management also proves to be advantageous for the controlling function. Based on the modeling of scenarios, controlling can convincingly realize its claim to be a business partner. Accordingly, scenario modeling will increasingly establish itself as a standard instrument in controlling.
The increasing use of scenario models is supported by the progressive digitalization of performance management. The development of integrated, cloud-based performance management platforms is a decisive step in this direction. The flexible modeling of company-wide, integrated scenarios thus receives the necessary technological basis.
However, investment in modern cloud platforms is only one of the central requirements. The development of modelling skills in controlling, the correct handling of scenarios in corporate communications and necessary adjustments in incentives also require some effort. The transition to a continuous scenario-based corporate management system can therefore realistically not take place in just a few weeks; nor is it a process that takes years. The justification for such a step will become apparent at the latest with the next crisis, when a company prepared in this way can fully exploit its advantages.
Authors: Kappes, M. / Klehr, D.
Note: This text is an English translation of “Simulation und Szenarien-Modellierung: Controllinginstrument in Krisenzeiten und darüber hinaus“, published by Haufe.de