Decision Tools: Scenario Analysis

How to Get Ready for the Unknowable Future

Published in

ClearPurpose

10 min readMar 27, 2024

This is the third in a series of articles on tools helpful to leaders in making hard decisions. This week we are looking at Scenario Analysis.

What It Is

Scenario Analysis is a planning approach that involves envisioning multiple future scenarios and understanding how each of those scenarios would impact your near term decisions and long term strategies. Even though it’s unlikely that any of the scenarios developed will develop exactly as envisioned, if the scenarios are selected well, the process will help you prepare for almost any outcome.

When To Use It

Scenario Analysis is most valuable in times of high uncertainty.

In the normal course of business planning, we can be relatively safe assuming that the business environment will continue to develop within reasonable bounds. Competitors will introduce new products, customer’s desires will shift somewhat, and external factors like the economy and politics will go through regular cycles, but in general we can expect that our industry and our business will continue to be manageable using our traditional planning methods.

However, there are times when aspects of the future become highly uncertain. New technologies or concepts are emerging and it’s not at all clear how broadly they will be accepted. New competitors are emerging and we can’t predict how disruptive their innovations will become. Dramatic shifts are occurring in the political, global, health, or economic landscape and we don’t know how significant they will become or how long they will last. If ignoring these uncertainties and simply planning for business as usual could dramatically damage or even destroy our business, then we need to take a different approach.

That’s when it makes sense to consider Scenario Analysis.

How to Use It

There are two aspects of “using” Scenario Analysis worth considering:

How to develop the scenarios
How to apply them to specific decisions and strategies

Let’s look at each:

Developing Scenarios

I’m sure that there’s more than one way to develop different scenarios, but the approach that I like to use focuses on choosing two different uncertainties to identify four possible future scenarios.

Here are the five steps I follow in developing the scenarios:

Prioritize uncertainties
For the top two, select two possible outcomes
Estimate the likelihood of each
Construct and name four scenarios
Create scenario narratives

Prioritize Uncertainties

I’ve previously written about the situation assessment discipline. In that article, I recommended using frameworks like PESTLE and Porter’s Five Forces to examine the external environment. I specifically suggested creating spreadsheets that considered the elements of these frameworks in terms of current state, known trends and disruptions, uncertainties, opportunities, and threats.

If you’ve done that, then you have an excellent start to identifying the uncertainties that will drive different scenarios. It’s worth noting that assessing the internal situation can also identify uncertainties, but the unknowns outside your business are almost always the ones with the greatest level of uncertainty and impact.

In doing your situation assessment, you likely will have identified a number of different uncertainties. For Scenario Analysis, you need to choose the two uncertainties that could potentially have the greatest impact on your business. It is best if these two are fairly independent of each other.

One approach to prioritizing uncertainties is to use a qualitative risk management array, considering two dimensions:

What is the likelihood that the future will deviate significantly from the current trend?
How impactful would it be if there were a significant deviation?

Select Possible Outcomes

Using this array, choose two outcomes that are closest to the top right of the array and that are reasonably independent of each other. In other words, if you have the uncertainties shown above, and C is only possible if A happens, then I would select A and B as the two uncertainties I would use.

Then, for each of these uncertainties, select two possible outcomes with the uncertainty.

Some uncertainties are binary — either they will happen or they won’t happen. For example, either the People’s Republic of China will invade Taiwan in the next 5 years or it won’t. In that case, your two possible outcomes are already defined — yes or no.

Most uncertainties have a range of possible outcomes. For example, you might identify an uncertainty around a health crisis. There’s a chance that there might not be another major health crisis in the next 5 years. There’s also a chance that there’s a health crisis as debilitating as COVID-19 was. And there are a range of possibilities in between. For uncertainties like this, I like to choose as my two outcomes one representing the worst possible outcome for my business (e.g. another COVID) and another representing the best possible outcome (e.g. no major health crisis).

Estimate the Likelihoods

Once you have selected the two uncertainties and identified the two possible outcomes for each uncertainty, you should estimate the likelihood of each of the four outcomes.

For binary uncertainties, this is fairly straightforward (although usually not easy). Using our example of China invading Taiwan, you could research the opinions of experts on the topic. For example, in December 2023, the Center for Strategic and International Studies surveyed 52 leading US experts and 35 leading experts from Taiwan on issues surrounding China’s relationship with Taiwan. Only 27% of US experts agree or strongly agree that China even has the ability to invade, and that number drops to 17% among Taiwanese experts. They believed that a blockade of Taiwan was more likely. Given this, we might assign a likelihood of an invasion in the next 5 years as 5% — which may be a little high, but represents some of the negative impact of a blockade. We would therefore assign a 95% likelihood of there not being an invasion.

For uncertainties with a range of outcomes the process becomes much more complex. Our goal is to split 100% between the two outcomes we’ve selected. In reality there may be an almost infinite number of potential outcomes (regional outbreak, global outbreak but limited economic impact, etc.), each of which individually would have very little likelihood of happening. To assign a likelihood, we mentally draw a line between the two outcomes and make our best guess at the likelihood of the outcomes on each side of the line. Again, it helps to search for expert opinions and studies that can help in our analysis.

For example, in a 2021 study published in the Proceedings of the National Academy of Sciences, scientists looked at the past 400 years of data to determine that there’s roughly a 2% likelihood in any given year of a pandemic with similar impact to COVID-19. That leads to the conclusion that there’s roughly a 10% likelihood of one occurring in the next 5 years. Because we would likely “draw the line” to include outbreaks with somewhat less impact, we might choose to assign a 20% likelihood to our “another COVID” outcome and an 80% likelihood to our “no major health crisis” outcome.

Construct and Name the Scenarios

Constructing the scenarios is a straightforward process. We simply combine the two possible outcomes of one uncertainty with the two possible outcomes of the other uncertainty to create four scenarios. We can even mathematically calculate the likelihood of each scenario by multiplying the likelihoods of each outcome.

Sticking with our China and COVID examples, these would be:

China doesn’t invade and no major health crisis (95% x 80% = 76% likely).
China doesn’t invade and a COVID-level crisis (19% likely).
China invades and no major health crisis (4% likely).
China invades and a COVID-level crisis (1% likely).

Once you’ve constructed the scenarios, it’s helpful to name each scenario. This makes the discussions that follow much more natural and will help people start to visualize what is happening in each scenario. Getting creative with the names can help people engage with the process. For example we might choose names for our four example scenarios of:

All’s Quiet (No/No)
2020 All Over Again (No/Yes)
Healthy Dragon Rising (Yes/No)
Dark Ages (Yes/Yes)

Create Scenario Narratives

Once the scenarios are constructed and named, you can start to envision what the future might look like under each scenario. Evaluate the impact on your company, your customers, your suppliers, and your competitors under each scenario. Start turning that into a story that you can tell to help people understand why you need to plan for different potential futures.

Specific questions to ask and answer in these narratives include:

How will our customers change their desires and behaviors in this narrative?
Are any of our long-time customers likely to go away in this scenario?
Are there any market segments that we haven’t served in the past who would now need what we offer?
Which competitors in our industry are best positioned and which worst positioned to succeed in this scenario?
Are there new technologies or new innovators that would likely become much more important and powerful in this scenario?
How would our suppliers be impacted in this scenario?
How would we need to change how we operate in this scenario?

Applying Scenarios

Once you’ve developed the scenarios, you can put them to work. Scenarios can help in making discrete decisions and in developing entire strategies. Let’s consider each.

Discrete Decisions

This entire series of articles is about decision making. There are many different approaches and tools that can be used in making decisions, but for simplicity sake let’s consider a simple process of evaluating possible options against a fixed set of criteria (e.g. financial impact, customer experience, employee experience, strategic alignment).

The straightforward way to apply scenarios to this form of decision making involves performing the decision analysis four times — once for each of the scenarios — and then applying the scenarios to calculate a weighted average perspective. Below is an example using the scenarios we’ve developed above:

Looking at the results of applying the scenarios to these options, here are some key takeaways:

Option 3 is the most conservative, hedging against the risks in our scenarios. However it performs the worst against the base case (“Quiet”), and since this scenario is 95% likely to happen it performs worst overall.
Option 1 appears to be the option optimized for the customer experience which probably contributes to its strong financial performance in the base case. It doesn’t perform as well as Option 3 in the two scenarios where China invades Taiwan, but ties with Option 2 for the overall best option.
Option 2 appears to be somewhat optimized for the employee experience and falls between the other two options in terms of the volatility of the financial performance. It isn’t the top in any of the scenarios and is last in three of the four scenarios, but overall ties as the overall best option.
The purely mathematical approach doesn’t tell us which option is best, but laying it out this way helps us understand the strengths of each option and how significant the risks are under each scenario.
We might be tempted to choose Option 1 because it has the best financial performance in the base case and does reasonably well across all scenarios, but we have to realize that, if we moved forward with this option and then China invaded Taiwan, the decision would likely become very damaging financially.

Developing Strategies

My definition of a strategy is that it is a framework that makes hard decisions easier. My favorite strategic framework is the Purpose Pyramid, which I’ve previously written about.

In the Purpose Pyramid, there are four main levels to the framework:

Purpose: A clear statement of what you are trying to achieve
Pillars: The three key accomplishments required to achieve the purpose.
Plans: The three specific activities under each pillar that you are currently pursuing to accomplish that pillar.
Principles: The non-negotiable values that will not be compromised in achieving the purpose.

For whatever strategy you are developing the Purpose and the Principles aren’t likely to change under different scenarios. The Pillars might change and the Plans are likely to change.

I recommend reading the full article on the framework to get a more complete picture, but in over-simplified terms the Pillars explain how you are going to achieve the Purpose. If you are successful in accomplishing all three Pillars, you should reasonably expect to successfully achieve the Purpose.

I would start by defining the Pillars for the base plan. What are the three most critical accomplishments that will enable achieving the purpose?

Next, ask the question, how would the Pillars change (if any) for the first scenario? Then repeat the exercise for each of the other scenarios. Given the likelihood of each scenario, what’s the best set of Pillars to achieve the Purpose under the most likely outcomes? Can you or should you tweak those Pillars any to provide flexibility in case any of the less likely scenarios start to play out?

Optimally you can define the Pillars in a way that enables them to remain relative stable for several years no matter how the future unfolds. The Projects level of the strategy framework, however, gets updated much more frequently. Even in the normal course of business, it’s not unusual for most or all of the Projects to change somewhat at least annually. Therefore, it’s less critical for the Projects to accommodate multiple scenarios.

It’s still helpful to identify the Projects for the base plan and then ask which of those would be significantly modified or replaced under different scenarios. Unless two or more scenarios are nearly equally likely, you don’t need to tweak your Projects to adjust for multiple scenarios, but it is still very helpful and wise to have a plan in mind for what you might change if a less likely scenario starts to play out.

Related Resources

Hopefully this article has helped you better understand Scenario Analysis and how to use it. Let me know if you ever need any help. You might also check out the articles below for more information and examples: