"What If" Analysis
Making Decisions by Exploring Scenarios
Denise is a successful retailer with three stores that sell women's accessories.
She's now considering opening a clothing store that specializes in luxury ladies' clothing from French designers.
She's written a business plan, which, of necessity, relies on a number of assumptions and best estimates related to things like competition, the health of the industry, and sales expectations.
But how can she test the plan to decide whether to go ahead? She needs to make sure the new business will remain strong and viable under a variety of challenging conditions. To do this, Denise has decided to use "What If" analysis.
In "What If" Analysis, a specific type of Scenario Analysis, you ask a series of "what if" questions to predict potential complications and the impact they'll have on company operations. Denise could ask questions like "What if another luxury clothing store opens on the same street?" and "What if my main supplier goes out of business?" Denise's questions could help her decide whether she has adequate safeguards in place to protect her, if the risks and complications she's thinking about actually happen.
If another luxury store opens in the same area, what impact can Denise expect on sales? How will these revised sales figures change the bottom line? Likewise, if her main supplier goes out of business, how will that affect sales and customer service? Are there other suppliers, and how long will it take to set up properly functioning relationships? And if she faces these challenges, how long can Denise sustain her operations given her cash flow needs?
There are many questions that you can ask and answer with "What If" Analysis. These could be high-level risk management planning questions, or they could be questions that have very specific, measurable impacts. It's up to you to choose the scope and depth of analysis. You could have a purely qualitative analysis or a purely quantitative one. A typical "What If" Analysis is somewhere in the middle, with elements of both.
Qualitative "What If"
As a risk management tool for decision-making, "What If" Analysis helps you brainstorm risks and then explore solutions. Denise's "what if" questions might include the following:
- What if a competitor opens across the street?
- What if my supply line is limited?
- What if currency exchange rates change?
- What if the sales tax increases?
Denise would respond to each question and make sure her business plan includes sufficient contingencies. Thinking further about the first question, "What if a competitor opens across the street?" there are a number of strategic options to investigate, including these:
- Reducing prices.
- Defining and marketing to a niche market.
- Offering a complementary line of products.
- Improving customer service.
Denise can then investigate each of these options and adjust the business plan or model accordingly.
Quantitative "What If" Analysis (Sensitivity Analysis)
A specific form of "What If" Analysis, called Sensitivity Analysis, looks at the effect of changes in the value of estimates or assumptions within an existing model. This asks "If this value changes, how does that affect the rest of the model?" As such, this type of analysis is typically done with a spreadsheet, and it's a tool routinely used by decision makers.
In Denise's situation, she might want to know the impact on her bottom line if she has to reduce prices. Using Sensitivity Analysis, she can manipulate her sales figures, and learn how much room she has to decrease prices. Likewise, she could look at changes to the spread between her currency and the euro to ensure that her margins are sufficiently robust to withstand projected changes.
By combining Sensitivity Analysis with the flexibility of a spreadsheet, you can quickly and easily see the effect on sales, margins, and net income if other inputs are changed. From there, you can determine which changes are significant, and therefore which ones require further investigation and planning. You may assume that an increase in your cost of goods sold is more significant than an increase in the rent for your store, however a quick Sensitivity Analysis allows you to test that assumption.
Where you have a good, probability-based understanding of how values may change, explore using Monte Carlo Analysis. This allows you to conduct sensitivity analysis with multiple inputs, giving you a consolidated probability distribution as an output.
Step-by-Step "What If" Analysis
Step One: Define the scope of the analysis.
Indentify and clearly define the boundaries for the risk-related information you need. Are you interested in the impact of potential risks related to sales? Maybe you want to make decisions related to your investment activity? Or perhaps you want to focus on issues related to staff retention? Our article on Risk Analysis helps you identify potential sources of risk, including risks from human activity, financial activity, and political changes.
When to Use "What If" Analysis:
Because "What If" Analysis is so straightforward, you can use it for almost any decision you face. Whether it's a go/no go decision or an operational planning issue, "What If" Analysis allows you to capture your concerns quickly and efficiently, and address the ones that are most likely to cause significant problems.
Step Two: Identify the significant problems to analyze further
The scope of your analysis will determine the problems you want to investigate. For sales issues, you'd likely start with questions related to supply, competition, costs, and demand. With investment activity, you'd focus on changes to interest rates, market conditions, and economic forecasts. Retention questions might look at the ability to offer a competitive wage, the cost of providing training opportunities, and organizational culture.
Step Three: Generate "what if" questions for each problem area
Brainstorm hypothetical situations that you believe could impact each issue. What might affect your sales, your investments, or your retention?
What if costs increase by 5 percent, 10 percent, and so on?
What if interest rates rise by 1/4 percent, 1/2 percent, and so on?
What if training costs rise by 2 percent, 4 percent, and so on?
Because your "what if" questions are mostly based on assumptions, it's also a good idea to test your assumptions. This helps you generate valid questions that are indeed worth investigating. Tools like the Ladder of Inference and Blindspot Analysis are particularly useful here.
Step Four: Respond to the "what if" questions
Respond to the "what if" questions by investigating further, testing your assumptions, and using Sensitivity Analysis where appropriate. If the impact is significant in a certain area, you may want to explore that in more detail. Other times, you may decide that the impact is not significant enough to justify more planning and assessment.
It's also a good idea to analyze the risks you've identified for probability and potential impact. Using the Risk Impact/Probability Chart, you can determine which questions represent the risks that you need to focus on the most. This helps you limit your focus to decisions related to reasonable and probable risk.
Step Five: Use the results in decision making.
After your analysis, adjust your plan appropriately, or implement new actions accordingly.
"What If" Analysis helps you explore the practical issues that you might face with a project, and it helps you determine the impact on key financial figures and other areas affecting the overall viability and sustainability of your company.
By looking at "What If" Analysis from a qualitative viewpoint, you can identify significant risks, and build appropriate risk mitigation into your plan. And by using it on a quantitative basis, through Sensitivity Analysis, you can explore your assumptions and model the impact on your project or business if reality differs from them. This is valuable information, as it can help you modify and improve otherwise flawed projects.