Analyst Perspectives

I thought of writing a note on this topic when multinational corporations started to withdraw their deposits from eurozone banks, but the pessimism that event engendered was short-lived. Now, as the monetary crisis deepens in Europe, it’s perhaps time to ask what your company would do if parts of its financial system implodes. You may think that your company will not be affected because it doesn’t do business with the eurozone. Or you may believe that it’s unlikely to happen and therefore not worth spending the time to consider the implications. I think both assumptions are mistaken.

Several years ago, during the U.S. financial crisis, I was leading a workshop on planning and budgeting. As an exercise I asked the participants to consider what they might do in an intermediate-term scenario of 12 percent dollar interest rates and 10 percent inflation. Most immediately reacted that “that will never happen.” Of course they were correct – it hasn’t happened. However, that wasn’t the point. Planning is about considering what might happen and understanding the specific, measurable consequences if a scenario should come true.

Unfortunately, contingency planning gets short shrift in most companies. People running companies, divisions or departments typically have limited patience with formal planning processes and believe that spending too much time on planning leads to “paralysis by analysis.” That can be true, but contingency planning, especially in finance organizations, need not be overly time-consuming if a company has the right planning tool and uses it correctly.

One approach to contingency planning is to have an individual analyst prepare a spreadsheet that models the company’s business and have the person use sets of assumptions about potential market conditions to prepare a report on the outcomes of these assumptions. This method has the advantage of being quick and consuming few resources. On the other hand, it is hardly collaborative, even if the analyst solicits input from business heads. Another approach is to replicate the budgeting process. Yet in many organizations this would be far too time-consuming, especially if the data is collected with desktop spreadsheets.

Corporations that already have a dedicated planning and budgeting tool can use it to develop a streamlined contingency planning process that is detailed enough to capture the key business drivers without requiring too long to complete. This approach starts by identifying those key business drivers and creating a model of the company that is driver-based. Even in a very large corporation, a contingency planning methodology that manipulates assumptions about the key drivers should enable executives and managers to explore collaboratively a range of assumptions and determine the impacts these might have on different parts of the organization and on the corporation’s profitability and cash flow. The advantage of such a collaborative approach (rather than having a “black box” analyst generate outcomes) is that it provides a useful structured dialogue about what might happen and the best approach to take if it does. (“Structured” in this sense means having hard numbers behind the descriptive language that people might use.) The software tool would be useful in short one-on-one and departmental meetings as well as in day-long, company-wide gatherings off-site.

At least for North American companies, one good reason for doing more contingency planning is that given today’s economic conditions they may have fewer options in reacting to major dislocations than they did three years ago and less time to make decisions. Most midsize and larger companies reacted to the last crisis by reducing headcount and limiting capital spending. While capital spending has increased, these companies have been reluctant to add people. Another crisis is likely to require spending cuts, but since they already have less obvious “fat,” where should organizations cut? It’s unlikely that across-the-board reductions would be the best approach, so executives need to understand how best to adapt their cost structure to a given set of conditions. It may be that the optimal approach is not to cut costs but to plan to limit profitability or even to lose money under some circumstances. Getting agreement on the latter two at the board level is best done before a crisis, not during one; ensuring that sufficient finances are in place to support a period of losses is only practical ahead of a crisis.

Keep in mind that contingency planning is not budgeting. Budgeting is about getting to a fixed set of numbers used for control and financial planning. Contingency planning is an open-ended discussion of what might happen and the best approach to achieving a company’s objectives under those circumstances. Corporations should make contingency planning a routine part of management meetings. However, to make this practical they need to create a streamlined process that incorporates driver-based business planning models and adopt software that enables them to explore conditions and outcomes interactively. Today, these sorts of meetings are limited to high-level thinking, usually based on gut feelings. A more rigorous approach, one that quantifies conditions and outcomes, is likely to produce better results. Companies will be better prepared to deal with today’s volatile business environment and make consistently better decisions faster.

Contingency planning requires companies to consider the normal range of events as well as some that are more than one standard deviation (in a general sense) from what’s expected. It requires incorporating structured interactive planning into business management and having the right tools, data and models available to make it interactive. What would happen to your company if the unthinkable happens? It doesn’t have to be a world financial crisis. It might be the loss of a major customer or the catastrophic disruption of your supply chain. “Fortune favors the bold” is an ancient Latin proverb, but Louis Pasteur is credited with the observation “Fortune favors the prepared mind.” Both are necessary for success, in my opinion but the latter is the concept most companies need to concentrate on.

Regards,

Robert D. Kugel – SVP Research