Guest Author - Consuelo Herrera, CAMS, CFE
Is a process where many potential outcomes are considered before making wise decisions. The Investors’ Dictionary (investordictionary.com) states that scenario analysis is a process of analyzing possible future events by considering alternative possible outcomes (scenarios). The analysis is designed to enhance an improved decision-making process by allowing more complete consideration of outcomes and their implications. Performing this analysis helps us in assessing the degree of forecasting risk and identifying those components that are the most critical to the success or failure of a decision.
The Financial Dictionary with respect to scenario analysis states that in risk analysis, is the process of considering different, possible outcomes of a decision. Scenario analysis may take a number of forms; for example, a company may consider the various potential returns on an investment and how each will affect the company's other business. Scenario analysis can also be used in policy making: the president can weight potential effects of a tax increase when deciding whether or not it would be beneficial to do so.
Forensic accountants are familiar with scenario analysis because it is crucial for them to present information in such a way that a layperson may see the difference between one situation and another and its economic impact just by looking at a simple table with both the worst and the best cases.
Scenario Analysis is the basic form of What-If analysis. Based on projected cash flows we can estimate the Net Present Value (NPV). To ensure a realistic estimate experts suggest the inclusion of an upper and lower bound on the components of a project. Example, if a corporation forecasts sales at 1,000 units per year. This estimate may be high or low, however the finance manager is certain that it is not off by more than 100 units in either direction. The lower bound would be then 900 units and an upper bound would be 1,100 units. Assumptions are made with respect to prices per unit, variable costs per unit, fixed costs per unit.
Corporation Sunshine, LLC determines that its base case, the initial set of projections, as follows:
Unit sales 7,000
Price per unit $70
Variable costs per unit $50
Fixes costs per year $60,000
To calculate the worst-case scenario, Corporation Sunshine, LLC assigned the least favorable value to each item. This means low values for items such as units sold and price per units and high values for costs. The opposite holds true for the best scenario. Corporation Sunshine, LLC assigned the most favorable value to units sold and price per units and lower values for costs.
Stay tuned for the outcomes considering the best and worst scenarios.