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One of the important lessons company executives should have learned over the past 15 years is that it’s dangerous not to do contingency planning, a subject that I’ve written about before. By this I mean real, think-outside-the-box contingency planning (not just extrapolating), which is especially important when doing long-range planning. The past decade or so has been punctuated by periods of elevated volatility in financial and product markets, and there’s a good probability it will occur again in predictable yet improbable ways. The dot-com boom and its resulting bust as well as the real estate bubble and collapse were in part liquidity-driven events. Many people recognized the artificiality of the rise in values during both of those boom times. There were naysayers questioning the longevity of the upturns, but as they continued unchecked and proved the skeptics wrong, most investors, analysts and advisors grew complacent and unwilling to consider truly unfavorable scenarios. By not planning for a bust, companies and individuals were not in position to react as swiftly and intelligently as they could have.
This sorry history came to mind during a discussion I had recently with the head of financial planning and analysis (FP&A) for an insurance company. The conversation began with advanced analytics and budgeting and then moved to integrating strategic long-range planning and annual budgeting. I asked whether the company had looked at scenarios in which interest rates rose rapidly over the next three years (say, 20-year U.S. Treasury bond yields rising to 5% from about 2.8% today) along with a range of foreign exchange rate scenarios (say, a dollar/euro exchange rate ranging from 1.60 to parity) because the company has substantial business outside the U.S. The answer was no. The response was not surprising because I knew from our research on planning that relatively few companies are able to do meaningful, in-depth contingency planning. Most cannot consider the full implications of specific scenarios that affect key drivers of their business (such as interest rates in the case of insurance companies), the specific impacts on each part of their business under these scenarios and how best to address or take advantage of them ahead of time. Instead, most simply look at vague “upside” and “conservative” forecasts.
Contingency planning, especially in a strategic context, has three distinct purposes. One is to gain a clear and realistic understanding of feasible options under different circumstances by quantifying the implications of different scenarios. The second is to have a structured dialogue about possible options that is built on quantifiable assumptions and outcomes; this provides the frame for a discussion designed to ensure that all executives are on the same page. The third objective is to be better prepared – to have an action plan or at least the foundation for one. Then if the unlikely becomes reality, the organization can implement necessary changes faster than starting from scratch. Contingency planning allows a company to avoid frittering away time deciding what to do next or relying on gut instinct at critical moments. Also companies don’t have to confine their efforts to planning for the worst-case result. Better-than-expected sales may make it possible to accelerate introduction of new products in another division or to bring a new production facility on line sooner. Determining the impact of major contingencies is an important component in making planning more strategic.
For an insurance company, returns on asset classes have important consequences for strategies in sales, pricing and risk management, to name just three key business decisions. A rapid rise in prevailing interest rates can affect its balance sheet and have regulatory impacts. Considering interest rate environments well in advance enables the company to deploy its resources to address opportunities and risks ahead of the curve and perhaps ahead of the competition.
Because no planning process can be completely accurate in all events, it’s important to understand the implications of different outcomes. Including contingency planning in the planning process prepares an organization to quickly generate a revised detailed plan. At least six months in advance any company should be considering the implications of both positive and negative business environments. As the economic outlook changes, executives would have the ability to adjust the plan to make decisions based on fact-based analysis, not hunches. They could see how changes in specific prices, costs, volumes, currency rates and interest rates would impact revenue, profit, working capital and weekly or monthly cash flow. Then they’d be ready to do rapid contingency planning to determine the best response when changes occur.
Our research finds plenty of things that companies can do to improve in planning and budgeting - contingency planning is one of them. One mental mistake they make is confusing planning with budgeting. The objective in budgeting is to narrow things down so that the budget can serve as a yardstick and control mechanism. Contingency planning has a larger purpose, to think expansively about what might happen and to consider the limits of what’s probable in order to have an idea of what to do should that outcome become a reality. It’s not necessary to consider every possibility, just the ones that are likely to have the greatest impact. Having the right software and using it properly is a prerequisite for effective contingency planning. Desktop spreadsheets are not the right technology because they are poorly suited to performing repetitive, collaborative enterprise tasks such as strategic and long-range contingency planning. A dedicated planning application enables companies to quickly adjust scenarios and basic assumptions and immediately see the impact of such changes.
Most of the world has been living in a period of financial repression for the past several years. Its sameness has lulled people into behaving as if it will continue forever. Events over the past 15 years should have taught business executives – especially CFOs – that this is precisely the time to consider what might happen to their business if interest rates change rapidly and consider further how best to respond to the challenges and opportunities that emerge.