How Many Budget Scenarios Should Be Prepared
The number of budget scenarios that a company should prepare largely depends on the complexity and uncertainty of its business environment. In general, it is common for businesses to prepare at least two scenarios: a base case scenario and a worst-case scenario. Some companies also prepare a best-case scenario.
Here’s a brief description of each:
- Base Case Scenario: This budget represents the company’s most realistic expectation of future results, given current knowledge and assumptions. It takes into account all known factors, such as sales trends, expected economic conditions, and planned business initiatives.
- Worst Case Scenario: This budget represents a situation where everything that could go wrong does go wrong. It typically involves factors such as a significant downturn in the economy, loss of key customers, or other adverse events. Preparing for this scenario allows the company to plan for risks and challenges that could significantly impact its operations and financial health.
- Best Case Scenario: This budget represents a situation where everything goes better than expected. It might include higher than expected sales growth, lower costs, or other positive outcomes. Although it’s less common to prepare this scenario, it can help the company to be ready to capitalize on opportunities if they arise.
Some companies may also choose to prepare additional budget scenarios based on different strategic initiatives or to reflect a range of possible outcomes in an especially uncertain environment.
Creating multiple budget scenarios can improve a company’s readiness to handle different possible futures. It allows management to make better-informed decisions and to be prepared to implement contingency plans if necessary. It also helps to stress-test the company’s plans and assumptions and can provide valuable insights into potential risks and opportunities.
Example of How Many Budget Scenarios Should Be Prepared
Let’s consider a hypothetical manufacturing company, “Mega Manufacturing Inc.”
Base Case Scenario: In this scenario, Mega Manufacturing Inc. assumes a steady state of the economy and industry-specific factors. Let’s say they expect a 5% growth in sales based on the past trends, a 3% inflationary increase in costs, and no major changes in the competitive landscape or in regulatory environment. They plan their expenses, investment, and cash flow needs accordingly.
Worst Case Scenario: In this scenario, they plan for potential adverse events. Let’s say there are rumors of an upcoming economic slowdown, and the industry they operate in is usually heavily affected by such changes. In this case, they might plan for a scenario where sales growth is negative, i.e., sales decrease by 10%. They also factor in higher costs due to potential supply chain disruptions and factor in potential losses from uncollectible accounts receivable. This helps them understand how much of a cash reserve they might need or how much they might need to cut expenses to survive this scenario.
Best Case Scenario: In this scenario, they plan for everything going better than expected. Assume that they are launching a new product that is getting a lot of positive attention in the market. So, they also create a budget where sales growth is 15%, costs increase is minimal due to efficiency in production and economies of scale, and cash flows are robust. This scenario helps them understand if they would need additional production capacity, personnel, etc., to meet this potential demand and where the additional profits could be invested.
By preparing these three scenarios, Mega Manufacturing Inc. can have a robust financial plan for the future, regardless of which way the wind blows. It helps them to understand their financial resilience, identify potential issues before they become a problem, and be prepared with action plans to capitalize on opportunities or mitigate risks.