Some facts on scenario approach for budget planning

Some facts on scenario approach for budget planning
16 March | 6 min. | Hotel financial management

Before 2020, the hotel business and the hospitality industry in general adhered to standard rules when making plans — a strategic plan for 5–10 years (a wider planning horizon is typical for stable markets such as Europe, in Russia often the financial model is no longer than 3 years), its update every 1–2 years and annual budgeting.

The process used to be regulated and clear, the annual budgeting guidelines used to be given in the strategic financial model or in its absence were based on the experience of previous years and key development benchmarks.

But in August 2020, when the operational and financial departments in the hotel used to begin the process of budgeting for the next year, the usual course of action was no longer possible. All strategic financial models had collapsed by this time, the past periods till 2019 no longer had any meaning, and 2020 was not a reference point for the next year.

There was complete uncertainty when no one with a probability of 95% (by the way a competently and qualitatively made budget should be executed at this percentage) could give key guidelines for planning. Everything has become uncertain. Will the business survive?

Will there be support measures? Will it be possible to attract at least the local market? Will the business manage to cover fixed costs and not get into debt? What measures should be taken to catch the wave and occupy the hotels in case of the market's revival?

The top-management and owners came up to the question — how to plan? And is it necessary at all?

The answer to the last question is YES, you should plan. The year 2020 has crippled the liquidity of many companies, so top-management and owners need to understand and assess what kind of cash gap is possible next. In addition, after all, the hotel management needs goals to strive for: it is not effective to go with the flow of the recession.

And, finally, planning allows you to optimize — to identify unnecessary expenses and points that suffer losses or where incomes can be increased. Or, maybe, during the recession, it's time to close for renovation and create a fundamentally new product while competitors are almost completely closed and suffer losses?

This decision definitely requires planning.

How should we plan in a time of uncertainty? How can we rely on plans when new restrictions from the government and neighboring countries are being imposed every week?

The usual bottom-up or top-down methods won't work. Or rather, it is unlikely that any plan you prepare with these approaches will be close to reality.

This is when scenario budgeting (what-if) comes to the rescue when several scenarios are considered during planning.

What is the scenario approach?

What-if scenarios or scenario approach implies considering several scenarios which will occur if their basic assumptions trigger. The goal is to analyze and calculate several plausible scenarios in order to work out possible actions for each. As a result, the company will be less exposed to risks and more adapted to changes.

Advantages of this approach during the recession:

  • Ability to respond quickly to external changes
  • Chance to analyze the existing alternatives in advance, rather than when the supposed changes have already occurred, and prepare the best actions in each case.
  • Worst-case scenario awareness and preparation of appropriate reserves

In addition, the scenario approach allows you to create strategic alternatives, develop new ideas, increase flexibility and reduce risks.

What steps should be taken to implement scenario planning in the company:

  • Identify the factors (basic events) that are taken as a principle in each of the scenarios
  • Develop decisions in case the basic events occur
  • Create methodological recommendations on how to reflect these factors in the budget, develop planning tools
  • Create regulations for the transition from one scenario to another and the corresponding analysis of the variance of actual vs. plan.

For effective scenario planning, scenarios must have a number of characteristics.

  • They must be realistic. For example, it is unrealistic to assume that within the first 3 months of 2021, all businesses will return to the level of 2019.
  • The scenario should be a decision-making trigger. For example, if the expected occupancy is below 10%, it may make sense to close the hotel.
  • No internal contradictions. For example, it is impossible to put both an increase in hotel occupancy and a significant reduction in operating personnel in the scenario.
  • Scenarios within the same package should differ significantly from each other — variability is important.

In scenario planning, there are often two opposite scenarios: optimistic and pessimistic. The first option involves a positive development of the situation.

The second considers the action of negative factors. However, the most likely one is often something in the middle, so a realistic/conservative option is often added.

In theory, the number of scenarios can be infinite, but in practice, it is difficult to prepare and use more than three. These scenarios apply to the entire project/hotel and include all the incomes and expenses for all departments.

At the same time, some budget accounts may be the same for all scenarios (for example, the cost of mandatory audits or property taxes).

Scenarios provide an opportunity to look at the business from different points of view, develop strategic decisions, and find new ideas.

Creating high-quality scenarios requires the time and effort of the company's financial and management staff, but it is worth it: the company becomes more stable and more successful.

Ksenia Bagaeva
About the Author:
CFO
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