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Probability doesn’t always work in business planning.

Writing about probability in business decision-making may strike a few readers as overcomplicated. It may strike a few readers as unnecessary. However, there's likely a thread of readers who are struggling with making decisions based on anticipated financial outcomes. They're choosing a path to sail and are unaware of which way to direct the boat. And, they may be wondering why their spreadsheets and forecasts are irrelevant after the first month. This blog is for that thread.

 

Understanding Probability

 

So what is a probability? It is the extent to which something is likely to happen. The most common probability we deal with is the weather. If the weather says there is a 50% chance rain, it means there is a 50% chance there will be more than 0.01 inches of rain during the time measure (usually an hour). It doesn't mean it will rain 50% of the time or rain on 50% of the region. It means there is a 1 in 2 chance it will happen. Often business decision makers like to apply this same logic to the decisions they are making and in particular use it in their forecasting logic and financial models. It doesn't always work.

 

There are a ton of tools businesses use to plan: Annual Operating Plans, Rolling Operating Plans, Financial Forecasts, Sensitivity Analysis, Scenario Planning, and Return on Investment calculations just to name a few. In some scenarios, it is appropriate to use probability and some it is not. I'll take time to dive into each of these planning tools in later writings.

 

When to Use Probability

 

So when does it make sense to use probability? It makes sense to use probability in a couple ways. One is when you know there are several outcomes likely for a particular event. If there are 6 possible outcomes you've identified if you make a decision and the outcomes are A. 62%, B. 36%, C. 1%, and the rest are less than 1 then I would suggest creating a financial model for A and B. This covers the vast majority of likely outcomes. You use probability to identify what outcomes to plan. However, the pit many fall into is to multiply the numbers associated with each probability on their AOP and create a weighted average of the statements. Which, in the end, creates a tool that's guaranteed to be both inaccurate and less useful.

 

Another possible business planning instance where you might want to consider using probability would be if you have many small accounts and you know that on average you have a 50% probability of landing the sales you have in your pipeline. I'd suggest planning your operations based on that probability of 50%.

 

When Not to Use Probability

 

Do not use probability if you are considering whether you will or will not land a large account. If the outcome is binary, and the event is large enough to change your operating model, like landing a large customer that would be 25% or more of your volume, then you need to make two plans. You should plan for if you get the customer and one for if you do not. It doesn't do any good to plan your business based on a 112.5% increase in business because there's a 50% chance you'll get a customer that increases your sales by 25% (50% X 25% = 12.5%, 100% + 12.5 = 112.5%).

Another situation is if you anticipate a merger or acquisition. If there's a 50% chance of it happening, then you need to plan your business for both the merger happening and the merger not happening. There are not many business scenarios I've witnessed where companies can be halfway merged, but yet a common practice is to plan these events probabilistically.

So in summary, if an event is binary (it either happens or not), or has distinct and defined outcomes, you should create a plan for each of these possible outcomes. If the event is not binary (many outcomes and a likely range or average are known for the outcome), then you should consider how to plan probabilistically.

I can't possibly go through every possible scenario, so this knowledge can't replace good judgment. I hope this article helps you in some way plan your business better.

Happy modeling!

For more information on financial modeling or forecasting, reach out via LinkedIn or tweet me @james_h_j.

James H Johnson CPA.CITP, MBA, CGMA