Forecasting techniques and model risk - Scenario planning se...

Learning Outcomes

After reading this article, you will be able to explain the main forecasting techniques used in performance management, differentiate between scenario planning and sensitivity analysis, and discuss the risks arising from unreliable assumptions. You will gain confidence in identifying model risk, explaining its sources, and applying these approaches to ACCA APM scenario-style questions—with focus on practical decision-making and exam assessment.

ACCA Advanced Performance Management (APM) Syllabus

For ACCA Advanced Performance Management (APM), you are required to understand how forecasting, planning under uncertainty, and model risk affect strategic and operational decision-making. This article aligns with:

• The application and evaluation of forecasting techniques for performance management
• The use of scenario planning and sensitivity analysis in business decision-making
• Identifying and managing the risks associated with model assumptions and forecasting
• Advising on the impact of uncertain data and modelling assumptions in APM scenario contexts

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which best describes scenario planning in performance forecasting?
   1. Forecasting a single best-estimate outcome
   2. Generating a range of plausible future situations
   3. Recording historical data only
   4. Modelling the probability of machine breakdowns
2. In sensitivity analysis, an input variable is changed until:
   1. The original budget is restored
   2. The target profit is doubled
   3. The decision outcome reverses
   4. Operating costs fall to zero

3. List two sources of model risk in performance forecasting.

4. True or false? Sensitivity analysis tests the combined effect of all variables changing together.

5. Briefly explain why reliance on uncertain assumptions in forecasting can lead to inappropriate management decisions.

Introduction

Forecasting is a core activity in performance management, enabling organisations to plan for the future. However, business environments are unpredictable. The accuracy of a forecast critically depends on the validity of model assumptions and the manager’s ability to consider uncertainty and risk. This article explains scenario planning, sensitivity analysis, and how to guard against model risk—essential skills for ACCA APM.

Key Term: forecasting
Producing estimates of future outcomes using historical data and assumptions about key drivers.

FORECASTING IN PERFORMANCE MANAGEMENT

Performance forecasts underpin resource allocation, target setting, and risk assessment in organisations. Common methods include trend analysis, regression, time series, and learning curves. Yet, all such models rely on input data and assumptions.

Key Term: model risk
The possibility that errors in a model’s structure, data input, or assumptions will lead to flawed forecasts and inappropriate decisions.

A model’s usefulness is limited if its assumptions do not reflect real-world variability. ACCA APM requires managers to question, adjust, and stress-test forecast results.

SCENARIO PLANNING

Scenario planning confronts uncertainty by developing a range of credible future situations (‘scenarios’) rather than a single forecast.

• Managers identify key drivers of uncertainty (economic, technological, regulatory, etc.)
• They construct detailed narratives for how these uncertainties could unfold (e.g., “pessimistic,” “most likely,” “optimistic”)
• Forecasts are created for each scenario, exploring operational, financial, and strategic outcomes

This approach supports proactive decision-making under risk and helps prevent overreliance on static plans.

Key Term: scenario planning
Building and analysing multiple plausible future situations to understand their impact on planned outcomes.

Worked Example 1.1

A manufacturing company is planning output for next year but faces uncertainty in input prices and demand. Describe how scenario planning can inform its production decision.

Answer:
The company may create three scenarios: (1) ‘Adverse’ – input costs rise, demand falls; (2) ‘Base Case’ – moderate input costs and stable demand; (3) ‘Favourable’ – costs drop, demand grows. For each, it forecasts profits, inventory needs, and funding requirements. Managers review the outcomes and devise contingency plans for each scenario, ensuring flexibility and robustness in operations.

SENSITIVITY ANALYSIS

Sensitivity analysis tests how changes in one input (cost, price, volume, etc.) affect the forecast result, holding other inputs constant.

• Used to identify which assumptions have the largest impact on outcomes
• Helps managers prioritise monitoring and data collection on critical factors
• Aids in setting more robust targets by showing ‘break-even’ or ‘indifference points’

Key Term: sensitivity analysis
Measuring how a change in a single assumption influences a forecast or decision outcome.

Worked Example 1.2

A retailer’s profit forecast relies on a projected sales price of £20/unit. If actual prices fall, at what minimum price would the profit forecast become zero? Outline the sensitivity analysis steps.

Answer:
The manager systematically reduces the sales price in the forecast model, recalculating profit at each step, until profit is zero. The price at this point is the ‘profit break-even’—revealing sensitivity to sales pricing assumptions. This highlights how much risk the company faces if price falls below forecast.

Revision Tip

Quantify how much a forecast variable must change to overturn a recommendation—clear calculations can score marks in the APM exam.

MODEL RISK AND THE IMPORTANCE OF ASSUMPTIONS

All forecasting relies on assumptions. If these are poorly chosen or become outdated, even advanced models provide misleading answers.

Key Term: assumption
A statement about an uncertain element—such as costs, growth rates, or market conditions—used as a basis for forecasts.

Key Term: model risk
The danger that a forecast misleads decision-makers because of errors in the model’s logic, data input, or flawed assumptions.

Model risk arises from:

• Unreliable or incomplete data
• Over-simplified or unrealistic assumptions (e.g., constant growth, fixed costs)
• Changes in market or regulatory environment not anticipated by the model
• Management bias—deliberate or unconscious

Unchecked, model risk can result in poor investment appraisal, budget shortfalls, or loss of competitive advantage.

Worked Example 1.3

A business uses a sales growth rate of 8% per year in its rolling forecast, based on market expansion over the last three years. Explain a model risk and suggest a mitigant.

Answer:
If industry conditions change (e.g., economic downturn), past growth rates may no longer apply, making the 8% projection unreliable. To mitigate, the company could regularly review and update the growth assumption, cross-check with industry forecasts, or run scenario/sensitivity analysis with lower growth rates.

Exam Warning

For ACCA Advanced Performance Management (APM), you may be asked to identify weaknesses in a set of forecasting assumptions. Always challenge whether figures are realistic, current, and justified.

MANAGING MODEL RISK

To reduce model risk and encourage more reliable forecasts:

• Use scenario planning to stress-test the forecast against extreme but plausible assumptions
• Perform sensitivity analysis to highlight where results are most vulnerable
• Document and regularly review all key assumptions with input from multiple stakeholders
• Compare forecast outcomes with actual results to refine methods
• Consider external benchmarks and industry data in setting model parameters

Summary

Forecasting underpins performance management but is threatened by uncertainty and modelling errors. Scenario planning and sensitivity analysis help address uncertainty and highlight risk, while regular review of assumptions protects against model failure. Recognising and controlling model risk is essential for sound decision-making in complex environments and a common APM exam topic.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain the purpose of forecasting and methods commonly used in performance management
• Define and apply scenario planning to uncertain business environments
• Conduct sensitivity analysis and interpret its results in decision-making
• Define and discuss model risk and assumptions in forecasting
• Identify sources of model risk and approaches to reduce its impact
• Challenge and improve forecast assumptions to strengthen business planning

Key Terms and Concepts

• forecasting
• model risk
• scenario planning
• sensitivity analysis
• assumption