Future events are far from certain in the business world. This is especially true for smaller businesses, which tend to have more volatility than larger organizations, or newer businesses without a proven track record of sales and costs. For this reason, probability distributions can be a great tool for estimating future returns and profitability.
A probability distribution is a statistical model that shows the possible outcomes of a particular event or course of action as well as the statistical likelihood of each event. For example, a company might have a probability distribution for the change in sales given a particular marketing campaign. The values on the "tails" or the left and right end of the distribution are much less likely to occur than those in the middle of the curve.
Advertisement Article continues below this adProbability distributions can be used to create scenario analyses. A scenario analysis uses probability distributions to create several, theoretically distinct possibilities for the outcome of a particular course of action or future event. For example, a business might create three scenarios: worst-case, likely and best-case. The worst-case scenario would contain some value from the lower end of the probability distribution; the likely scenario would contain a value towards the middle of the distribution; and the best-case scenario would contain a value in the upper end of the scenario.
One practical use for probability distributions and scenario analysis in business is to predict future levels of sales. It is essentially impossible to predict the precise value of a future sales level; however, businesses still need to be able to plan for future events. Using a scenario analysis based on a probability distribution can help a company frame its possible future values in terms of a likely sales level and a worst-case and best-case scenario. By doing so, the company can base its business plans on the likely scenario but still be aware of the alternative possibilities.
Advertisement Article continues below this adIn addition to predicting future sales levels, probability distribution can be a useful tool for evaluating risk. Consider, for example, a company considering entering a new business line. If the company needs to generate $500,000 in revenue in order to break even and their probability distribution tells them that there is a 10 percent chance that revenues will be less than $500,000, the company knows roughly what level of risk it is facing if it decides to pursue that new business line.