The Definition of Sensitivity Analysis Essay

When conducting sensitivity analysis, start with the expected forecast and then vary key assump tions to accommodate the possibility of different outcomes. Sensitivity analysis is also referred to as ‘Whatif’ analysis. As part of an ideal planning process, you should identify all the key assumptio ns that are likely to have a critical impact on forecasted financial results.

Examples of criti ssumptions we tend to see fluctuating are key input costs, unit sales growth or exact overall wage increases. Use of sensitivity analysis as a planning tool can provide value to managers in a number of ways: Allows managers to look at how profit and other outcomes will be affected wh en one or more critical assumptions change Improves strategic awareness of the varying types of environmental scenarios that are possible, and in particular the extent of impact of each Helps in planning the most appropriate decisionmaking strategies to deal wit h different possible outcomes

Enables managers to effectively assess and manage certain risks All futureoriented information, be it a projected financial statement or foreca Sted investment schedule, will have a level of uncertainty to it. Some assumptions will be so minor that they do not merit sensitivity analysis. For example, if you have a fix edprice contract to build a new facility, capital costs are not likely to fluctuate material ly from that contract price. But if the same building is being constructed on a timeandmat erials basis, then the range of possible outcomes is significantly wider.

You will often find the most sensitive assumptions pertain to future operation Uncertainty often exists in the markets we serve (demand, price customers ar e willing to pay, etc. ). Multiple products or services add uncertainty around forecasted mi estimates. Often input costs will fluctuate, particularly those with a large com ponent of commodities such as oil, gas, steel, or other raw materials where market price s can fluctuate widely. A professional CPA can answer the question, ‘M/hat is the most sensitive assu mption, or the top three, in any futureoriented information?

And in doing so, the CPA fa cilitates the right discussion about the risks and rewards of the management decision. Sensitivity analysis is an applicable analysis tool in a variety of situations, but t he key triggering situational factor is the request to prepare analysis of future results based on a set of assumptions. Some of the relevant applications of sensitivity analysis in the PEP include: Costvolumeprofit analysis Capital budgeting Compilation of a financial forecast or projection Business valuation Net present value analysis Planning budgeting, and forecasting

Example 1: Planning and Budgeting Sensitivity analysis can be very useful in the planning and budgeting process. Consider the following (simplified) budgeted income statement for next year, based on actual expectations: To ensure a pessimistic view of what might be the worstcase situation, you id entify that the budget is based on a number of assumptions with potential downside as f ollows: Pressures on pricing might force the company to drop prices 2% from current expectations. The overall increase in salaries could be as high as 3. 5% (the budget above as sumes 2. 5%).

Other costs may potentially rise 5% higher than the current plan. These assumptions can be analyzed individually or in aggregate to determine the potential impact on operating income. The adjusted numbers are as you see below in the revised budget: The aggregate sensitivity impact of these three assumptions would negatively reduce operating income by $2,51 7 or 31 % from the initial budget. Armed with this in formation, management can now assess the severity of this scenario, as well as the likeli hood of it taking place, and make decisions as they deem them appropriate to mitigate t hese risks.

Example 2: CostVolumeProfit Analysis Costvolumeprofit modelling is used in virtually every industry. Because every environment has some level of uncertainty, Sensitivity analysis can be a very nsightful complement when the two are used in tandem. Two primary pieces of inform ation that we can gain by using these tools together are: How will the profitability forecast change with a fluctuation in one (or more) o f the critical assumptions? What does a change in one (or more) of the critical assumptions do to the bre akeven point? Assume the following information for the nextyear forecast for a new product

Expected profit would be: Revenue ($250. 00 x 1,000) – Variable Costs ($150. 00 x 1,000) – Fixed Costs ($4 0,000) $60,000 Breakeven units would be: Fixed Costs / (Selling Price – Variable Cost) = $40,000 / ($250. 00 – 50. 00) = 400 units The company has determined that with the addition of $50,000 in fixed costs i t can reduce variable costs by $60 per unit. It would like to know whether the forec asted profit and breakeven would improve if it made the investment. Let’s look at the new critical parameters now: Expected profit would now be: Revenue ($250. 00 x 1 ,000) – Variable Costs ($90. x 1 ,000) 000) = $70,000 Fixed Costs / (Selling price – Variable Cost) = $90,000 / ($250. 00 – $90. 00) = 563 units ” Fixed Costs ($90, The company can take away from this sensitivity analysis at least two key piec es of information. One: expected profits will improve by undertaking the new inves tment. Two: the breakeven has shifted upward (from 400 units to 563 units), thus creating more risk. So while there are more potential profits to be made, there is also a downside risk in that it must sell more units to break even (due to the increase in committed fixed c osts).

Practical Tip for Spreadsheet Sensitivity Analysis If using a spreadsheet to conduct the analysis, create a separate worksheet wi thin your Excel file where all the key assumptions are entered. Then, use other sheets t o prepare your financial schedules, and in doing so always link back to the sheet with th assumptions listed. Your assumptions should only be entered once, so that a change from the assumptions sheet flows through all the forecasts. Then when it co mes to preparing a sensitivity analysis, you can quickly change the assumption in one place and see the overall result quickly.