Sensitivity Analysis
Sensitivity analysis is the tool that calculates the impact of one independent variable to the others. In management accounting, we use it to calculate the change of company net profit if other factors change. These factors includes selling price, selling quantity, cost of raw material, etc.
Sensitivity analysis frequently uses in both business and economics in order to study the impact on variable to the others. Management need to prepare for the change, which is out of their control. It is commonly known as what-if analysis.
The business use this method to measure their profitability position in the market. If company depend on any factor will be a risk for business when the factor change. The company is making a good profit; however, when the price of raw material increase 10% will destroy everything. So it is very risky, while the supplier can increase the price at any time. Top management need to know this risk and have an excellent strategy to prevent it from happening, they can have a fixed contract to lock the price with the supplier. They can purchase from various vendors to decrease the suppliers’ power.
Example of Sensitivity Analysis
Company A produces the product P, and it estimates that they will be able to sell 1,000 units in a month. The other information as below:
- Direct material: 5$ per unit
- Direct Labor: $8 per unit
- The fixed cost: $ 10,000 per month
- Selling price: $ 25 per unit
Please do the sensitivity analysis. If there are the change in variable cost, fixed cost, selling price and sale quantity, how the profit impact.
Solution
| Sale | 25,000 | |
| Variable cost: | ||
| DM | 5,000 | |
| DL | 8,000 | (13,000) |
| Contribution | 12,000 | |
| Fixed Cost | (10,000) | |
| Profit | 2,000 |
Analysis:
- If the variable cost increase 15% (13,000 * 1.15 = 15,000) the contribution will drop to $ 10,000 and our profit will be zero. Any increase in material more than 15%, will make this project lose.
- If the fixed cost increase by 20% (10,000 *1.20 = 12,000), it will be equal to the contribution, and the profit will be zero too. Any increase in fixed costs of more than 20% will make this project lose.
- Selling price decreases by 8% ($25 * 0.92 = $23) will reduce the sale amount to $23,000, and the contribution will drop to $10,000, and there is no profit. Any decreasing in the price of more than 8% will make this project lose.
- If the sale quantity drops 80 units, the sale amount will drop to $23,000 and cause the profit to zero. Anything drop more than that will make this project lose.
What are the Advantages of Sensitivity Analysis?
| Advantages of Sensitivity Analysis | |
|---|---|
| Analyze many possible outcomes | This method tries to predict the potential consequences if something changes. The management team will be able to understand the impact and plan for any possible solution. It will estimate the outcome upon our concern, which can happen when one thing changes. |
| Strong and weak spot analysis | We will be able to understand our company’s strengths and weaknesses. Some companies may have high customer loyalty where the price will not impact their selling quantity, and it show us a good sign. The others have a massive impact on the interest rate, an increase of one percent will decrease most of their profit. |
| Improve Decision making for management | Sensitivity analysis will provide many possible results that happen due to the change of any variables. When all information is put into consideration, the company will be able to make much more good decisions. |
| Resource allocation | The company will be able to allocate the resource more efficiently. The company needs to maintain a secure area. And increase its resource for the area where they are far behind the competitors. |
| It is not too complicate | Everything is so simple to understand and explain to others. Increasing direct material and direct labor will lead to a decrease in gross margin as well as the profit. The price change will reduce our sales volume, and it will reduce profit. |
| Identify the cash flow impact | The business will need to have a steady cash flow to continue its operation, such as paying the staff, suppliers, and make a new investment. This method can analyze the impact of any factor to the sale volume, which the primary source of cash inflow for the business. Company can prepare the cash reserve in case of an emergency. |
What are the Disadvantages of Sensitivity Analysis?
| Disadvantages of Sensitivity Analysis | |
|---|---|
| Base on assumption | The analyzing may rely on the assumption for history data, which may not correct. A slight error with this assumption, the complete analysis will be useless. For example, the management assumes that the product is inelastic to selling price. However, it is not the same when the company is raising the selling price. As a result, a huge sale volume decrease; it will cause more trouble for the company. |
| Assume other factors do not change, only one variable change | This analysis will put other factors in the same position when we want to analyze any specific variables. In real life, all variables are subject to change. If we want to analyze many variable factors at the same time, Simulation is the best solution. |
| No clear result, not point to correct decision | Sensitivity analysis will provide many impacts on the outcome, but it does not point to the best choice which can have full benefit. It just provides information on the impact which may not happen. |
| It does not look at the probability of change | Sensitivity analysis only tells the effect of variable change. However, it does not show the possibility of those changes. The company does not have an unlimited resource to prepare for the impact which may not incur. |