Sensitivity Analysis

A technique for analysing uncertainty about the outcome of a decision.

1. All forecasts are predictions of future outcomes. Forecasts of profitability are based on
the accuracy of the productions of future costs and future revenues.
2. The starting point is an estimate of what the outcome will be based on estimates for key
variables, such as selling price, sales volume and unit variable cost fixed cost
expenditures.
3. Sensitivity analysis may be used because there is uncertainty about some of these
estimates.

3 useful approaches:

a) To estimate by how much costs and revenues would need to differ from their estimated
values before the decision would change
b) To estimate whether a decision would change if estimated costs were x% higher than
estimated, or estimated revenues y% lower than estimated
c) To estimate by how much costs and/or revenues would need to differ from their estimated
values before the decision-maker would be indifferent between two options

Class Exercise

Awesome Co has estimated the following sales and profits for a new product which it may
launch on to the market.

$ $
Sales (2,000 units) 4 000
Direct materials 2 000
Direct labour 1 000 3 000
Contribution 1 000
Fixed costs 800
Profit 200

REQUIRED

Analyse the sensitivity of the project to changes on key variables.

Compiled by: Cheryl.TYX

Solution

1. If fixed costs are more than 25% estimate (200/800), the project would make a loss.
2. If unit costs of materials are more than 10% above estimate (200/2 000), the project
would make a loss.
3. Similarly, the project would be sensitive to an increase in unit labour costs of more than
$200, which is 20% above estimate.
4. Moreover, the project would become unprofitable if the selling price is more than 5%
(200/4 000) below the estimate, given no change in sales volume.
5. The margin of safety, given a breakeven point of 1 600 units, is 20% (400/2 000).
6. Therefore, the items to which profitability is most sensitive are selling price (5%) and
material costs (10%).

Sensitivity analysis can help to concentrate management attention on the most important
factors.

Example 1

Planned sales of ‘diorth’ are 5 000 units at $20 per unit.

Variable costs are predicted to be $5 per unit.
Fixed costs are estimated to be $52 000.
A forecast income statement based on this information shows:
$ $
Sales (5 000*$20) 100 000
Variable costs (5 000*$5) (25 000)
Fixed costs (52 000) (77 000)
Profit 23 000

𝑇𝑜𝑡𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡

Break-even point = 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 = $52 000/ $15 = 3 467 units

A loss would be incurred if planned sales volume fell below 3 467 units.

A loss would result if:

 Sales volume fell by 30.66 percent

(1 533 margin of safety/5 000 predicted sales volume)*1 000

 Selling price fell by 23 percent

($23 000/$100 000)*100

 Variable costs rose by 92 percent

($23 000/$25 000)*100

 Fixed costs rose by 44.23 percent

($23 000/$52 000)*100

Compiled by: Cheryl.TYX