Engineering Economics in Canada

Chapter 11
Dealing with Uncertainty: Sensitivity Analysis
 11.1 Introduction
• Most economic evaluations involve
estimating project parameters.
– E.g. Prices, interest rates, magnitude
and timing of cash flows.
• Sensitivity analysis develops a better
understanding of how uncertainty affects
the outcome of the evaluation

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 Sensitivity Analysis Methods
• Sensitivity graphs illustrate the sensitivity
of a particular measure to one-at-a-time
changes in the uncertain parameters of a
project.
• Break-even analysis can answer such
questions as: “What production level is
necessary in order for the PW of a project
to be greater than zero?”
• Scenario analysis allows us to look at the
impact of varying several parameters at a
time.

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 11.2 Sensitivity Graphs
• Sensitivity graphs are used to assess the effect
of one-at-a-time changes in key parameter
values on a performance measure.
– begin with the “base case” where all the
estimated parameters values are used to
evaluate the project.
– then vary parameters above and below the
base case one at a time, holding all other
variables fixed.
• A graph of the changes in a performance
measure brought about by these changes is
called a sensitivity graph.

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 Example 11.1
• Corporation C is replacing their current
steam plant with a 6-megawatt new
plant that will produce both steam and
electric power.
• Summary data is provided in Table 11.1
• What is the present worth of the
incremental investment in the
cogeneration plant?
• What is the impact of a 5% and 10%
increase and decrease in each of the
parameters of the problem?
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 Table 11.1

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 Figure 11.1

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 Benefits and Shortcomings…
• the benefits of a sensitivity graph
– it can be used to select key parameters
in an economic analysis.
– It is easy to understand and
communicates a lot of information in a
single diagram.
• The shortcomings of sensitivity graphs
– they are valid only over the range of
parameter values in the graph.
– they do not consider the interaction
between two or more parameters.
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 11.3 Break-even Analysis
• Break-even analysis is the process of
varying a parameter of a problem and
determining what parameter value causes
the performance measure to reach some
threshold or “break-even” value.
• In Example 11.1, a break-even analysis
could answer the question “What MARR will
result in a zero present worth?”
• This analysis would be particularly useful if
they were uncertain about the MARR and
wanted to find a threshold MARR above
which the project would not be viable.
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 Break-even Analysis…

• Break-even analysis applied to multiple

projects can answer questions like “Over
what range of interest rates is project A
the best choice?” or “For what output
level are we indifferent between two
projects?”
• The point of doing this analysis is to try
to get a better understanding of how
sensitive a decision is to changes in the
parameters of the problem.
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 11.3.1 Break-Even Analysis for a Single
Project

• break-even analysis can be applied to a

single project to illustrate how sensitive
a project evaluation is to changes in
project parameters.
• continue with Example 11.1 to expand
upon the information provided by the
sensitivity graphs.

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 Example 11.2
• The present worth of the cogeneration
plant is quite sensitive to the savings in
electricity costs, the MARR, and the
initial costs.
• What range of values results in a viable
project (i.e., PW > 0)?
• What are the “break-even” parameter
values which make the present worth of
the project zero?
• Construct a graph to illustrate the
present worth of the project as a
function of each parameter.
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 Figure 11.2

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 Figure 11.3

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 Figure 11.4

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 Example 11.2 …Observations
• Figure 11.2 shows the present worth of the
project as a function of the MARR. It shows
that the break-even MARR is 17.73%.
• Figure 11.3 shows that the first cost can be
as high as $4 126 350 before the present
worth declines to zero.
• Figure 11.4 provides a break-even chart for
the savings in electrical power costs.
Provided that the annual savings are above
$849 207, the project is viable. Below this
break-even level, the present worth of the
project is negative.
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 11.3.2 Break-Even Analysis for Multiple
Projects
• How do changes in parameter values affect
which project or projects are chosen?
– For multiple independent projects break-
even analysis can be carried out on each
project independently.
– For mutually exclusive projects, the best
choice will seldom stand out as clearly
superior from all points of view.
– The best choice may depend on a particular
interest rate, level of output, or first cost.
• A break-even comparison can reveal the range
over which each alternative is preferred.

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 Example 11.3
• Westmount Waxworks is considering buying
a new wax melter for their line of replicas of
statues of government leaders. They have
two choices, Finedetail and Simplicity. The
proposals are shown in Table 11.3
• Which is the preferred supplier
– as sales vary from 30 000/year to
200 000/year?
– as the “other costs” per unit for the
Simplicity model range from $0.45/unit to
$0.75/unit?

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 Table 11.3

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 Figure 11.5

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 Figure 11.6

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 Example 11.3 Observations
• Since 30 000 units per year is the lowest sales will
likely be, and sales have averaged 50 000 units per
year over the past five years, it appears that the
Simplicity wax melter would be the preferred choice,
assuming that its “other costs” per unit is $0.55.
• We see that the best choice is not sensitive to the
“other costs” of the Simplicity wax melter.
• It would appear that the Simplicity model is the
better choice if sales are at all likely to exceed the
break-even sales level of 38 199.

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 Summary
• Introduction
• Sensitivity Graphs
• Break-Even Analysis
– For a single project
– For multiple projects
• Scenario Analysis

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