Key Skills: What is Sensitivity Analysis?
Some people might think that sensitivity analysis is posting something controversial on Twitter and watching the responses of the people on the internet typing up a storm. That is not the type of sensitivity analysis we are going to talk about today.
Sensitivity Analysis is a technique that can be used to examine the effect of changes in the variables that will affect the outcome of a decision. This is also commonly referred to as “what if” analysis because the question that drives sensitivity analysis is “what would happen if…?”
This skill is taught in both accounting classes as well as quantitative analysis classes and it allows the user to change input variables and see how they impact an output result of a model. While this may seem very nebulous at first and only usable in academic or corporate financial settings, it's applicable in everyday life and for small businesses.
One of the most common uses of sensitivity analysis that I teach involves messing determining when a business can break even during changed circumstances. To do this, the first thing to do is find the break-even amount based off the company's fixed monthly costs and variable costs to sell each good or service. Once those amounts have been established, it is possible to solve for the breakeven amounts. After that breakeven amount is established, we start messing with the assumptions a little bit and ask some “what if?” questions. What if the company raised its prices? What if the Company uses cheaper material? What if the company replaced some of its variable costs with fixed costs? By changing these numbers in the model, you find the new breakeven amount based on the new circumstances.
While it may seem like we're just playing with numbers for no benefit, here's how a business owner might use this technique in a real life scenario: A business owner might see this and say "If I want to take an affiliate deal with this influencer and they take a cut of every sale I am going to need to sell 200 more units than I usually would this month to break even." After making that assessment, the business owner can see if the influencer has the appropriate following and influence to increase sales by that much, and then determine whether to take the deal.
In addition to calculating break even amounts, sensitivity analysis can facilitate the analysis of operating income analysis, operating budgets for departments, and even your own personal finances.
The perfect example of using sensitivity analysis for personal finance is when you want to finance a home or a car. and either circumstance the amount you pay on a monthly basis is based off a loan formula. the inputs for this loan equation are:
The amount to be financed (which is determined by the price and the amount of money you put down),
The interest rate,
The term of the loan, and
Other additional costs (such as financing charges and private mortgage insurance).
Once you put all this information into Excel with the appropriate formulas, you can perform your own sensitivity analysis by changing the inputs and observing the change in the output. I consistently do this while looking at purchasing real estate to determine what my monthly costs would be.
Sensitivity analysis has been traditionally used to prepare for uncertain future situations, and as 2020 has shown us, the world can be a very uncertain place. This means that the ability to recognize the situation, create a model, perform a sensitivity analysis, and interpret the results is essential.
Because we believe this topic is so important, we're going to do two special things. The first thing is we created a quick write up to supplement this blog post in a PDF which you can find right here. Here’s a quick preview:
The second thing we're going to do is create a follow-up for next week's blog that walks through performing sensitivity analysis step-by-step and provide some examples on how to make this knowledge work for you. See you then!