In this article, an attempt is made to provide an answer to the question; what is sensitivity analysis in a very simple and non technical manner. An all encompassing approach is taken to accommodate people of different understanding of the subject matter, so, if you are new to the field of accountancy and you wondering if you would grasp some concepts as quickly as you would like, don’t worry. Just sit back and enjoy this simplified article that explains the meaning of sensitivity analysis.
EXPLANATION, MEANING AND DEFINITION OF SENSITIVITY ANALYSIS
Sensitivity analysis is a management accounting tool used by those at the top of organization to analyse scenarios. This process of gaining insight into likely outcome of events is commonly referred to as a what-if analysis. It is used to test the effect of critical and non critical variables on the overall profitability of a company.
Management incorporate sensitivity analysis into the capital budgeting process in order to get an idea of the possible relationship that might exist between certain components of the proposed project, contribution, sales, profitability, liquidity and the overall working capital management of an entity.
The main purpose and mission of sensitivity analysis is not to quantify or measure risk, but to ascertain the responsiveness of net present values (NPVs) to variables that are used to calculate it. This is because the process appraising investment opportunities using NPV method is based on certain assumptions that are based on forecasting thereby making it uncertain.
Sensitivity analysis is one of the most widely used risk analysis tools that attempt to measure the extent of change in variables and underlying assumptions that would bear impact on the bottom line of the cash-flow and profitability of a project. The idea of appraising a project before committing resources to it is to give managers the chance of having a bigger picture of what value the project would add to the overall success of the business.
The problem however is that this wonder evaluation technique call NPV is based on the inputs projections, forecasting and calculation of variables that then serves as input in the decision making process.
A lot of people do confuse sensitivity analysis with ratio analysis and other tools like variance analysis and contribution analysis. Although sensitivity analysis has some similarities with the managerial accounting tools mentioned above, they are not the same.
Some finance professionals have in recent times question the usefulness of sensitivity analysis as a risk assessment tool. They claim that the disadvantages of employing this method of incorporating risk and uncertainty into investment appraisal process lack some practical sense as it is all based on assumption that might not materialise eventually. This argument of these groups of people will now bring us to the topic of advantages and disadvantages of sensitivity analysis
ADVANTAGES OF SENSITIVITY ANALYSIS
Simplicity: there is no complicated theory to understand. Unlike most concepts in finance and accounting where a level of theory needs to be appreciated before applying a method.
Directing management’s efforts: management needs a level of concentration is discharging their duties. Sensitivity analysis identifies areas that are crucial in the attainment of overall organizational goal as contained in the mission and vision statement of an organization. Any area that is identified as highly sensitive will be closely monitored by the management.
Source of planning information: through the application of sensitivity analysis, information is made available to management in the form which facilitates the application of professional judgement when discharging their managerial duties.
Ease of being automated: the process of analysing different possible effects of a variable of the acceptability of a project can be done in a flash by simply plugging in the variables in sensitivity analysis software that would accurately perform the calculation and leave you with making decision.
As a quality check: management’s attention to the importance of implementing quality control in the processes that have high impact on the success or failure of a project is intensified when they know how crucial a variable is in the investment analysis process.
DISADVANTAGES OF SENSITIVITY ANALYSIS
Treatment of variables in silos: one of the assumptions of sensitivity analysis is that variables are independent of themselves. For example, management assumes that material price changes would not affect the prices of other variables. In reality, companies can increase the selling prices of their goods if material price should go up. This weakness can be resolved using a management accounting technique called simulation where more than one variable can be tested at a time.
It is not relative in nature: sensitivity analysis only considers the extent of variable change. It does not take into account the probability of such changes taking place.
Not a solution in standalone form: it is not an optimizing technique in the sense that the information it provides is only a basis for further analysis, interpretation and finally decision making. But, when you think of it differently, you will notice that this isn’t really a weakness, after what technique or process can stand on its own? J