Sensitivity Analysis

Sensitivity Analysis is a financial modeling technique used to determine how the different values of an independent variable affect a particular dependent variable under a given set of assumptions.

Definition and Importance of Sensitivity Analysis

Sensitivity Analysis evaluates how changes in input variables impact an output variable, offering insight into the robustness of an investment or project. It is crucial for risk management and decision-making in finance and business.

Key Components of Sensitivity Analysis

• Independent Variables: These are the input variables that are altered to observe changes in the dependent variable. Examples include sales volume, costs, or interest rates.
• Dependent Variable: This is the output that is measured, often a financial metric such as Net Present Value (NPV), Internal Rate of Return (IRR), or profit margin.
• Scenario Analysis: A related concept where multiple variable changes are assessed together, simulating different economic or market conditions.

How to Conduct Sensitivity Analysis

The typical process involves the following steps:

1. Identify the Base Case: Determine the default assumptions and values for the variables involved.
2. Change Input Variables: Adjust the values of independent variables one at a time to capture the range of potential outcomes.
3. Analyze Results: Evaluate how these changes affect the dependent variable through various metrics.

Real-World Example of Sensitivity Analysis

Consider a company evaluating a new product launch. The key independent variables might include marketing costs, manufacturing costs, and sales price. The dependent variable could be forecasted profits.

If marketing costs are increased by 10%, decreased by 10%, or kept the same, the respective profits can be calculated:

• Base Case: $500,000 profit at $200,000 marketing cost.
• 10% Increase: $450,000 profit.
• 10% Decrease: $600,000 profit.

By analyzing these variations, the company can understand the sensitivity of its profits to changes in marketing spending, helping them make more informed strategic decisions.