What is Sensitivity Analysis?

Malcolm Tatum

Sensitivity analysis is a strategy that is helpful in determining what could happen if a specific variable within a projection fails to function as originally envisioned. The idea is to identify possible deviations that could occur if one or more variables are changed or discarded, and how those changes would affect the eventual outcome. From this perspective, this type of analysis makes it possible to prepare for outcomes other than the desired goal, thus minimizing the ill effects if those variables do fail to perform or influence as anticipated.

Businessman with a briefcase
Businessman with a briefcase

Within the process of conducting a sensitivity analysis, it is possible to look at each factor or variable that has relevance to the projected outcome. For example, if an business anticipates that launching a new product will result in an increase of twenty-five percent in annual earnings, the analysis may look at how the earnings would be affected if consumer response were only half as enthusiastic as originally predicted. As part of the development of different scenarios where a given variable failed to function as projected, the matter of an increase in the cost of raw materials may also be considered, determining what impact that increase would have on the profits earned by the new product line.

While there are exceptions, a sensitivity analysis does not typically include the development of scenarios that have below a certain potential for actually coming to pass. Instead, the process focuses on identifying and projecting the outcome if certain variables that do have at least a reasonable chance of taking place should occur. For this reason, the sensitivity analysis tends to remain somewhat grounded in facts and makes use of those facts in creating the alternative scenarios. What is considered a reasonable scenario will vary somewhat from one industry to the next, and will depend a great deal on general economic conditions as well as factors that apply to the industry where the business operates and the internal function of the business itself.

Conducting a sensitivity analysis is important to any attempt to assess potential project profitability. Allowing for changes in sales figures or changes in cost of raw materials allows businesses to prepare alternative responses that can minimize the impact if all does not go as planned. When utilized efficiently, this form of analysis can go a long way toward keeping a business competitive within the marketplace, and demonstrating a sustained ability to manage a wide range of events that derail other businesses that do not take the time to consider alternative outcomes.

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