CHAPTER 5

SENSITIVITY
ANALYSIS
 SENSITIVITY ANALYSIS
Introduction
In all our preceding discussions we had arrived at a
particular decision (in the form of acceptance or rejection
of a proposal, and the selection of one alternative among
different possible alternatives) in a given situation
assuming that the estimates or the expected value for
different variables such as initial cost, receipts,
disbursements, interest rate, life of the assets, salvage
value etc. were accurate and constant.
Unfortunately in real life situation it is not.
 Barring (except) few variable, such as initial cost of the
asset, rest all the variables are all our estimates or
forecasts which may prove to be wrong on most of the
occasions.
 The life of the asset could be longer or shorter than our
estimate;
 The interest rate could be higher or lower than the
assumed value and so on.
 The salvage value may be more or less than the assumed
value.
We may like to know what will happen to the net present
worth associated with a particular investment alternative
when some variables like incomings (receipts) value or
outgoings (Expense) value vary from its expected value.

Sensitivity analysis

It is aimed to study the impact of change in the value of

variable(s) on the economic decision in a particular situation.

In a sense it aims to answer “what if”.

For example what will happen if the annual disbursement
or cost value increases by 10% or 20% from the current
value?
 Will it turn the positive present worth into negative?
 Will it change the earlier decision?
 The changes (increase or decrease in the assumed values)
in the variable values may or may not lead to reversal of
our earlier decision.
If a slight change in one variable makes the reversal of
decision from let’s say acceptance of one alternative to the
rejection we say that the variable is highly sensitive.

Whereas, even if a large change in one variable does not

change the decision we say that the variable is not
sensitive or insensitive.
The sensitivity analysis is also aimed to identifying the
sensitivity of a particular variable.
Once the identification has been made of variables in
categories such as highly sensitive, less sensitive or
insensitive the management can focus their attention to
the highly sensitive variables.
That is for such variables they can put more energy and
effort in preparing their estimate.
In some situations, external help in the form of
engagement of consultants can also be thought of.
 Different forms of sensitivity analysis
In its simplest form, sensitivity analysis for a single
alternative can be performed and the impact (on decision)
of change in single variable can be studied.
Then there could be simultaneous changes in two variables
corresponding to a single alternative can be studied.
Finally for a single alternative we can study the changes in
more than two variables at a time.
 Sensitivity analysis can be performed for more
than one alternative.
Here also we can see the impact of variation of
one variable on the decision.
There can be cases in which we would like to
change two variables at a time or more than
two variables at a time and see their impact on
the decision arrived earlier by assuming all the
variables as fixed or constant.
 Sensitivity analysis can be performed with any method
of evaluation of alternatives for example
Pw, Aw or Internal rate of return analysis.
Also the analysis can be performed at different stages of
project either
pre tax or post tax cash flows.
However, it is preferable to perform sensitivity analysis
with post tax cash flow.
It is customary to show the results of sensitivity
 Examples
Consider the given Description Alternative 1
alternative to acquire a Acquisition cost Birr. 500,000
new piece of equipment.
Annual Incomings Birr. 100,000
The acquisition cost,
incomings, outgoings, Annual Outgoings Birr. 5,000
salvage value, interest
Salvage value Birr. 50,000
rate and service life
associated with the Interest rate 12%

alternative are provided Service life 10 years

in this table.
Net present worth
= -500,000 + 100,000(P/A, 12%, 10) – 5,000(P/A, 12%,
10) + 50,000(P/F, 12%, 10) = 52869.4
Let’s assume that the estimate of incoming value goes
wrong and instead of Birr. 100,000 it is Birr. 90,000.
Thus the new net present worth keeping all other
variables same would be
=(-500,000 + 90,000(P/A, 12%, 10) – 5,000(P/A, 12%,
10) + 50,000(P/F, 12%, 10) =-3632.8
We find that the decision taken on net present worth
would get reversed.
The above analysis could be performed in terms of
percentage variation in incoming values also.
Let the percentage variation in incomings be x. We can
find the percent change in incomings at which the net
present worth becomes zero.
In this example, if the incoming value decreases by P %
the net present worth turns out to be negative.
The value of incoming at which net present worth is zero
is known as break even point.
 60000

50000

40000
Net Present Worth Rs.

30000

20000

10000

0
90,000 95,000 100,000

-10000
Incomings Rs.

Sensitivity graph showing the effect of changes in

incomings on net present worth
Similar analysis can be performed by changing other

variables one at a time.

The slope of the sensitivity line indicates the sensitivity
of a particular variable.
The steeper the slope, the more sensitive the variable is
and the milder the slope, the less sensitive the variable.
Next we take the variables: incomings and service life
together and study their sensitivity.
In order to perform the sensitivity analysis of two
variables simultaneously for example incomings (R) and
life of the equipment (N) we write the expression of net
present worth as given below:
NPW = -500,000+R (P/A,12%,N) – 5,000(P/A,12%,N)
+50,000(P/F,12%,N)

There are two ways to show sensitivity analysis

Family of curves

Isoquants
 Family of curves representation

One variable is kept fixed while another variable is varied.

For example, Assume that service life N is fixed at some

value N1 and net present worth is computed for different
values of incomings R.
 Isoquants
An indifference line is plotted by varying two variables say
service life N and incomings R at a time while keeping all
the other variables fixed.

For drawing the indifference line first we try to get points say
(N1,R1), (N2,R2),...at which the net present worth is zero?
 Changes in more than two variables at a time
Conducting scenario (consequence) analysis is the best
approach when performing sensitivity analysis involving
changes in more than two variables at a time.

In scenario analysis a number of scenarios such as best

scenario, objective scenario, and worst scenario (in some
texts these scenarios are referred to as: less favorable
estimate, objective estimate, and more favorable estimate)

The objective of such scenario analysis is to get a feel of

what happens under the most favorable or the most adverse
configuration of key variables.
For example the best, normal and the worst scenario for the
previous example could be as given below:
Example
Variables Worst Normal Best
Incomings 85,000 100,000 115,000
Outgoings 7,000 5,000 4,000
Salvage value 25,000 50,000 60,000
Interest rate 15% 12% 10%
Service life 8 years 10 years 12 years

Corresponding to each of the above scenarios, the net

present worth can be computed.
Based on the net present worth values for each of the
scenarios the decision maker would be in a better position
to take the decision.

For example,

If the NPW of the worst scenario is a large negative value,

and the NPW of the objective and best scenarios are low
positive value, and moderate positive value the decision
would be not to acquire the asset.
Advantages and Limitations of Scenario Analysis
Scenario analysis is considered superior to sensitivity
analysis because it considers variations in more than two
key variables together.

However, scenario analysis has some limitations:

 It assumes that there are few well delineated scenarios
which may not be true in many cases.
 There is a huge requirement of data to perform scenario
analysis.

For example even for 6 input variables we would require 6

x 3=18 input data altogether corresponding to the best,
normal, and worst scenarios.
Sensitivity analysis for more than one alternative
Here also we can vary one variable, two variables or more
than two variables at a time.
We discuss the variation in one variable only.

For illustrating the sensitivity analysis corresponding to

changes in one variable, we take up the following two
alternatives in which the information on acquisition cost,
the incomings, the outgoings, salvage values, interest rate,
and service life are provided.
 Example
Description Alternative 1 Alternative 2
Acquisition cost 500,000 400,000
(First cost)
Incomings 100,000/yr. for 10 yrs. 80,000/yr. for 10 yrs.
Outgoings 5,000/yr. for 10 yrs. 10,000/yr. for 10 yrs.

Salvage value 50,000 40,000

Interest rate 12% 12%
Service life 10 years 10 years
 Solution
The net present worth of alternative 1

= -500,000+100,000 (P/A,12%,10)

-5,000(P/A,12%,10)+50,000(P/F,12%,10)

= -500,000+100,000*5.6502-
5000*5.6502+50,000*0.3220 =52,869
The net present worth of alternative 2
= -400,000+80,000 (P/A,12%,10)
-10,000(P/A,12%,10)+40,000(P/F,12%,10)
= -400,000+80,000*5.6502-10,000*5.6502
Now let’s change each of these variables one by one.
For example, consider the changes in the variable
‘incoming’.
In case the ‘incoming’ of alternative 1 changes to
90,000 from the existing 100,000 the new net present
worth of alternative 1 changes to - 3633
 We can find that if the incoming value reduces to 90,642.99 the
decision is reversed. (net PWV=0)
Such analysis addresses the questions such as:
At what value of incomings the alternative 1 is preferred to
alternative 2?
At what service life of the assets, the alternative 1 is preferred to
alternative 2?
 limitation of sensitivity analysis
It is non probabilistic in nature.
One may recollect that for none of the cases we
considered the likelihood of occurrence of a particular
variable value.
It merely shows us what happens to the NPW, AW or
ROR when there is a change in some variable(s),
without providing any information on the likelihood of
the changes.
Commonly, in sensitivity analysis only one variable is
changed at a time which may not reflect the real world
situation as variables tend to move together,
There is subjectivity involved in the sensitivity
analysis. Thus the sensitivity analysis may lead one
decision maker to accept the proposal while other may
reject it.
Benefits of performing sensitivity analysis
(1) It shows how robust or vulnerable(exposed to be
harmed) a particular alternative is to changes in the value
of different variables,
(2) It enables the decision maker to distinguish the
sensitive variables from insensitive variables thus the
decision maker can focus its attention in making the
estimate of sensitive variables,
BREAK EVEN
ANALYSIS
 Profit and Loss Terms
In terms of costs and revenues there are three
possible profit and loss points for a business
activity.
Breakeven: total revenue = total costs
Just getting along
Profit region: total revenue > total costs
Putting money in the bank
Loss region: total revenue < total costs
Going into debt
 Break even analysis
Another way of performing sensitivity analysis
Here we are more concerned about finding the value
(called the break even point) at which the reversal of decision
takes place.
not much emphasis was given on finding this break even
value.
what will happen to the project if the invoice or
billing declines or costs increase or something else
happens.
 Cont,….
how much should be produced and sold at a
minimum to ensure that the project does not 'lose
money'.

The minimum quantity at which loss is avoided is

called the break-even point.

The break even analysis is also referred to as cost-

volume-profit analysis.
 Cont,….
Addresses the decision of whether to make or buy a
product. whether to own or rent an equipment
Making the product involves two cost elements:
◦ Fixed costs
◦ Variable costs
Buying the product involves only one cost element, the
selling price.
However, the price may either be constant or variable
based on the quantity.
Linear Breakeven Analysis
 ILLUSTRATION
A Ready Mix Concrete (RMC) manufacturer wants to
find out the minimum production of concrete which
will just be able to recover its total cost incurred in a
particular month.
The total cost (TC) incurred in a month is the sum total
of its indirect cost (IC) and direct cost (DC).
The indirect costs in this example are those costs which
are incurred irrespective of concrete production taking
place or not.
However, the direct costs are proportional to the
volume or quantity of production.
By definition the total cost TC = IC + DC
Let the sales price fixed by the RMC supplier is P per
unit concrete sold.
If the quantity of concrete sold is n units, the revenue R
would be computed by the expression R= n x P.
The total cost TC = IC + n x DC
Gross profit Z for the period would be defined as:
Z = R – TC = n x P – IC – n x DC
= n x (P-DC) – IC.
The net profit after taking taxes into account is given by
Z’= Z x (1-t) where t is the tax rate.
Break even point is defined where profit equals zero. In
order to determine the concrete quantity n at which the
RMC seller just recovers its total cost we equate total
cost to revenue. Thus at break even point,
Total cost TC = Revenue R. (Note at this point Profit Z = 0).
We have,
TC = R at break even.
 n x DC + IC = n x P
B x DC + IC = B x P (the quantity produced at Break
even point is denoted with B, thus n= B at break even.)
 B = IC/ (P-DC)
The denominator (P-DC) in the expression is also
known as ‘contribution’.
For n less than B, the RMC seller is making losses,
while for n greater than B, the RMC seller is making
profits.
The point of intersection of the total cost and revenue
lines is known as break even point.
The ordinate corresponding to this intersection point
gives the break even quantity of concrete to be
produced in order to just recover the total cost incurred
by the RMC seller.
 Linear Breakeven Analysis-Example
A Ready Mix Concrete company sells RMC for a price of Birr. 3500/ cum. If the
fixed cost of the company for the production are Birr. 40,000/month and the variable
cost associated with per cum production of RMC is Birr. 1500/ cum, determine the
breakeven quantity.
Revenue R = 3500 X
Cost Profit

Total cost (TC) = 40,000 + 1500 X

Loss

Variable cost: 1500 X

Fixed Cost: Birr. 40,000

Savings : S = R – TC = 3500 X – (40000 + 1500 X)

Breakeven: S = 0, 3500 X = 40,000 + 1500 X
=20
B Quantity (X)
The companies try to lower the break even point
by resorting to different means such as
◦ (1) increasing the sales price,
◦ (2) reducing the total cost of production,
◦ (3) increasing the quantity of production.

Utility (use) of break even analysis

The break even analysis is useful in situations such as:
◦ make or buy decision situation,
◦ lease or purchase decision and so on.
Assumptions Of Linear Break Even Analysis
Income is only from the productions under study. In the
previous example it was assumed that the ready mix
concrete manufacturing company is into concrete
production only.
Whatever quantity is produced is sold out.
The per unit direct cost, indirect cost, and sales price
associated with the production are constant over the
study period. These are also constant over the quantity

produced.
 Another Example
DC = 7/ UNIT, Sales price P= 12/unit

Indirect cost IC = 400

 B = IC/ (P-DC)

Break even point = 400/ (12- 7) = 80

The break even point can be lowered to 40 by

◦ Reducing the indirect cost to 200
◦ Reducing the direct cost to 2
◦ Reducing the sales price to 7
THE END