Sensitivity Analysis
tutor2u
https://www.youtube.com/watch?v=56-iiZEjqnU

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0:00 hi there let's take a look at a concept called sensitivity analysis and start with a question
0:07 how sensitive are your teeth when you brush them in the morning are they sensitive to cold or heat well that's the kind of question that
0:14 you ask yourself when you do sensitivity analysis not about your teeth but about the assumptions that are used in various business forecasts so
0:24 sensitivity analysis is all about challenging and analyzing the effect of changes in assumptions used in forecasts and as we know there
0:33 are various different places in business where we may need to forecast some information i've listed some out there on the screen let's pick out a couple of
0:40 them perhaps the uh one of the most important forecasts in business the cash flow forecast so we make assumptions about when cash
0:48 will come into the business and how much when will cash go out what about investment appraisal we clearly make assumptions there about
0:55 what the project cash flows are going to be and when they arise how likely is it that they will arise at certain times in the future
1:04 what will be the initial investment could that change and of course when we make break-even analysis and we forecast our profit we're making assumptions
1:12 about things like selling prices variable cost per unit and forecasts of fixed costs so business forecasts are full of
1:20 assumptions and sensitivity analysis allows us to challenge those assumptions it asks questions like how reliable are the assumptions made
1:29 what happens if things turn out significantly differently and also which assumptions are most significant which are the ones that we
1:37 need to forecast to focus on in our forecast so sensitivity analysis helps us answer these kind of questions
1:46 let's take a look as an example of sensitivity analysis which is often called what-if analysis this is particularly useful when you're looking
1:54 at sales and profit forecasts and our little example here is going to use a forecast profit and you may want to have a go at this and pause the video
2:03 at a couple of stages to work out some numbers so if you do so pause the video now and grab a pencil or paper and a calculator
2:11 and we'll work through this for the next minute or two here's our here's our small scenario managers of the business are forecasting
2:18 the profit they hope to achieve next year and they've made some assumptions here selling price per unit of 100 pounds per unit
2:26 variable cost per unit of 30 pounds per unit fixed cost for the year of 500 000 pounds and forecast sales of units
2:36 now if you want to have a go at this have a go pause the video and try to calculate what you believe the forecast profit is for this business based on
2:44 those assumptions let's take a look if you've had a go at doing that that's cool if not let's look
2:51 at what the forecast profit is and the answer is 200 000 pounds because if you apply those assumptions uh 10 000 units at 100 pounds per unit
3:00 must mean revenue of a million pounds our variable costs 10 000 units 30 pounds each are 300 000 pounds don't forget our fixed costs
3:10 500 000 pounds so the difference profit is the difference between revenue variable costs and fixed costs and it's 200 000 pounds so our forecast is 200
3:20 000 but we've made some assumptions there so how sensitive is this forecast to those assumptions and what happens if we change them that's the beauty of
3:29 sensitivity analysis so what we'll do is we'll just spend a minute having a look to see what happens if our assumptions were worse
3:37 by 10 for each of the four assumptions so rather than the selling price per unit being 100 pounds it's 90 pounds rather
3:46 than the variable cost per unit being 30 pounds it's actually 10 percent worse 33 pounds per unit and similarly for fixed costs they are higher than expected and
3:54 forecast sales 10 low than expected now again if you want to have a go have a go at calculating the forecast profit
4:02 by making each of those changes not all together what's the impact of making one change at a time for example
4:10 just changing the selling price from 100 pounds to 90. so again if you want to have a go pause the video and then we'll go through what those impacts are
4:20 for those of you still with me we're going to go through the effects and maybe if you've just joined back here having had a go at one two
4:26 calculations let's see how your numbers compare with my numbers well the effect is by changing one variable at a time what if analysis that
4:36 the forecast profit is always going to be worse because our assumptions are 10 worse but the impact on forecast profit is
4:43 different so just to show that in uh absolute terms and also the percentage terms if we lower the selling price from 100 to
4:53 90 pounds per unit the forecast profit falls from two hundred thousand pounds to one hundred thousand pounds that's a fifty
5:01 percent fall similarly if we uh let's take the bottom one there if we uh sell ten uh if we sell nine 000 units not 10 000 units so
5:11 1 000 fewer units than we forecast if our assumption is 10 worse the effect on profit is that the profit is 130 000 pounds
5:21 which is 35 down and so we should be able to see from those calculations the sensitivity of the forecast to the four different
5:30 assumptions there and we can see just using the highlighter here that the selling price per unit turns out to be the assumption which is most sensitive
5:39 in terms of the effect on the forecasts fifty percent down by changing a ten percent uh by a fall
5:48 in the selling price of ten percent so there we go that's an example of a sensitivity analysis our forecast profit is 200 000 pounds but we just checked to
5:56 see what happens if we vary the assumptions and we find out that the most significant assumption is this selling
6:03 price of a hundred pounds per unit well what does that mean what does that show what are the benefits and drawbacks
6:11 of sensitivity analysis well clearly a benefit is that we can focus on the most significant assumptions so on that previous example there how
6:21 confident are we that we'll achieve a selling price per unit of 100 pounds could it be that we have to achieve or offer a much lower selling price to
6:28 achieve the forecast sales units particularly if demand is price sensitive and of course it helps us challenge our
6:36 forecast challenge our assumptions which is always good in business the worst thing in business is to have overly optimistic forecasts and then
6:43 you're constantly having to explain and work out why things aren't as good as they you thought they were going to be one of the drawbacks of sensitivity
6:49 analysis as with all uh appraisal techniques like this is that you're only as good as the forecasts that you make and the assumptions you make and you're
6:59 only testing one assumption at a time so is that a drawback i'm not sure it's too much of a drawback i think it's a good uh it's a robust and valid way of
7:10 challenging a forecast made in business you might argue that sensitivity analysis is a complicated concept i'm not sure that's entirely valid either
7:19 but nevertheless there are some potential drawbacks to the use of sensitivity analysis so there we go that's what six minutes
7:27 seven minutes an introduction to and hopefully a useful example of sensitivity analysis
7:52 you