It’s almost impossible to know with certainty from the present, the possible outcome of a future business undertaking. The outcome is often covered by uncertainty.
This uncertainty is better understood by accepting the fact that every business idea is a future event with uncertain number of possible unknown outcomes.
Also, every project faces a risk. There is the probability of it being exposed to loss from a variance existing between the actual outcome and the expected outcome.
A business risk and uncertainty can’t be wished away because not all factors that affect business survival and success are controllable.
Some like the product life cycle, government policies and some environmental factors can’t be controlled by investors.
Therefore, to ensure the success of a business or project idea, it’s important to assess risks and uncertainties which a business idea could be exposed to.
Apart from the existent of sophisticated methods, you can use the simple sensitivity analysis approach to assess the risk and uncertainty in a project appraisal (another simple approach is the expected value)
What is sensitivity analysis?
Sensitivity analysis is a simple and practical approach that varies the values of key factors one at a time and shows the effect of the variation on the outcome of the project.
The goal of this approach is to show which factor affects the outcome the most.
Key factors varied usually are determined by such questions as; what if the unit cost changes by a certain percentage? What if the sales price per unit changes by a certain percentage? What if the sales volume changes? What if the inflation rate changes? What if the target market is not won? What if the capacity is under utilized by a certain percentage? And so on.
The aim of using sensitivity analysis in project appraisal as mentioned earlier, is to identify and keep a close watch on variables most sensitive to the success of a project.
If a project is not making profits then it’s failing. So, sensitivity analysis ascertains the effects of changes on profit forecasts (or cash flows) and eventually, on the Net Present Value (NPV) of a project.
The critical question is, “How much do changes in a significant variable affect the calculated NPV and the discounted cash flow (DCF) rate?
An ecample, a business that makes $200,000 sales revenue yearly by selling to an average of 2,000 buyers expects it sales revenue to increase by 10% when its average yearly buyers increase by 20% to 2,400.
This business can use these figures to determine the effect of percentage changes in average buyers on sales revenue. The percentage changes in average buyers could be flexed either downwards or upwards.
Sensitivity analysis helps investors to analyze all available information to create strategies that minimize adverse effects of risk and uncertainty on a project.
Although sensitivity analysis is used to identify the most sensitive variables, it doesn’t tell the possibility of the occurrence of a variation.