Sensitivity Analysis: Definition
Sensitivity analysis involves examining what happens to a budget when changes are made in the assumptions on which it is based. It is also known as what-if analysis, and it can be carried out using a spreadsheet or manual calculations.
Manual calculations are easier if they focus only on the parts of the budget that are subject to change.
Importance of Sensitivity Analysis
Sensitivity analysis has various essential applications in today’s businesses.
For example, sensitivity analysis can be applied to determine how sensitive the cash budget is to possible changes in the initial assumptions.
If a change in one assumption generates only a small cash difference, there isn’t any reason to be too concerned. However, a change in one assumption can sometimes lead to dramatic shifts in the company’s cash position.
Sensitivity analysis, therefore, is useful to determine which assumptions are critical and which have less impact.
The technique investigates the impact that changes would have on the budget, ensuring managers are aware of how the situation could vary from our expected position.
Sensitivity analysis is sometimes called “what-if analysis.” This is an excellent name because it perfectly sums up what it focuses on. The technique simply shows the analyst what will happen to the budget if changes happen.
The procedure for sensitivity analysis involves “trying out” various alterations from the original assumptions to assess the impact.
This can be achieved by changing one category of receipts or payments (e.g., what if the purchase price increases by 5%?).
It can also be achieved by investigating the effect of more than one change in combination (e.g., what if the purchase price increases by 5% and we have to pay off a loan in one month, not two?).
You may be asked to perform sensitivity analysis in a given task, so we’ll examine the numerical techniques shortly. Before we do that, it’s worth examining an important practical tool for carrying out sensitivity analysis: the computer spreadsheet.
Using a Spreadsheet for Sensitivity Analysis
The format of a cash budget is easy to reproduce on a computer spreadsheet. Formulas are used to help us avoid having to carry out all the arithmetic.
Once you’ve opened a spreadsheet, it’s a simple matter of inputting data or adding new rows/columns (e.g., for additional receipts or payments).
When the spreadsheet for a cash budget is configured correctly, the total amounts for receipts and payments will automatically adjust when changes are made, together with the bank/cash balances at the bottom of the budget.
An example of a cash budget layout is shown below. There are two illustrations in this example:
- A normal view, showing the figures (upper illustration)
- An alternate view showing the formulas used (lower illustration)
Although the practical use of spreadsheets is difficult to incorporate into AAT simulations, the knowledge and understanding requirements of the unit include computer modeling.
Performing Sensitivity Analysis Manually
The types of changes to data that are applied in sensitivity analysis generally fall into one of three categories. These categories are discussed below.
1. Changes in Underlying Volumes
Changes in underlying volumes are changes in the sales units or the production or purchase units. To some extent, it could apply to overheads or fixed assets (e.g., hiring or buying additional equipment not included in the original budget).
2. Changes in Prices
We will initially deal with straightforward price changes. In the next section, we will examine the impact of inflation and how to deal with it.
3. Timing Changes
We also need to assess the impact of situations in which the receipts and payments are the same as the original cash budget but they occur at different times.
Examples include allowing longer (or shorter) credit terms on sales or paying for purchases or other outgoings at a different time than was originally planned.
There are two approaches used to change the cash budget data:
- Redraft the whole cash budget: While this is simple when working with spreadsheets, it would be very time-consuming manually, especially if there were several options to consider.
- Calculate the impact on monthly cash movements by examining the changes proposed: This approach requires the application of some logic to the problem but it is quicker than redrafting the whole budget
The second technique is often required in AAT simulations. This article will now examine in more detail how this is carried out. The key is to consider each month separately and perform the calculations for that month:
- Any change in receipts, and
- Any change in payments, that together result in
- A change in cash movement
The revised closing cash balance for that month can then be calculated and carried forward to the next month. The exercise can be carried out in the form of a table.
Sensitivity Analysis Examples
We will use a straightforward example to demonstrate the process used to perform sensitivity analysis.
The following cash budget is based on all sales made on two month’s credit. March sales are estimated at $8,000.
Suppose that we want to determine the impact of changing the terms of sale to one month’s credit, with effect from January sales. For simplicity, we will assume that all our customers comply with the revised terms.
By following the procedure outlined above, we would get the following results:
In the above example, two months’ sales receipts would arise in February, increasing the receipts for that month by $6,000. The changes in receipts for March and April result from receiving different month’s sales than originally planned.
The overall result is a new bank balance at the end of April of $5,000 instead of the original overdrawn figure of $3,000.
Note that using this technique, it is only necessary to examine those lines in the cash budget that are subject to change. Here, there was no impact on payments, and so there was no need to revisit those figures.