What Is a Sensitivity Analysis?

Sensitivity analysis is a powerful tool for assessing the potential impacts of changes in key variables on business outcomes. This technique is the edge you need to power optimal decision-making, strategic planning, and resource allocation.

Sensitivity analysis, also known as what-if analysis or simulation analysis, determines how independent variables affect a dependent variable based on certain assumptions in a specific scenario, enabling strategic decision-making and optimal resource allocation.

Sensitivity Analysis: Key Takeaways

  • Sensitivity analysis determines how changes to an independent variable affect a particular dependent variable under a set of assumptions or conditions.
  • As an in-depth study of all the variables impacting certain business areas, it allows decision-makers to make specific improvements and sound decisions regarding resources and investments.
  • Understanding the outcome of a decision under different assumptions combined with other analysis methods such as PEST and scenario planning can give you a lasting competitive edge.
  • It involves determining the effects of changes in input variables (like interest rates or stock prices) on an outcome (like bond prices or company valuation).
  • Aids management in achieving strategic goals by understanding the impact of variable changes.

We’ll be using our expertise at Business2Community to walk you through how to perform a sensitivity analysis in 6 simple steps. We also cover practical examples, limitations, and more.

Pro Tip: If you’re already familiar with the process and just need the right tool, we provide a Sensitivity Analysis Calculator below. It’s straightforward and efficient for those who need to quickly assess variable impacts.

What is the Purpose of Sensitivity Analysis?

Sensitivity analysis is a critical tool used to predict the potential impacts of changes in variables on specific outcomes within business models. Its primary purpose is to identify how different input variables can influence a dependent variable under certain assumptions.

This technique is invaluable for decision-makers who need to understand and prepare for the variability in key business metrics due to fluctuations in market conditions or internal factors.

By providing a systematic approach to assessing risk and uncertainty, sensitivity analysis helps businesses optimize their strategies, ensuring that they remain robust across various scenarios.

What Are the Two Main Benefits of Performing Sensitivity Analysis?

  1. Improved Decision-Making: Sensitivity analysis provides a clearer picture of potential risks and opportunities, enabling managers and leaders to make more informed decisions. By understanding which variables have the most significant impact on outcomes, businesses can prioritize resources and initiatives effectively.
  2. Enhanced Risk Management: This analysis allows businesses to identify and mitigate risks before they become problematic. By foreseeing how changes in inputs can affect outputs, companies can develop strategies to handle potential adverse scenarios, thus reducing the likelihood of negative impacts on their operations.

Who Needs to Conduct a Sensitivity Analysis?

In business environments, which are characterized by uncertainty and complexity, sensitivity analysis is particularly valuable.

It measures how sensitive your business outcomes are to a change in an input, such as product pricing, loan interest rates, customer foot traffic, and more.

Business owners, professionals, and decision-makers in different business areas need to use it to inform decision-making, manage risk, and optimize performance.

For example:

  • Entrepreneurs and business owners use the analysis to examine scenarios affecting their companies’ most important drivers and understand the business impact of various decisions on operations.
  • Finance managers use sensitivity analysis to determine the financial impact of certain variables on making investments and revenue growth.
  • Financial analysts and investors use sensitivity analysis to improve their understanding of uncertainty in the market and how changes in financial variables like interest rates, inflation, and market fluctuations impact financials, valuations, and investment returns.
  • Operations managers use sensitivity analysis to assess the impact of supply chain disruptions, changes in material costs, and operational inefficiencies on the company’s bottom line.
  • Project managers use the analysis to determine the impact of varying factors like project costs, timelines, and resource allocations on the overall success and viability of projects.
  • Growth marketing teams use sensitivity analysis to determine how certain variables can be adjusted to improve marketing strategies.

Sensitivity Analysis Use Cases

With its ability to model the impact of different inputs on outputs, sensitivity analysis is ideal for a range of business use cases, including:

Making Predictions

Sensitivity analysis allows for predictions using historical data.

For example, an investor might perform the analysis to help make predictions about the share prices of publicly traded companies or how interest rates will affect bond prices.

Similarly, a sales manager might use the analysis to establish how much total sales will rise in relation to higher percentages of customer traffic or how much money the company can generate if customer traffic increases by 10%, 30%, or 70%.

Sensitivity use cases

Identifying Success Factors

Sensitivity analysis helps businesses identify the factors that have a significant impact on ROI metrics.

By varying these factors across an entire range of values, businesses can identify which ones influence their performance most.

For example: an ecommerce store might discover that customer retention rate and average transaction value are key success factors.

Assessing Risk and Uncertainty

Sensitivity analysis enables decision-makers to evaluate and mitigate risks associated with their choices.

A manufacturing company can evaluate the impact of various factors such as raw material prices, labor, and exchange rates on profitability.

The company can then develop contingency plans to address any concerns.

Optimizing Decision-making

By systematically adjusting different variables, sensitivity analysis allows decision-makers to identify the values that lead to desired outcomes. For instance:

  • In project management, the analysis can help identify project schedules that are least sensitive to delays or changes in resource availability. Additionally, it can be used to determine the net present value (NPV) or the internal rate of return (IRR) of a project.
  • In marketing, the analysis drives effective marketing strategies by revealing which factors are significant with respect to product, pricing, and promotion decisions.

What Is Sensitivity Analysis in NPV?

When it comes to Net Present Value (NPV), sensitivity analysis serves as a strategic tool to examine how the variability of different input parameters, such as cost of capital or cash inflows, affects the profitability of a project or investment.

It aids financial analysts and investors in determining the most sensitive variables that could impact the projected returns of a project.

By simulating different scenarios where key inputs vary, stakeholders can gauge potential risks and make more informed decisions about whether to proceed with, modify, or abandon a project based on its financial viability.

Fast Fact: A small change in the discount rate used in NPV calculations can significantly alter the projected value of an investment, making it crucial to perform sensitivity analysis to understand potential fluctuations.

How to Perform Sensitivity Analysis: A Quick Guide

Before we dive into the process, let’s break down the types of sensitivity analysis, as well as a general formula for conducting it.

Types of Sensitivity Analysis

The two main types of sensitivity analysis include:

  • Local sensitivity analysis: Focuses on the impact of small changes in one input variable at a time, assuming other variables are constant, and is appropriate for analyses like one-at-a-time (OAT) analysis.
  • Global sensitivity analysis: Determines the effects of simultaneous changes in multiple input variables and is suitable for complex models like Monte Carlo simulation.

Sensitivity Formula

Since sensitivity analysis explores a wide range of input and output variables, the formula can vary depending on the context and complexity of the situation.

However, a common approach involves dividing the percentage change in the output by the percentage change in the input to arrive at a sensitivity value or ratio.

sensitivity formula

This ratio indicates how sensitive outputs are to changes in inputs and forms a mathematical model for evaluating the impact of various scenarios on business outcomes.

Generally, a higher sensitivity value suggests that the output is more sensitive to changes in the input.

Already know what you’re doing and just want to get straight to our sensitivity analysis calculator? Just collect your data, scroll down to the calculator, input your info, and hit calculate.

Now, let’s dive into the 6 simple steps to perform a sensitivity analysis.

Step 1: Establish Your Objective

Start by defining the questions you would like your analysis to answer. This may include understanding how different factors affect your business’s profit, sales volume, or any other key performance indicator (KPI).

Step 2: Identify your Input Variables

Target variables are the key factors related to your operations or performance that you can manipulate in your analysis — they are the “inputs” to your model. Although these variables vary from one business to another, common examples include sales, profit margins, cost of goods sold, marketing expenses, production costs, and customer acquisition costs.

A good starting point is to consider the variables that directly affect revenue or expenses, as these have the greatest impact on your bottom line.

sensitivity vs outputs

Step 3: Establish Your Base Case

Once you have your variables defined, develop a baseline scenario or model that reflects the current state of a factor before any adjustments are made. For example, in a baseline model of sales, a company sells 1,000 units per month at $500 per unit, generating $500,000 in monthly revenue.

The key data points in the model include the unit price ($500), monthly sales volume (1,000 units), and monthly revenue ($500,000), where unit price and sales volume are the inputs that can be adjusted in the analysis.

This model will serve as the point of comparison for the analysis, allowing input variables to be adjusted to produce a range of business outcomes.

Model example

Step 4: Conduct Sensitivity Analyses

  1. For a chosen factor, say revenue (as in the model above), adjust one variable at a time. For example in our model, we could change the unit price while keeping the other parameters unchanged.
  2. Calculate the percentage change between the old input and new input – in this case, the new unit price and old unit price – and the resulting percentage change in the revenue output.
  3. Substitute these two values into the sensitivity formula (Sensitivity = Percentage change in output / Percentage change in input) to determine the rate of sensitivity.

Say your sensitivity value is 2. This implies that a 1% change in your input variable results in a 2% change in your output. For a comprehensive picture of sensitivity, this ratio or new model is what you will use to generate outcomes for various percentage changes in your input variable.

Step 5: Test a Range of Values

Decide on a plausible range (10% to 60%; 5% to 40%, etc.) for each input variable to test different scenarios. For easier interpretation, consider compiling all your different outcomes in data tables.

Next, examine the full range of outcomes produced by your analysis. Identify the variables that are likely to have the most significant impact on your business while keeping in mind the potential limitations, risks, and opportunities associated with different scenarios.

Step 6: Optimize Your Strategies

Use the insights gained from the analysis to improve your models, inform better business decisions, and help you prioritize areas for further research or investigation. Consider the following questions:

  • Which variables should you prioritize, adjust, and monitor?
  • What can you do to mitigate risks and capitalize on opportunities?
  • What additional information do you need to improve your original analysis or model structure to support more informed decisions?

Sensitivity Analysis Calculator

Now that you know how to prepare and complete a sensitivity analysis, it’s time to start calculating. All you have to do is plug in your information into our sensitivity analysis calculator.

Sensitivity Analysis

Examples of Sensitivity Analysis

Below, we provide two simple examples of sensitivity analysis to demonstrate its value in a business context.

Example 1: Revenue Sensitivity to Price Changes

Based on historical data, a coffee shop sells an average of 3,000 cups per month at $4 per cup, for a total monthly revenue of $12,000. The coffee shop owner would like to explore revenue sensitivity to price changes and evaluate the impact of increasing the price to $4.50 per cup.

  • The price per cup would increase from $4.00 to $4.50, so the input change would be 12.5%.
  • Revenue would increase from $12,000 to $13,500, so the output change would also be 12.5%.

To calculate the sensitivity of revenue to the price change, the owner applies the sensitivity formula as follows:

Percentage change in output / Percentage change in input = Sensitivity

12.5% / 12.5% = 1

A sensitivity value of 1 indicates that a 1% increase in the price per cup results in a 1% increase in revenue. The owner compiles a data table showing the outcomes for price and revenue changes at different percentages as shown below.

Sensitivity Example 1

Interpretation

Based on the analysis, revenue is sensitive to price changes. However, this assumes that the number of cups sold remains constant, which isn’t always the case as demand is price-sensitive. To make optimal pricing decisions, the coffee shop owner will also need to take other factors — such as the sensitivity between price changes and the number of units sold — into account.

Example 2: Customer Acquisition Sensitivity to Budget Changes

A marketing manager wants to evaluate the impact of marketing spend on customer acquisition. On a marketing budget of $20,000, the company acquires 400 new customers a month. The manager would like to determine the sensitivity of budget changes on customer acquisition and estimates that a budget of $25,000 could acquire 600 new customers.

  • The marketing budget would increase from $20,000 to $25,000, so the input change would be 25%.
  • The number of new customers acquired would increase from 400 to 650, so the output change would be 62.5%.

To calculate the sensitivity of customer acquisition to the budget changes, the manager applies the sensitivity formula as follows:

Percentage change in output / Percentage change in input = Sensitivity

62.5% /25%=2.5

A sensitivity of 2.5 indicates that a 1% increase in the marketing budget results in a 2.5% increase in revenue. Based on this sensitivity model, the manager draws up a data table showing a range of outcomes for budget increases.

Sensitivity example 2

Interpretation

The analysis suggests that customer acquisition is highly sensitive to budget changes.

As such, the marketing manager concludes that raising the marketing budget would be a great strategy for growth. However, because market dynamics and customer responsiveness can change over time, the manager will need to continuously monitor and test this relationship.

How to Adjust a Sensitivity Analysis

Sensitivity analyses can be adjusted by modifying key variables to improve their impact on business outcomes.

For example: if your analysis reveals that profitability is highly sensitive to sales, consider adjusting and testing different pricing structures to evaluate their impact on profitability.

Additionally, to positively influence your analysis:

  • Ensure the data set being analyzed is reliable and accurate.
  • Ensure your adjustments are realistic and based on plausible scenarios.
  • Regularly conduct different sensitivity analyses to account for new data or changes in the external environment.
  • When dealing with many variables and very complex models, use sophisticated modeling techniques and statistical software.

Limitations of Sensitivity Analysis

While it offers valuable insights into how different values affect certain variables, sensitivity analysis has limitations.

It relies on assumptions about the relationships between variables; so, if these assumptions are incorrect, the accuracy of the results is impacted. In addition, these assumptions don’t account for possible future scenarios or unknown variables.

Furthermore, local sensitivity analysis methods like the one explored in this guide focus on the impact of changes in one variable at a time while holding other factors constant. However, in real-world scenarios, variables are interdependent and change concurrently.

Please note: Changing one factor such as discount rate or product units, is likely to affect other factors such as the selling price.

pest analysis

Finally, as sensitivity analysis relies on historical data to predict the effect of variables on outcomes, it doesn’t account for the current or future state of external business factors and competitor efforts.

To complement sensitivity analysis and address its limitations, consider scenario planning for broader scenario analysis, PEST analysis for a deeper understanding of external environmental factors, and multivariate analysis for a comprehensive understanding of the relationships between multiple variables.

Sensitivity Analysis vs. Scenario Analysis

While both sensitivity analysis and scenario analysis are used to examine the effects of changes in variables on business outcomes, they differ significantly in their approach and focus.

  • Sensitivity analysis looks at the impact of changing one variable at a time, keeping others constant, to understand how sensitive an outcome is to changes in that variable.
  • In contrast, scenario analysis examines the effects of simultaneous changes in multiple variables to understand what might happen in different complex scenarios, such as a market downturn or a regulatory change.

Thus, while sensitivity analysis provides insights into the “what if” of single changes, scenario analysis offers a broader, multivariable perspective on potential future states.

Wrapping Up: The Value of Sensitivity Analysis

The ability to react quickly to changes in the environment, make sound decisions, and utilize resources efficiently is a form of competitive advantage.

By using the sensitivity analysis calculator and formulas, business decision-makers can model the potential outcomes of any given scenario, unlocking insights to improve performance and mitigate risk.

Although it has limitations, sensitivity analysis can be combined with other forms of analysis such as scenario planning, multivariate analysis, and PEST analysis to form a more comprehensive understanding of a business.

Overall, sensitivity analysis is a valuable analysis tool that will help you understand the relationship between key business variables. Use it to identify your business’s most influential success drivers and steer your business toward a lasting competitive edge.

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