Thursday, February 18, 2010

Sensitivity Analysis or What If Analysis and Uncertainty

Sensitivity analysis is relatively a new term in management accounting. It is a “what if” technique that managers use to examine how a result will change if the original predicted data are not achieved or if an underlying assumption changes.

In the context of CVP analysis, sensitivity analysis answers the following questions:

a. What will be the operating income if units sold decrease by 15% from original prediction?

b. What will be the operating income if variable cost per unit increases by 20%?

The sensitivity of operating income to various possible outcomes broadens the perspective of management regarding what might actually occur before making cost commitments.

A spreadsheet can be used to conduct CVP-based sensitivity analysis in a systematic and efficient way. With the help of a spreadsheet, this analysis can be easily conducted to examine the effect and interaction of changes in selling prices, variable cost per unit, fixed costs and target operating incomes.

Statement showing CVP Analysis for Dolphy Software Ltd.

Revenue required at $. 200 Selling Price per unit to earn Operating Income of

Fixed cost Variable cost

per unit 0 1,000 1,500 2,000

2,000 100 4,000 6,000 7,000 8,000

120 5,000 7,500 8,750 10,000

140 6,667 10,000 11,667 13,333

2,500 100 5,000 7,000 8,000 9,000

120 6,250 8,750 10,000 11,250

140 8,333 11,667 13,333 15,000

3,000 100 6,000 8,000 9,000 10,000

120 7,500 10,000 11,250 12,500

140 10,000 13,333 15,000 16,667
From the above example, one can immediately see the revenue that needs to be generated to reach a particular operating income level, given alternative levels of fixed costs and variable costs per unit. For example, revenue of $. 6,000 (30 units @ $. 200 each) is required to earn an operating income of $. 1,000 if fixed cost is $. 2,000 and variable cost per unit is $. 100. You can also use exhibit 3-4 to assess what revenue the company needs to breakeven (earn operating income of Re. 0) if, for example, one of the following changes takes place:

• The booth rental at the ABC convention raises to $. 3,000 (thus increasing fixed cost to $. 3,000)

• The software suppliers raise their price to $. 140 per unit (thus increasing variable costs to $. 140)

An aspect of sensitivity analysis is the margin of safety which is the amount of budgeted revenue over and above breakeven revenue. The margin of safety is sales quantity minus breakeven quantity. It is expressed in units. The margin of safety answers the “what if” questions, e.g., if budgeted revenue are above breakeven and start dropping, how far can they fall below budget before the breakeven point is reached? Such a fall could be due to competitor’s better product, poorly executed marketing programs and so on.

Assume you have fixed cost of $. 2,000, selling price of $. 200 and variable cost per unit of $. 120. For 40 units sold, the budgeted point from this set of assumptions is 25 units ($. 2,000 ÷ $. 80) or $. 5,000 ($. 200 x 25). Hence, the margin of safety is $. 3,000 ($. 8,000 – 5,000) or 15 (40 –25) units.

Sensitivity analysis is an approach to recognizing uncertainty, i.e. the possibility that an actual amount will deviate from an expected amount.

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