Have you ever wondered how businesses prepare for uncertain business conditions, from fluctuations in raw material costs or potential sales volume? In FP&A, analysts rely on sensitivity analysis to test assumptions and predict outcomes. For those new to FP&A, mastering this skill can set you apart early in your career.
Sensitivity analysis is one of the most powerful analyses you’ll use in FP&A. This introduction explores the fundamentals of sensitivity analysis, including what it is, how to build one, and why it’s an essential skill for FP&A analysts.
Sensitivity analysis evaluates how changes in one or more input variables affect financial outputs like revenue, costs, or profit.
Sensitivity analysis supports data-driven business decision-making by providing insights into the potential risks and rewards tied to key business drivers.
In sensitivity analysis, not all outcomes are equally likely. Consider the probability of different results and focus on the most realistic of potential outcomes.
Defining Sensitivity Analysis
Sensitivity analysis is a method used to test how changes in certain factors, like costs or sales, affect a final result, such as profit or cash flow.
In technical terms, sensitivity analysis evaluates the relationship between input assumptions (e.g., costs, revenues, interest rates) and outcomes (e.g., profit, cash flow, or net present value).
Sensitivity analysis allows FP&A professionals to understand and communicate the impact of changes in key business drivers. Analysts rely on sensitivity analysis to develop accurate budgets and forecasts. CFOs and other executives use the insights from sensitivity analyses to assess the impact of unexpected changes on the business and confidently plan for the future.
FP&A analysts need to know how to perform sensitivity analysis for more than just budgeting and forecasting, such as:
Identifying Risks: Sensitivity analysis enables you to identify potential risks by testing how small changes in costs or sales can ripple through the financials.
Supporting Informed Decisions: By providing a framework to weigh different assumptions, sensitivity analysis helps decision-makers allocate resources and plan for uncertainty.
Demonstrating Analytical Rigor: Conducting sensitivity analysis showcases your ability to anticipate challenges and provide data-backed insights.
When to Use Sensitivity Analysis
Sensitivity analysis is most helpful in evaluating how multiple interconnected changes, like a supply-chain disruption paired with pricing shifts, could affect a business.
Sensitivity Analysis vs. Scenario Analysis
The distinction between sensitivity analysis and scenario analysis is a common question among new FP&A analysts. Understanding the difference helps you know the best analytical tool to use and for what purpose.
Sensitivity analysis focuses on testing isolated changes in specific drivers, like raw material costs or sales volume.
Use sensitivity analysis when you need to isolate a key business driver, such as raw material costs, to understand how changes would impact financial outcomes like gross margin or net income.
Scenario analysis evaluates the impact of one or more variables and larger events like economic shocks or business expansion on financial outcomes.
Use scenario analysis when you need to compare a best-case scenario (strong demand and smooth operations) with a worst-case scenario (slower-than-expected growth and higher-than-anticipated costs)
For now, we’ll focus on sensitivity analysis — an invaluable skill for any FP&A analyst looking to provide actionable insights to business decision-makers.
Real-World Applications of Sensitivity Analysis
To illustrate when to use sensitivity analysis, here are a few examples of how it’s used across industries to address real-world financial challenges:
1. Retail and Manufacturing
Evaluate how fluctuations in raw material costs impact gross margins. For example, a 10% rise in material costs might lower margins by 3%. This data helps you identify where the business can make adjustments to maintain profitability.
2. Airlines
Analyze how changes in fuel prices affect ticket pricing and overall profitability. If fuel costs rise by 5%, how much would ticket prices need to increase to preserve margins?
3. Hospitality
Assess how changes in Net Promoter Score (NPS) influence repeat bookings and revenue. A 0.2-point increase in NPS could result in a 15% rise in repeat business, reducing the need for costly new customer acquisition.
How to Build a Sensitivity Analysis Step-by-Step
Starting with sensitivity analysis can feel intimidating but understanding the steps to create an analysis makes it manageable. The following tutorial guides you through these steps using a real-world example: your manager assigns you to analyze how freight costs affect the company’s total cost of goods sold (COGS).
Sensitivity analysis allows you to model potential freight costs and present the findings to your procurement team. For instance, you could show how a $5 increase per pallet could result in a $50,000 rise in total costs across the company’s 12 locations.
Step 1: Define the variables
Identify the variables affecting your output and determine which variables are inputs or assumptions. These variables set the foundation for your sensitivity analysis.
In this example, our variables include one input and three assumptions:
Input: Freight cost per pallet (currently $50).
Assumptions:
Annual pallets shipped: 10,000.
Baseline freight cost: $500,000.
Baseline COGS (including freight): $5,500,000.
Step 2: Establish a Range
Determine plausible ranges for the input variable (freight cost per pallet). This step ensures you test realistic changes to your key driver.
For this analysis, your ranges should represent the $5 increase per pallet. Make sure you also include a baseline:
Ranges:
$50 (baseline), $55, $60, $65
Step 3: Set Up the Model
Build a simple sensitivity model to calculate total freight costs and COGS for each freight cost scenario. Use the following steps in Excel or a similar tool:
Input your freight cost variables in a column.
Calculate total freight cost by multiplying the freight cost per pallet by the annual number of pallets shipped (10,000).
Add the calculated freight costs to the baseline COGS (excluding freight) to determine total COGS for each $5 increase in freight cost per pallet.
Freight Cost per Pallet ($)
Total Freight Cost ($)
Total COGS ($)
50
500,000
5,500,000
55
550,000
5,550,000
60
600,000
5,600,000
65
650,000
5,650,000
Step 4: Analyze and Interpret
Review the outputs and determine what conclusions you can draw from them:
Highlight how changes in freight costs impact total freight expenses and COGS.
In this case, a $5 increase per pallet (from $50 to $55) results in a $50,000 rise in freight costs and a corresponding increase in total COGS.
Use visuals like bar charts or line graphs to communicate trends effectively. A simple bar chart like the one below allows non-finance stakeholders and management to quickly grasp the impact of increased freight costs on COGS.
Pro Tip: Remember that not all outcomes are equally likely. When presenting your analysis, consider the probability of different results and focus on the most realistic scenarios.
Best Practices for Sensitivity Analysis
To make your sensitivity analysis effective and actionable, approach it with a clear strategy and follow these best practices:
Focus on Key Drivers: Don’t get bogged down in unnecessary details. Prioritize the variables that have the most significant impact on financial outcomes.
Highlight Material Variances: Direct attention to impactful changes. For example, a 1% change in sales volume might be less critical than a 5% change in raw material costs.
Present Clear Insights: Use visuals like simple graphs or Excel waterfall charts to make your findings easy to understand for stakeholders.
By following these best practices, your sensitivity analysis will uncover risks and opportunities and serve as a practical decision-making tool for stakeholders.
Master Sensitivity Analysis to Boost Your Career in FP&A
Sensitivity analysis is your ticket to navigating uncertainty with confidence. Understanding how specific changes affect financial outcomes allows you to help business leaders make informed decisions and plan for various outcomes. If you’re just starting out in FP&A, adding sensitivity analysis to your skill set will position you as a trusted advisor in strategic planning.
Ready to dive deeper? Explore CFI’s FP&A for New Analysts course and start building career-defining expertise today!
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