Components of a Sensitivity Analysis

Three Components of Murray's Sensitivity Analysis:

Notice the "Heading" of the Sensitivity Analysis depicts the name of the company (Scholarship Information Services), the type of statement to follow (Sensitivity Analysis) and the date of the analysis (for the year ending December 31, 200X).

SCHOLARSHIP INFORMATION SERVICES
SENSITIVITY ANALYSIS
FOR YEAR ENDING DECEMBER 31, 200X

Although the Heading may seem simple, it's extremely important and should never be omitted from any financial statement or analysis.

2. SALES PERCENTAGE FACTORS
Sales percentage factors indicate the sales percentage increases and decreases, in which the analysis is based upon. As you can see, Scholarship Information Service's Sensitivity Analysis uses the following sales percentage factors.

 15% Decline in Sales 10% Decline in Sales 200X OriginalForecasted Figures 10% Incline in Sales

Therefore, Murray's Sensitivity Analysis will show how his 200X "original" Forecasted Net Income will change if his "original" 200X sales forecast decreases by 15% & 10%, and if his "original" 200X sales forecast increases by 10%. PLEASE NOTE: you may choose any Sales Percentage Factor for your forecasted sensitivity analysis.

The third column, entitled "200X forecasted figures" represents Murray's 200X original Forecasted Income Statement. Furthermore, the sales percentage factors will be applied to the values appearing under this column.

3. THE BODY
The final component of the sensitivity analysis is The Body. The Body consists of four main areas - A) Sales, B) Variable Costs, C) Fixed Costs and D) Net Income. Lets look at each component separately.

A) SALES:
Sales (in dollars or in units) are the driving force behind a sensitivity analysis. The reason is simple - expenses & costs either increase, decrease or remain the same when sales levels are changed. And when sales, expenses, and/or costs increase or decrease, from their original values, a company's net income (bottom line) will change.

Recall from Budget 2 entitled "Developing Your Sales Budget", Murray estimates that he will sell 4,000 units at \$26.00 each during the 200X business year. As a result, he projects his sales (in dollars) for 200X at \$104,000 (4,000 units x \$26.00 = \$104,000). This value is depicted under the column entitled "200X Forecasted Figures" (see below).

 15% Decline in Sales 10% Decline in Sales 200X OriginialForecasted Figures 10% Incline in Sales SALES: Total Sales (A) \$88,400 \$93,600 \$104,000 \$114,400

If Murray actually sells 10% fewer products in 200X than originally forecasted, then his total unit sales would be 3,600 units ( 4,000 units - 10% = 3,600 unit sales) and his total dollar sales would be \$93,600 (3,600 units x \$26.00 = \$93,600). Or if Murray actually sells 15% fewer products in 200X than originally forecasted, then his total unit sales would be 3,400 units ( 4,000 units - 15% = 3,400 unit sales) and his total dollar sales would be \$88,400 (3,400 units x \$26.00 = \$88,400).

On the other end of the continuum, if Murray actually sells 10% more diskettes in 200X than originally forecasted, then his total unit sales would be 4,400 diskettes (4,000 units + 10% = 4,400 unit sales) and his total dollar sales would be \$114,400 (4,400 units x \$26.00 = \$114,400).

B) VARIABLE COSTS:
Variable Costs are costs or expenses that DO fluctuate with the production or the sale of one "additional" unit. In other words, if sales levels are increased by 10%, then variable cost items will also increase by 10%. Similarly, if sales levels decrease by 10%, variable cost items will also decrease by 10%.

Cost of Goods Sold is ALWAYS considered a Variable Cost. Why? If a company sells more products than originally forecasted, then it will be required to purchase, buy and use more finished products or direct materials. On the other hand, if a company sells fewer products than originally forecasted, then it will be required to purchase, buy and use fewer finished products or direct materials.

As indicated below, the only Variable Cost of Scholarship Information Services is its Cost of Goods Sold (COGS).

 15% Decline in Sales 10% Decline in Sales 200X Original Forecasted Figures 10% Incline in Sales VARIABLE COSTS: Cost of Goods Sold (B) \$10,200 \$10,800 \$ 12,000 \$ 13,200

Recall from previous discussions, Murray expects to sell 4,000 units during his 200X business year. In addition, the cost to purchase and ship each diskette is estimated at \$3.00. Thus, it will cost the company \$12,000 to purchase the 4,000 diskettes it plans to sell during the 200X business year ( 4,000 units x \$3.00 each = \$12,000). This value is presented under the column entitled "200X Original Forecasted Figures".

If, however, Murray actually sells 10% fewer products in 200X than originally forecasted, then his total unit sales would be 3,600 units ( 4,000 units - 10% = 3,600 unit sales). As a result, the firm's Cost of Goods Sold would be \$10,800 (3,600 units x 3.00 = \$10,800). This value is presented under the column entitled "10% Decrease In Sales". Similarly, if the company actually sells 15% fewer products in 200X than originally forecasted, then its total unit sales would be 3,400 units ( 4,000 units - 15% = 3,400 unit sales). As a result, the firm's Cost of Goods Sold would be (3,400 units x \$3.00 = \$10,200). This value is presented under the column entitled "15% Decrease In Sales".

On the other end of the continuum, if Murray actually sells 10% more products in 200X than originally forecasted, then his total unit sales would be 4,400 units (4,000 units + 10% = 4,400 unit sales). As a result, his Cost of Goods Sold would be \$13,200 (4,400 units x \$3.00 = \$13,200). This value is presented under the column entitled "10% Increase In Sales". In summary, your Cost of Goods Sold will ALWAYS be considered a Variable Cost and therefore, will ALWAYS fluctuate with sales increases and decreases.

C) FIXED COSTS

In the above discussion, we defined a variable cost as a cost or an expense that fluctuates with the production or sale of one "additional" unit. A Fixed Cost, however, is cost or an expense that does NOT fluctuate with the production or sale of one "additional" unit. In other words, fixed costs are costs that do NOT increase when a company produces or sells one additional unit. Nor does a fixed cost decrease when a company sells one less unit. Think of a fixed cost as a cost or an expense that remains relatively fixed or constant over a one year business period.

Examples of Fixed Costs include; advertising, office rent, leasing expense, telephone expense, wages, utilities expenses, bank charges, interest expenses, deprecation, salaries, etc... Usually, but not in all cases, ALL OPERATING EXPENSES ARE GENERALLY CONSIDERED FIXED COSTS. In our example, for instance, Murray has assumed that all his forecasted operating expenses are Fixed Costs. Below illustrates Murray's Operating Expenses and hence, his Fixed Costs for his 200X forecasted business year. The chart also depicts his Forecasted Fixed Costs at various sales increases and decreases.

 15% Decrease in Sales 10% Decrease in Sales 200X Original Forecasted Figures 10% Increase in Sales FIXED COSTS: Marketing Expenses: Promotional Pamphlet Expense \$ 4,000 \$4,000 \$4,000 \$ 4,000 University Advertising Expense \$ 8,000 \$8,000 \$8,000 \$ 8,000 Newspaper Advertising Expense \$25,998 \$25,998 \$25,998 \$25,998 Administrative Expenses: Office Salaries Expense \$15,600 \$15,600 \$15,600 \$15,600 Employer Costs (11% of Salary) \$1,716 \$1,716 \$1,716 \$1,716 Office Supplies Expense \$2,500 \$2,500 \$2,500 \$2,500 Internet Account Expense \$ 325 \$ 325 \$ 325 \$ 325 Telephone Expense \$1,200 \$1,200 \$1,200 \$1,200 Business Registration Expense \$1,200 \$1,200 \$1,200 \$1,200 Message Centre Expense \$4,600 \$4,600 \$4,600 \$4,600 Rent Expense \$9,600 \$9,600 \$9,600 \$9,600 Professional Fees Expense \$4,992 \$4,992 \$4,992 \$4,922 Bank Charges Expense \$ 240 \$ 240 \$ 240 \$ 240 Miscellaneous Expenses \$1,800 \$1,800 \$1,800 \$1,800 Depreciation Expense, Auto \$1,000 \$1,000 \$1,000 \$1,000 Depreciation Exp., Equipment \$1,400 \$1,400 \$1,400 \$1,400 TOTAL FIXED COSTS (C) \$84,171 \$84,171 \$84,171 \$84,171

Notice, the Fixed Cost do not change from the 200X original forecasted figures when sales are increased or decreased. Moreover these Costs are relatively constant or fixed over the 200X business year (\$84,171).

D. NET INCOME BEFORE TAXES
Net Income Before Taxes is calculated by subtracting Variable Costs and Fixed Costs from Sales.

 15% Decrease in Sales 10% Decrease in Sales 200X Original Forecasted Figures 10% Increase in Sales SALES (A) \$88,400 \$93,600 \$104,000 \$114,400 VARIABLE COSTS (B) \$10,200 \$10,800 \$ 12,000 \$ 13,200 FIXED COSTS (C) \$84,171 \$84,171 \$84,171 \$84,171 NET INCOME BEFORE TAX \$(5,971) \$(1,371) \$7,829 \$17,029

In 200X, Murray is forecasting a Net Income Before Tax of \$7,829 (assuming he sells 4,000 diskettes for \$26.00 each and that all costs are accurate). If however, in 200X he sells 10% fewer diskettes than originally forecasted or 3,600 units, Murray's Net Income will be negative \$1,371 (better known as a net loss). If in 200X, Murray sells 15% fewer products than originally forecasted or 3,200 units, his Net Loss will be \$5,971. On the other hand, if in 200X, the company sells 10% more units than originally forecasted or 4,400 units, its Net Income Before Tax will be \$17,029.

Most firms, when developing a sensitivity analysis, apply an income tax rate to their Forecasted Net Incomes Before Tax. This provides a more accurate look at a company's net income(s) on a after tax basis. For example, assuming Murray estimates that his combined federal and state/provincial income tax rate will be 30%, he would calculate the Net Income After Tax as follows:

 15% Decrease in Sales 10% Decrease in Sales 200X Original Forecasted Figures 10% Increase in Sales Net Income Before Taxes \$(5,971) \$(1,371) \$7,829 \$17,029 Less: Income Tax Rate (30%) \$ 0.00 \$ 0.00 \$2,349 \$ 5,109 Net Income After Taxes \$(5,971) \$(1,371) \$5,480 \$11,920

In essence, a Sensitivity Analysis is simply a series of forecasted income statements at various sales levels. It estimates the forecasted earnings of a company, assuming the original forecasted sales are off by 10%, 20% 30% or any other percentage. By doing so, an entrepreneur, as well as an investor, can better assess the earnings capability of the business.

Categories: Forecasting