## Sensitivity Analysis - Sales, Costs, Fixed Costs and Net Income

3. - THE BODY OF THE SENSITIVITY ANALYSIS

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, then a company's net income (bottom line) will change.

Lets assume Resume Services estimates that it will sell 4,000 units at \$26.00 each during the 200X business year. As a result, the company projects its sales (in dollars) for 200X at \$104,000 (4000 units x \$26.00 = \$104,000). As shown below, this value is depicted under the column entitled "200X Original Forecasted Figures".

 15% Decline in Sales 10% Decline in Sales 200X Original Forecasted Figures 10% Incline in Sales Sales \$88,400 \$93,600 \$104,000 \$114,400

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

On the other end of the continuum, if the company actually sells 10% more products in 200X, than originally forecasted, its total unit sales would be 4,400 units (4,000 units + 10% = 4,400 unit sales) and its 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%, for example, variable cost items will also decrease by 10%. Examples of variable costs may include, but not limited to, the following costs and expenses;

• Cost of Goods Sold - (Explanation :if a company sells more products than originally forecasted, 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 less finished products or direct materials).
• Commissions paid to employees on each sale made - (Explanation: if a company sells more products than originally forecasted, then commissions to its sale people will be higher. Similarly, if a company sells fewer products than originally forecasted, commissions will be lower.
• Other variable costs may include credit card charges, toll free charges, and service bureau charges. (Note: some firms elect to exclude these charges from their variable cost list due to the immaterial principal. Moreover, these firms would consider such charges as fixed costs).

As indicated below, the only variable cost of Resume Services is its Cost of Goods Sold (COGS).

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

Recall, Resume Services estimates that it will sell 4,000 units during its 200X business year. Lets assume, the cost to produce each product is \$3.00. Thus, it will cost the company \$12,000 to produce the 4000 units 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, the company actually sells 10% fewer products in 200X, than originally forecasted, its total unit sales would be 3,600 units ( 4,000 units - 10% = 3,600 unit sales). As a result, the firms 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, its total unit sales would be 3,400 units ( 4,000 units - 15% = 3,400 unit sales). As a result, the firms 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 the company actually sells 10% more products in 200X, than originally forecasted, its total unit sales would be 4,400 units (4,000 units + 10% = 4,400 unit sales). As a result, its 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"

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, on the other hand, is a 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 product. Nor does a fixed cost decrease when a company sells one less product. Examples of fixed costs include; advertising, office rent, leasing expense, telephone expense, wages, utilities expenses, bank charges, interest expenses, printing of checks, depreciation, and salaries. Think of a fixed cost as a cost or an expense that remains relatively fixed or constant over a one year business period. The 200X Forecasted Fixed Costs for Resume Services are presented below.

 15% Decline in Sales 10% Decline in Sales 200X OriginalForecasted Figures 10% Incline in Sales OPERATING EXPENSES / 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 Total Marketing Expenses \$37,998 \$37,998 \$37,998 \$37,998 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 Business Cards, etc. Expense \$ 250 \$ 250 \$ 250 \$ 250 Printing of Checks Expense \$ 75 \$ 75 \$ 75 \$ 75 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 Toll Free Services Expense \$9,600 \$9,600 \$9,600 \$9,600 Credit Card Service 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 Expense, Equipment \$1,400 \$1,400 \$1,400 \$1,400 Total Administrative Expenses \$46,173 \$46,173 \$46,173 \$46,173 TOTAL OPERATING EXPENSES \$84,171 \$84,171 \$84,171 \$84,171

Notice, the Forecasted Fixed Costs do not change from the 200X original forecasted figures when sales are increased or decreased. Moreover, these costs are relatively constant over the company's 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 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, Resume Services is forecasting a net income before taxes of \$7,829 (assuming they sell 4000 units and all costs are accurate). If however, the company sells 10% fewer products than originally forecasted or 3600 units, its net income will be negative \$1,371 (better known as a net loss). If the company sells 15% fewer products than originally forecasted or 3200 units, its net loss will be \$5,971. On the other hand, if the company sells 10% more units than originally forecasted or 4400 units, its net income before taxes will be \$17,029.

Most firms, when developing their sensitivity analysis, apply a tax rate to the forecasted net incomes. This provides a more accurate look at the company's net income(s) on a after taxes basis. For example, assuming Resume Services estimate that their combined federal and state/provincial tax rate will be 40%, the company would calculate their net incomes after tax as follows;

 15% Decrease in Sales 10% Decrease in Sales 200X Forecasted Figures 10% Increase in Sales Net Income Before Taxes \$(5,971) \$(1,371) \$7,829 \$17,029 Less: 40% tax rate \$ 0.00 \$ 0.00 \$3,132 \$ 6,812 Net Income After Taxes \$(5,971) \$(1,371) \$4,697 \$10,217

In essence, a sensitivity analysis is simply a series of forecasted income statements at various sales levels. It consists of three main components - 1. The Heading (company name, type of statement, and the statement's date), 2. The Sales Percentage Factors (10%, 20%, and 30% increase and decrease in sales, for example), and 3. The Body (Sales, Variable Costs, Fixed Costs, and Net Income Before Taxes).

Categories: Financial