Sensitivity analysis: if one assumption in the annual budget turns out wrong, which one cuts profit the most — price, volume or raw materials?
A bakery's budget plans for a profit of 700 million soum. If the price comes out 10 percent lower, profit falls by 71 percent; if raw materials become 10 percent more expensive, it falls by 31 percent. How to change each assumption in turn to find the most dangerous one, how to calculate each indicator's "safety margin" and what happens when two things get worse at the same time.
Jasur, the director of "Tong Pishiriq" LLC, looked over next year's budget and asked one question: "If one of these figures turns out wrong, which one will cost us the most?" The budget rested on five main assumptions, and there was no time to check all of them with the same care. Muxlisa, the finance specialist, gave the answer in a single table.
All amounts are hypothetical and compiled by the author. Taxes are left out for simplicity.
Five assumptions in the budget
| Assumption | Value | Annual amount, million soum |
|---|---|---|
| Sales volume | 200 000 boxes | – |
| Price per box | 25 000 soum | revenue 5 000 |
| Raw materials per box (flour, fat, sugar, packaging) | 11 000 soum | 2 200 |
| Wages (do not depend on volume) | – | 1 200 |
| Other fixed costs (rent, utilities, transport) | – | 900 |
| Planned profit | 700 |
Calculation: 5 000 − 2 200 − 1 200 − 900 = 700 million soum.
The method: change one, keep the rest in place
The essence of sensitivity analysis is simple: move one assumption in the unfavourable direction, for example by 10 percent, keep the other four as planned and write down how much profit changed. Then move on to the next assumption. Because all of them are changed by the same percentage, the results can be compared with each other directly.
| If the assumption changes 10% in the unfavourable direction | Calculation | Profit, million soum | Change in profit |
|---|---|---|---|
| Price falls from 25 000 to 22 500 soum | revenue falls by 500 | 200 | −71.4% |
| Volume falls from 200 000 to 180 000 boxes | revenue −500, raw materials −220 | 420 | −40.0% |
| Raw materials rise from 11 000 to 12 100 soum | raw materials +220 | 480 | −31.4% |
| Wage fund rises from 1 200 to 1 320 | +120 | 580 | −17.1% |
| Other fixed costs rise from 900 to 990 | +90 | 610 | −12.9% |
If this list, sorted by strength of impact, is drawn as a chart, the longest bar is at the top and the shortest at the bottom, and the shape looks like a whirlwind. That is why it is often called a "tornado chart".
Why is price stronger than volume?
In both cases revenue falls by the same 500 million soum. But when volume falls, less raw material is used as well: if 20 000 fewer boxes are baked, 220 million soum of raw materials is saved. When the price falls, every box still needs the same flour and fat, and the whole loss of revenue comes straight out of profit.
The practical conclusion: for "Tong Pishiriq" the most important question is not "how much will we sell?" but "at what price will we sell?". Muxlisa proposed checking competitors' prices and discount negotiations with large buyers first.
Each assumption's "safety margin"
The second question: how much can each indicator worsen before profit falls to zero? To find out, divide 700 million soum by the amount linked to that indicator.
| Indicator | Calculation | For profit to fall to zero |
|---|---|---|
| Price | 700 / 5 000 | must fall by 14% |
| Volume | 700 / (5 000 − 2 200) | must fall by 25% |
| Raw material price | 700 / 2 200 | must rise by 31.8% |
| Wage fund | 700 / 1 200 | must rise by 58.3% |
| Other fixed costs | 700 / 900 | must rise by 77.8% |
This table states the risk in a different language: on price, "Tong Pishiriq" has a margin of only 14 percent, while on rent and utilities it is almost 78 percent. Spending a lot of time renegotiating the lease brings less benefit than thinking pricing policy through carefully.
If two assumptions get worse together
Changing one at a time has a weakness: in real life indicators often change together. If a competitor launches a cheaper product, both price and volume may fall at the same time.
- If price and volume both fall by 10%: 180 000 × 22 500 = 4 050; raw materials 180 000 × 11 000 = 1 980; profit 4 050 − 1 980 − 1 200 − 900 = −30 million soum, that is, a loss.
- If we simply add up the separate effects: 700 − 500 − 280 = −80. The actual result differs by 50 million soum, because the reduced price is now multiplied by the reduced volume.
- If price falls by 5% and raw materials rise by 10%: revenue 4 750, raw materials 2 420, profit 4 750 − 2 420 − 2 100 = 230 million soum.
That is why sensitivity analysis is a first step: it shows which assumption needs to be studied more deeply. For situations in which several indicators change together, separate scenarios are built ("good year", "average year", "difficult year").
How to do it in your own budget
- Pick out the 4–6 main assumptions that affect profit and write each of them as an amount.
- Change each one by the same percentage in the unfavourable direction and recalculate profit. Do not change the others.
- Sort the results by change in profit from largest to smallest: spend more time checking the assumptions at the top of the list.
- For each indicator, calculate the limit at which profit falls to zero and tell management in plain language: "if the price falls by more than 14 percent, we make a loss".
- For indicators that may change together, calculate at least one difficult scenario.
The "Tong Pishiriq" budget did not change, but the way of working around it did: now the average selling price is checked first every month, because it is the one that "eats" profit fastest.
Test yourself
5 questions on this topic: pick an option or reveal the answer.
The "Shirin non" bakery has annual revenue of 120 mln soums and net profit of 18 mln soums. What is the return on sales (net profit / revenue)?
The annual net profit of a joint-stock company was 90 mln soum, of which 36 mln soum was allocated to dividends (hypothetical example). What is the dividend payout ratio (dividends / net profit × 100%) and what does it mean?
A joint-stock company's annual net profit is 90 mln soum, of which 10 mln soum is directed to dividends on preferred shares. The weighted average number of ordinary shares outstanding during the year is 40 000. What are the earnings per ordinary share (EPS = (net profit − preferred dividends) / number of ordinary shares)?
A company took a bank loan of 48 000 000 soums to use for building a new warehouse, at 18% simple interest per year. Construction is in progress. What is one month's interest, and how is it recorded under the table in paragraph 75 of NAS No. 21?
The Barhayot pharmacy chain earned a net profit of 45 mln soums during the year. Average equity is 300 mln soums. What is the return on equity (net profit / average equity × 100%)?
Answered: 0 / 50 of 5 correct
All tests →See also
Sources
- Fundamentals of financial management and management accounting (general concepts) · sensitivity analysis: measuring the change in the result when one input assumption is changed while the others are held constant; ranking by impact (tornado chart); limitation of the method: interdependence of the indicators and their combined effect are not taken into account; general knowledge
- Example, company and character names, volume, price, cost amounts and calculations · compiled by the author, hypothetical; taxes are left out for simplicity