Running a business successfully is the act of balancing multiple variables, from raw material costs to interest expense, product pricing, marketing expenses, sales volumes, and more. Calculating and managing the interactions between different business metrics is key to the growth and continuity of a business. Just like the weight of a feather is enough to send a well-balanced pile of rocks tumbling, this balance in various business factors is so delicate that even a slight change can upset the whole business. That’s exactly where sensitivity analysis can come to your aid.
Sensitivity analysis, also known as “what if” analysis, is a method for identifying the factors that can lead to an imbalance in your carefully structured business plan, while also quantifying their impact. It can help businesses predict possible outcomes right at the budgeting, forecasting, and planning stages, thus enabling them to take calculated risks and avoid nasty surprises or challenges.
What Sensitivity Analysis Tells Business Managers
All business plans and budgets are based on assumptions that the variables will move in a certain direction. There is no guarantee that your assumptions will work out as planned, and this uncertainty poses a risk. Sensitivity analysis aims to reduce this risk by visualizing and comparing potential variations in your business metrics. It gives you a range of possible outcomes to work around. So, you know the upside and the downside of your outcome if your key assumptions change.
Suppose you run a dry-cleaning business and have the objective to increase revenue by 10%. There could be 10-20 factors influencing your revenue, such as rent and occupancy in the neighbourhood, competition, season, lack of promotion, higher prices, and more. The sensitivity analysis will tell you the variables that can have a meaningful impact on the revenue numbers.
If occupancy rises by 8%, revenue rises by 5%. If the price falls by 2%, volume rises by 10%. This sensitivity analysis tells the business owner that a price dip can increase revenue. The business owner can use this information to promote a 2% discount and attract customers.
This is a basic illustration. In the real world, business objectives are not that simple. A business wants to boost revenue and grow but also wants to contain the risk of going over budget or being overworked, which can affect quality. That short-term revenue growth may come at the cost of poor quality and damaged relationships with recurring customers.
Highly Sensitive Variables for Profits, Revenue, and Debt
Common variables that can move cash, profit, or debt coverage are:
Price and Sales Volume in Marketing: Marketing teams test price sensitivity at three price points to see how it affects sales volume. This helps you forecast revenue and profit if you offer a discount or increase the price.
Cost of Goods Sold in Budgeting: Budgeting teams do a cost sensitivity analysis to see the impact on profits when suppliers raise rates. For instance, a 5% increase in raw material cost reduces your profit by 7% since they are your biggest expense. This helps businesses set realistic budgets and look for alternative suppliers for a better deal to improve profits.
Timing for Working Capital (Cash): Timing of receivables and payables is important to know how much working capital you should keep for a smooth flow of money. For every 1 day of delay, you may need X amount of cash.
Interest Rates in Debt Management: If you have $100,000 worth of floating loan on your balance sheet, a 1% increase in interest rate could increase your interest expense by $1,000 annually. The company may prioritize repayment of floating-rate loans in a rising interest rate environment.
How to Use Sensitivity Analysis to Manage Business Growth
In the dynamic business environment, things are constantly changing, some that you can control and some you can’t. If the success of your product depends on the product arriving at the market on the 15th of September, that is poor planning. A strong growth plan considers everything that can go wrong, such as a supply chain disruption, competition, a sudden spike in raw material prices, and a labour strike. However, it does not act upon everything.
A business growth may have 20 inputs that you can control. So you measure the sensitivity of each input and prioritize three to five inputs that have the highest sensitivity to growth, and put your efforts there. This helps you give your team realistic business targets, rather than send them on a wild goose chase. Using limited resources where it matters the most can help you grow sustainably.
The sensitivity of each input changes depending on your business conditions and the macro environment. So you have to keep doing sensitivity analysis at regular intervals using the latest data.
For instance, a retailer does a footfall sensitivity analysis for the holiday season and finds that every 100,000 increase in footfall increases revenue by $80,000. So it can ask the marketing team to promote footfall through events and sales. However, the sensitivity changed in the April to June quarter, when a 100,000 increase in footfall increased revenue by just $10,000. Instead of wasting money on year-long promotions, the company can spend on promotions during the holiday season to get maximum growth from minimum effort.
Instead of making assumptions, sensitivity analysis uses real-time data to guide your decisions.
How to Use Sensitivity Analysis to Manage Business Challenges
While sensitivity analysis helps businesses maximize growth, it also helps manage challenges by identifying the breakeven point below which profits turn to losses. Many businesses use sensitivity as a risk management tool to draw a warning line or a minimum amount.
For instance, a retailer may have a minimum order value of $200 for home delivery. An order value below $200 won’t cover the logistics cost. On one side, the retailer is increasing sales by offering home delivery, but managing costs by keeping a minimum order value.
There is a common misconception that the biggest-looking expense drives the forecast. It is the most influential variables that drive the numbers. A store rent of $15,000 in a prime area may account for 15% of your $100,000 revenue. Add a 2% discount, and it could drive revenue to $125,000, whereas a 10% lower rent in a different area could bring $1,500 in cost savings at $100,000 revenue. Would you rather pay that extra $1,500 rent to get $25,000 more revenue or settle for $100,000 revenue? Sensitivity analysis can help you make the right choice by identifying the influential variables that can move the needle.
Contact Glenn Graydon Wright LLP in Oakville to Help You Make Informed Business Decisions
A professional business consultant can help you use sensitivity analysis and various other tools to grow responsibly and sustain growth even when things go south. To learn more about how Glenn Graydon Wright LLP in Oakville can provide you with the best accounting and business consulting services, contact us by phone today at 905-845-6633, or connect with us online to schedule your initial consultation.