Saturday, March 17, 2012

Sensitivity Analysis: Your Stress Test - [Note: A More Detailed Re-Posting]

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During the course of these three next articles (starting with this one) on The Business And Project Planning And Management Blog, we will cover three crucial topics. Each one is essential to thorough business planning, project planning and risk assessment. They are:

1) Sensitivity Analysis -- Your Business' "Stress Test";

2) Breakeven Analysis -- Your Business' "Tipping Point";

3) Variance Analysis -- Your Business' "Marksmanship".

Sensitivity Analysis (your business' 'stress test') is one of the most useful analytic and planning tools ever invented and it is dramatically underutilized. It is an anticipatory device which can expose each and all of the areas of vulnerability in your business or project plan. Following is a frighteningly confusing diagram which I was going to use to illustrate some aspect (any aspect!) of Sensitivity Analysis. I was too confounded by the picture to post it up at the beginning of this otherwise important and serious article; so, I'll just put it here. Ignore it if you can. My apologies.

Senseless Sensitivity Analysis Illustration which serves no useful purpose.
Sensitivity Analysis is utilized to isolate the effect that a change in any one independent business variable will have on profitability. It truly shows the sensitivity (or vulnerability) of your business or system model to a change in any given independent variable. It not only mathematically demonstrates the amount of the change, but it shows the degree to which a seemingly small change can disrupt profitability.

If it is used as an analytical tool with respect to each and every component or aspect of your model, it will not only provide you with the degree of vulnerability which your business has to any one of its "moving parts," but it allows for pre-emptive and multidimensional planning for a shift in any of the value of any of the components.

An example of these components (independent variables) follows:

A business, seen as an isolated, defined system is really like a multivariate equation, where each component contributes to the ultimate dependent variable -- profit or success. Some of these critical equation variables (using a highly-simplified business model, i.e., the legendary "Acme Widget Company") include:

1) your selling price per unit - which could relate to competition, market demand, branding, et cetera);

2) the volume of units which you sell - which could be related to your market share, the aggressiveness and number of your competitors and, of course, demand, etcetera;

3) your direct cost to produce each unit at a given production level (this cost is usually considered a variable cost), but it actually may behave more like a  "step" function, where a larger scale of manufacture permits you a lower cost per unit sold due to volume discounts, efficiencies of scale. Incidentally, if your finance your company's sales or purchase orders and this cost is subject to fluctuation in terms of interest rates or discount rates, these count as variable costs, too;

4) your costs to facilitate sales (such as marketing, advertising, branding, public relations, social media sales commissions, celebrity endorsements, and the like;

5) your fixed cost required at any level of production - whether you make 1 widget (i.e., the extremely limited edition), or 5 million widgets (i.e., you have a 43.7%* share of the international widget market, and you even post banners at NASCAR, and donate funds to construct entire wings at children's hospitals).
* I've invented this statistic. I thought it would be a clever diversion from serious, meaningful, instructive writing. And it was.

The above components can be organized into categories (or modules) in a profit and loss template, and you could see the effect on profit or potential magnitude of loss by inserting a series of different values for any given variable in the template.

When you perform this simulation exercise on any one particular variable (we can call it the 'independent variable,' the 'isolated variable' or the 'target variable' -- they are all synonymous) in the profit and loss template, you can see its singular effect on the bottom line, and the level of sensitivity or vulnerability which you have to that target variable.

If you were to do this exercise with each category as the sole target variable (leaving the others the same, to the extent that that was logical), you could determine certain critical "alarm" levels for each variable. Going further, if you could create warning levels for each of these variables at which would trigger these alarms prior to their reaching critical levels, you would have some true "fail-safe" or "mitigating" controls on your business before you were to even construct it.

Going a step further, if you truly understand the factors that govern each of the analyzed variables, you can truly be ahead of any negative ripple in your business. If you intend to operate in a business where gross profit margins are small and your cost of goods sold (what you pay your supplier to obtain the goods) could rise significantly, you must prepare a contingency plan. This rise in cost can be brought about through a number of mechanisms, including, but not limited to: 1) dealing with a monopolistic supplier; 2) dealing with a sole source which has grown too big to favor your business with good prices; 3) a genuine shortage of a commodity (scarcity) which is driving the cost upwards; 4) ordering quantities which are too small to give you the benefit of a quantity or bulk purchase discount, and a host of others, each of which can be identified and addressed.

Stress test your business or project plan prior to implementing it by utilizing sensitivity analysis. Find your stress points and have a contingency plan to address each and every one of them. Once you've identified vulnerabilities, sensitivities or risks, you can mitigate each one of them in your planning and constant business monitoring process.

Fortunately, there are some sensitivity analysis programs and tools which you may deploy either prior to a business start-up (sort of like a simulation drive), or on a business which is already in operation (sort of like a 'pit check').

If you'd like, you can simply enter the following search terms into Google for a veritable cornucopia of programs and tools to make this important exercise easier:


Douglas E. Castle for The Business And Project Planning And Management Blog

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