Qualitative and Quantitative Steps of Sensitivity Analysis
One of the most important parts of Capital Budgeting is decision-making. The important factors to consider are the number of investments and the profit from participating in the project. Many decisions are based on assumptions that are likely to be questionable sometimes, so it is important to examine if the cost elements react to changes in assumptions and decisions (Patole, 2021). One of the tools for the estimation of these factors is the sensitivity analysis. According to Patole, sensitivity analysis is the tool that “checks the sensitivity of the overall findings to limitations of the data, assumptions, and the approach to analysis” (p. 90).
For example, a hair salon is able to use sensitivity analysis to examine how the use of coupons can affect the number of treatment items that customers purchase. There is a risk that this measure will not be successful as some customers only visit the hair salon once. In order to check this assumption, customers need to be divided into three groups, depending on their loyalty to the salon: “random customers,” “regular customers,” and “advanced customers.” Sensitivity analysis will show how using coupons influences each group (Horita & Yamashite, 2019). It will help in decision-making regarding if the salon should do coup issuing or if it is better to find an alternative.
Parameters for Sensitivity Analysis
The main purpose of sensitivity analysis is to explore how the cost is influenced when there is an alteration in assumptions and basic rules. There are various methods to conduct sensitivity analysis. For example, the parameters for analysis are possibly to include odds ratio, risk ratio, or risk difference. These elements are used for dichotomous outcomes. If the results are continuous, sensitive analysis can be based on the standardized mean difference (Patole, 2021). Sensitivity analysis could be based on different criteria, including both numerical and arbitrary values (Patole, 2021).
Main Tasks of Sensitivity Analysis
The first necessary task is to examine how the cost is affected by changes in key assumptions. Task two is to find out all the consequences caused by changes. Then, it is important to identify which assumptions influence the cost the most and what factors were affected by alterations more than others. If recalculation of the cost shows a significant change in cost estimation caused by little changes in some elements, it means that element is cost sensitive (Cost estimating, 2021, para.3).
Qualitative and Quantitative Steps of Sensitivity Analysis
The sensitivity analysis combines both quantitative and qualitative steps to proceed. First, the identification of the key factors that influence the cost the most and basic rules and assumptions should be provided. Secondly, it is necessary to re-evaluate the cost after the changes to one of the cost drivers have been provided. The third step is to analyze the interactions between the cost elements and examine the results. Then, steps two and three should be repeated: all cost drivers should be tested by altering the assumptions and basic rules, and each change should be analyzed. Finally, the results should be estimated in terms of what cost drivers are more likely to change the cost estimate and whether or not alterations influence the preferred outcome (Cost estimates, 2021, para. 6). Sometimes sensitivity analysis demands an examination of the highest and lowest points of the uncertainty parameters (Cost estimating, 2021, para. 5). It is necessary to understand what the key elements affecting the cost are.
Project’s Risks Incorporated into a Capital Budgeting Analysis
Sensitivity analysis is the most popular technique to handle uncertainty. It helps to identify the most unstable factors that are subject to changes and to calculate the risk. If the change in key factors leads to a significant change in results, then there is a serious risk for the outcome of the project. The analyst should do market research to estimate the probability of change and identify the major vulnerabilities. Then possible risks should be estimated as significant or not. Based on these data, the decision on whether or not to engage in the project is made (Tantau, 2019).
References
Cost Estimating (2021). Step 8 Conduct Sensitivity Analysis. AcqNotes. Web.
Horita, Y. & Yamashita, H. (2019). Bayesian network considering the clustering of the customers in a hair salon. Cogent Business & Management, 6(1), pp. 1-15. Web.
Patole, S. (Ed.). (2021). Principles and practice of systematic reviews and meta-analysis. Springer Nature.
Tantau, A. (2019). Refrotting for optimal energy perfomance. IGI Global.