## Sensitivity Analysis explained using Examples

5. SENSITIVITY ANALYSIS

A sensitivity analysis shows the effects on Net Income when forecasted sales are increased or decreased by various percentages. Since your forecasted sales will NEVER be one hundred percent accurate, the sensitivity analysis shows investors how your forecasted net income will change if your original sales forecast increases by 30%, 20% and 15% or if your original sales forecast decreases and a 15% or 20 %, for example. The percentages chosen for your sensitivity analysis is up to you, however, avoid percentages of 14% or lower.

Many entrepreneurs develop only one sensitivity analysis ( for their first year operation). Others develop three sensitivity analysis; one for each forecasted year of operation. Whichever format you plan to use is not important, what is important, however, is that you include this analysis in your business plan. It shows the investor that you understand; 1) the forecasting process and 2) that your original sales forecasts generally do NOT materialize as envisioned.

Like Break-even Analysis, the Sensitivity Analysis uses your forecasted income statement as its starting point. The analysis relies on distinguishing between Forecasted Fixed Costs and Forecasted Variable Costs. Recall, Forecasted Fixed Costs are costs and expenses that do NOT fluctuate with sales increases or decreases. Forecasted Variable Costs are costs and expenses that DO fluctuate with sales increases or decreases.

Below provides an example of J&B's sensitivity analysis for its first forecasted year of operations. Notice, J&B has chosen a sales percentage increase of 15% of its original sales forecast and a sales percentage decrease of 20% of its original sales forecast.

 J&B INCORPORATEDSENSITIVITY ANALYSISFOR PERIOD MAY 1, 200W TO APRIL 31, 200X Pessimistic 20% Decrease in sales Original Sales Level Optimistic 15% Increase in sales SALES IN UNITS & DOLLARS: Sales in Units 6,306 units 7,882 units 9,064 units Weighted Average Selling Price \$73.89 \$73.89 \$73.89 TOTAL DOLLAR SALES * \$465,950 \$582,401 \$669,739 VARIABLE COSTS: Cost of Goods Sold \$104,153 \$130,191 \$149,720 TOTAL VARIABLE COSTS * \$104,153 \$130,191 \$149,720 FIXED COSTS: Advertising Expense \$130,000 \$130,000 \$130,000 Wages & Employee Benefits \$122,366 \$122,366 \$122,366 Casual Labor \$ 2,400 \$ 2,400 \$ 2,400 Office Supplies \$ 1,500 \$ 1,500 \$ 1,500 Rent Expense \$ 12,000 \$ 12,000 \$ 12,000 Telephone/Fax Expense \$ 3,600 \$ 3,600 \$ 3,600 Professional Services \$ 7,000 \$ 7,000 \$ 7,000 Insurance Expenses \$ 1,500 \$ 1,500 \$ 1,500 Toll-free above Variable \$ 15,685 \$ 15,685 \$ 15,685 Bad Debt Expense \$ 5,824 \$ 5,824 \$ 5,824 Interest on Operating Loan \$ 2,000 \$ 2,000 \$ 2,000 Internet Storage & Accounts \$ 2,550 \$ 2,550 \$ 2,550 Miscellaneous Expenses \$ 2,400 \$ 2,400 \$ 2,400 Depreciation Exp. - Equipment \$ 3,142 \$ 3,142 \$ 3,142 Depreciation Exp.- Furniture \$ 606 \$ 606 \$ 606 Amortization of Initial R&D Costs \$ 15,924 \$ 15,924 \$ 15,924 Amortization of Future R&D Costs \$ 24,720 \$ 24,720 \$ 24,720 TOTAL FIXED COSTS * \$353,218 \$353,218 \$353,218 TOTAL COSTS \$457,371 \$483,409 \$502,938 Net Income Before Taxes \$ 8,579 \$ 98,992 \$166,801 Less: Estimated Tax Rate (30%) \$ 2,574 \$ 29,698 \$ 50,040 Net Income (Loss) After Taxes \$ 6,005 \$ 69,294 \$116,761 *      All Operating Expenses are considered Fixed Costs. **    The only Variable Cost is J&B's Cost of Goods Sold. ***  Figures are rounded.

Notice, J&B's forecasted Operating Expenses are considered to be Fixed Costs (IE: they do not fluctuate with sales increases or decreases). Also, the company's Variable Costs, in this example, include only the Cost of Goods Sold (COGS will always fluctuate with sales increases or decreases and therefore will always be considered variable). The only other item, in the above example, that fluctuates with sales is Sales itself! In other words, if you increase the original forecasted sales by a certain percentage, then sales will have to increase by that amount (in units sold and in dollars). Alternatively if you decrease the original sales forecast by any amount, then SALES in units sold and in dollars will certainly change by that amount or percentage.

This concludes our discussion on how your projected sensitivity analysis should appear in your Financial Plan. Remember, it is imperative to understand the theory behind the sensitivity analysis before attempting to forecast your own. To learn more about this financial analysis, please refer to the section entitled "The Sensitivity Analysis". When you understand the theory behind each financial statement and analysis, you will be equipped with the necessary tools needed to Forecast Your Own Forecasted Financial Statements.

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