Back to basics uncertainty and sensitivity

01/11/2012 20:13

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Velocity October 2012
Back to basics uncertainty and sensitivity

Back to basics uncertainty and sensitivity

October 2012

This is the second article in a two part feature by Bob Scarlett on risk, probability, uncertainty and
sensitivity, of use to students studying for or exempt from papers C03, C04, P1 and P2.
Conditions of uncertainty often arise where different alternative outcomes are possible but the decision
maker cannot assign discrete probabilities to those alternatives. A different range of techniques then
becomes appropriate.
Part one of this feature considered situations where the decision maker is confronted by conditions of
uncertainty but where those conditions can be expressed in the form of a limited number of discrete
alternative outcomes, each capable of having a known probability assigned to it.
However, conditions of uncertainty sometimes arise where there is not a limited number of discrete
outcomes and it is not possible to assign known probabilities. In such cases the sensitivity analysis
approach may be appropriate.

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Back to basics uncertainty and sensitivity

01/11/2012 20:13

Example
Two alternative designs for the unit are under consideration. 100 unit sales are forecast at a selling price of
GBP40 each. Cost details of the designs are:
Design A 1 kilo flubber per unit + GBP1500 fixed costs
Design B 2 kilos flubber per unit + GBP500 fixed costs
Flubber can cost between GBP0 and GBP30 per kilo depending on market conditions which are highly
volatile and unpredictable.
Required: Compare the two alternative designs using sensitivity analysis.
The alternatives can be tested for sensitivity to the flubber price, which is the critical variable. The profit
generated by the two designs across the whole range of possible flubber prices is as follows:
Flubber
GBP per kilo

Design A
Profit GBP

Design B
Profit GBP

2500

3500

5
10
15

2000
1500
1000

2500
1500
500

20
25
30

500
0
-500

-500
-1500
-2500

Lets take the profit generated by design A at a flubber price of GBP10 per kilo to illustrate the workings
of the above figures:
Sales
Flubber cost
Fixed costs
Profit

GBP

4000 (100 units x GBP40)

1000 (100 units x 1 kilo x GBP10)
1500
1500

This sensitivity analysis situation may be represented graphically as follows :

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Back to basics uncertainty and sensitivity

01/11/2012 20:13

The chart indicates that with a break even flubber price of GBP25 per kilo, design A offers a profit over
83% (25/30) of possible outcomes. A also offers a better return than B at all flubber prices over GBP10
per kilo, that being 66% (20/30) of possible outcomes.
The profit outcome from adopting design A is less sensitive to the flubber price than is that of design B as
evidenced by the shallower slope of the line representing design A on the above chart. However, design B
offers the highest best-case outcome at a flubber price of GBP0 per kilo.
The decision makers choice between designs A and B is not clear cut and involves behavioural factors in
the assessment of risk and reward:
The risk averse investor would probably prefer design A because of its relatively low risk profile.
The chart illustrates design As lower sensitivity to movement in the flubber price and less exposure
to actually suffering a loss.
The risk seeker might favour design B because of its high best-case outcome regardless of the
higher exposure to uncertainty involved.
In some situations, a number of factors impacting on the outcome of a decision may involve uncertainty.
The sensitivity analysis approach can be used to test each of these uncertain factors in turn in order to
identify which of them is most likely to cause a problem or offer an opportunity.
Example two
Proposed design C for the unit is under consideration.
The base case for the appraisal of design C is that 100 unit sales are forecast at a selling price of GBP40
each with cost details as follows: 1 kilo flubber (cost GBP10 per kilo) per unit + GBP1500 fixed costs
It is considered that unit sales volume, fixed costs and the price of flubber are all uncertain and capable of
a 25% variation in each case.
Required: appraise design C using sensitivity analysis.
The base case gives a profit of GBP1500, being GBP4000 sales, less GBP1000 flubber cost, less
GBP1500 fixed costs. A variation in each of the uncertain factors may be tested for independently with
the following result:
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Back to basics uncertainty and sensitivity

01/11/2012 20:13

Sensitivity cases
25%
Design C Base case Units (fav)
GBP
profit

GBP1500 GBP2250
%
50%
movement

Units
Flubber
(adv)
(fav)
GBP750 GBP1750

Flubber
(adv)
GBP1250

17%

Fixed c. fixed c.
fav)
(adv)
GBP1875 GBP1125
25%

Let us take the profit generated by design C in the sensitivity case of a 25% favourable variance in the unit
sales volume in order to illustrate the workings of the above figures:
Sales
Flubber cost
Fixed costs
Profit

GBP

5000 (125 units x GBP40)

1250 (125 units x 1 kilo x GBP10)
1500
2250

The above analysis does not give any conclusive evidence concerning the viability of the design.
However, it identifies those factors to which the economics of the design are most sensitive.
It can be seen that a 25% movement in unit sales produces a 50% movement in profit whereas a 25%
movement in the flubber price produces only a 17% movement in profit. So, in appraising design C,
attention should focus more closely on the reliability of the unit sales forecast than on the flubber price.
The management accountant often has to incorporate an allowance for risk and uncertainty into decision
support and planning activities. The techniques that may be used rarely provide definitive answers to the
questions that may be asked. Allowing for risk and uncertainty is more of an art than a science.
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Back to basics uncertainty and sensitivity

01/11/2012 20:13

Find out more

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