Profitability estimates are no better than the inherent accuracy of the data.
Changes in sales
prices, manufacturing costs and inflation affect these estimates especially when the predicted data
are cast far into the future.
SENSITIVITY ANALYSIS OF PROJECT PROFITABILITIES
Profitability estimates are made on the basis of net present value (NPV) and discounted-cash-flow rate of return (DCFRR).
Single values of (NPV) and (DCFRR) are computed from a given set of cash-flow data, which are subjective estimates of
sales revenue, total expense, fixed capital cost, etc. It is important to determine how sensitive a profitability estimate is
to possible errors in the cash-flow predictions. For example, if the sales revenue is 10% lower than predicted, what is the
reduction in the calculated (NPV)? Therefore, we shall examine the effect on profitability of variations in the forecasts of
cash-flow data.
EFFECT OF CASH-FLOW VARIATIONS ON CASH INCOME
Annual cash income, ACI, is given by:
ACI =AS – ATE
ACI is the relatively small difference between two relatively large numbers, the revenue from annual sales, AS, and the total
annual cost or expense, ATE, required to produce and sell the product, excluding any allowance for plant depreciation. A
small error in estimating AS or ATE can make a significant difference to the cash income. Net annual cash income, ANCI , is
related to ACI by:
ANCI = ACI- AIT
where AIT is the annual amount of income tax.
An economic study should pinpoint the areas most susceptible to change. It is easier to predict expenses than either
sales or profits. Fairly accurate capital-cost and processing-cost estimates can be made. However, for the most part,
errors in these estimates have a correspondingly smaller effect than changes in sales price,
sales volume, and raw-materials and distribution costs.
Sales and raw-materials prices may be affected by any of the following: discounts and allowances, availability of
substitutes, contract pricing, government regulations, quality and form of the materials, competition.
Sales volume may be affected by any of the following: new uses for the product, new markets, advertising, quality,
overcapacity, replacement by another product, competition, timing of entry into the market.
Distribution costs depend on
• Plant location.
• Physical state of material (whether liquid, gas or
solid).
• Nature of material (whether corrosive, explosive, flammable, perishable or toxic).
• Freight rates.
• Labor costs.
Distribution costs may be affected by any of the following: new methods of materials handling, safety regulations,
productivity agreements, wage rates, transportation systems, storage systems, quality, losses, seasonal effects.
It is worthwhile to make tables or plot curves that show the effect of variations in costs and prices on profitability.
This procedure is called sensitivity analysis. Its purpose is to determine which factors the profitability of a project is most
sensitive to. Sensitivity analysis should always be carried out to observe the effect of departures from predicted values.
For many years, companies and countries have lived with the problem of inflation or the falling value of money. Costs in
particular, labor costs tend to rise each year. Failure to account for this in predicting future cash flows can lead to serious
errors and misleading profitability estimates.
Another important factor is the tendency of product prices to fall as the total national or international volume of
production increases. Sales prices may fall by 20% for a doubling in volume of production. No profitability estimate is
better than the inherent accuracy of the data.
Effect of a Decrease in Revenue From Sales
The revenue from annual sales is related to the annual cash income and the total annual cost by Eq. (1). If the revenue
from annual sales falls below the base-case value AS by an amount ∆AS, the annual cash income is reduced by an amount
∆ACI , given by:
∆ACI= ∆AS
Annual amount of tax, AIT, is given by:
AIT
Where AD is the annual depreciation charge, AA is the annual amount of any other allowances, and t is the fractional tax
rate. The effect of a reduction in As by an amount CiA, is to reduce A„ by an amount MIT given by: