Chapter 6Chapter 6

Profit Sensitivity Analysis

Profit sensitivity analysis (PSA)Profit sensitivity analysis (PSA)

Profit sensitivity analysis (PSA) is a management information tool that assesses how profit reacts to changes in various key variables that make up the overall profit figure.

It is a valuable tool in profit planning and decision-making as it can show which factors have the greatest influence on profit.

Key variablesKey variables

The profit multiplier or sensitivity The profit multiplier or sensitivity rating rating

The process in applying PSA is to take any one variable and assess the effect on profit of changes to that variable. For example, should sales volume increase by 10 per cent and the resulting effect on profit is an increase of 15 per cent, then profit is deemed to be sensitive to changes in sales volume. This sensitivity can be measured through the profit multiplier or sensitivity rating which in the above case is 1.5 times (15% 10%).

The profit multiplier or sensitivity rating is calculated as follows:

Profit multiplier / sensitivity rating = Effect on profit

Change in key variable

Profit multiplier / sensitivity rating = Effect on profit

Change in key variable

Example 6.1: Profit sensitivity Example 6.1: Profit sensitivity analysisanalysis

A) Competition is such that sales A) Competition is such that sales volume drops by 10 per centvolume drops by 10 per cent

B) The business is forced to cut prices B) The business is forced to cut prices by 10 per cent to maintain sales by 10 per cent to maintain sales

C) Cost of raw material increases by 10 C) Cost of raw material increases by 10 per cent per cent

D) D) Variable costs increase by 10 Variable costs increase by 10 per cent per cent

E) E) Fixed costs increase by 10 per cent Fixed costs increase by 10 per cent

Interpreting the sensitivity ratingsInterpreting the sensitivity ratings

More sensitive to changes in selling price than to changes in costs and changes in sales volume.

Reductions in cost of sales have a greater effect on profit than reductions in fixed and other variable costs.

Ultimately in maintaining satisfactory profit levels, this business should pay particular attention to pricing levels, after which it should focus on cost of sales / variable costs and sales volume.

Key variable Sensitivity ratingSales volume 2 timesSales price 5 timesCost of sales 2.5 timesOther variable costs 0.5 timesFixed costs 1

Key variable Sensitivity ratingSales volume 2 timesSales price 5 timesCost of sales 2.5 timesOther variable costs 0.5 timesFixed costs 1

Illustration 6.1: Profit sensitivity Illustration 6.1: Profit sensitivity analysisanalysis

Illustration 6.1: Profit sensitivity Illustration 6.1: Profit sensitivity analysisanalysis

Illustration 6.1: Profit sensitivity Illustration 6.1: Profit sensitivity analysisanalysis

Key variable Sensitivity ratingSales volume 8Sales price 10Cost of sales 1Other variable costs 1Fixed costs 7

Key variable Sensitivity ratingSales volume 8Sales price 10Cost of sales 1Other variable costs 1Fixed costs 7

Fixed and variable cost structuresFixed and variable cost structures

If break-even is not achieved, the extent of the loss is minute

Must achieve higher levels of sales to break-even

To achieve high profit levels, high volume sales must be generated (low contribution/sales margin)

Once break-even point is achieved, high levels of profit can be achieved (high contribution/sales margin)

Limitations of sensitivity analysisLimitations of sensitivity analysis

It does not assign probabilities on the possibilities of fluctuations in key variables.

It does not consider the effect on projected outcomes of more than one variable at a time.