Sensitivity analysis

Definition

Sensitivity analysis is a technique used to determine how the variation in the output of a model can be attributed to changes in its input parameters. This process is vital in assessing the robustness of decisions, particularly in capacity planning, by evaluating how changes in capacity or market demand impact overall performance and profitability.

5 Must Know Facts For Your Next Test

1. Sensitivity analysis helps decision-makers understand which variables have the most influence on a model's outcome, aiding in prioritizing areas that require further investigation.
2. In capacity decisions, sensitivity analysis can reveal how sensitive projected profits are to changes in production capacity or market conditions.
3. This technique can be used to evaluate various scenarios, helping businesses plan for best-case and worst-case situations.
4. Sensitivity analysis can also identify critical thresholds where a slight change in input can lead to significant shifts in outcomes, highlighting areas of vulnerability.
5. By incorporating sensitivity analysis, businesses can make more informed commitments regarding investments and resource allocation.

Review Questions

• How does sensitivity analysis enhance decision-making in capacity planning?
  • Sensitivity analysis enhances decision-making in capacity planning by allowing businesses to see how variations in capacity levels or demand affect financial outcomes. By identifying which inputs have the most significant impact on performance, managers can focus their attention on critical factors that may influence profitability. This understanding helps ensure that resources are allocated effectively, reducing risks associated with over or under-capacity.
• Discuss the role of sensitivity analysis in evaluating the potential risks associated with different capacity decisions.
  • Sensitivity analysis plays a crucial role in evaluating potential risks by simulating various scenarios based on changes in key inputs related to capacity decisions. This approach allows businesses to anticipate how fluctuations in demand or production costs could affect overall performance. By analyzing these scenarios, organizations can develop strategies to mitigate risks and make more resilient commitments regarding their capacity investments.
• Evaluate the implications of ignoring sensitivity analysis when making capacity commitments in a volatile market environment.
  • Ignoring sensitivity analysis when making capacity commitments in a volatile market can lead to significant financial consequences. Without understanding how sensitive outcomes are to changes in inputs, businesses risk overcommitting resources or misallocating investments based on inaccurate assumptions. This oversight can result in missed opportunities during peak demand periods or increased losses during downturns, ultimately jeopardizing the company's competitiveness and financial stability.

Related terms

Capacity Planning: The process of determining the production capacity needed to meet changing demands for products.

Decision Trees: A graphical representation of possible solutions to a decision based on different conditions and their potential outcomes.

Risk Assessment:

The systematic process of evaluating potential risks that may be involved in a projected activity or undertaking.