Sensitivity analysis

Definition

Sensitivity analysis is a technique used to determine how the different values of an independent variable will impact a particular dependent variable under a given set of assumptions. It helps assess the robustness of an outcome, especially in cost-benefit analysis of public projects, by examining how changes in input assumptions or parameters affect the overall results and conclusions.

5 Must Know Facts For Your Next Test

1. Sensitivity analysis can highlight which assumptions are most critical to the results, helping decision-makers focus on the most impactful variables.
2. This analysis often involves varying one parameter at a time while keeping others constant to see how changes affect the outcome.
3. It is especially useful in public projects where uncertainties exist about costs, benefits, or future conditions, allowing for more informed decision-making.
4. By performing sensitivity analysis, analysts can identify potential risks and areas where further research may be needed before proceeding with a project.
5. It provides insights into how changes in economic conditions, policy changes, or project specifications could alter the feasibility and desirability of a public investment.

Review Questions

• How does sensitivity analysis enhance the effectiveness of cost-benefit analysis in public projects?
  • Sensitivity analysis enhances cost-benefit analysis by allowing analysts to understand how varying key assumptions can influence project outcomes. This technique identifies which factors have the most significant impact on benefits and costs, ensuring that decision-makers are aware of potential risks. By revealing the extent to which results depend on specific inputs, sensitivity analysis provides greater confidence in the conclusions drawn from the cost-benefit analysis.
• Discuss the implications of not conducting sensitivity analysis when evaluating public projects through cost-benefit analysis.
  • Failing to conduct sensitivity analysis can lead to misguided decisions based on overly optimistic or rigid assumptions. Without this examination, decision-makers might overlook critical variables that could dramatically change the project's viability or success. This oversight increases the risk of unforeseen costs or missed benefits, ultimately jeopardizing public resources and trust in governmental projects.
• Evaluate how sensitivity analysis can inform future policy decisions related to public investments based on changing economic conditions.
  • Sensitivity analysis can significantly inform future policy decisions by highlighting how varying economic conditions could affect public investments. By analyzing different scenarios, such as shifts in interest rates or changes in demand for services, policymakers can better understand potential outcomes and make more resilient choices. This proactive approach not only aids in budgeting but also prepares agencies for adapting strategies as circumstances evolve, ensuring efficient allocation of resources and maximizing public benefit.

Related terms

Cost-Benefit Analysis:

A systematic approach to evaluating the strengths and weaknesses of alternatives used to determine options that provide the best approach to achieving benefits while preserving savings.

Discount Rate: The interest rate used to discount future cash flows to their present value, critical in evaluating the net present value of a project during cost-benefit analysis.

Risk Assessment:

The process of identifying, analyzing, and evaluating risks associated with a project or investment, often informing decisions made in sensitivity analysis.