Financial forecasting & modelling is all about trying to predict the future of your business. Something we’re pretty used to at Brixx!
We are always attempting to make these predictions as accurate as possible but no one has a crystal ball.
You need to use a range of tools and techniques to help explore an uncertain future in order to be prepared for whatever happens.
Sensitivity analysis is one of those tools and it can be a very handy way to look at your business.
If you’ve just created your financial forecast, then sensitivity analysis is the next logical step in planning your business’ future.
What is Sensitivity Analysis?
Sensitivity analysis is the measurement of how sensitive one “thing” is to a change in another “thing”.
One “thing” will be a financial result, such as revenue and the other “thing” will be an assumption used to calculate that financial result – such as changes in cost of sales.
“How sensitive is my profit margin to a change in supplier prices?”
The answer to this will show how impactful a change to supplier prices are to profitability.
Doing this across a number of variables allows you to understand where the sensitive areas of your business are.
Sensitivity analysis can help you identify and plan for potential risks in your business, ultimately making your business safer.
The future is always going to involve a degree of risk, but doing sensitivity analysis around your business’ variables can help identify those risks and inform the actions to take to help reduce those risks.
Let’s take a look at 3 examples of sensitivity analysis in action and see how they can help us plan better.
Key Examples of Sensitivity Analysis
For the following section, I’m going to be using a plan I’ve built in Brixx for a hypothetical audiobook business.
I’ll be using this to highlight some of the questions you can ask and examples of the insights you can gain when carrying out a sensitivity analysis.
Here’s the scenarios I’m going to test:
- How sensitive is my gross profit to changes in publisher fees?
- How sensitive is my gross profit to changes in payment gateway fee?
A bit of context on the audiobook business:
We sell audiobooks through our own platform, with publishers providing us copies of the audiobooks.
The publishers take a fee ranging from 25-60% on each copy sold, acting as a cost of sale for the business. The other cost of sale is the payment gateway charge.
The structure in Brixx is as follows:
How this works is the green icons are Income Components, meaning they are income for my business. The red icons linked to green are Cost of Sale Components, whatever it cost my business to make the sale that it’s linked to.
Example 1 – How sensitive is my gross profit to changes in publisher fees?
My sales are directly impacted by the fees that a publisher takes from each sale. As I stated earlier, fees for each sale range from 25-60%, dependent on the publisher.
It is feasible that publishers will either raise or lower their fees – although not all at once.
So I’d like to analyse how sensitive my gross profit is to changes in publisher fees, this might end up being a specific publisher.
I will run a sensitivity analysis to see changes across the board if fees are increased.
Here’s what my fees are currently and what the increased fees are:
|Publisher||Current Fee||Fee after 10% increase|
|Simon & Schutster||50%||55%|
Here’s my gross profit in Brixx with my current fees:
Changing the fees to 10% higher on each publisher and this is what my gross profit looks like:
Here’s what’s happened:
|Current Fees||Increased Fees|
|Total of publishers||£10,940.53||£12,004.32|
So a 10% change in my publisher’s cost of sales led to a 7.45% decrease in my gross profit.
So, how is this interesting? What this shows us is that as my cost of sales increases, my gross profit will decrease at almost the same rate. It’s not quite a 1 to 1 change as there are other factors that impact my gross profit (my payment gateway charge).
It is a significant factor though. It gets even more interesting when we look at this on an individual basis.
In Brixx, I have created a second, linked cost of sale component that I can toggle on or off to replicate a 10% increase in the fee for Random House.
Sensitivity of Gross Profit if just Random House changes:
|Random House||Current Fees||Increased Fees|
|Cost of Sales||£10,940.53||£11,368.51|
So a 10% change in Random House cost of sales led to a 3% decrease in my gross profit.
Here are the rest of the gross profit sensitivity results when analysing one publisher at a time:
|Publisher||% Change in CoS||% Change in Gross Profit|
|Simon & Schutster||+10%||-1.1%|
Looking at the two tables above gives us an indication of how big that 3% change is relative to the rest of the publishers.
This is where the analysis gets interesting:
- Random House has the biggest impact on my gross profit, it carries 3x more impact than the next highest publisher.
- We can say my gross profit is 10x more sensitive to changes in fees from Random House than Silksound Books.
- If Random house were to increase their fee by 10% I would have to renegotiate at least 3 other publisher down 10% just to maintain my current margins
- The next most sensitive is Simon & Schuster at a 1.1% change – still a lot less than Random House.
From this analysis, I should ensure that Random House doesn’t increase their fee. But, as I sell a lot of their books, I potentially have grounds to negotiate my fee lower, as I know from my scenario testing that this will have a positive impact on my gross profit.
Now, the results of this analysis might have been obvious to a business owner with their finger on the pulse of their business. It lines up proportionally to the revenue made from each publisher.
However, it’s useful to run this exercise anyway to really hammer home the impact in cold hard figures. It’s also useful to be able to express the impact of these changes to other decision makers in the business, investors or your team.
Sometimes the results can be surprising even if you keep a close eye on your operations!
We’ve been analysing the cost of sales changes that affect my gross profit, and whilst publisher fees are the main driver, there is another part of my cost of sales that is left to analyse…
Example 2 – How sensitive is my gross profit if my payment gateway changes their percentage charge?
Currently, my payment gateway takes a 1.2% fee on every sale I make.
That contributes to the cost of sales along with my publisher’s fees.
Now that the analysis has been done on the effect of increasing publisher fees on my cost of sales, the next logical step is to complete the cost of sales picture by analysing the payment gateway fee.
The best way to do this is to carry on with the table we created above, let’s bring that back to help compare how the changes in payment gateway fee also impact the gross profit.
I’ll add a new row for a change in payment gateway charge at a 10% increase, which brings my charge from 1.2% to 1.32%.
|% Sensitivity change||% Change in Gross Profit|
|All Publisher fees||+10%||-7.45%|
We can see from this table that the change to my gross profit is a 0.2% decrease if my payment gateway was to increase their fee by 10%.
What this now tells me is that my gross profit is far less sensitive to a change in payment gateway fee than to publisher fees.
Theoretically, if my gross profit was more sensitive to a change in payment gateway charge, I might want to think about changing gateway if they were increasing their charges.
This is where things start to get a bit more complex. It’s not quite as simple as just switching providers in a day. These things do take time and more importantly money.
Any changes you make in business are likely to have a knock-on effect.
So if I wanted to change providers, I might be able to negotiate a lower fee on each order, however, it will cost me about £7000 in development time to change.
It costs me this as I have to either employ a development team or pull my own team off their current projects to migrate all customers, and customer information, billing, payment processes etc.
How long will it take for you to recoup those costs in the form of a lower fee? And are there any other benefits to changing providers?
All these factors will influence your decision, so best to explore every possibility.
Things are never as simple as they seem! Keeping track and being aware of all the knock-on effects is super important.
Sensitivity analysis in other industries
Our Audiobook business is a digital company with a simple Cost of Sales categories. This analysis can become even more important in other businesses.
A manufacturing company building products from a variety of different materials would have a lot to delve into.
Sensitivity analysis of all the different material costs would be key to understanding how their Gross Profit is derived and where vulnerabilities or opportunities lie.
We’ve been focusing on Gross Profit but this is just one metric you can investigate!
All areas of your business can be broken down in this way, from the sensitivity of your cash flow to payment timings to the sensitivity of your operating margin to your salary levels.
Sensitivity analysis is a fantastic tool in any business’s forecasting arsenal. It provides you with the ability to stress-test your business in different ways, identifying risks, and can help you prepare your best, worst, and base case scenarios.
As you are measuring how one variable responds to a change in another, you can only make one change at a time, which can make the process a little bit time consuming, a limitation you should be aware of.
Owing to this limitation, you should look at the areas of your business that you believe will be most susceptible and likely to change.
In my example business above, I knew that my publisher fees are one of the most volatile parts of my business, they also form a huge part of my costs of sales, meaning that I expected changes in these to heavily impact my gross profit.
We saw that one publisher in particular had the greatest impact if a change was made. This made me aware that I should be careful around that fee – it also brought to my attention that I might have grounds to negotiate that fee lower, as I sell a lot of their audiobooks.
Ultimately, the sensitivity analysis is the first step in identifying which parts of your business are most susceptible to change. It won’t fix these issues, but it will make you aware of them and allow you to form some action items to prepare for them.