How do you apply sensitivity analysis to target profit analysis?

1 What is sensitivity analysis?

Sensitivity analysis is a technique that measures how the changes in one or more variables affect the outcome of a model or a calculation. In the context of target profit analysis, sensitivity analysis helps you evaluate how your profit will vary if your sales volume, selling price, variable cost, or fixed cost differ from your initial assumptions. For instance, you can use sensitivity analysis to determine how much your sales volume can decrease before you start losing money, how much you can increase your selling price without affecting your sales volume, how much you can reduce your variable cost per unit to enhance your profit margin, and how much you can invest in fixed cost to boost your production capacity or quality.

2 How to perform sensitivity analysis?

To perform sensitivity analysis, you need to use the basic target profit formula, which is: Target profit = (Sales volume x Selling price) - (Sales volume x Variable cost per unit) - Fixed cost. This formula shows the relationship between four variables that affect your profit: sales volume, selling price, variable cost per unit, and fixed cost. To perform sensitivity analysis, identify the variable you want to change and the range of possible values for that variable. Then calculate the target profit for each value of the variable, using the formula and keeping other variables constant. Lastly, compare the target profit for each value of the variable and analyze the impact of the change on your profit goal. For example, increasing your selling price from $10 to $15 will increase your target profit from $3,000 to $8,000.

3 How to interpret the results?

The results of sensitivity analysis can help you understand how sensitive your profit is to the changes in one or more variables. You can use the results to identify the break-even point, which is the sales volume, selling price, variable cost per unit, or fixed cost that will result in zero profit. Additionally, you can determine the margin of safety, which is the difference between your actual or expected sales volume and the break-even sales volume. The degree of operating leverage indicates how responsive your profit is to the changes in sales volume; a higher degree of operating leverage means that a small change in sales volume will have a large impact on profit.

4 How to use sensitivity analysis for decision making?

Sensitivity analysis can provide you with information about the potential outcomes and risks of different scenarios, allowing you to make better decisions. Through this method, you can evaluate alternative courses of action and choose the one that maximizes your profit or minimizes your loss. Additionally, sensitivity analysis can be used to assess the impact of external factors and uncertainties on your profit and plan accordingly. Finally, this technique can help you monitor and control your performance, allowing you to take corrective actions if needed by comparing your actual results with your target profit and identifying sources of variance.

5 How to improve your sensitivity analysis skills?

Sensitivity analysis is a valuable skill for management accounting, as it helps you plan, evaluate, and control your business activities and achieve your profit goals. To improve your sensitivity analysis skills, one can practice using different methods and tools such as tables, graphs, formulas, or software. Excel can be used to create data tables or charts that show how your target profit changes with different values of one or more variables. Additionally, sensitivity analysis can be applied to real-world problems and cases that involve target profit analysis, such as analyzing the profitability of a new product launch, a price change, a cost reduction, or a capital investment. Lastly, learning from other experts and sources that use sensitivity analysis for management accounting is beneficial; books, articles, blogs, or podcasts can explain how to use sensitivity analysis for target profit analysis or other applications.

6 Here’s what else to consider

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