Sensitivity analysis involves two approaches, scenario analysis and switching values.
Scenario analysis – testing ‘what if’
Use scenario analysis to work out how future uncertainty may affect your options. Scenarios can highlight major uncertainties and assumptions the proposal's success depends on.
Identify variables that can affect the net benefits of your preferred option. Variables can include exchange rates, salary costs, demand drivers, timing or assumptions. Use the risk and uncertainty process to identify variables.
Focus your scenario analysis on ‘what if’ questions to work out the expected Net Present Value for several scenarios. For example, what if:
- a variable increased 10% or 50% (or other possible variation)
- Government changed related policy, or critical legislation is not passed?
If these events occur, should the proposal go ahead? Under what circumstances does the preferred option change? A common approach is to test three scenarios:
- base scenario
- worst case scenario
- best case scenario.
Switching values
Switching values is a ‘what if’ scenario test to work out how much a variable would need to change to alter the choice of the preferred option. Judgements may be necessary to model how the change would alter the choice of the preferred option.
Examples of variables likely to impact on the robustness of the choice of the preferred option may include:
- growth of real wages
- forecast revenues
- demand
- prices
- assumptions about the transfer of risk.
Knowing how costs fall into fixed, step, variable and semi-variable groups can also help to understand the sensitivity of the costs of given options.
Example of sensitivity testing
| Sensitivity testing of preferred option | Conservative scenario | Base scenario | Optimistic scenario |
|---|---|---|---|
| Exchange rate (NZD$ per USD$) | $0.60 | $0.66 | $0.75 |
| Negotiated discount | 10% | 15% | 25% |
| Net Present Value | $29 | $35 | $40 |
You can make various ‘what if’ scenarios by varying exchange rate and discount factors. You can then consider the impacts on the options analysis and the robustness of the preferred option.
In the example above and keeping the discount constant at 15%, the analyst determines that a worsening in the exchange rate is enough to change the choice of the preferred option. The exchange rate of $0.60 is then a ‘switching value’.
Switching value analysis is an important input to the decision on whether a proposal should go ahead. Clearly highlight these risks to decision-makers so they can accurately assess the degree of robustness of the preferred option.