Management Of Professional Judgment – Sensitivity, Scenario, Break-even And Simulation

Sensitivity Analysis

Question:

Discuss About The Management Form Of Professional Judgment?

Sensitivity analysis is the accounting tool used by top management in companies to make a deep analysis for a  given scenario. This analysis is also referred to as what-if-analysis as it commonly involves the process of getting an insight into the possible outcome of a given event. It is used to determine the important and unimportant factors on the greater profitability of the business. Top management involves this analysis in the process of capital budgeting so as to have an insight of the likelihood of the rapport that may ensue between various parts of the project sales, contribution, liquidity and the working capital management of an entity (???????, ?.?. and ?????, ?.?., 2011)

The purpose of the  analysis is not to solely determine  risk but  rather to determine the reaction of NPV to various factors used in its calculation. This is due to the fact that the process of NPV involves some assumptions founded on forecast thus rendering  it uncertain. Sensitivity analysis is one variable of the commonly used analysis tool to measure the extent of change in factors and the related assumptions that would have the impact on the profitability and the projected cashflow. The process of allowing managers to appraise a project before allocating resources to it is paramount as it gives the manager an insight of what the project would contribute toward the overall success of the business(Cooke-Davies, T.J., 2001)

Sensitivity analysis tool as analysis tool has a various advantage such as 1.simplicity- in that there is no complicated theory involved as opposed to the most concept in accounting and finance where the certain theoretical concept has to be appreciated before a method is applied.2.It helps in directing the management`s effort. It identifies important areas as far as attainment of the organizational goal is concerned and any facet which is regarded as highly sensational will be highly monitored.3.Source of information through the use of this analysis, various information is availed to the management in the form that aid in the use of professional judgment.

Notwithstanding its advantages, sensitivity analysis has got some disadvantage in that it fails to provide clear result as the term pessimistic and optimistic may have a different meaning to different people. Furthermore, it focuses on the relationship between factors for instance sales volume may be related to cost but each factor is analyzed in a different manner.

Scenario Analysis

Scenario Analysis is a way in which possible future events are ascertained and analyzed. It is a very crucial tool in finance and in economics and it is used extensively to make future projections. It does not try to manifest one specific scenario but rather the alternative possible outcome. The main aim in carrying out the Scenario Analysis is to estimate the risk associated with a specific plan against different situations that could possibly arise as the plan unfolds. Scenario analysis is not dependent on the past outcomes.

Scenario Analysis is a way of configuring some thought about the future. Outcomes are evident based on different expected scenarios and so are the avenues that lead to that scenario from the current state of affairs, hence giving the institution more space to vary plans accordingly. Extremely positive or negative scenarios allow are stress-tested and proper risk mitigation done if considered appropriate.

An example of a scenario is that involving” good, middling and bad “This kind of levels allows for a prudent spread of insights. It is also likely to come up with other types or levels of scenarios, But caution should be exercised to avoid excessive scenarios as the law of diminishing returns may rapidly come into action and the extra complication may hinder the realization of useful results.

‘’Base case scenario’’-it is a scenario that is considered average based on the assumption from the management. For instance, when calculating the NPV, the rates mostly used are cash flow growth rate, discount rate and tax rate.

‘’Worse case scenario ‘it considers the worst or severe result that may occur in a given scenario. For an instant, when calculating the NPV, the highest likely discount rate is taken and the possible cash flow growth rate is subtracted.

‘’Best Case Scenario ‘This is the optimal projected scenario and it is most likely implemented by the management to achieve their goals. For example, when calculating the NPV, the least possible discount rate, lowest likely tax rate or highest possible growth rate is used.

They are myriads of benefits of performing scenario analysis in finance. These include: Future planning-this gives the investors an idea of the risk and returns involved in a future investment. It also helps investors to be proactive-thus investor can avoid and decrease possible loss that results from factors that are uncontrollable. Scenario analyses help in avoiding risk and failures by assessing investment possibility. Lastly scenario analysis aid in projecting investment losses and returns. By virtue of the tools used it is possible to calculate the values of the potential gains or losses.

Break-even Analysis

Notwithstanding the said benefits, scenario analysis has got a number of limitations that make it difficult to be solely depended on by top management when making company`s financial decision or when there are budgeting for their available capital. First and foremost scenario analysis is very limited to a few discrete outcomes and may fail to clearly capture another possible outcome that may be envisaged if a more rigorous analysis is carried out. Therefore, this analysis limits the decision makers to explore other possible outcomes that may be attributed to a certain project hence leading to making wrong conclusions. Secondly coming up with the scenario probabilities has proven to be difficult as it is mostly based on individual discretion due to lack of a standard procedure for getting those probabilities. Thirdly, Scenario analysis make an assumption of  a excellent interrelation between the inputs in the best case and worst case scenario. This assumption is a rather exaggerated assumption and may lead to making the wrong conclusion regarding a certain decision. Lastly, the scenario analysis technique does not provide a decision rule from which one can accept or reject a decision. This limitation gives room for final decision to be arbitrarily determined hence rendering the whole process unreliable and undependable.

This analysis aims at finding the  level of sales that will ensure the business will not operate under the loss or in other words“ how much can the sales be downsized and the business proceed to make profit’’. It is that level of sale that the company will make zero profit. This method finds the sales required to break-even. (Alhabeeb, M.J., 2012 )

The breakeven point is that point where  sum total of  income is equivalent to the  sum total of expenses i.e fixed and variable cost. It is that point that is similar to the level of production, below which the company operate at a loss. Break even analysis involves grouping two main production cost i.i variable cost-those cost that varies with the different meaning of output fixed cost-those costs that are  indirectly related to the  output production (Tsorakidis, N., Papadopoulos, S., Zerres, M. and Zerres, C., 2011). Total fixed and variable costs are then compared with revenue from sales to get the amount of sales at which the company makes no profit and no loss. This analysis is a very important tool because it is used by managers to project the results of their plans. In this regard, It computes the value of sales which the business or company breaks even. Thus this tool is indeed pivotal in the budget making process or in cases there is development of a new product. The breakeven point formula is used where the business determine the exact amount sales item that is required to give a certain level of profit. Also, the marketing department of the company can make use of break even analysis to determine the results of an increase in the amount of production or when considering the alternative of venturing in machinery that involves high technology..

Simulation

Break even analysis operates under three keys assumption. First is the Mean price per unit sales-this constitutes the price received per unit of sale made. The sales figure is obtained from the sales forecast. Secondly, this analysis assumes Average cost per unit of output- is the variable cost of each unit of sales. For example, if one purchase good for resale, then this cost constitutes the amount one  pay for, on average, for the goods that you resale and in case of offering services, it constitutes what cost an individual per unit of service delivered. Thirdly is the monthly fixed costs-fixed cost are those type of cost that would continue even if one goes bankrupt. In this case, it is recommended that regular running fixed costs be used because it gives one a better insight on financial realities.

Break even analysis enables the company to ascertain the effect of efficiency and cost to the overall profitability of the company. It also aids in analyzing the relationship that exists between variable and fixed cost. Using the break even analysis it is possible to foretell the effect that will ensue due to change in the prices of goods and services that that particular company offers and lastly it makes it possible to calculate profit and losses that are realized at different levels of sales and production.

However Break even analysis has a number of limitation which includes: The assumption that sales prices do not change at all levels of output, this is not practically true as the sales prices are subject to variation depending on the status of the economy. It also makes an arise assumption that production and sales are the same. This may not be true as what is produced is not necessarily what is sold. The break even charts take quite a lot of time to prepare and hence it is time-consuming and lastly the break even analysis can be applied to a single product.

This is a method where countless calculations are used to get the likely outcome and the possibility for any choice of action (Smith, D.J., 1994). The simulation analysis can be understood by virtue of the following steps.1.modelling the project-this shows how the NPV is related to the exogenous variables. The parameters constitute those variables that are specified by the decision maker and are held constant. The exogenous variables are determined randomly and are out of control of the decision maker.2.The second step is to get the values of the parameters and attach the probability to the random variables that arises from the outside factors.3.select any value from the probability distribution of the independent variables.4.Calculate the NPV  of randomly generated independent variables and the parameters values.5.Repeat the two above steps to obtain a large number of simulated values of NPV.This simulation analysis forces the decision makers to consider all the interrelation and uncertainties surrounding the project.

Simulation analysis has an advantage over other techniques as it allows to foretell things that never happened before and to run situations out of the historical confines. However, theories that are satisfactorily predictive are rare to come by and it may take years to develop. Despite simulation being applicable to a variety of context, a formal set of best practice and rules is not available and for this reason, the simulation modeling may be difficult for new researchers who may lack references to refer from.

Conclusion

Thus the above various techniques for capital budgeting may be employed in undertaking capital budgeting process by the top management. As it has been indicated each technique has its advantage and disadvantage and as such the best technology should be used depending on what plan. It is only prudent for the management to subject any project that they want to undertake to several of the discussed techniques because the use of one independent technique may not reveal all the result that is required to make the final decision. Therefore all of the discussed techniques are important as far as capital budgeting is concerned and are hence extensively used by top management of various companies to define the viability of a project.

ANALYTICAL EXAMPLE: BREAK EVEN ANALYSIS

A company expects to sell 20,000 units at $20 each. The variable cost per unit is $10 and the fixed cost is $20,000 per annum. Calculate breakeven point in units and in sale revenue.

Breakeven point= fixed cost divide by (sales price per unit minus variable cost per output)

                              =20000/20-10

                              =20000/10

                             = 2000 units

To get the sales revenue at break even point, the web divide the fixed cost by the contribution  to sale ratio i.e $20,000/0.5=$40,

References

???????, ?.?. and ?????, ?.?., 2011. Sensitivity Analysis in Capital Budgeting.

Cooke-Davies, T.J., 2001. Towards improved project management practice: Uncovering the evidence for effective practices through empirical research. Universal-Publishers.

Alhabeeb, M.J., 2012. Break?Even Analysis. Mathematical Finance, pp.247-273.

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Tsorakidis, N., Papadopoulos, S., Zerres, M. and Zerres, C., 2011. Break-Even Analysis. Bookboon.

Ross, S.A., Westerfield, R., Jaffe, J.F. and Roberts, G.S., 2002. Corporate finance (Vol. 7). New York: McGraw-Hill/Irwin.

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