5.69 Sensitivity analysis is fundamental to appraisal. It is used to test the vulnerability of options to unavoidable future uncertainties. Spurious accuracy should be avoided, and it is essential to consider how conclusions may alter, given the likely range of values that key variables may take. Therefore, the need for sensitivity analysis should always be considered, and, in practice, dispensed with only in exceptional cases.
5.70 The calculation of switching values shows by how much a variable would have to fall (if it is a benefit) or rise (if it is a cost) to make it not worth undertaking an option. This should be considered a crucial input into the decision as to whether a proposal should proceed. It therefore needs to be a prominent part of an appraisal.
5.71 Examples of variables that are likely to be both inherently uncertain and fundamental to an appraisal are the growth of real wages, forecast revenues, demand, prices, and assumptions about the transfer of risks. A prior analysis of costs into fixed, step, variable, and semi variable categories can help in understanding the sensitivity of the total costs of proposals.
BOX 15: EXAMPLE OF SENSITIVITY ANALYSIS
A new IT system costs £1million and is expected to yield staff savings of £150,000 per year over a period of 10 years. Discounting at 3.5 per cent the NPV of these costs and benefits is £247,000. Suppose the estimates of staff savings assumed that the IT system would replace 15 staff with an average cost per person of £10,000. A possible sensitivity test is as follows: what if the IT system replaces only 10 staff? Staff savings would then fall to £100,000 per year and the NPV turns negative (minus £168,000). |