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Analysis of Risk and Sensitivity

management, business, risk, risk analysis, risk management, sensitivity analysis

Forecasters make assumptions from past data. Some of the dependent variable data, e.g. sales, in the forecast may be significant and may be sensitive to variations in forecasted values of other independent variables. A forecast for sales may be 10 per cent, but variations in independent variables may suggest growth rates of 5 per cent or 15 per cent. It is valuable to know, therefore, the probability that each of these three forecasts will actually happen.

There are valuable techniques that may help to reduce uncertainty of the future. The idea of sensitivity analysis is to look at a scheme’s profitability by putting a piece of data in the calculations while the remaining data are kept fixed. The advantages of this method are:
•it can be seen whether more exact information would be useful in arriving at a decision;
•whether specific items should be controlled after a decision has been taken.

In the area of investment decisions, probability forecasts are very important, e.g. variable estimates of future sales costs and prices will affect the estimated rates of return on capital invested in projects.

A single-figure estimate of the return on an investment is not so valuable as a number of figures in the form of a distribution of the probability of the happening of various returns on investment.

Probability distributions are obviously more informative than single figures of returns, as managers can take risks into account when selecting projects. The return chosen will depend upon a manager’s attitude towards risk.

Estimates are taken of the worst and the best likely conditions and re-estimates of the value of items. Probability distributions for the values of each of the different items are then made and evaluated by random selection methods weighted by probabilities. Risk analysis can highlight schemes where the profitability is subject to greater than normal uncertainly, so that management’s attention can be directed to schemes requiring closer control.

Both sensitivity and risk analysis complement one another in their approach to the ever-present aim to reduce uncertainty in strategy and tactics.

More sophisticated techniques are also used to assess future possibilities, e.g. morphological analysis, the Delphi technique, scenarios, cross- impact analysis, value profiles and priority analysis and probability diffusion indices.
Published: 2007-04-14
Author: Martin Hahn

About the author or the publisher
Martin Hahn PhD has received his education and degrees in Europe in organizational/industrial sociology. He grew up in South-East Asia and moved to Europe to get his tertiary education and gain experience in the fields of scientific research, radio journalism, and management consulting.

After living in Europe for 12 years, he moved to South-East again and has worked for the last 12 years as a management consultant, university lecturer, corporate trainer, and international school administrator

www.martin-hahn.net

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