Financial management is both an art and science. In my previous post, the financial management tools, Return on Investment (ROI) and Sensitivity Return on Investment (SROI), illustrated the science of projecting cost and benefits for a program. We must be aware of the level of uncertainty and unknown when we make thees project. This comes the ‘art of financial management’ – sensitivity analysis, which is a process used to discover which assumptions are critical (or sensitive) to the analysis.
This is done by testing a number of plausible values for each important variable
- vary the discount rate
- vary the probabilities
- vary the cost parameter (if possible)
- vary the benefits parameters (if possible)
Any problem, alternative, value, variable, or assumption can be subjected to sensitivity analysis.
- list all the variables relevant to the policy problem
- establish a range of likely values for each
- holding all others constant, test the range of values for one variable to see if any one (or all) decision criteria are affected. This establishes the sensitive variables.
- test the sensitive variables
- contingency analysis
- cost overrun calculation
- feasibility of the project