How are sensitivity, scenario, and break-even analyses used to see the effects of forecasting errors on project profitability?

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How are sensitivity, scenario, and break-even analyses used to see the effects of forecasting errors on project profitability?



Answer: Good managers realize that the forecasts behind NPV calculations are imperfect. Therefore, they explore the consequences of a poor forecast and check whether it is worth doing some more homework. They use the following principal tools to answer these "what if" questions:

- SENSITIVITY ANALYSIS, in which one variable at a time is changed.
- SCENARIO ANALYSIS, in which the manager looks at the project under alternative scenarios.
- SIMULATION ANALYSIS, an extension of scenario analysis in which a computer generates hundreds or thousands of possible combinations of variables.
- BREAK-EVEN ANALYSIS, in which the focus is on how far sales could fall before a project begins to lose money. Often the phrase "lose money" is defined in terms of accounting losses, but it makes more sense to define it as "failing to cover the opportunity cost of capital" - in other words, as a negative NPV.

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