SENSITIVITY ANALYSIS

Yan Liu
Department of Biomedical, Industrial & Human Factors Engineering
Wright State University

Yan Liu, Department of BIE, Wright State University

Introduction
Before implementing a decision, we should
Verify that numbers are entered correctly and calculations were performed properly
Identify the specific assumptions behind the analysis

What is sensitivity analysis?

A systematic study of how the solution to a decision model changes as the
assumptions are varied
Varying one, two, or all the parameters simultaneously

Also known as what-if analysis

Why is sensitivity analysis important?

Helps to obtain a fuller understanding of the dynamics of the decision problem
whether the alternatives are robust

Helps to identify the important elements in the decision problem

To construct a requisite decision model

Yan Liu, Department of BIE, Wright State University

Introduction
Applications of sensitivity analysis
Problem identification level
Is this the right problem to solve (The error of the 3rd kind: solving a wrong
problem)

Problem structure level

Is there any piece of the puzzle missing?

How large is the impact of each variable?
How important is the uncertainty of a variable?

Yan Liu, Department of BIE, Wright State University

Eagle Airlines Case

Dick Carothers, the president of Eagle Airlines, wants to expand his operation. Eagle
airlines owns 3 aircrafts and provides 50% charter fights and 50% scheduled commuter
service (only 90 min. of flying time on average). He has a news that a small airline in
the Midwest is selling an airplane (Piper Senecca).

The owner of Senecca has offered: 1) sell the airplane outright at price $95K
(Carothers could probably buy it for $85K ~ $90K) or 2) sell an option to purchase
the airplane within a year at a specified price (the cost of the option is $2.5k ~
$4k).

The properties of the airplane: 1) new engines, FAA maintained; 2) contains all the
needed equipment; 3) 5 seats; 4) operating cost: $245/hour; 5) Fixed cost: $20k
yearly insurance + finance charges

Finance charges: borrow 40% of the price at 2% above the prime rate (currently
9.5%, but subject to change)
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Yan Liu, Department of BIE, Wright State University

Eagle Airlines Case

Revenue: 1) charter flights at $300 - $350 per hour; 2) scheduled flights at
around $100 per person per hour (plains are 50% full on average); 3) expect
to fly the plane 800 ~1000 hours per year (50% charter flights)

Carothers can always invest his cash in the money market at 8% yearly
interest rate

Variables in control: 1) the price he is willing to pay; 2) the amount financed

Variables not in control: 1) insurance cost; 2) operation cost

Yan Liu, Department of BIE, Wright State University

Eagle Airlines Case

Objectives
Maximize profits
Profits = Revenue Cost
Revenue:

Cost:

Revenue from charters = (charter flight ratio)*(hours flown)*charter

price

Revenue from scheduled flights = (1-charter flight ratio)*(hours
flown)*(ticket price)*(#seats)*(capacity of scheduled flights)
Fixed cost = insurance+Finance=insurance + (purchase price)*(%
financed)* (interest rate)
Variable cost = (hours flown)*(operating cost/hour)
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Yan Liu, Department of BIE, Wright State University

Eagle Airlines Case

Decisions to make and alternatives

Purchase decision
1) Purchase the airplane outright
2) Purchase the airplane a year later with the option
3) Put money in the money market

Proportion financed
Any amount between 30% to 50%

Charter price
Any amount between $300 $350/hour

Ticket price for scheduled flights
Any amount between $95 $108/hour
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Yan Liu, Department of BIE, Wright State University

Eagle Airlines Case

Uncertain Events (relevant to the decision)

Charter flight ratio

Hours flown

Capacity of scheduled flights

Insurance

Purchase price

Interest rate

Operating cost/hour

Yan Liu, Department of BIE, Wright State University

Eagle Airlines Case

Hours
flown

Operating
cost
Insurance

Purchase
Price

Interest
rate

Charter
flight ratio

Variable
Cost

Charter
Revenue

Total
Cost

Revenue

Fixed
Cost
Finance
Cost

Profit
Proportion
financed

Capacity on
scheduled flights

Ticket
Price

Scheduled
flight
revenue

Charter
Price

Purchase
Seneca

Influence Diagram of Eagle Airlines Decision

Yan Liu, Department of BIE, Wright State University

Eagle Airlines Case

Ranges of Input Variables for Eagle Airlines Decision
Variable
Hours flown
Charter price/hour
Ticket price/hour
Capacity of scheduled flights
Ratio of charter flights
Operating cost/hour
Insurance
Proportion financed
Interest rate
Purchase price

Base Value

Lower Bound

Upper Bound

800
$325
$100
50%
50%
$245
$20,000
0.40
11.5%
$87,500

500
$300
$95
40%
45%
$230
$18,000
0.30
10.5%
$85,000

1000
$350
$108
60%
70%
$260
$25,000
0.50
13%
$90,000
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Yan Liu, Department of BIE, Wright State University

One-Way Sensitivity Analysis

Examine whether a variable really makes a difference in the decision
by varying its value while keeping other variables at their base
values (best guesses)
Question: Under what condition is this procedure adequate?
Profit

$4,200

664

Purchase Seneca

Hours Flown
Money Market

One-Way Sensitive Analysis of Hours Flown

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Yan Liu, Department of BIE, Wright State University

Tornado Diagram
A bar (or line) is used to represent the range of payoffs due to the
variation of an input variable
Allows us to compare one-way sensitive analyses for many input
variables at once
Capacity of
scheduled flight
Operating cost
Hours flown
Charter price
Interest rate

Profits

Purchase price
Money Market

Tornado Diagram of Eagle Airlines Decision

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Yan Liu, Department of BIE, Wright State University

Two-Way Sensitivity Analysis

Studying the joint impact of changes in two variables
In the Eagle Airlines example, suppose we want to conduct a two-way sensitivity
analysis of the two most critical variables capacity of the scheduled flights (CS) and
operating cost (OC)
Set all the other input variables at their base values, yielding
Profit = $130,000+$200,000*CS-800*OC-$24,025
If Profit < $4200 (market value), then it is less profitable to purchase the airplane
If Profit > $4200 (market value), then it is more profitable to purchase the airplane

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Yan Liu, Department of BIE, Wright State University

Two-Way Sensitivity Analysis

Two-way Sensitive Analysis of Eagle Airlines Decision

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Yan Liu, Department of BIE, Wright State University

Sensitivity to Probabilities
Studying the impact of uncertainties of events
License
Technology

Patent
$23M
Continue
Awarded
Development
(0.7)
Develop Production
Development
and Marketing to Sell
Result
Product
No Patent
Development
-$2M
(0.3)
Decision
Stop Development
$0

Demands High
(p=?)
$43M
Demands Med.
$21M
(q=?)
Demands Low
$3M
(1-p-q)

Decision Tree of Research-and-Development Decision

EMV(A)=0
Strategy A: Stop development
Strategy B: Continue development, license technology
EMV(B)=$15.5M
Strategy C: Continue development, develop production & marketing EMV(C)=28p+12.6q+1.5M
EMV(C) and EMV(B) are always greater than EMV(A), so only EMV(B)
15
and EMV(C) need to be compared

Yan Liu, Department of BIE, Wright State University

Sensitivity to Probabilities
p
A

EMV(C)>EMV(B)

EMV(C)<EMV(B)
0.05

EMV(C)=EMV(B)
B

Two-way Sensitive Analysis of Probabilities for Research-and-Development Decision

16

Yan Liu, Department of BIE, Wright State University

Exercise
Question 5.11 in the textbook
A friend of yours can invest in a multiyear project. The cost is $14,000. Annual
cash flows are estimated to be $5,000 per year for six years but could vary
between $2,500 and $7,000. Your friend estimates that the cost of capital
(interest rate) is 11%, but it could be as low as 9.5% and as high as 12%. The
basis of decision to invest will be whether the project has a positive net present
value. Construct a tornado diagram for this problem. On the basis of the tornado
diagram, advise your friend regarding either (1) whether to invest or (2) what to
do next in the analysis.

Yan Liu, Department of BIE, Wright State University

Exercise
Question 5.11 in the textbook (Cont.)

NPV = x0 +

x1
(1+ r )

x2

x6

+ (1+ r ) 2 + + (1+ r )6

x0 = $14,000

When X1=X2== $5,000 and r=11%, NPV=$7,152.69

When X1=X2== $2,500 and r=11%, NPV=$-3,423.67
When X1=X2== $7,000 and r=11%, NPV=$15,613.76
When X1=X2== $5,000 and r=9.5%, NPV=$8,099.13
When X1=X2== $5,000 and r=12%, NPV=$6,557.04

Yan Liu, Department of BIE, Wright State University

Exercise
Question 5.11 in the textbook (Cont.)
$2,500
Cash flows

$7,000

Interest rate
-$3,423. 67
NPV -$4,000

12%

$4,000

9.5%

$8,000

$15,613.76
$12,000
$16,000

Conclusion: NPV is not sensitive to the change of the interest rate but very sensitive to the
range of cash flows. Therefore, it would be appropriate to set the interest rate at 11% for the
analysis but to model the uncertainty about the cash flows with some care.