Video: Sensitivity and Scenario Analysis

In this lesson, Nick Palazzolo, CPA, demystifies the complexities of sensitivity and scenario analysis, breaking them down into understandable and applicable concepts. Unpacking sensitivity analysis, he describes how to assess the impact of changing one or more factors within a given financial framework, such as the effects of varying sales or costs on operating income. He also contrasts this with scenario analysis, explaining how to compare completely different financial outcomes by preparing and weighing multiple models. With clear examples and a practical approach, Nick walks through the calculations, showing the influence of a single change and how to apply probability weightings to forecast future financial scenarios, ensuring a solid grasp on the subject matter.

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Video Transcript

Instructor: Nick Palazzolo

Nick Palazzolo is head instructor of ExamPrep.ai CPA Review. Nick's teaching style is engaging & upbeat, combining practical Big 4 tax & assurance expertise with years of 1-on-1 coaching. His lessons are concise and emphasize what you need to know to pass. Whether you're a recent grad or working full-time, we’re confident you can conquer your CPA exams with Nick’s review.

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Sensitivity analysis. We have sensitivity and scenario analysis. Now, I'm a sensitive guy. You may be a sensitive individual as well, but that's not what this is going to be talking about here. Sensitivity analysis is a what-if analysis. It lets us take option A, meaning we're operating, we're making X dollars, we have X costs, right? And we tweak one or more factors to see the results, with certain components being changed. All of our numbers are the same, right? Our salaries, expenses, our revenues, our amount of employees. But if we open up a new factory or if we open up a new product line, right? Or if revenues decrease by 5%. So another name is a what-if analysis. As a company can try to assess what if we raise the sale price or what if we reduced our cost? And I'll give you examples of both of these. After scenario analysis is a little more comparing option A versus option B versus option C.

Again, sensitivity analysis, we have option A and we're changing one thing within that option, whereas scenario analysis is completely different options comparing one versus the other. One of the most significant issues with sensitivity analysis is that it's detached from reality. Assuming that all other factors except those we are changing will remain constant, is unrealistic. What does that mean? Well, generally, if you're just changing your sales estimates, I mean, your sales aren't going to just change out of nowhere and nothing else is going to stay stagnant. If your sales increase, it's probably likely that your costs increased as well or the amount of employees you had changed. So that's the essentially unrealistic nature of a sensitivity analysis. For example, if a firm uses a sensitivity analysis to see what would

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