Lesson 8

Quantitative Techniques
in Decision Making
 Learning Outcomes

At the end of this chapter, the students

should be able to:
 Evaluate the impact of uncertainty and risk
on decision making
 Apply sensitivity analysis on both short and
long run decision models
 Analyse risk and uncertainty by calculating
expected value tables
 Prepare and apply decision trees
 Decision Making

Decision making is about what will happen in

the future.
A decision is made based on the
understanding of certain facts that is known
today but that has future consequences can
cannot be predicted.
Ideally the decision maker would prefer to
know with certainty what the future
consequences would be for each choice
facing him today
 Decision Making

However, in the real world, decisions must be

made in the knowledge that their
consequences, although probable are rarely
100% certain, i.e. we cannot guarantee an
outcome.
Therefore for effective decision making, the
decision maker should consider the effects of
risks and uncertainty into the evaluation
process.
 Decision Making

The uncertainty about the future outcome can

sometimes be reduced by obtaining more
information about what is likely to happen.
Information can be categorised upon how
reliable it is likely to be predicting what will
happen in the future. Perfect information is
information that is guaranteed to predict the
future with 100% accuracy while imperfect
information is information which might be
good and useful but wrong in the prediction of
the future.
 Risk and Uncertainty

Risk
 Involves situations or events which may or
may not occur, but whose probability of
occurrence can be calculated statistically
and the frequency of their occurrence
predicted from past records.
Uncertainty
 Are those outcomes which cannot be
predicted with statistical confidence
 Risk and Uncertainty

The difference between risk and

uncertainty lies of the fact whether or
not sufficient information is available to
allow the lack of certainty to be
quantified.
 Risk Preferences

Risk Seeker
 Is a decision maker who is interested in the best
outcomes, no matter how small the chance that
they may occur. He is willing to take high risk in
exchange for high returns.
Risk Averse
 Is a decision maker who acts on the assumption
that the worst outcome might occur. He is not
willing to take any risk and prefers a guaranteed
outcome. His returns are therefore low
 Risk Preferences

Risk Neutral
 Is a decision maker who is concerned with the
most likely outcome. He is willing to take some
amount if risk in return for a higher return that the
risk averse decision maker.
Utility theory propounds that an individual’s
attitude towards risk will depend upon the
sum of money involved.
 Allowing for Uncertainty

Conservatism
 Involves estimating outcomes in a conservative
manner in order to provide a built-in safety factor
and is associated with risk aversion and prudence.
Possible Outcomes
 Involves the measure of the most likely outcomes
by considering the worst likely, most likely and
best possible outcomes using mathematical
calculation. This will show managers the full range
of possible outcomes
 Possible Outcomes
Omega Ltd is trying to set the sales price for one of its
products. Three prices are under consideration and the
expected sales volumes and costs are as follows:
Price per unit (RM) 4.00 4.30 4.40
Expected Sales (units)
Best Possible 16,000 14,000 12,500
Most likely 14,000 12,500 12,000
Worst Possible 10,000 8,000 6,000
Fixed costs are RM 20,000 and variable cost of sales are
RM 2.00 per unit
Determine
Determine which
which price
price should
should be
be chosen?
chosen?
 Sensitivity Analysis

Is a modelling and risk assessment procedure in

which changes are made to significant variables in
order to determine the effect of these changes on the
planned outcome.
Approaches taken:
 Estimating by how much costs and revenues would need to
differ from their estimated values before the decision would
change
 Estimate whether a decision would change if estimated
costs were x% higher or revenues y% lower than estimated.
 Sensitivity Analysis

The essence of the approach is to carry

out the calculation with one set of
values for the variables and then
substitute other possible values for the
variable to see how this affects the
overall outcome.
 Sensitivity Analysis

Sensitive Ltd has estimated the following sales and

profits for a new product which may be launched
soon.
Sales ( 2,000 units) 4,000
Variable costs: Material 2,000
Labour 1,000 3,000
Contribution 1,000
Incremental Fixed Costs 800
Profit
200

Analyse the sensitivity of the project

 Probabilities

Is the likelihood that an event or state of

nature will occur. It is normally expressed in
decimal form with a value between 0 and 1.
A value of 0 denotes that the event is unlikely
to occur while a value of 1 denotes that the
event is guaranteed to occur.
Any other value between this range denotes
the % chance that event is likely to occur
A probability distribution lists all possible outcomes for an
event and the probability that each will occur:

Student A Student B
probability probability
Outcome:
Pass examination 0.9 0.6
Do not pass 0.1 0.4
1.0 1.0
Probability distributions provide more meaningful
information than stating the most likely outcome (i.e.both
students will pass).
 Probabilities

When probabilities are assigned to different outcomes, it is

common to evaluate the worth of a decision as the
expected value or weighted average of these outcomes.
Expected values
 Is the financial forecast of the outcome of a course of action
multiplied by the probability of achieving that outcome. The
information can be expressed in the form of a probability
distribution, i.e. a list of all the possible outcomes of an event and
the probability that each will occur
If a decision maker is faced with a number of alternative
decisions, each with a range of possible outcomes, the optimum
decision is the one that gives the highest expected value.
The choice of the option with the highest expected value
is known as “Bayes’ Strategy”
 Bayes’ Strategy

Suppose a manager has to choose between

mutually exclusive options A and B, and the
probable outcomes of each option are as
follows:
Option A Option B
Probability Profit Probability Profit
0.8 5,000 0.1 (2,000)
0.2 6,000 0.2 5,000
0.6 7,000
0.1 8,000
Evaluate the options
 Quick Check 

See example QRS Ltd.

 Decision Trees

Is a pictorial method of showing a sequence

of interrelated decisions and their expected
outcomes. Decision tress can incorporate
both the probabilities of, and values of,
expected outcomes.
All the possible choices that can be made are
shown as branches on the tree, and all
possible outcomes of each choice are shown
as subsidiary branches on the tree.
 Decision Trees

Constructing a decision tree

 Each decision tree starts from a decision point with the
decision options that are currently being considered.
 It is conventional to draw decision trees from left to
right
 A decision point is signified by the symbol “square”
 An outcome point is signified by the symbol “circle”
 Once the tree is drawn, the branches and sub-
branches are labeled with the probabilities, outcome
values and expected values
 Quick Check 

Beethoven Ltd has just invented a new product

and the company is faced with two options, to
test market the product or abandon the product.
If the company test markets the product, the
cost will be RM100,000 and the market
response could be positive or negative with
probabilities of 0.60 and 0.40. If the response is
positive the company could either market is full
scale or abandon the product.
 Quick Check 

If it markets the product full scale, the

outcome might be low, medium or high
demand and the respective net gains /
(losses) would be:
gain/losses probability
Low (200,000) 0.20
Medium 200,000 0.50
High 1,000,000 0.30
 Quick Check 

If the results of the test marketing is negative

and the company goes ahead and markets the
product, estimated losses would be RM600,000.
If at any point, the company abandons the
product, there would be a net gain of RM50,000
from the sale of scrap. All the financial values
have been discounted to the present.
Draw a decision tree and evaluate the decision to
be made.