decision under risk and uncertanity

DECISION MAKING
FACILITATOR:GREGORY ADEN
Decision making
Decision-making is one of the most important managerial functions. It may involve

choosing between alternatives. A cost benefit analysis has to be carried out in order to
weigh each alternative. While doing so, it is very important to consider only those costs
and benefits that are relevant to the concerned alternative. A management decision of any
sort ultimately boils down to a cost-benefit analysis‘ which involves weighing up the
different alternatives. In order to arrive at the best possible solution, the decision-maker
needs to know which costs are really relevant to a decision and therefore merit
consideration.
Relevant cost / revenue for decision
making
Are the costs / revenues pertinent to the making of a specific managerial decision.
These are essentially the future costs / revenues and should differ amongst the
possible alternative courses of action. Hence cost that remain the same
irrespective to decision making are not relevant cost such cost are irrelevant.
Features of relevant cost
 The differential (incremental) costs, In simple terms differential or incremental cost is

the expenditure which will be incurred or can be avoided as a result of making a
decision. The main difference between these two costs is that the incremental cost
measures the additional unit cost for an addition in output. The incremental cost is
expressed as cost per unit whereas the differential cost is measured in total. Both these
costs are useful in planning and decision making and thereby help to choose the best
alternative
 Future costs, Expected future costs that are a direct outcome of a decision are the only
relevant costs in taking the decision and any cost that has already been incurred is not
at all relevant. Whenever a decision is taken to do a job or to take up an activity, the
costs related to that job or activity are future costs, and therefore, obviously relevant.
 cash costs are relevant The relevant costs are cash outflows only; implying that the
costs that do not reflect any cash expenditure are not considered when taking a
decision
Irrelevant costs for decision making
 Sunk costs are costs that have already been incurred in the past. They are irrelevant
for decision making, because they cannot be changed. For example depreciation on
machinery is a sunk cost. This is because the cost of purchasing the machinery has
already been incurred when the machinery was purchased and it does not affect any
future action
 Committed costs are costs that will occur in the future due to management‘s decision
in the prior period and is not subject to management control on a short term basis. Just
like sunk costs these costs cannot be changed and therefore are irrelevant to a
decision making process
 The non-cash costs which include depreciation, notional costs (rent, interest and other
fixed costs), and absorbed overheads
Decision making under environment
of uncertainty and risk
 Uncertainty arise when the actual state of affairs differs from the desired.
uncertainity may also give rise to favorable opportunities. Decision making involves
bridging the gap between the situation as it stands and the desired situation through
problem solving and creating opportunities.
 Risk is basically defined as the final outcome of a decision may differ from that which
was expected when the decision was taken. There are number of risk which
organizations faces. Examples include market risk, credit risk, liquidity risk,
operational risk, legal and regulatory risk, strategic risk, business risk, reputation risk
etc. Risk usually has negative implications, with regards to potential loss. However,
the potential for better than expected returns also habitually exists.
Continued
 Risk comprises two elements. 1. The first is the probability (or likelihood) of
occurrence of a negative event during the lifetime of operation of a facility; 2. The
second is the consequence of a negative event which has taken place.
 Uncertainty, on the other hand, is closely related to risk. The term―uncertainty
emphasizes that the decision must be made on the basis of incomplete knowledge
about projects that do not yet physically exist.
 Uncertainties arise from the randomness of events, along with three sources of
errors, namely: data errors (uncertainties about past events) forecasting errors
(uncertainties about future events) residual errors (i.e., the differences between
observed and expected values)
Continue
several possible outcomes
UNCERTANIT
RISK Y
Past experience
NO experience
• probabilities
NO probabilities
Continue
 Despite the clear distinction between risk and uncertainty, while making decisions,
managers tend to ignore this distinction and usually treat both risk and uncertainty
as one. Risk and uncertainty have a significant impact on managerial decision
models, depending on the risk appetite of the decision maker. Risk appetite refers to
the amount of risk that an individual / entity / body is willing to accept in order to
fulfil its strategy (i.e. the attitude towards risk). Risk attitude is the liking or disliking
of uncertainty and hence the magnitude of possible gains or losses
Attitudes toward risk are generally grouped into THREE different categories according to
organizational preference:
 Risk averse These organizations are the most cautious while accepting any kind of
risk. They avoid risk wherever possible, but are willing to accept some risks. Such an
attitude towards risk makes organizations miss out on profit opportunities by
resisting or slowly adapting to innovative products or practices.
Continued…
 Risk neutral These organizations prefer a balanced approach to risk and try to
minimize risk while pursuing profit opportunities. They recognize that there is
some level of risk in almost every situation and understand the need to accept
some level of risk.
 Risk loving or risk seeking These organizations enjoy taking risks and challenges.
They often opt out of expensive‘ mitigation strategies. Typically these
organizations take up projects where the residual risk is quite high and hence
cannot be managed. They pursue profit opportunities that risky ventures present
because they want to benefit from the risk-return trade-offs.
Example
 The return on investment is expected as shown below, find the Expected value
project A Project B
ROI Probability ROI Probability

of return of return
10% 0.45 6% 0.3
12% 0.35 8% 0.3
14% 0.25 10% 0.4
Decision-making techniques under
uncertainty
 Maximax, maximin and minimax regret are decision-making techniques adopted in

situations of uncertainty. They are suitable techniques to be used under uncertainty due
to unavailability of historical data, lack of experience, etc
1. Maximax This is an optimistic approach to decision-making. Leonid Hurwitz suggested
this decision criterion. Under this approach, the alternative that maximizes the maximum
outcome for every alternative strategy is selected.
The steps followed in this approach:
i. Find out the maximum payoff for each of the strategies.
ii. Select the maximum out of the maximum payoffs for each strategy as identified in the
preceding step.
iii. The payoff thereby selected is the maximum out of the maximum payoffs i.e., Maximax.
iv. Identify the strategy corresponding to the Maximax payoff.
Continued..
2. Maximin This is a pessimistic approach to decision-making. Under this approach,

the alternative that maximizes the minimum most value of the outcomes for every
alternative strategy is selected.
Steps followed in this approach:
i. Find out the minimum payoff for each of the strategies.
ii. Select the maximum out of the minimum payoffs for each strategy as identified in
the preceding step.
iii. The payoff thereby selected is the maximum out of the minimum payoffs i.e.
maximin.
iv. Identify the strategy corresponding to the maximin payoff.
Continued
3. Minimax regret This is a strategy that tries to minimize maximum possible

regret (i.e. opportunity loss) by adopting a strategy.
In this approach the following steps are to be adopted:
i. For each of the states of nature find out the regret.
Regret = Maximum payoff for a state of nature – Payoff for the strategy,
This will give a regret table.
ii. From the regret table, find out the maximum regret for each strategy.
iii. Select the minimum from the maximum regret selected above – minimax.
iv. Select the strategy corresponding to the minimax regret.
Example
 Pretty, a cosmetics dealer wants to decide on the amount of advertising

necessary for her products. The following is the profit table corresponding to the
advertisement expenditure. Which strategy should Pretty adopt under the
maximax approach?
Demand Low Average High
advertisemen advertisemen advisement
t t
High 155 165 185
Average 140 150 160
Low 130 120 125
Solve
 Sweetie, a confectionery shop owner likes to buy 110 kg of either chocolate-

flavoured pastry or strawberryflavoured pastry from the producer at the beginning of
the week. The chocolate- flavored pastry costs her TZS6,000 per kg, which she sells
at TZS8,000 per kg. Similarly, the strawberry- flavored pastry costs her TZS4,000 per
kg which she sells at TZS7,000 per kg. The potential demands per week for these
pastries are expected to be 90, 100 or 110 kg. Any pastries remaining unsold at the
end of the week are repurchased by the producer for TZS3,000 per kg.
Required:
Identify which of the pastries Sweetie should buy, using:
(a) Maximin criterion
(b) Maximax criterion
(c) Minmax regret criterion
Decision-making techniques under risk
 Expected value
 Decision tree
 Value of perfect information
Continued…
 CLASS ILLUSTRATIONS

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DECISION MAKING

Decision-making is one of the most important managerial functions. It may involve

 The differential (incremental) costs, In simple terms differential or incremental cost is

several possible outcomes

ROI Probability ROI Probability

 Maximax, maximin and minimax regret are decision-making techniques adopted in

2. Maximin This is a pessimistic approach to decision-making. Under this approach,

3. Minimax regret This is a strategy that tries to minimize maximum possible

 Pretty, a cosmetics dealer wants to decide on the amount of advertising

 Sweetie, a confectionery shop owner likes to buy 110 kg of either chocolate-

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