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COURSE NO.

7 DECREASING THE ACTION OF RISK FACTORS


ON BUSINESSES BY USING THE METHOD OF UTILITIES ESTIMATION
CONTENTS: 1. Introductory notions 2. The algorithm of the method 3. Case Study Objectives: - understanding the necessity of using the modern calculation and optimization methods for managerial decisions taken in risky situations; - learning the algorithm of the method and the specific mathematical model; - developing the abilities necessary to correctly solve some situations regarding businesses in risky situations.

Recommended bibliography:
Horobet A. - Managementul riscului n investiiile internaionale. Editura All. Bech, 2005, Bucureti Iliescu C. - Mangementul riscului, Editura Dacia, 2000, Bucureti Ilie L.,- Managementul firmei. Editura Dacia, 2003, Bucureti

1. Introductory notions The manager (the managerial team) uses this method in order to choose an operating variant aut of many possible variants. The algorithm of the method is based on the following axioms: a) If X and Y are the consequences of two operating variants, then the variant with the consequence X is preferred to the one with the consequence Y if and only if U(X)>U(Y), where: U(X) = the utility of the variant with the consequence X U(Y) = the utility of the variant with the consequence Y b) If the utilities of two variants of the multitude of possible variants are considered to be known, according to them, the utilities of the other functions can be determined; c) If the utility function has the properties a and b, then it can suffer a linear profitiv transformation. The consequence is a numerical value that is assigned to every criterion established by the decision body corresponding to every operating variant. The consequence is expressed in different measurement units (length, weight, time, quantity, etc.). The utility is a numerical value permitting the unitary (non-dimensional) expression of the consequence (in order to be able to make arithmetical operations with the consequences).

2. THE ALGORITHM OF THE METHOD Establish the variants of managerial operation. Establish the criteria according to which each variant is analysed. Establish the consequences for every criterion and variant. Transform consequences into utilities. Rank the criteria. Calculate the importance coefficients for each criterion. Establish the utility function for each variant by weighting it with the value of the importance coefficient. Choose the optimum variant (by applying the axiom a).

3. CASE STUDY NO. 8 The company AGRO S.R.L. has prospected three possible markets so as to launch its product TON-2000 (tuna fish can). The market analysis is based on the following criteria: C1 = product quality; C2 = product cost; C3 = sales average value per day; C4 = risk rate The consequences for every criterion and variant are given by the following matrix (these values resulted by measurements, calculation and evaluation):
Ci Vi V1 V2 V3

C1
1.5/1 1/1 0.9/1

C2
1.2/1 0.8/1 1.4/1

C3
46 80 33

C4
0.6 0.4 0.8

We have to establish the optimum variant for managerial operation for the company AGRO S.R.L. Solution: a) The operating variants are represented by the 3 markets which the product can be launched on (V1 = market no. 1, V2 = market no. 2, V3 = market no. 3) b) The criteria for analysing every variant are established in such a manner that the most relevant consequences for the company should result (product quality, product cost, sales average value per day, risk rate).

c) The consequences resulted by measuring, evaluating and comparing, the mathematical calculation, are determined by specialists and written down for every variant and criterion. In our case: C11= 1.5/1 and it expresses the ratio between the (companys) product quality and the quality of a similar product existing on the market no. 1. C12= 1/1 and it expresses the ratio between the (companys) product cost and the cost of a similar product existing on the market no. 1. C13= 46, it represents the sales average value of the product / day; C14= 0.6, the risk coefficient assumed if it is decided to launch the companys product on the market no. 1. d) In order to transform consequences into utilities, we use the following relations: U(Cij) = U(Cij) =
min Cij Cij min Cij Cij

, when the optimal condition is MINIMUM , when the optimal condition is MAXIMUM

Cij = the consequence for the variant i and the criterion j Uij = the utility for the variant i and the criterion j In order to apply one of the above relations, we need to write down in the matrix the optimum type according to the nature and action of the corresponding criterion. For instance, for C1 (the product quality) we apply the MAXIMUM optimal type. For C4 (risk rate) the optimal type is MINIMUM.

e) Criterion ranking is done by comparing them one to another in a comparing matrix, thus:
C1
C1 C2 C3 C4 0 1 1 1 1 1

C2
1

C3
0 0

C4
0 0 0

RANK
III IV II I

C1 product quality C2 product cost C3 sales average value per day C4 risk rate C1 C2 (C1 is more important so we write the figure 1 in its corresponding box) C1 C3 (C3 is more important so we write the figure 0) - In this way, we continue till the end; - By summing up the points, we determine the rank of the criterion in the hierarchy;

f) The importance coefficient Kj is determined for every criterion with the following relation: 1
Kj

2loc

where: j = the criterion no.; 2 = constant value; rank = the rank given to the criterion in the hierarchy thus: K1 = 2 ; K2 = 2 g) In order to establish the utility, in the given matrix we calculate the utilities according to the relations given in point d, then we calculate the importance coefficients and we multiply every utility with the value of the corresponding coefficient.
3 4

1 0.12 8

1 0.06 16

K1C1 0.12

K2C2 0.06 0.039 0.06 0.03

K3C3 0.25 0.14 0.25 0.17

K4C4 0.50 0.33 0.50 0.25

The sum of utilities

V1 V2 V3

10.12= 0.12 0.07 0.07

0.62 0.88 0.52

In the end, the companys manager chooses the 2nd variant, as U(V2) > U(V1 and V3).