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MANAGEMENT

AND COST
ACCOUNTING
SIXTH EDITION

COLIN DRURY

Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8


© 2004 Colin Drury
Part Three:
Information for decision-making

Chapter Twelve:
Decision-making under conditions of risk & uncertainty

Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8


© 2000 Colin Drury
© 2004 Colin Drury
12.1a

RISK AND UNCERTAINTY

1.The decision-making model involves the following stages:

(i) Identify objectives.


(ii) Search for possible courses of action.
(iii) Identify potential events or states of nature.
(iv) List possible outcomes for each state of nature applying to each
alternative course of action.
(v) Measure the pay-off for each alternative course of action.
(vi) Select course of action.

2. Probabilities are used to measure the likelihood that an


event or state of nature will occur.

Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8


© 2000 Colin Drury
© 2004 Colin Drury
12.1b

3. 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

4. Probability distributions provide more meaningful information than


stating the most likely outcome (i.e.both students will pass).

Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8


© 2000 Colin Drury
© 2004 Colin Drury
12.2a

1. Instead of presenting probability distributions for each alternative, two


summary measures are often used:

(i) expected value.


(ii) standard deviation.

2. The expected value is the weighted average of the possible outcomes.


It represents the long-run average outcome if thedecision were to be
repeated many times.

Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8


© 2000 Colin Drury
© 2004 Colin Drury
12.2b

Example

Product A probability distribution

(1) (2) (3)


Estimated Weighted amount
Outcome probability (col.1× col.2)
£
Profits of £6 000 0.10 600
Profits of £7 000 0.20 1 400
Profits of £8 000 0.40 3 200
Profits of £9 000 0.20 1 800
Profits of £10 000 0.10 1 000
1.00 8 000 Expected value

Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8


© 2000 Colin Drury
© 2004 Colin Drury
12.3

Product B probability distribution

(1) (2) (3)


Estimated Weighted amount
Outcome probability (col. X col.2)
£
Profits of £4 000 0.05 200
Profits of £6 000 0.10 600
Profits of £8 000 0.40 3 200
Profits of £10 000 0.25 2 500
Profits of £12 000 0.20 2 400
1.00 8 900 Expected value

Which product should the company make?

Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8


© 2000 Colin Drury
© 2004 Colin Drury
12.4a
1. Product C probability distribution

Estimated Expected
Outcome probability value (EV)
£
Loss of £4 000 0.5 (2 000)
Profit of £22 000 0.5 11 000
9 000

2. Product C has a higher EV than either products B or C, but it is subject


to greater uncertainty.

3. The standard deviation is often used to measure the dispersion of the


possible outcomes:

• SD of A = £1 096
• SD of B = £2 142
• SD of C = £13 000
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
12.4b

4. The standard deviation measures dispersion around the


expected value, but does not measure downside risk. The
SD would increase if product C was replaced with £122 000
instead of £22 000, but does this make the product more
risky?

5. The coefficient of variation V is a relative measure of risk:


V = Standard deviation
Expected value

For example, a SD of 200 with an EV of 2 000 has the same


relative variation as a SD of 2 000 with an EV of 20 000.

6. Where possible, it is preferable to focus on probability


distributions rather than summary measures of EV and SD.

Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8


© 2000 Colin Drury
© 2004 Colin Drury
12.5

Attitudes towards risk

1. The selection of an alternative is influenced by an individual ’s attitude


towards risk.

Example
Possible outcomes A B
Recession 90 0
Normal 100 100
Boom 110 200
Expected value 100 100
The probability of each outcome is 1/3.

2. The two alternatives have the same EV but different levels of risk.

3. - A risk-seeker will prefer B.


- A risk-averter will prefer A.
- A risk-neutral individual will be indifferent between A and B.

Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8


© 2000 Colin Drury
© 2004 Colin Drury
12.6a

Decision trees

Decision trees are useful for clarifying alternative courses of


action and their potential outcomes.

Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8


© 2000 Colin Drury
© 2004 Colin Drury
12.6b

Example
A company is considering whether to develop and market a new product.
Development costs are estimated to be £180 000, and there is a 0.75 probability
that the development effort will be successful and a 0.25 probability that the
development effort will be unsuccessful. If the development is successful, the
product will be marketed, and it is estimated that:

(i) If the product is very successful,profits will be £540 000.


(ii) If the product is moderately successful,profits will be £100 000.
(iii) If the product is a failure,there will be a loss of £400 000.

Each of the above profit and loss calculations is after taking into account the
development costs of £180 000. The estimated probabilities of each of the above
events are as follows:

(i) Very successful 0.4


(ii) Moderately successful 0.3
(iii) Failure 0.3

Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8


© 2000 Colin Drury
© 2004 Colin Drury
12.7

Decision tree for example on slide 12.6

Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8


© 2000 Colin Drury
© 2004 Colin Drury
12.8a

Maximin, maximax and regret criteria

1. Can be applied where it is not possible to assign


meaningful probabilities to alternative courses of action.

Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8


© 2000 Colin Drury
© 2004 Colin Drury
12.8b
Example
Low High
demand demand
Machine A £100 000 £160 000
Machine B £10 000 £200 000

2. With the maximin technique the largest payoff is selected based on the
assumption that the worst possible outcome will occur.
Machine A = £100 000
Machine B = £10 000
Decision = Choose product A

3. With the maximax technique the largest payoff is selected assuming the
best possible outcome will occur.
Machine A = £160 000
Machine B = £200 000
Decision = Choose product B

4. The aim of the regret criterion is to minimize the maximum possible regret.

Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8


© 2000 Colin Drury
© 2004 Colin Drury
12.8c

Regret table
Low High
demand demand
occurs occurs

Choose machine A 0 £40 000


Choose machine B £90 000 0

The maximum regret is £40 000 for A and £90 000 for B.

Therefore,choose A.

Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8


© 2000 Colin Drury
© 2004 Colin Drury
12.9

Portfolio approach

1. Alternatives should not be considered in isolation. Account


should be taken of how they interact with existing activities and other
alternatives.

Example
States of nature Umbrella Ice-cream Combined
manufacturing manufacturing activities
£ £ £
Sunshine –40 000 +60 000 +20 000
Rain +60 000 –40 000 +20 000

Assume there are only two possible states of nature.

2. Each activity is risky on its own, but when the activities are
combined risk is eliminated.

Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8


© 2000 Colin Drury
© 2004 Colin Drury