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Jun 18, 2019

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Opportunity cost

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Opportunity cost

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AND COST

ACCOUNTING

SIXTH EDITION

COLIN DRURY

© 2004 Colin Drury

Part Three:

Information for decision-making

Chapter Twelve:

Decision-making under conditions of risk & uncertainty

© 2000 Colin Drury

© 2004 Colin Drury

12.1a

(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.

event or state of nature will occur.

© 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

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

© 2000 Colin Drury

© 2004 Colin Drury

12.2a

summary measures are often used:

(ii) standard deviation.

It represents the long-run average outcome if thedecision were to be

repeated many times.

© 2000 Colin Drury

© 2004 Colin Drury

12.2b

Example

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

© 2000 Colin Drury

© 2004 Colin Drury

12.3

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

© 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

to greater uncertainty.

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

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?

V = Standard deviation

Expected value

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

distributions rather than summary measures of EV and SD.

© 2000 Colin Drury

© 2004 Colin Drury

12.5

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.

- A risk-averter will prefer A.

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

© 2000 Colin Drury

© 2004 Colin Drury

12.6a

Decision trees

action and their potential outcomes.

© 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:

(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:

(ii) Moderately successful 0.3

(iii) Failure 0.3

© 2000 Colin Drury

© 2004 Colin Drury

12.7

© 2000 Colin Drury

© 2004 Colin Drury

12.8a

meaningful probabilities to alternative courses of action.

© 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.

© 2000 Colin Drury

© 2004 Colin Drury

12.8c

Regret table

Low High

demand demand

occurs occurs

Choose machine B £90 000 0

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

Therefore,choose A.

© 2000 Colin Drury

© 2004 Colin Drury

12.9

Portfolio approach

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

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

combined risk is eliminated.

© 2000 Colin Drury

© 2004 Colin Drury

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