Probability Analysis

Remark M. Montalban
Faculty, Department of Accountancy
College of Business and Accountancy, Holy Name University
 What is probability analysis?
▰ A type of analysis which considers the uncertainty of events in the
decision-making process.

▰ Types of decision-making under probability analysis:

▻ Decision making under certainty – for each decision alternative,
there is only one event, and therefore only one outcome. The event
has a 100% chance of occurrence.
▻ Decision-making under conditions of risk – the probability
distribution of the possible future states of nature is known.
▻ Decision-making under conditions of uncertainty – each
decision alternative has several events or outcomes. The probability
distribution of the possible future states of nature (events) is not
known and must be determined subjectively. 2
 What is probability analysis?

▰ Probability Distribution – specifies the values of the variables and

their respective probabilities.

▰ Probability – a mathematical expression of doubt or assurance about

the occurrence of a chance event. Its value varies from zero (0) to one
(1) or 100%.
▻ Probability of 0 – the event cannot occur.
▻ Probability of 1 or 100% - the event is certain to occur.
▻ Probability between 0 and 1 - indicates the likelihood of the
event’s occurrence.
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 Types of Probability Analysis

▰ Objective Probabilities – calculated from either logic or actual

experience. Example, the probability that a coin will yield heads is
0.50 or 50% on any single toss.

▰ Subjective Probabilities – estimates of the likelihood of future

events are based on judgments and past experience. Example, the
likelihood that a winner in an amateur singing contest will become a
successful recording artist.
Basic Terms used in Probability

▰ Mutually Exclusive – if two events cannot occur simultaneously.

▰ Joint Probability – both events will occur.
▰ Conditional Probability – one event will occur given that the
other event has already occurred.
▰ Independent Events – the occurrence of one event has no effect
on the other event.
▰ Dependent Events – the occurrence of one event has an effect on
the other event.
▰ Payoff - the value assigned to the different outcomes from a
decision.
Basic Terms used in Probability

▰ Expected Value - The expected value of an action is calculated by

multiplying the probability of each outcome by its payoff and
summing the products. Expected value represents the long-term
average payoff from repeated trials.

▰ Payoff (decision) table - Presents the outcomes (payoff) of

specific decisions when certain states of nature (events which are
not controllable by the decision-maker) occur. The payoff table is a
helpful tool for identifying the best solution given several decision
alternatives and future conditions that involve risk.
Basic Terms used in Probability

Expected Value of Perfect Information

▰ Perfect Information – the knowledge that a future state of nature (event)
will occur with certainty. In this case, it is assumed that the probability
distribution is an accurate representation of the relative frequency of future
demand and that the decision maker knows exactly when each possible
event will occur.
▰ Expected value of perfect information – the difference between the
expected value without perfect information and the result if the best action
is taken given perfect information.
▰ Cost of perfect information – management may have the opportunity to
acquire additional information that may help in choosing the best
alternative. However, obtaining information requires the incurrence of cost.
Illustration No. 1
A Company is planning to produce a new product, Calamay Pizza. A
marketing consultant prepared the following payoff probability
distribution describing the relative likelihood of monthly sales volume
levels and related contribution margin for Calamay Pizza.
Monthly sales volume Probability Contribution margin

15,000 units 40% P75,000

18,000 30% 90,000
27,000 15% 135,000
36,000 10% 180,000
45,000 5% 225,000
Decision Tree – a graphic representation of the decision
points, the alternative courses of actions available to the
decision maker, and the possible outcomes from each
alternative, as well as the relative probabilities and the
expected value of each event.
Illustration No. 2
Mr. B. Hon cooks and sells “Pansit in a Box.” Each box of pansit is sold
for P50 during regular hours, that is from 10am to 8pm. If every box is
sold by 8pm, Mr. B. Hon calls it a day. However, all unsold boxes by 8pm
are sold at half the regular price up to 9pm. The variable cost per box is
P30.

Past experience has shown that the daily sales demand (up to 8pm) and
their probabilities are as follows:

Sales per day Probability

500 boxes 0.20

600 boxes 0.70
700 boxes 0.10
THANK YOU!

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