Risk Reduction Techniques in Management Decision Making Essay Example

Therefore the manager can use this to decide the required minimum level of sales needed to make a reasonable profit. The manager can assess the risk by calculating the margin of safety. The margin of safety is the difference between the planned unit sales and the break-even sales. It shows how far sales can fall below the planned level of sales before losses occur [ (Horngren et al. , 2008) ].

Cons: There are many assumptions which may not be realistic in practice. It is assumed that production facilities do not change with different level of sales.

As activity is expanded it will eventually be constrained by a lack of one of the factors of production [ (Crowther, 2004) ]. It is assumed that changes in opening and closing inventories are not significant [ (Brown, 2009) ]. The sales price per unit, variable cost per unit and total fixed costs are assumed to be constant. These functions are more uncertain in reality.

CVP is more suitable for short term decisions. Management, however, are more interested in long term planning. Technology is changing constantly and this has an effect on the cost function of a firm [ (Crowther, 2004) ].This is not taken into account in CVP.

Probabilities and Expected Values

The probabilities show the likelihood of certain outcomes occurring. The expected value is the sum of the multiples of the outcomes by their respective probabilities. Pros: When management are trying to maximise profit, the decision of the appropriate option to take is aided by a probability distribution. Probabilities consider the uncertainty of the profit figures and not just the profit figures alone. Management can calculate the probability of two

or more independent events occurring together.Expected values are easy to calculate and understand. The whole distribution can be represented by one figure [ (Lucey, 2002) ].

Cons: The probabilities are based on assumptions which may not be realistic. The expected value figure ignores the range and skewness and assumes the decision maker is risk neutral. It is more suitable where there are a number of similar decisions to be made over a long period of time. Therefore it is not appropriate for once off decisions [ (Lucey, 2002) ]

Decision Trees

Decision trees are a diagrammatic representation of the possible courses of action. Each course of action is represented by a branch. Pros: Certain variables may be dependent on other variables and therefore there are many possible outcomes. Decision trees help make this easier to understand. It takes account of multiple variables in a clear way. The tree allows a complete strategy to be formed taking account of all the possibilities [ (Drury, 2008) ]. The decision tree may be more meaningful to management. They are most useful when management are dealing with difficult decisions with multiple possible outcomes.They also take account of probabilities.

Cons: They can only be used to evaluate specific criteria. Decision trees are more useful if there are a few relevant attributes but less so if there are many complex interactions [ (Rokach and Maimon, 2008) ]. Decision trees use expected values and therefore are subject to similar disadvantages as expected values as outlined above.

Perfect Information

This involves seeking extra information in order to reduce risk. Market research can be used to achieve this.The difference between the expected values under perfect information and under

normal circumstances is calculated. The cost of the information is then deducted. If there is an overall benefit then the extra information is valuable. Pros: There is no risk due to the perfect information. Therefore the decisions for management should be easier to make. Knowing the exact cost structure would allow the firm to use CVP analysis reliably.

Cons: Perfect information means all uncertainty is removed. This is rarely achievable and therefore this concept is more theoretical than practical.Information is also costly to attain.

Simulation Simulation is a technique for studying a system that involves setting up a model of the real system and then performing experiments on the model rather than on the system. It is used in problems like inventory control and production planning.

Pros: The simulation model can be used to test different alternatives that would be too expensive or impractical to perform on the real system. Simulation is useful where other analytical techniques are not applicable.Simulation is cheaper and less risky than altering the real system [ (Lucey, 2002) ].

Cons: The models are complex and therefore they can take up significant amounts of managerial and technical time. Computer expertise is also required and this may not be available [ (Lucey, 2002) ]. Simulations do not always result in the optimal outcome. The manager makes the decision based on the tested alternatives. The optimal decision may not have been tested. Simulations are not relevant to all management decisions.

Maximin and Minimax Regret Criteria

The maximin payoff involves determining the worst outcome for each decision and then choosing the maximum of these outcomes. For the minimax regret, the regrets for each outcome are calculated in a table.

The highest

regret under each decision is selected and then the decision with the minimum of these maximums is chosen. Pros: The minimax regret results in an outcome where the regret is reduced. Therefore the risk of having big regrets is minimised. Also, reducing the risk of incurring the worst possible outcome is an advantage to management. Cons: The outcomes for both of these criterions may be different.

The maximin choice is conservative. For example, a decision with a worst payoff of €1 would be chosen instead of a decision with a worst payoff of €-1, even though this decision has a potential payoff of €10,000 compared to a potential payoff of only €1 for the chosen decision. Probabilities are not assigned to the different outcomes.

Diversification

Diversification is a technique that mixes a wide variety of investments within a portfolio. Diversification smoothes risk in a portfolio so that the positive performance of some investments will neutralize the negative erformance of others [ (Investopedia, 2009) ].

Pros: Diversification spreads risk. Unfavourable events which may affect one project will have a much lower affect on the firm overall. The firm would not be dependent on one particular market.

Cons: Investments must be in unrelated industries to achieve risk reduction. There is a management cost associated with implementing a diversification strategy. If investments are made in other countries there may be political and legal requirements [ (Scribd, 2009) ]. It can be difficult to achieve for small firms.

Real Options

An option is a right but not an obligation to take some action now or in the future for a predetermined price. There are options to expand, to abandon and to delay. These options have

value. The option to expand has value if demand is higher than expected and the option to abandon has value if demand is lower than expected. The option to delay has value if the core variables are changing with a favourable trend.

Pros: Options allow projects to be abandoned or delayed. This reduces the risk if projects do not go to plan.Real options integrate managerial flexibility into the valuation process which assists in making the best decision [ (Brach, 2003) ]. Research and development can be implemented in stages allowing it to be stopped if the project is deemed unprofitable and therefore saving on a large research and development cost that may have otherwise been incurred. Real options allow adjustments to be made by the firm after a project is accepted. This is not possible with the net present value method and other methods of valuing capital budget projects [ (Ross et al. , 2008) ].

Real options allow the market value of a project to be calculated. The market value is the net present value plus the value of the options. Cons: There is ambiguity and uncertainty as to the right method to value and price the real option [ (Brach, 2003) ]. Real options require time and resources. A cost benefit analysis would be required.

Conclusion

I believe the superior approaches in reducing risk are sensitivity analysis, CVP, decision trees and diversification. CVP should be used in conjunction with sensitivity analysis.CVP assumes that there is certainty in terms of the assumptions of the cost structure and the sales price.

In reality these can change. Sensitivity analysis looks at how these changes affect profit. Diversification is an effective technique

to spread risk. If a project performs poorly due to certain circumstances, the overall affect on the firm will be less severe because other projects will benefit from these circumstances. Decision trees, unlike many techniques, give management a clear and meaningful picture of the alternative courses of actions.The other main techniques are inferior due to having a lower overall benefit to a firm, taking into account the advantages and disadvantages.

Probabilities and expected values are based on assumptions which may not be realistic. Perfect information is rarely achievable and therefore highly theoretical. The models involved in simulation are complex and may not be technically feasible by the firm’s technical staff. There is ambiguity in valuing real options. The maximin and minimax regret criteria are highly conservative. This may not reflect the managements risk nature.

Bibliography

1. Brach, M. A. (2003) 'The Evolution of an Idea', in Real Options in Practice, John Wiley ;amp; Sons, Inc. Brown, D. G. (2009) 'Breakeven Analysis', in Introduction to Costs Accounting: Methods and Techniques, Globusz.
2. CliffsNotes (2009) Cost-Volume-Profit Analysis, [Online], Available: http://www. cliffsnotes. com/WileyCDA/CliffsReviewTopic/Cost-Volume-Profit-Analysis. topicArticleId-21248,articleId-21229. html.