Risk Reduction Techniques in Management Decision Making

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Risk Reduction Techniques in Management Decision Making

11/3/2009

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1. Sensitivity Analysis

This is a technique that shows how different variables affect the value of a particular variable. For example, it shows the affect on profit following a change in sales price and/or volume.

Pros:
Sensitivity analysis shows the sensitivity of economic payoffs to uncertain values such as discount rates. Management can see the profitability of a project if input values change [ (Marshall, 1995) ]. It is easy to use and understand. Therefore it is most useful when more advanced and time consuming techniques are not possible. Management can see which factors are the most influential in achieving the projected profit of a project. The technique is also beneficial when presenting a project to a group of people. The management team will be better able to answer the ‘what-if’ questions [ (Marshall, 1995) ].

Cons:
There is no measurement of the likelihood of the changes occurring. There is no probability value attached. A small change in an input value could make a project unprofitable but there could be a 0.1% chance of it happening. Therefore, by just looking at the sensitivity analysis the management team might decide not to go ahead with the project but in reality they should because of the low probability of it occurring.

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2. Cost-Volume Profit Analysis (CVP)

CVP analysis is used to determine how changes in costs and volume affect a company's operating income and net income [ (CliffsNotes, 2009) ].

Pros:
CVP analysis is simple to undertake due to the assumptions. It provides an understanding of the affect of the level of activity on profits. The break-even point can be calculated. This is the level of sales needed to make a net income of zero. 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.

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3. 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...
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