Decision-making

• Opportunity cost is the cost of the next best alternative forgone
• E.g. after finishing school you could start a business or go to university, if you start a business the opportunity cost is university
• One role of managers is decision making
• Decisions can be scientific i.e. based on data or intuition
• All decisions have an opportunity cost i.e. the cost of one decision in terms of the next best alternative foregone
• All decisions carry risks and rewards as well as being based on uncertainty
• Both risk and uncertainty deal with unknowns
• Risks (quantifiable)

  • it is possible to add a possibility to quantify the degree of risk
  • it is measurable
• Uncertainties (non-quantifiable)

  • it is not possible to add a quantifiable probability as the outcome is too unpredictable
  • it is not measurable
• Business decision making involves both risk and uncertainties
• Scientific

  • supported by quantifiable evidence
  • encourages logical thought process
  • may require expensive data
  • time consuming
  • quantitative e.g. decision trees
• Intuition

  • allows for quick decision making
  • encourages innovation and creativity
  • difficult to justify
  • reliant on experience and expertise
• The following factors are critical when deciding which approach to use

  • speed of decision
  • information available
  • size of the business
  • predictability of the decision
  • character of the purpose or culture of the company
• Decision trees are a tool to assess which decision to make
• Decision trees are like a model of the various options of a decision, including the probability of different consequences and the financial outcomes of each option
• Decision trees assess the risk and reward of a decision
• Square - a decision node, this is used where a decision / choice has to be made
• Circle - a chance node, this is used where there are a number of possible outcomes
• A line is used to show the options and the possible outcomes
• The rules of drawing a decision tree

  • draw from left to right
  • cost of decision shown in brackets under option line
  • probabilities are shown under the possible outcome lines
  • expected returns are shown at the end of the outcome
• Decision trees

  • calculations carried out from right to left
  • calculate EV of uncertain outcomes (value of outcome x probability)
  • add the expected outcomes of uncertain outcomes (at the chance node)
  • subtract the cost of the option
  • net gain of an option
  • repeat for any other branches
  • select option with highest net gain
• Benefits of decision trees

  • makes manager think about different options that have and consider the possible consequences of each one, may uncover possibilities that hadn't been considered before
  • using decision trees may result in a more logical, less rushed process based on evidence rather than gut feeling
  • it forces managers to quantify the impact of each decision considering the forecast costs, benefits and possibilities of events happening
  • decision trees provide a logical comparison of the options available to a manager at a given time
• Limitations of decision trees

  • decision trees only include financial and quantifiable data, they do not include qualitative issues such as the workforces reaction to different options (workforce reactions)
  • use estimates of the probability of different outcomes and the financial consequences of each outcome
  • it is difficult to use decision trees effectively when the range of possible outcomes is not clear
  • may use decision trees, not because they believe in their value but because they can be used to justify a decision