Risk Reduction Techniques in Management Decision Making
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
11/3/2009
-------------------------------------------------
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.
-------------------------------------------------
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
Bibliography: Brach, M.A. (2003) 'The Evolution of an Idea ', in Real Options in Practice, John Wiley & Sons, Inc. Brown, D.G. (2009) 'Breakeven Analysis ', in Introduction to Costs Accounting: Methods and Techniques, Globusz. CliffsNotes (2009) Cost-Volume-Profit Analysis, [Online], Available: http://www.cliffsnotes.com/WileyCDA/CliffsReviewTopic/Cost-Volume-Profit-Analysis.topicArticleId-21248,articleId-21229.html. Crowther, D. (2004) 'Cost-Volume-Profit Analysis ', in Managing Finance: A Socially Responsible Approach, Elsevier Butterworth-Heinemann. Drury, C. (2008) 'Decision-Making Under Conditions of Risk and Uncertainty ', in Management and Cost Accounting, 7th edition, Pat Bond. Horngren, Sundem, Stratton, Burgstahler and Schatzberg (2008) 'Introduction to Cost Behaviour and Cost-Volume Relationships ', in Introduction to Management Accounting, 14th edition, Pearson Prentice Hall. Investopedia (2009) Diversification, [Online], Available: http://www.investopedia.com/terms/d/diversification.asp. Lucey, T. (2002) 'Probability and Decision Making ', in Quantitative Techniques, 6th edition, TJ International, Padstow, Cornwall. Lucey, T. (2002) 'Simulation ', in Quantitative Techniques, 6th edition, TJ International, Padstow, Cornwall. Marshall, H.E. (1995) 'Sensitivity Analysis ', in The Engineering Handbook, CRC Press, Inc. Rokach, L. and Maimon, O. (2008) Data Miming with Decision Trees, World Scientific Publishing Co. Pte. Ltd. Ross, Westerfield, Jaffe and Jordan (2008) 'Risk Analysis, Real Options, and Capital Budgeting ', in Modern Financial Management, 8th edition, McGraw-Hill Companies, Inc. Scribd (2009) Advantages and Disadvantages of Diversification, [Online], Available: http://www.scribd.com/doc/12376024/Advantages-and-Disadvantages-of-Diversification.