Responsibility Accounting

7. Which type of responsibility center has the greatest amount of autonomy?

A. Revenue center.
B. Cost center.
C. Profit center.
D. Investment center.
8. Which of the following is responsibility center?
A. Expense center
B. Profit center
C. Investment center
D. All of the above
9. The characteristics of a responsibility system for a JIT, or lean organization include
A. Competition between subsystems.
B. Independence of subsystems.
C. Cross functional measurements.
D. A and B.
10. The responsibility centers, for control purposes, may be classified into _____ types.
A. Five
B. Three
C. Four
D. None of the above
11. The area of focus on responsibility center is
A. Quantum of sales
B. Quantum of production
C. Optimum utilization of resources
D. All of the above
12. In responsibility cost accounting the costs in focus are
A. Controllable costs
B. Uncontrollable costs
C. Both A and B
D. None of the above
13. In responsibility accounting, responsibilities of various groups or individuals are identified in terms
of
A. Work
B. Revenue
C. Cost
D. All of the above

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14. Responsibility Accounting is also known as

A. Profitability accounting
B. Activity accounting
C. Both A and B
D. None of the above
15. Which of the following represent arguments against traditional responsibility accounting?
A. It tends to promote competition between segments of a company.
B. It tends to promote subsystem, or local optimization.
C. It tends to ignore many of the interdependencies within an organization.
D. All of the above.
16. Which of the following characteristics is not associated with traditional responsibility accounting?
A. Assumes optimization of the parts will optimize the whole.
B. Assumes independence of the parts.
C. Places emphasis on the performance of individuals.
D. Attempts to control processes.
17. Responsibility Accounting is also known as
A. Profitability accounting
B. Activity accounting
C. Both A and B
D. None of the above
18. Responsibility Accounting is also called ........................ Accounting
A. Profitability
B. Management
C. Authority
D. None of these
19. Responsibility accounting is used for ........................
A. cost control
B. planning
C. decision making
D. pricing
20. The performance of investment centre is based on ........................
A. Cost of the centre
B. Profit of the centre
C. Profit and investment of the centre
D. Revenue of the centre

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21. In responsibility accounting the organization is divided into different ........................ centers
A. Responsibility
B. Cost
C. Profit
D. None of these
22. A cost centre is a segment of the organization where the manager is responsible for ........................
A. Costs
B. Inputs
C. A or B
D. None of these
23. Both costs and revenues are measured in ........................ centers
A. Cost
B. Profit
C. Revenue
D. All of these
24. A centre where the manager is responsible for sales is ........................
A. Cost centre
B. Revenue centre
C. Investment centre
D. Sales Centre
25. The performance of investment centre is based on ........................
A. Cost of the centre
B. Profit of the centre
C. Profit and investment of the centre
D. Revenue of the centre
Answers:
1- C, 2-C, 3-A, 4-A, 5-A, 6- C, 7- D, 8- D, 9- C, 10- B, 11- C, 12- A, 13- D, 14- C, 15-E, 16-D, 17-C, 18-
A, 19-A, 20- C, 21- A, 22-C, 23- B, 24-B, 25- C.

 State True or False

1. Responsibility accounting is the system for collecting and reporting revenue and cost information
by areas of responsibility
2. A responsibility accounting system produces responsibility reports that assist each successively
higher level of management in evaluating the performances of subordinate managers and their
respective organizational units.
3. A key task of the management accountant is to create accounting systems that ensure that costs are
incurred in accordance with expectations.

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4. Responsibility reports for subordinate managers and their immediate supervisors normally include
comparisons of actual results with flexible budget figures.
5. In the functional approach, company activities and responsibilities are organized according to major
functions, such as marketing, manufacturing, and finance.
6. Goals defined for each area of responsibility should be attainable with efficient and effective
performance.
7. Responsibility accounting is more far-reaching.
8. A cost center is an organizational unit whose manager has the authority only to incur costs and is
specifically evaluated on the basis of how well costs are controlled
9. A profit center is an organizational unit whose manager is responsible for generating revenues and
managing expenses related to current activity.
10. A revenue center is strictly defined as an organizational unit that is responsible for the generation of
revenues and has no control over setting selling prices or budgeting costs.
Answers:
1- True, 2- True, 3- True, 4- True, 5- True, 6- True, 7- True, 8-True, 9- True, 10-True.

 Fill in the Blanks

1. An ………………….is an organizational unit whose manager is responsible for managing revenues
and current expenses.
2. A unique challenge for the design of ………………………………. arises from the instance in
which one responsibility center supplies its outputs largely to other internal responsibility centers
3. ……………………………should be prompt and timely.
4. ……………………………………help each successively higher level of management in evaluating
the performances of subordinate managers and their respective organisational units.
5. ……………………………………. of the production division can be held accountable for all direct
and indirect costs incurred in his division.
6. A …………………………. manager may emphasize production efficiency and deemphasize the
pleas of sales personnel for faster service and rush orders.
7. In most cases, it is relatively easy to identify ………………………...with specific managers.
8. The most elementary form of responsibility center is the ……………………………….
9. The …………………………resolves many of the problems just noted for the cost and revenue
center concepts by combining the two.
10. A unique challenge for the design of …………………………………arises from the instance in
which one responsibility center supplies its outputs largely to other internal responsibility centers.
Answers:
1- Investment center, 2- Responsibility centers, 3- Report, 4- Responsibility reports, 5- Divisional
manager, 6- Cost centre, 7- Activities, 8- Cost center, 9- Profit center, 10- Responsibility centers.

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 Short Essay Type Question

1. Differentiate between a cost center and a profit center.
2. What is the major shortcoming of using income from operations as a performance measure for
investment centers?
3. Differentiate between a profit center and an investment center.
4. How are revenue variances computed?
5. Why and how are support department costs allocated to operating departments?

 Essay Type Question

1. Why should the factors under the control of the investment center manager (revenues, expenses,
and invested assets) be considered in computing the rate of return on investment?
2. The rates of return on investment for ABC Co.’s three divisions, East, Central, and West, are 26%,
20%, and 15%, respectively. In expanding operations, which of ABC Co.’s divisions should be
given priority? Explain.
3. Which factors determine whether a firm should be decentralized or centralized?
4. How are decentralization and responsibility accounting related?
5. What are the four primary types of responsibility centers, and what distinguishes them from each
other?

Practical Problems
 Multiple Choice Questions
1. There are three departments A, B and C in a company. The sales of A, B and C are ₹ 3,52,000, ₹
2,88,000 and ₹ 1,60,000, respectively. The variable costs of A, B and C are ₹ 2,40,000, ₹1,76,000
and ₹ 1,44,000 respectively. The direct fixed costs of A, B and C are ₹ 28,000, ₹ 22,400 and ₹12,800.
Rank the different departments on basis of relative profitability.
A. A- Rank 3, B- Rank 1 and C- Rank 2
B. A- Rank 2, B- Rank 1 and C- Rank 3
C. A- Rank 3, B- Rank 2 and C- Rank 1
D. Insufficient data
2. In a company Department A recorded loss in the first half of the current year. The sale of department
is ₹ 90,000 and uncontrollable costs are ₹ 91,000, Advice the management whether its operations
should be continued or terminated.
A. Continued
B. Terminated
C. Insufficient information
D. None of the above

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3. In a control report of Department X, it is mentioned as indirect materials are ₹1,000, indirect labour
₹900, Overtime Charges ₹100, Depreciation on equipment ₹500, Allocated factory overhead (38%
of factory space) ₹4,300, Allocated overhead of repair shop is ₹ 1,200. Determine total costs treating
department X as a responsibility center.

A. ₹ 3,200

B. ₹ 2,200

C. ₹ 1,200

D. None of the above

Answers:
1- A, 2-C, 3-A.

 Comprehensive Numerical Questions

1. The printing department of a large company informs the marketing department that the price of
printing 1,00,000 colour flyers will be ₹ 60,00,000. The marketing department submits the material
for the flyer two weeks later than originally planned and tells the printing department that the
scheduled date of completion has been advanced two weeks. In order to achieve the new schedule,
the printing department incurs an additional production cost of ₹15,00,000.
(1) In an organisation using responsibility accounting, where would the additional costs be
assigned? Would these costs be considered controllable costs? What effect might this have on
future printing orders from the marketing department?
(2) In an organisation that does not use responsibility accounting, where would the various costs be
assigned? What effect might this have on future printing orders from the marketing department?
2. A merchandising firm sells its goods through department stores and discount houses which it has
setup for operating the sales. The ROI of both businesses is 20 per cent and has the following data:

Department Stores Discount Warehouses

Particulars
₹ ₹
Divisional profit 20,000 32,000
Divisional investment 1,00,000 1,60,000
Divisional sales 2,00,000 4,80,000
Evaluate the two Divisions.
3. A bank considers acquiring new computer equipment. The computer will cost ₹1,60,000 and result
in a cash savings of ₹70,000 per year (excluding depreciation) for each of the five years of the
asset’s life.
It will have no salvage value after five years. Assume straight-line depreciation (depreciation
expensed evenly over the life of the asset). The company’s tax rate is 15 per cent, and there are no
current liabilities associated with this investment.

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Required:
(a) What is the ROI for each year of the asset’s life if the division uses beginning-of-year net book
value asset balances for the computation?
(b) What is the economic value added each year if the weighted-average cost of capital is 25 per
cent?
4. The following information relates to the operating performance of two divisions of ABC India, for
last years:
X Division Y Division
Operating Profit ₹ 8,00,000 ₹ 12,00,000
Total Assets (acquisition cost) 40,00,000 75,00,000
Total Assets (current replacement costs) 60,00,000 80,00,000
Required:
(a) Compute the return on investment (ROI) of each division, using total assets stated at acquisition
cost as the investment base.
(b) Compute the ROI of each division, using total assets based on current replacement cost as the
investment base.
(c) Which of the two measures do you think gives the better indication of operating performance?
Explain your reasoning.
5. The income from operations and the amount of invested assets in each division of Devon Industries
are as follows:
Income from Operations Invested Assets
Goods Division ₹ 80,000 ₹ 4,00,000
Health care Division 41,600 2,60,000
Commercial Division 70,000 3,20,000
Required:
(a) Compute the rate of return on investment for each division.
(b) Which division is the most profitable in terms of amount invested?
6. For each of the following service departments, identify an activity base that could be used for
charging the expense to the profit centre.
(a) Central purchasing
(b) Legal
(c) Accounts receivable
(d) Duplication services

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(e) Electronic data processing

(f) Telecommunications
7. ABC Company has income from operations of ₹ 20,125 invested assets of ₹ 87,500 and sales of
₹1,75,000. Use the DuPont formula to compute return on investment and show
(a) the profit margin,
(b) the investment turnover, and
(c) return on investment.
8. The Commercial Division of Tata Company has income from operations of ₹1,35,000 and assets of
₹6,50,000. The minimum acceptable rate of return on assets is 10%. What is the residual income for
the division?
9. LT Company has income from operations of ₹50,000, invested assets of ₹200,000, and sales of
₹5,00,000. Use the DuPont formula to compute the return on investment and show
(a) the profit margin,
(b) the investment turnover, and
(c) return on investment.

10. XYZ Company uses economic value added (EVA) to evaluate top management performance. In
2022, ABC Company had net operating income of ₹54,580 lakhs, income taxes of ₹15,230 lakhs
lion, and average noncurrent liabilities plus stockholders’ equity of ₹1,55,740 lakhs. The company’s
capital is about 30% long-term debt and 70% equity. Assume that the after-tax cost of debt is 5%
and the cost of equity is 11%.

Required:

1. Compute economic value added (EVA).

2. Explain what EVA tells you about the performance of the top management of XYZ Company in
2022.
 Unsolved Cases
Analyse the following cases and comment:
1. A manager of a fast food restaurant may be held responsible for reporting on variances in the profits of
the unit, even though he or she does not have control over either the cost of the food or the price it is
sold for. Decisions outside of the manager’s control should not be part of the manager’s performance
evaluation. Even so, the manager can and should still be held responsible for reporting on the results
because he or she is in the best position to explain the variances between actual and budgeted items.
2. Assigning some percentage of each operating department’s contribution to covering common costs
reminds each department that it is a part of a larger organization, and as such it has a responsibility to the
larger organization to maintain earnings that are adequate to cover a portion of the firm’s indirect costs;

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and it formalizes their accountability for doing so.

3. In evaluating segment performance and the segment manager’s performance, it is important to distinguish
between the performance of the manager and the performance of the segment the manager manages. On
a contribution income statement by segment, direct fixed costs controllable by others are the same as
non-controllable traceable fixed costs. Costs that are traceable to a segment but controlled by someone
other than the segment manager are used in evaluating the performance of the segment, but they should
not be used in evaluating the performance of the segment manager.
4. When a company reports operating results according to responsibility center, each responsibility center’s
report contains a partial balance sheet showing the assets under its control, the liabilities incurred for the
purchase of those assets, and an operating income statement showing the responsibility center’s revenues
and expenses. However, shareholders’ equity does not appear on the individual responsibility center
balance sheets because equity belongs to the whole corporation. Equity cannot be divided up among
responsibility centers, and it cannot be affected by any decision made by any individual responsibility
center manager.
Since no individual responsibility center has any equity on its balance sheet, no individual responsibility
center manager has any authority to determine how equity should be raised. Decisions about raising
equity to finance capital investments (that is, sale of new common or preferred stock or the use of
retained earnings) can be made only by senior management.
Therefore, the operating decisions made by the individual division managers affect the total assets
employed by their divisions, the working capital they have to work with, and the total assets they
have available to them (whether the assets are employed or not). The operating decisions made by the
individual division managers cannot affect shareholders’ equity.
5. Relationship between responsibility accounting and cost control
There is a direct relationship between responsibility accounting and cost control. Costs are easier to
control when a responsibility accounting system is in effect. Department heads know immediately
when cost overruns occur and can work quickly to reduce them. Department heads are aware that their
supervisors are receiving data on their performance and will make efforts to perform in a more cost-
efficient manner.

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Key Terms
Cost Center: A cost center is the smallest segment of activity or area of responsibility for which costs are
accumulated.
Investment Center: Investment center, like a profit center, is responsible for both revenue and expenses, but
also for related investments of capital.
Profit Center: Some business units have control over both costs and revenues and are therefore evaluated on
their profit outcomes.
Responsibility Accounting : Responsibility accounting is an underlying concept of accounting performance
measurement systems.
Responsibility Center: A responsibility center is an organizational unit headed by a manager, who is
responsible for its activities and results.
Revenue Center: Revenue center can be defined as a distinctly identifiable department, division, or unit of a
firm that generates revenue through sale of goods and/or services.
Responsibility Reports: The responsibility accounting performance report is a budget that compares actual
and budgeted amounts of controllable costs for a department and its manager.

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 Decision Theory

SECTION - H
DECISION THEORY

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538 The Institute of Cost Accountants of India

A Decision Theory

Decision Theory 10

This Module includes -

10.1 Decision Making under Certainty

10.2 Decisions Making under Risk

10.3 Decision Making under Uncertainty

10.4 Decision Tree

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Decision Theory

SLOB Mapped against the Module

To appreciate quantitative tools for decision making in dynamic environment
shrouded with risks and uncertainties. (CMLO 2a, 2b).

Module Learning Objectives:

After studying this module, the students will be able to
 Appreciate the decision making process in the context of ever changing business environment.
 Fathom the process of decision making under conditions of certainty, uncertainty and risk.
 Understand the basic aspects of Decision Tree.

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Decision Theory 10

D
ecision making is the most significant aspect of the management process. Efficacy of every aspect of
management (planning, organizing, control, etc.) is pivoted on the effectivity of the decision making
process. Effective decision making is linked to fulfilment of the objectives of the organization. An
elaborately designed decision making process helps to make a more deliberate and effective decision.
The steps of the process are discussed below:
Step 1: Identify the decision – it is important to identify the nature of decision that the decision maker is faced
with. This paves way for making effective decisions.
Step 2: Gather relevant information - Before decision making, it is important to gather all relevant information.
The source of information can be two types,
 Internal source- information available within the organisation.
 External source – information that are available beyond the scope of the organisation.
Step 3: Identify the alternatives – on the basis of the information collected the alternatives are zeroed upon. At
this juncture it is important to make a list of all possible alternatives in order to make a correct and effective
decision.
Step 4: Consider the evidence - In this step, the decision maker uses his knowledge and emotion to imagine
what it would be like if one particular alternative is chosen and carried out. This would have to be thought about
for all the possible alternatives. As the decision maker goes through this process (often with subtlety), he starts
developing a notion as to which alternative results in the achievement of the organisational goal.
Step 5: Take action - In this step the decision maker is ready to make his call which is decided upon in the
previous step.
Step 6: Review of the decision - After the above steps are undertaken and a decision is arrived at, the process of
evaluation has to begin where the impact of the decision is considered. If the desired result is not achieved, the
whole process has to be revisited.
The theoretical underpinnings of the decision making process is the subject matter of Decision Theory. The
following aspects are noteworthy:
 Decision theory involves economic and statistical approaches for studying an individual’s choices. Because
it is based on ideas, attitudes, and wishes, analysts refer to it as a theory of choice.
 Decision theory enables the entity to make the most rational decision feasible in unknown and uncertain
conditions, repercussions, and behaviours.
 In order to make better business decisions, companies worldwide use this theory to understand how customers
and markets operate.

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 Mathematicians, economists, marketers, data and social scientists, biologists, psychologists, philosophers,
and politicians use two theory forms: normative and descriptive1.
Though decision theory deals with the methods for determining the optimal course of action when a number of
alternatives are available, given that the consequences cannot be forecast with certainty2, for the purpose of this
section of the study note, discussion is restricted to problems occurring in business, with consequences that can
be described in Rupees of profit or revenue, cost or loss. For these problems, it is reasonable to consider that the
best alternative is the one which results in the highest profit or revenue, or lowest cost or loss, on the average, in
the long run.
Certainty3, Uncertainty and Risk
It is obvious from the above discussion that the decision maker has to choose between alternatives. There are
several possible alternatives (or outcomes) of an act (choosing between alternatives) which has to be endorsed
in favour of, such that the end result, in terms of Rupees, is optimised. This is the fundamental aspect of
decision theory. Now, the moot question is whether there is information regarding happening/ not happening
of the outcomes. There can be as such two extreme cases; one where there is perfect information of happening/
not happening of the outcome. This is a situation where there is relevant past experience to enable statistical
evidence for predicting the possible outcomes. This is the case of decision making under certainty. The other
extreme is a situation where there are several possible outcomes, but there is no previous statistical evidence
to enable the possible outcomes to be predicted. This is the case of decision making under uncertainty. In this
particular situation probabilities cannot be assigned to the various states of nature (condition of happening/not
happening of a particular state of the future). Thus there arises a third situation where there is predictability of
happening/ not happening of future state of nature (condition of happening/not happening of a particular state
of the future). This is the case of decision making under condition of risk. The terms ‘risk’ and ‘uncertainty’ are
used interchangeably but there is significant difference between the two. A comparison chart is presented in the
following lines which helps to understand the basic difference between the two. In making decisions under risk,
the decision maker can predict the possibility of a future outcome, but when making decisions under uncertainty,
the decision maker cannot. Risks can be managed while uncertainty is uncontrollable. The decision maker can
assign a probability to risks events.
BASIS FOR COMPARISON RISK UNCERTAINTY
Meaning The probability of winning or losing Uncertainty implies a situation where
something worthy is known as risk. the future events are not known.
Ascertainment Measurable Not Measurable
Outcome Chances of outcomes are known. The outcome is unknown.
Control Controllable Uncontrollable
Minimization Yes No
Probabilities Assigned Not assigned
Comparison Chart
1
This aspect of the study of Decision Theory is beyond the scope of the study note. However, students may refer the website mentioned in parenthesis
for in-depth understanding ([Link]
2
It is important to note that most of the academic discussions on short term decision making (most of which is discoursed in Module 4 of this study
note) occurs under conditions of certainty.
3
It is important to note that the the distinction between risk and uncertainty is not essential for analysis in cost and management accounting and the
terms are often used interchangeably in courses on Cost and Management accounting. But the distinction is essential part of Decision Theory as
discussed in books on Operations Research. (Please refer Operations Research - An Introduction, Tenth Edition, by Hamdy A. Taha (Chapter 15:
Decision Analysis and Games)).

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In the following lines the conditions are introduced briefly:

(i) Decision making under conditions of certainty
Decision making is about selecting the best alternative from among an array of alternatives. The ‘best’ alternative
refers to that particular alternative which helps a firm to maximise its profit4 or minimise its cost. In decision
theory, the alternatives are referred as acts and the possible events are referred as states of nature (outcomes of
a random process).
The condition of certainty imply that the future is known and thus the probability of happening/ not happening
of an event is one. All the models of short term decision making discoursed in Module 4 of this study note are
under conditions of certainty5. In simple words, the decision-maker is conformed to what will happen when a
decision is being made. It is a condition where the future is cent percent definite. This situation is conformed
because of the availability of all reliable information. Thus the cause and effect are known with certainty. Due to
known conditions, there are no conflicts in decision-making. This condition exists in routine decisions such as
day-to-day activities, payment of wages, salaries, etc. Another example is when a person is going to buy a car, he
can collect all the relevant information about that car, and he gets confirmed as to what type of car he is buying.
This is erroneous as the terms ‘uncertainty’ and ‘future’ are fabricated into each other. It is a well-accepted fact
that the future is uncertain. In the ever changing business environment, even in the short term, nothing can be
assumed to be cent percent assured, even under conditions of perfect information. As such, the notion of perfect
information is also a misnomer.
The entire gamut of short term decision making that operate under conditions of certainty is often referred as
the deterministic model. Though there are severe criticism for the models, they exist in the world of academia
because of their simplicity and significant contribution to the knowledge base.
(ii) Decision making under condition of uncertainty
Uncertainty lies on the other end of the continuum6. In certainty, as discussed in the previous paragraph, the
future is known and the decision maker, thus, need not worry about the happening /not happening of a particular
state of nature as the future is cent percent assured. Whereas under condition of uncertainty, the future states
of nature are unknown. There is no information available on the happening /not happening of the future state
of nature. In decision making under uncertainty, the probability distribution associated with the states is either
unknown or cannot be determined. This lack of information has led to the development of special decision
criteria which would be discussed in brief, in later section of this module.
(iii) Decision making under condition of risk.
The term ‘risk’ is one of the most discoursed terms in finance literature. Various aspects of financial risk and its
management is taken up for discussion in a later paper7. In simple terms, risk is a situation, where the decision
maker is neither certain nor uncertain about the future states of nature. Thus there is imperfect information about
the happening/ not happening of the future events. In mathematical terms, probabilities may be assigned to
happening/ not happening of the future events. The probabilities may be either priori probabilities, derived from
inherent symmetries, like the throw of a dice (the probability of throwing a four is one –sixth as there is one event
favourable and six events that may occur) or statistical probabilities, obtained through analysis of homogenous
data (for example, the chance of rain on 16th August 2022 may be assigned by looking into the weather report of
last two hundred years. If rain had occurred on 60 days out of 200 days, then it may be said that the probability
of rain on 16th August 2022 is 60/200=0.3 and the probability of rain not happing on 16th August 2022 is 0.7).
4
In corporate finance, maximisation of shareholders’ wealth (SWM) is preferred objective of the firm.
5
This is seldom true under conditions of long term where the impact of the uncertain future is obvious.
6
Today, the complex business environment is referred as VUCA environment which is an acronym for (V)Volatility, (U) Uncertainty, (C) Complexity
and (A) Ambiguity. It applies to applied to assess the complex environments where tasks may vary and change as fast as the environment around
them. Under such conditions the deterministic models (conditions of certainty) losses much of their lustre and decision making under uncertainty
is considered as more significant.
7
Students may refer to Module 4 of paper 20A for in-depth knowledge of financial risk and various aspects of financial risk management.

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Decision Making under Certainty 10.1

I
n decision theory, utility matrices are combined with various types of information about states of nature.
The decision maker may or may not be able to gather prior information about the states of nature. In cases
when only one state of nature is to be considered because of the nature of the problem or because of lack
of information8 are called decision-making under certainty. If the decision maker is certain as regards to
the probability of happening/ not happening of an outcome, he is said to operate under condition of certainty.
On the contrary, if the decision maker has imperfect information or no information about the happening/ or
not happening of an event he is said to operate under conditions of uncertainty or risk. Thus it may be stated
that in the realm of decision making, under condition of certainty each action will lead invariably to a specific
outcome. In this situation only one state of nature exits and its probability is one. The following illustrates the
understanding.
Solved Cases 1
Mr Pratap is considering setting up his stall in the playground in the evening of a particular day, say 20th August
2022. He has the option of selling ice creams or coffee. He has the option of buying Ice creams9 from a whole
seller @ `56 each and selling them for @ `60 each. Thus he would make a profit of `4 on each Ice cream cone.
On a sunny day he sales 200 cones, but if it is a rainy day then sales fall and thus he is able to sell only 80 cones.
On the contrary, he can sell coffee whereby he can make a profit of `6 per cup. On a sunny day he sales 100
cones, but if it is a rainy day then sales increases and thus he is able to sell 160 cups.
This can be represented in the following pay off matrix:

Particulars States of Nature

Acts Sunny Day Rainy Day
Sale Ice Cream ` 800 10
` 320
Sale Coffee ` 600 ` 960
Now, on the morning of 20th August 2022 he wakes up and find that it has been raining from the previous day
night and for clarification he calls the met office and they confirm that it would rain for the whole day. Thus he
faces a situation of certainty as there is only one state of nature and that is it being a rainy day. Thus his decision
whether he would sell Ice cream or Coffee is based on one certain information and thus the above payoff matrix
may be reduced to one with a single state of nature (Rainy Day).
8
This is the case for various deterministic models of decision making like make or buy, shutting down of a product line, replacement of a machinery
etc. This are discoursed in details in Module 4 of this study note.
9
For simplicity it is assumed that only one type of ice creams is bought and sold namely, Strawberry ice creams in cones.
10
This is calculated as profit per cone of ice cream (`4) × number of cones sold (200). The other values in the payoff matrix are calculated in the same
manner.

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Particulars States of Nature

Acts Rainy Day
Sale Ice Cream ` 320
Sale Coffee ` 960
Thus Mr Pratap is better off if he sales Coffee on 20th August 2022, at the playground as the payoff (`960) from
selling coffee is higher than the payoff from selling ice cream. This is particularly because of the fact that it is
known with certainty that the 20th August 2022 would be a rainy day.
Decision Matrix
The standard format for the evaluation of alternatives in decision theory is that of a decision matrix. In a decision
matrix, the alternatives open to the decision-maker are tabulated against the possible states of nature. The
alternatives (acts) are represented by the rows of the matrix, and the states of nature by the columns. The decision
matrix is also referred as the payoff matrix when the cell values are presented in terms of net benefit. For the
purpose of understanding a payoff table, or decision matrix, is shown below. The decision will be made among
m of alternatives, identified as A1, A2, A3……… Am There may be more than one future “state of nature” N. The
model considered here allows for n different futures. These future states of nature may not be equally likely, but
each state will have some (known or unknown) probability of occurrence Since the future must take on one of
the n values of the sum of the n values of must be 1.0. The outcome (or payoff, or benefit gained) will depend on
both the alternative chosen and the future state of nature that occurs. For example, if the alternative Ai is chosen
and state of nature Nj takes place (as it will with probability pj), the payoff will be outcome Oij A full payoff table
will contain m times n possible outcomes.
Table: Decision Matrix
States of Nature/Probability
N1 N2 ----- Nj ----- Nn
Alternative
P1 P2 ----- Pj ----- Pn
A1 O11 O12 ----- O1j ----- O1n
A2 O21 O22 ----- O2j ----- O2n
----- ----- ----- ----- ----- ----- -----
Ai Oil Oi2 ----- Oij ----- Oin
----- ----- ----- ----- ----- ----- -----
Am Oml Om2 ----- Omj ----- Omn
Under condition of certainty there would be only one state of nature as the future is known with certainty. Thus
the decision matrix or payoff matrix would be as given below.
Pay off Matrix (under condition of certainty)
Alternative State of nature (pj = 1)
A1 O1
A2 O1
A3 O1
A4 O1
Am Om

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Decisions Making under Risk 10.2

In finance literature, there are various connotation of the term ‘Risk’. The most frequently used has a negative, ‘a
condition in which there is a possibility of an adverse deviation from a desired outcome’.
In a risky environment, the decision maker operates under condition of imperfect information. A manager may
understand the problem and the alternatives, but has no guarantee how each solution will work. This is a fairly
common condition under which the decision maker operates.
When new and unfamiliar problems arise, non- programmed decisions are specifically tailored to the situations at
hand. The information requirements for defining and resolving non-routine problems are typically high. Although
computer support may assist in information processing, the decision will most likely involve human judgment.
Most problems faced by higher‐level manager’s demand non-programmed decisions. This fact explains why
the demands on a manager’s conceptual skills increase as he or she moves into higher levels of managerial
responsibility.
When a manager lacks perfect information risk arises. Under a state of risk, the decision maker has incomplete
information about available alternatives but has a good idea of the probability of outcomes for each alternative.
While making decisions under a state of risk, managers must determine the probability associated with each
alternative on the basis of the available information and his experience.
In decision theory, under risk the decision maker assumes that there exist a number of possible future states of
nature as is presented in the previous table. Each has a known (or assumed) probability of occurring, and there
may not be one future state that results in the best outcome for all alternatives Examples of future states and their
probabilities are as follows:
 Weather will affect the profitability of alternative construction schedules. In this case the probabilities of rain
and of good weather can be estimated from historical data.
 Alternative economic futures (boom or bust) determine the relative profitability of conservative versus high-
risk investment strategy. In this case the assumed probabilities of different economic futures might be based
on the judgment of the experts.
Probabilities
Probabilities are mathematical expression which is used to denote the likelihood that an event or state of nature
will occur. It is expressed in decimal and varies between 0 and 1. When the probability of occurrence of an
event is 0, it denotes nil likelihood of occurrence whereas a value of 1 signifies absolute certainty – a definite
occurrence. For example, the chance that 8 would come up in a throw of a dice is 0 as there are no faces of 8 in
a dice. And the chance that a head or a tail would come up in a throw of a coin is 1 as those are the two events
possible in a throw of a coin11. A probability of 0.6 means that the event is expected to occur six times out of ten.

11
Ignoring the chance that the coin would land vertically on its edge in a throw.

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The total of the probabilities for events that can possibly occur must sum to 1.0. For example, if a tutor indicates
that the probability of a student passing an examination is 0.6 then this means that the student has a 60 per cent
chance of passing the examination. Given that the pass/fail alternatives represent an exhaustive listing of all
possible outcomes of the event, the probability of not passing the examination is 0.4. The information can be
presented in a probability distribution. A probability distribution is a list of all possible outcomes for an event and
the probability that each will occur. The probability distribution for the above illustration is as follows:
Outcome Probability
Pass examination 0.6
Do not pass examination 0.4
Total 1.0
Objective and Subjective Probabilities
Probabilities are categorised either as objective and subjective. Glyn A. Holton12 posits ‘according to objective
interpretations, probabilities are real. We may discover them by logic or estimate them through statistical
analyses. According to subjective interpretations, probabilities are human beliefs’. Objective probabilities are
either pre-defined or are arrived at from statistical inferences. This is corroborated in the works of Frank Knight
who in 1921 stated that probabilities (objective) may be obtained in two manners:
 A priori probabilities are derived from inherent symmetries, as in the throw of a die.
 Statistical probabilities are obtained through analysis of homogenous data.
As such, objective probabilities are established mathematically or compiled from historical data. Tossing a coin
and throwing a dice are examples of objective probabilities. For example, the probability of heads occurring
when tossing a coin logically must be 0.5. This can be proved by tossing the coin many times and observing the
results. And the chance of getting a 1 in a throw of dice is 1/6.
In business decisions, the probabilities (chances of a particular state of nature of happening/not happening) are
often estimated based on managerial judgement. Probabilities established in this way are known as subjective
probabilities because no two individuals will necessarily assign the same probabilities to a particular outcome.
Subjective probabilities are also known as uncertainty16 and are based on an individual’s perspectives of future
events and their impact on operations of the entity.
Two important aspects of Probability
When the weather forecaster says there is a 40% probability that it will rain today, it also implicitly means there
is a 60% probability that it will not rain. This illustrates the two basic requirements of probability:
1. The probability values assigned to each of the possible outcomes must be between 0 and 1; and
2. The probable values assigned to all of the possible outcomes must total 1.
Independent Events and Mutually Exclusive Events Independent Events
If the occurrence or non-occurrence of one event does not change the probability of the occurrence of the other
event, the two events are said to be independent.
The addition law can be used when there are two possible events and we want to know the probability that at

12
A comprehensive understanding about risk and uncertainty is presented in a conceptual paper titled ‘Defining Risk – Perspectives’ (available at
[Link]

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least one of the events will occur. In other words, for events A and B, we want to know the probability that event
A or event B or both events will occur.
Events that are independent and not mutually exclusive can have sample points in common. That is, in some
cases both A and B can occur. We need to include those cases in our calculation of the probability that at least
one of the events will occur; but we do not want to double count them because of counting them once with A’s
probability and again with B’s probability.
The union of events A and B is the event containing all the sample points belonging to A or B or both. It represents
the probability that either A or B will occur, including the probability that both will occur.
Calculating the Joint Probability of two Independent Events
The area of the overlap—the joint probability—is the probability that both events will occur. That area qualifies
to be included in the probability that either one of the events will occur, because one of the events certainly
occurs in the area of the overlap. But we want to include it once, not twice, so we subtract it from the sum of the
two events’ probabilities.
For example, if the probability of Event X occurring is 20% and the probability of Event Y occurring is 25%
and they are independent and not mutually exclusive events, the probability of both X and Y occurring is 0.20 ×
0.25, or 0.05 or 5%.
Mutually Exclusive Events
If events are mutually exclusive, it means that if one of them occurs, the other event cannot occur. Either one or
the other can occur but not both.
Solved Cases 2 (Independent Events and Mutually Exclusive Events)
In its sales forecasting, an appliance retailer develops a set of probabilities for sales in each of its product lines
for the coming year. Sales forecasts for two of these product lines are as follows:
Refrigerators: There is a 30% probability that sales of refrigerators will be ₹50,00,000; a 50% probability that
sales will be ₹75,00,000; and a 20% probability that sales will be ₹1,00,00,000.
Electric Ranges: There is a 25% probability that sales of electric ranges will be ₹20,00,000; a 55% probability
that sales will be ₹30,00,000; and a 20% probability that sales will be ₹ 50,00,000.
The forecasts for these appliances relate to sales for the following year. Therefore, the actual events (sales of
refrigerators and ranges) will both be occurring at the same time. The forecast for sales of refrigerators is not
dependent on sales of electric ranges occurring, and the forecast for sales of electric ranges is not dependent on
sales of refrigerators occurring. Thus sales of refrigerators and sales of ranges are independent of each other.
What is the probability that sales of refrigerators will be ₹75,00,000 or sales of electric ranges will be ₹30,00,000
next years? According to the above information:
(i) The probability that sales of refrigerators will be ₹75,00,000 next year is 50%.
(ii) The probability that sales of electric ranges will be ₹30,00,000 next year is 55%.
(iii) The probability that sales of refrigerators will be ₹75,00,000 and that sales of electric ranges will be
₹30,00,000 is 0.50 × 0.55, which equals 0.275 or 27.5%.
Therefore, the probability that sales of refrigerators will be ₹75,00,000 or sales of electric ranges will be ₹
30,00,000 next year or that both events will occur next year is 0.50 + 0.55 − 0.275 = 0.775 or 77.5%
In the example above, refrigerator sales of ₹75,00,000 and electric range sales of ₹ 30,00,000 are not mutually

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exclusive. In other words, it is possible for refrigerator sales to be ₹75,00,000 and for electric range sales to be ₹
30,00,000. In fact, we calculated the probability of that occurring as 27.5%.
What if instead the retailer wanted to know the probability of refrigerator sales being either ₹50,00,000 or
₹75,00,000? That makes our probability question one of mutually exclusive events. Refrigerator sales cannot be
₹50,00,000 and ₹75,00,000 at the same time.
(i) The probability that sales of refrigerators will be ₹ 50,00,000 next year is 30%.
(ii) The probability that sales of refrigerators will be ₹ 75,00,000 next year is 50%.
Therefore, the probability that sales of refrigerators will be ₹ 50,00,000 or ₹ 75,00,000 next year is 0.30 + 0.50
= 0.80 or 80%
Note: Independent events and mutually exclusive events are very different.
Two events A and B are independent if the occurrence or non-occurrence of one event does not change the
probability of the occurrence of the other event.
Two events A and B are mutually exclusive if only one of them can occur, that is, when one of them occurs, the
other event cannot occur.
Dependent Events and Conditional Probability
When there are two events, A and B, and the occurrence of B depends upon the occurrence of A, the probability
that both events will occur is the probability that the first event will occur, multiplied by the conditional probability
that the second event will occur given that the first event has already occurred.
Three Methods of Assigning Probable Values
Three methods are used to assign probable values to possible outcomes: The Classical Method, the Relative
Frequency Method, and the Subjective Method.
1. Classical Method: This method assumes that each possible outcome has an equal probability of occurring.
Thus, if there are ten possible outcomes, each outcome is assumed to have a 10% probability of occurring.
This is the method used to assign probabilities to coin tosses or dice rolls. Business decisions don’t usually
involve coin tosses or dice rolls, so the classical method is seldom used in situations of business uncertainty.
2. Relative Frequency or Objective Method: When factual information is available that can be used to
determine the probability of something occurring; the use of that information to assign probabilities is called
the relative frequency method. The information may come from a sample, analytical data, or any other
reliable source.
3. Subjective Method: This method is used when neither the classical nor the relative frequency methods can
be used because the possible outcomes are not equally likely and relative frequency da-ta is not available.
With the subjective method of assigning probabilities, we use whatever data is available and add to that
data our own experience and intuition. After considering all available information, we assign a probable
value that expresses our degree of belief that the outcome will occur. Subjective probability is personally
determined, and different people will assign different probabilities to the same event. Despite this relative
freedom in assigning probabilities, the two necessary requirements for all probabilities must nevertheless be
met:
(i) The probable value for each possible outcome must be between 0 and 1; and
(ii) All the probabilities for all the possible outcomes must total 1.
Sometimes the various methods are used in combination, such as when probabilities are determined by
combining estimates from the classical or relative frequency methods with subjective probability estimates.

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Expected Value (or Expected Return)

The concept of expected value is very important. The expected value of an action is found by multiplying the
probability of each potential outcome by its payoff. Therefore, expected value, or expected return, is a weighted
average of the possible returns, with the weights being the probabilities of occurrence. The expected value of a
discrete random variable is the weighted average of all the possible values of the random variable. The weights
are the probabilities for each of the values. The expected value is the mean value, also known as the average
value.
A weighted average can be calculated only for discrete probability distributions. It is not possible to calculate a
weighted average for a continuous probability distribution because the number of possible variables is infinite.
The general model of decision making under risk when probabilities may be assigned in an objective manner to
the states of nature is through the Expected Value criterion. In the below mentioned lines a Caselet is furnished
for conceptualisation of the model.
Solved Cases 3
Subbuji is a small vendor who is undecided on what to sell in the fairground as a fair is to be organized in ten
days. He has the option of selling tea or ice creams on a day one (16th August 2022) of the fair. He has made a
projection that selling tea would fetch him a profit of ₹300 if it rains on 16th August 2022, but if it is sunny and
humid on the day, he would not have much customers and then he would make a profit of ₹30. If he sells ice
cream his profit is much higher (₹150) if 16th August 2022 is hot and humid, but if he decides to sell ice cream
and it rains on that day then his profit would be ₹10. How would he make the decision of what to sell (tea or ice
cream) on 16th August 2022?
Solution:
Subbuji has to decide on selling tea or ice – cream on 16th August 2022. These are termed as acts. On 16th
August 2022 when these acts are to take place it can either be sunny and humid or rainy. These are called states
of nature. Subbuji’s decision (to sell tea or ice – cream) is reliant on the information he can garner on the states
of nature. The information on chance of the day being ‘sunny and humid’ or being ‘rainy’ can be got from data
of the last years. Subbuji can visit the met office and check the data of the last 200 years13. This would mean 200
data points about whether 1st June 2022 would be ‘sunny and humid’ or ‘rainy’. After collection of the data,
Subbuji finds that out of 200 days (past data) it rained for 30 days. From this he can infer that the probability of
rain on 16th August 2022 as 0.15 (30/200). And the probability of the day being ‘sunny and humid’ is 0.85 (1 –
0.15). Once Subbuji has got this information about the state of nature he can frame the expected pay off matrix
and take his decision based on expected value criterion.

States of Nature
Probability of Occurrence Hot and Humid Rainy
0.85 0.15
Sell Tea 30 300
Acts
Sell Ice-Cream 150 10
The 2×2 Matrix (for expected value14 calculation)

13
Any number of years is possible. And it is to be noted that greater the data, higher is the accuracy of statistical inference. But collection of more data
involves more cost. Thus it is to be noted that there is a cost of information. And there is a trade-off between more data and more cost of gathering
data.
14
Expected Value of an Opportunity (EV) is a term used to describe the expected value of a business opportunity.

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The expected value (on the basis of which the decision is to be taken) is given as
EV = ∑P(Xi) × Xi
Where P(Xi) = Probability of occurrence of event i and Xi is the payoff related to the event i
in the given case, the EV (tea) = 30 × 0.85 + 300 × 0.15 = 70.5 and
EV (ice –cream) = 150 × 0.85 + 10 × 0.15 = 129.
Since this is pay off, Subbuji would choose that act which gives the highest pay off. Thus Subbuji takes his
decision about which act to consider based on the highest expected value in case of pay off. This is only possible
if the decision maker has access to information about the probability of occurrence of the various states of nature.
Such a situation is referred as a risky situation. Information about the probability of occurrence of the state of
nature is got either through statistical inference as Subbuji did, or are priori (defined from previous like in a throw
of dice).
Other aspects of decision making under conditions of risk are discoursed in details in later section of this study
note.
However, in a very real sense risk does not always implicitly carry a negative connotation. Where investments
are concerned (both capital investments and security investments), risk is the possibility that an investment’s
actual return will differ from its expected return. This difference may be either positive or negative.
Investment Appraisal and Risk15
Condition of risk denotes situation where the decision maker have information about happening/ not happening
of an event. The decision maker denotes the likelihood of happening/ not happening of an event in terms of
probabilities. For example, a decision maker can assign 70 per cent probability that returns from a project will
be in excess of ₹1,00,000. This also means that there is a 30 per cent probability that returns will be less than
₹1,00,000.
Risk for an investment can be measured by the variability, or dispersion, of its potential returns around the mean
return. The mean return is given by the expected value of the returns. The variance and the standard deviation of
a set of potential returns are measurements of their dispersion about the mean. Thus, the risk of an investment is
measured by the variance and standard deviation of its potential returns.
In everyday usage the terms risk and uncertainty are not clearly distinguished. If one is asked for a definition,
one should not make the mistake of believing that the latter is a more extreme version of the former. It is not
a question of degree; it is a question of whether or not sufficient information is available to allow the lack of
certainty to be quantified.
Such type of environment is very sure and certain by its nature. This means that all the information is available
and at hand. Such data is also easy to attain and not very expensive to gather.
So the manager has all the information he may need to make an informed and well thought out decision. All the
alternatives and their outcomes can also be analysed and then the manager chooses the best alternative.
Another way to ensure an environment of certainty is for the manager to create a closed system. This means he
will choose to only focus on some of the alternatives. He will get all the available information with respect to
such alternatives he is analysing. He will ignore the other factors for which the information is not available. Such
factors become irrelevant to him altogether.
15
This aspect is discoursed in details in Module 2 of Paper 14. For comprehensive understanding of the topic, students may look into the said module.

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Standard Deviation and Variance as a Measure of Risk

The variance and standard deviation both give an idea of the variability of the possible values about the mean.
The variance and the standard deviation measure how far from the mean (the expected value) the various possible
values lie. The variance is used to summarize the variability in the values of a random variable. Another word for
this variability is dispersion. The amount of variability in the values of the random variable around their mean (or
average) is the amount by which they are dispersed, or the amount of their dispersion. The amount of dispersion
is important because it is a measurement of risk. The greater the dispersion of the values around their mean, the
greater the risk associated with the values because there is a larger chance that the actual results will be different
from the expected value. If the values are highly dispersed about their mean, then they vary widely from their
expected value.

The variance of a population is represented by σ2 (sigma squared). The variance is the sum of the squares of all
the differences or deviations from the mean (average), weighted according to their probabilities. The difference
from the mean of each result is important because it indicates the distance that particular measurement is from its
expected value. The variance is actually a weighted average of the squared deviations. The standard deviation is
the positive square root of the variance. It is represented by σ (sigma).

Variation within the possible cash flows for each project is also important because a project with a high variability
of cash flows has more risk than a project for which all the possible cash flows are close together.

The standard deviation of the probability distribution of these subjectively determined potential cash flows
expresses the dispersion, or variability, of possible returns around the expected return. If the standard deviation
is large, it means the variability of returns is large and the risk of the project is higher. Thus, standard deviation is
a measure of risk. By expressing differences from the expected return in terms of numbers of standard deviations
from the mean (expected return), we can state the probability that the actual return will fall within an interval
relative to the mean, or expected return. The greater the standard deviation, the greater is the potential for loss
or gain.

Standard deviation is always expressed in the same units as the distribution. Thus, if the distribution is a
distribution of annual rates of return on an investment, the returns and the standard deviation of the returns
are both expressed as annual percentages. If the distribution is a distribution of annual cash flows in units of
currency, both the cash flows and the standard deviation of the cash flows will be expressed as currency amounts.

The variance and standard deviation of each of the expected cash flows is calculated in the same way as the
variance and standard deviation. The narrower the distribution of the data, the lower the standard deviation
will be. The lower the standard deviation, the lower the risk. The wider the distribution of data, the higher the
standard deviation and the higher the risk. Standard deviation is a measure of the dispersion of a probability
distribution and thus a measure of the riskiness of a project.

Again coefficient variation also measures the risk. Coefficient of variation is the relative measure of dispersion.
It measures the standard deviation relative to the mean in percentages. The coefficient of variation is calculated
simply by dividing the standard deviation by the expected return (or mean):

Standard Deviation of Return

Coefficient of variation =
Expected Return

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For example, assume that investment in financial instrument A has an expected return of 20% and a standard
deviation of 15%, whereas investment in financial instrument B has an expected return of 25% and a standard
deviation of 20%. The coefficients of variation for the two investments will be:
Standard Deviation of Return 15%
Coefficient of variation (A) = = = 0.75
Expected Return 20%
Standard Deviation of Return 20%
Coefficient of variation (B) = = = 0.80
Expected Return 25%
The interpretation of these results would be that investment in financial instrument A is less risky, as the coefficient
of variation of the investment is lower. Another test statistic relating to dispersion is the standard error which is a
measure often confused with standard deviation. Standard error is the measure of variability of a sample, used as
an estimate of the variability of the population from which the sample is drawn. When we calculate the sample
mean, we are usually interested not in the mean of this particular sample, but in the mean of the population from
which the sample comes. The sample mean will vary from sample to sample and the way this variation occurs is
described by the ‘sampling distribution’ of the mean. We can estimate how much a sample mean will vary from
the standard deviation of the sampling distribution. This is called the standard error (SE) of the estimate of the
mean.

Illustration 1

We are comparing two investment projects. Both have expected returns of 20%, but the standard deviation of
Project A’s returns is 15%, while the standard deviation of Project B’s returns is 9%. Which one is relatively
riskier?

Solution:

CV of Project A = 0.15 ÷ 0.20 = 0.75

CV of Project B = 0.09 ÷ 0.20 = 0.45

Because it has a higher Coefficient of Variation (CV), Project A is the relatively riskier project.

Illustration 2

Two investments have different expected returns. Project A’s expected return is 20% and the standard deviation
of its returns is 15%. Project B’s expected return is only 10%, while the standard deviation of its returns remains
at 9%. Which project is relatively riskier?

Solution:

CV of Project A = 0.15 ÷ 0.20 = 0.75

CV of Project B = 0.09 ÷ 0.10 = 0.90

Because Project B’s expected return has decreased from 20% to 10%, as compared to example 1, above Project
B’s coefficient of variation has increased from 0.45 to 0.90. Therefore, Project B is now the relatively riskier
project.

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Illustration 3
You are required to select from the following two Projects, which are mutually exclusive:
Project X:
Estimated Net Cash Flows (₹) Probability
2,000 0.3
3,000 0.4
4,000 0.3
Project Y:
1,000 0.2
2,000 0.2
3,000 0.2
4,000 0.2
5,000 0.2
The Expected value of both the Projects = ₹3,000
Solution:
Since, Expected Value of both the Projects are same, hence, we are required to compute Standard Deviation and
Co-efficient of Variations of both the Projects:
Computation of SD of Project X
Cash Flow(X) Probability (p) EV (Xp) X- X̅ p (X- X̅)2
₹ ₹ Variance ₹
2,000 0.3 600 -1,000 3,00,000
3,000 0.4 1,200 0 0
4,000 0.3 1,200 +1,000 3,00,000
EV X̅ = 3,000 6,00,000
SD of Project X = ₹ 775 √ p(X - X̅)2 )
)
√p(Y - Ῡ) )
)
On the basis of similar calculations, the SD of Project Y = ₹ 1,414. 2

Decision:
Project X is selected, since SD is less, having less variability.
We can also calculate Co-efficient of Variation (CV):
Project X = (SD ÷ Mean) × 100 = (₹ 775 ÷ ₹ 3,000) × 100 = 25.83 %
Project Y = ₹ 1,414 ÷ 3,000 = 47.13 %.
Decision:
Project X is selected, since its CV is less.

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Expected Value in Estimating Future Cash Flows

Expected value is a term that means a weighted average of the possible values using the probabilities as the
weights. Any time the word “expected” is used in the context of an “expected value” or an “expected cash flow,”
it refers to the idea of calculating a weighted average of the possible values using the probability of each value
as its weight.
Estimating, or projecting, future cash flows are an important application of expected value. It is used in capital
budgeting analysis for evaluating potential projects. It is important to know how to calculate estimated future
cash flows from a potential project for use in a capital budgeting analysis.
A budgeted amount of future cash flow is often thought of as an absolute number. Unfortunately, though, future
cash flows cannot be accurately ascertained because there are many events that can affect a project’s net cash
flows. Every project has numerous possible future cash flows. A project has a range of estimated cash flows that
reflect different possibilities that management can foresee.
In determining the various possible cash flows, management must:
1) To determine which influences have affected the net cash flows of similar projects in the past, such as
economic conditions, labour conditions, or international conditions, and then
2) To make assumptions about each of those events and the manner in which those events might affect the
project. For instance, if a recession is expected, management might assume that demand for the project’s
product will be below normal.
3) Once these specific assumptions have been formulated, the management accountant then estimates the
impact that each assumption could have on the net cash flow in each year of the project’s life. The manager
develops several possible cash flow levels for each year, along with probabilities of each cash flow level
occurring. This will be a discrete probability distribution (not a continuous one), and the probabilities for
each year will all sum to 1 or 100%.
4) The management accountant will then calculate the expected value for the net cash flow for each year of the
project’s life by calculating the weighted average of all the possible cash flows for each year.
5) These calculated expected values of future cash flows will be the cash flows used in the capital budgeting
analysis for each year.
Approaches have been developed to choose the best option when the decision maker has several alternatives and
there is uncertainty with respect to future events.
Decision Models

Let us consider the case of a manufacturing company, which is interested in increasing its production to meet the
increasing market demand. The following steps are required to be considered in the context of Decision Model:

Step I. To determine all possible alternatives

The first obvious step involved before making a rational decision is to list all the viable alternatives available in
a particular situation. The following options are available to the manufacturer:

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(a) To expand the existing manufacturing facilities (Expansion);

(b) To setup a new plant (New facilities);

(c) To engage other manufacturers to produce for him as much as is the extra demand (Sub- contracting).

Step II. To identify the future scenario

It is very difficult to identify the exact events that may occur in future. However, it is possible to list all that
can happen. The future events are not under the control of the decision-maker. In decision theory, identifying
the future events is called the state of nature. In the case which we have taken of a particular manufacturing
company, we can identify the following future events:

(a) Demand continues to increase (High demand)

(b) Moderate demand

(c) Demand starts coming down (Low demand)

(d) The product does not remain in demand (No demand).

Step III. To prepare a pay-off table

The decision-maker has to now find out possible payoffs, in terms of profits, if any, of the possible events taking
place in future. Putting all the alternatives together (Step I) in relation to the state of nature (Step II) gives the
payoff table. Let us prepare the payoff table for our manufacturing company.

State of nature
High Demand Moderate Demand Low Demand No Demand
Expansion 1 2 3 4
New Facilities 5 6 7 8
Sub-Contact 9 10 11 12
Pay-off Table
If expansion is carried out and the demand continues to be high (one of the 12 alternatives), the payoff is going to
be maximum in terms of profit of say ₹ X. However, if expansion is carried out and there is no demand (situation
4), the company will suffer a loss.
Step IV. Selecting the best alternative
The decision-maker will, of course, select the best course of action in terms of payoff. However, it must be
understood that the decision may not be based on purely quantitative payoff in terms of profit alone, the decision-
maker may consider other qualitative aspects like the goodwill generated which can be encashed in future,
increasing market share with an eye on specially designed pricing policy which ultimately gives profits to the
company, etc.

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Decision Making with Probabilities

If a decision maker can estimate the probabilities of the future events, these should be incorporated into the
decision model. In the steps in constructing payoff tables or decision trees, probabilities are used in determining
payoffs. A common approach to decision making under uncertainty is the expected value criterion. The expected
value (EV) of a decision alternative is calculated as follows:

EV (alternative) = (probability of first state of nature) × (outcome of that state of nature) + (probability of second
state of nature) × (outcome of the second state of nature) + . . . for all states of nature.

In essence, the EV represents a weighted average of the outcomes, using probabilities as weights. The alternative
selected is the one with the highest EV for maximization problems and the lowest EV for minimization problems.

Illustration 4

Building Ltd. owns land in Noida and intends to build a condominium development on the site. The company is
deciding on whether to build a small, medium or large development. Demand is uncertain and fluctuates; demand
could be low, medium or high. Management at Building Ltd. has determined profit payoffs will be:

Demand (all amounts in ₹ 000s)
Alternatives Low Medium High
Small D1 1,400 1,400 1,400
Medium D2 1,100 1,600 1,600
Large D3 (1,300) 1,200 2,100
Management has determined the probabilities of demand to be:

Low = P (low) = 0.20

Medium = P (medium) = 0.35

High = P (high) = 0.45

Solution:

The expected value of each alternative is calculated as:

Alternatives:

Small EV = 0.2(1400) + 0.35(1400) + 0.45(1400) = ₹ 1,400

Medium EV = 0.2(1100) + 0.35(1600) + 0.45(1600) = ₹1,500

Large EV = 0.2(-1300) + 0.35(1200) + 0.45(2100) = ₹ 1,105

Conclusion

Using the expected value criterion and absent of any qualitative considerations, the best alternative is to build a
medium condominium complex as this provides the highest expected value.

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Illustration 5

The following information is available for a Company:

Sales Volume (units) Probability (%)

10,000 10

12,000 15

14,000 25

16,000 30

18,000 20

Projected sales and costs are as under:

Sales Price per unit: ₹ 6; Variable Cost per unit: ₹ 3.50; Fixed Costs: ₹ 34,000

Required:

(i) Probability that the Company will at least Break-even

(ii) Probability that the Profit will be at least ₹ 10,000.

Solution:

(i) Contribution per unit = ₹ 2.50 (₹ 6 - ₹ 3.50)

BEP (units) = Total Fixed Costs ÷ Contribution per unit = ₹ 34,000 ÷ ₹ 2.50 = 13,600 units.

The probability that at least Break-even = 0.25 + 0.30 + 0.20 = 0.75 = 75%.

(ii) The Profit will be at least ₹ 10,000:

Then, BEP (units) = ₹ 34,000 + ₹ 10,000 ÷ ₹ 2.50 = 17,600 units.

The required Probability = 20%

Limitations of the Expected Value Model:

 Not all future events are foreseeable and, therefore, may be omitted from the model

 The model assumes future events are independent of each other. There can be overlap between future events.

 It is difficult to accurately assess the probability of future events.

 The model ignores qualitative considerations in making a decision.

 The model ignores the decision maker’s attitude towards risk. The expected value model assumes the
decision maker is risk neutral. If the decision maker is risk seeking or risk averse, both the expected value of
the decision and its dispersion become relevant in choosing the best decision.

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Expected Value of Perfect Information (EVPI)

If we assume that an economic forecasting service is available that can reveal the future state of the economy
with absolute certainty. This service has a proprietary computer model that has never been wrong, but the service
costs ₹ 35,000. Should we purchase it?
Perfect information is knowledge about the future that would enable us to make the best choice today for any
possible situation in the future. If we knew in advance the future state of the economy, we could make a much
more informed choice between say, Project X and Project Y.
As we calculate the expected value of this perfect information, keep in mind that we do not know in advance
what the perfect information will be. In other words, we must determine what it would be worth to us to know
this perfect information before we know what we are buying.
Companies can sometimes obtain information that reduces or eliminates the uncertainty associated with the
different future events/states of nature of a problem. The EVPI refers to the maximum amount a company would
pay to obtain this information.
Formula to calculate EVPI:
EVPI = EV of best alternative with perfect information - EV of best alternative without perfect information
Illustration 6
In Illustration 4, the best alternative was to build a medium condominium complex as this resulted in the highest
expected value (EV = ₹1,500). If perfect information were available, that is, the probabilities were known with
certainty, the optimal decision strategy is:
If low demand occurs, build a small complex.
If medium demand occurs, build a medium complex.
If high demand occurs, build a large complex.
Findout EVPI.
Solution:
The expected value of this optimal decision strategy is:
0.20 (1,400) + 0.35(1,600) + 0.45(2,100) = ₹1,785
Therefore, the EVPI is:
EVPI = EV of best alternative with perfect information - EV of best alternative without perfect information
= ₹1,785 - ₹1,500 = ₹ 285
Limitations of EVPI
Perfect information is rarely, if ever, available. When determining whether to obtain additional information, the
decision maker must weigh the additional expected value arising from perfect information against the costs of
obtaining this information.
Pay-off tables
Pay-off tables identify and record all possible outcomes (or pay-offs) in situations where the action taken affects
the outcomes.

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Illustration 7
ABC Company Co is trying to set the sales price for one of its products. Three prices are under consideration,
and expected sales volumes and costs are as follows.
Price per unit ₹4 ₹4.30 ₹4.40
Expected sales volume (units)
Best possible 16,000 14,000 12,500
Most likely 14,000 12,500 12,000
Worst possible 10,000 8,000 6,000
Fixed costs are ₹ 20,000 and variable costs of sales are ₹ 2 per unit.
Which price should be chosen?
Solution:
Here we need to prepare a pay-off table showing pay-offs (contribution) dependent on different levels of demand
and different selling prices.
A. Price per unit ₹4 ₹4.30 ₹4.40
B. Contribution per unit (A - ₹2) ₹2 ₹2.30 ₹2.40
C. Total contribution towards fixed costs (₹) (B × units):
Best possible 32,000 32,200 30,000
Most likely 28,000 28,750 28,800
Worst possible 20,000 18,400 14,400
(a) The highest contribution based on most likely sales volume would be at a price of ₹4.40 but arguably a price
of ₹4.30 would be much better than ₹4.40, since the most likely profit is almost as good, the worst possible
profit is not as bad, and the best possible profit is better.
(b) However, only a price of ₹4 guarantees that the company would not make a loss, even if the worst possible
outcome occurs. (Fixed costs of ₹20,000 would just be covered.) A risk averse management might therefore
prefer a price of ₹4 to either of the other two prices.

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Decision Making under Uncertainty 10.3

I
n the absence of homogenous data, neither priori probabilities nor statistical inferences can be used to
define an opinion about a data set. Frank Knight (1921) used the term ‘measureable uncertainty’ to describe
opinions based on probabilities. On the other, he used the term ‘unmeasurable uncertainty’ to describe
opinions based on human judgements16. In simple terms, situations where objectives probabilities cannot
be assigned to the states of the nature as no prior information is available gives rise to the condition of decision
making under uncertainty.
Uncertainty, in common parlance, is a state of not knowing whether a proposition is true or false. Suppose Mr
ASA went to a casino. There the dealer is about to roll a dice. If the result is a six, Mr ASA is going to lose `100.
What is Mr ASA’s risk? What, is the subjective opinion (subjective probability) that Mr ASA will lose `100?
It may seem to be one chance in six (which is a general answer). But it is not known from previous how may sides
the dice have. The information that the die is 10 sided one changes the perspective about probability of throwing
a six. This example illustrates how one can be uncertain but not realize it. To clarify, an individual is uncertain
of a proposition if she
 does not know it to be true or false or
 is oblivious to the proposition.
Probability is often used as a metric of uncertainty, but its usefulness is limited. At best, probability quantifies
perceived uncertainty.
A decision problem, where a decision-maker is aware of various possible states of nature but has insufficient
information to assign any probabilities of occurrence to them, is termed as decision-making under uncertainty. A
decision under uncertainty is when there are many unknowns and no possibility of knowing what could occur in
the future to alter the outcome of a decision.
The decision maker feels the uncertainty about a situation when he can’t predict with complete confidence what
the outcomes of the actions will be. The decision maker experiences uncertainty about a specific question when
he can’t give a single answer with complete confidence.
Launching a new product, a major change in marketing strategy or opening the first branch could be influenced
by such factors as the reaction of competitors, new competitors, technological changes, changes in customer
16
The famous definition of Frank Knight (1921) reads; ‘to preserve the distinction . . . between the measurable uncertainty and an unmeasurable
one we may use the term “risk” to designate the former and the term “uncertainty” for the latter’. This statement is Knight’s famous definition of
risk. Risk relates to objective probabilities. Uncertainty relates to subjective probabilities. (available at [Link]
uploads/papers/[Link])

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demand, economic shifts, government legislation and a multitude of conditions which are beyond the control
of the decision maker. These are the type of decisions facing the senior executives of large corporations who
commits huge resources often on gut feeling.
A situation of uncertainty arises when there are more than one possible consequences of selecting any course of
action.
Decision making under uncertainty, as under risk, involves alternative actions whose payoffs depend on the states
of nature. Specifically, the payoff matrix of a decision problem with m alternative actions and n states of nature
can be represented by a m × n matrix, as follows;

s1 s2 s3 …… sn
a1 p (a1, s1) p (a1, s2) p (a1, s3) p (a1, sn)
a2 p (a2, s1) p (a2, s2) p (a2, s3) p (a2, sn)
a3 p (a3, s1) p (a3, s2) p (a3, s3) p (a3, sn)
.
.
.
am p (am, s1) p (am, s2) p (am, s3) p (am, sn)

The element ai represents action i and the element sj represents state of nature j. The payoff or outcome associated
with action ai and state sj is p(ai, sj). In decision making under uncertainty, the probability distribution associated
with the states sj, j = 1, 2, c, n, is unknown as it cannot be determined. This absence of information has led to the
development of some special decision criteria which may be categorised as
1. Maximin (Minimax)
2. Laplace
3. Savage
4. Hurwicz
Each of the above are discussed briefly with illustration
1. The Minimax (Maximin) Criterion
The maximin (minimax) criterion is based on the conservative attitude of making the best of the worst-possible
conditions). The logic is simple. The decision maker would zero upon such a decision which will give him
optimum results under the given condition.
If p(ai, sj) is loss or cost , then selection of an action is made on the basis of minimax criterion as the objective
would be to minimise loss or cost (as the payoff denotes loss or cost)
On the contrary, If p(ai, sj) is profit or revenue , then selection of an action is made on the basis of maximin
criterion as the objective would be to maximise profit or revenue (as the payoff denotes profit or revenue).
2. The Laplace Criterion
This is based on the principle of insufficient reason. The simple argument is that because the probability
distributions are not known, there is no reason to believe that the probabilities associated with the states of
nature are different. The alternatives are thus evaluated on the basis of the assumption that all states of nature are

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equally likely to occur. Given that the payoff p(ai, sj) represents gain, the best alternative is the one that yields the
maximum expected value (using equal probability). And in situation payoff p(ai, sj) represents loss the minimum
value represents the best alternative.
3. The Savage Criterion
Under this rule, the degree of conservatism in the minimax (maximin) is moderated by replacing the (gain or
loss) payoff matrix p(ai, sj) with a loss (or regret) matrix, r(ai, sj). The following illustration is given as to why the
transformation is suggested and how it is undertaken. This is also known as minimax regret criterion.
The following loss matrix is noted from a particular decision problem. The p(ai, sj), where the payoff is loss, is
given as

s1 s2
a1 ` 11,000 ` 90
a2 ` 10,000 ` 10,000
Since the payoff matrix represents cost, Minimax criterion is to be applied on the basis of the conservative
principle. Thus maximum values of each row is considered and the minimum of them is considered and the
action representing the minimax value is the best decision.

s1 s2 Row Max
a1 ` 11,000 ` 90 ` 11,000
a2 ` 10,000 ` 10,000 ` 10,000  Minimax
The application of the minimax criterion shows that a2, with a definite loss of `10,000, is the preferred alternative.
However, it may be better to choose a1 because there is a chance of limiting the loss to `90 given that s2 occurs.
This is the situation which is posited by the Savage rule. Transforming the above payoff matrix into a regret
would be helpful to moderate the degree of conservatism. Transforming the above payoff into a regret matrix,
the following is derived at. The regret is arrived at deducting the minimum value of a column from all the values
of that column. This is on the basis of the opportunity cost principle.

s1 s2 Row Max
a1 ` 1,000 `0 ` 1,000  Minimax
a2 `0 ` 9,910 ` 9,910
4. The Hurwicz Criterion
The minimax and the maximin criteria, discussed above, assumes that the decision-maker is either optimistic
or pessimistic. These are, as such, two extreme cases and a more realistic approach would be to consider the
degree of optimism or pessimism of the decision-maker. The Hurwicz criterion, is designed to represent different
decision-making attitudes, ranging from the most liberal (optimistic) to the most conservative (pessimistic). This
is also referred as condition of equal likelihood.
One parameter α is used as the index of optimism. If α = 0, then the criterion reduces to conservative minimax
criterion, on the basis of the best of the worst conditions. If α = 1, then the criterion is generous because it is based
on the underlying assumption of the best of the best conditions. The degree of optimism (or pessimism) can be
adjusted by selecting a value of a between 0 and 1. In the absence of strong feeling regarding extreme optimism
and extreme pessimism, α = 0.5 which indicates a fair choice, neither.

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Illustration 8 (Illustration on Profit Matrix)

Given the following Payoff table of profits generated by an entity under differing condition of the future state of
nature.
States of Nature
Alternatives
S1 S2 S3 S4
A1 3 5 8 -1
A2 6 5 2 0
A3 0 5 6 4
State which can be chosen as the best act using:
(a) Maximax,
(b) Maximin,
(c) Minimax regret (Savage criterion),
(d) Equal likelihood (Laplace criterion),
(e) Hurwicz Alpha criterion α=0.4
Solution:
a) Maximax:
Max (Max Ai) = Max (8, 6, 6) = 8
Decision:
Select A1
b) Maximin:
Max (Min Ai) =Max (-1, 0 ,0) =0
Decision: Select A2 or A3
c) Savage Criterion (Minimax regret)
i. Formulation of the regret table17
The Regret Table

States of Nature
Alternatives
S1 S2 S3 S4
A1 -3 0 0 -5
A2 0 0 -6 -4
A3 -6 0 -2 0
ii. The negative signs are dropped as the table represents loss (regret) matrix while the original matrix is a
profit matrix.
17
Subtracting the maximum (since the problem refers to minimax regret) of each column from each element of that particular column.

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The Regret Table

States of Nature
Alternatives
S1 S2 S3 S4
A1 3 0 0 5
A2 0 0 6 4
A3 6 0 2 0
iii. Min (Max Ai) = Min (5, 6, 6) = 5
Decision: Select A1
d) Laplace: Under this condition, the associated probabilities are considered to be equal for each state of nature
i.e., 1/4 (as there are four states of nature).
Expected pay-offs are :

States of Nature
Alternatives Expected Value = Payoff × Probabilities
S1 S2 S3 S4
[EV= ∑P(Xi) × Xi]
0.2518 0.25 0.25 0.25
A1 3 5 8 -1 3.75
A2 6 5 2 0 3.25
A3 0 5 6 4 3.75
From the above calculation of expected value, it is noted that A1 and A3 has the maximum expected pay-off.

Decision: Select A1 or A2

e) The Hurwicz Criterion19

D = α (Maximum in Ai) + (1 – α) (Minimum in Ai) [α = 0.4]

D(A1) = (0.4 × 8) + (0.6×-1) = 2.6

D(A2) = (0.4 × 6) +(0.6 × 0) = 2.4

D(A3) = (0.4 × 6) + (0.6 × 0) = 2.4

D(A1) has the maximum Expected Value.

Decision: Select A1

18
These are the assumed probabilities, which is the fundamental assumption in the Laplace criterion
19
It is important to note that α is a parameter of optimism. If α = 0, then the criterion reduces to conservative minimax criterion which seeks the best of
the worst conditions. If α = 1, then the criterion is generous because it seeks the best of the best conditions. The degree of optimism (or pessimism)
can be adjusted by selecting a α value between 0 and 1. From this point of view, the formula for D (expected value) would reverse if the problem
is profit maximisation or cost minimisation.

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Illustration 920 (Illustration on Cost Matrix)

Julien Point School (JPS) is preparing a summer camp in the jungles of Bagora, District of Darjeeling to train
individuals in wilderness survival. JPS estimates that attendance can fall into one of four categories: 200, 250,
300, and 350 persons. The cost of the camp will be the smallest when its size meets the demand exactly. Deviations
above or below the ideal demand levels incur additional costs resulting from constructing more capacity than
needed or losing income opportunities when the demand is not met. Letting a1 to a4 represent the sizes of the
camp (200, 250, 300, and 350 persons) and s1 to s4 the level of attendance, the following table summarizes the
cost matrix (in thousands of Rupees) for the situation:

s1 s2 s3 s4
a1 5 10 18 25
a2 8 7 12 23
a3 21 18 12 21
a4 30 22 19 15

State the best alternative using: (i) Minimax, (ii) Laplace, (iii) Savage Criterion (Minimax Regret), (iv) Hurwicz
Criterion.
Solution:
The problem is analyzed using the following:
i. The Minimax Criterion

s1 s2 s3 s4 Row Max
a1 5 10 18 25 25
a2 8 7 12 23 23
a3 21 18 12 21 21  Minimax
a4 30 22 19 15 30

ii. The Laplace Criterion

Assume equal probabilities (1/4) as there are four states of nature.

s1 s2 s3 s4 EV= ∑P(Xi) × Xi Figures in ` thousand

a1 5 10 18 25 1/4 (5+10+18+25)=14.5 ` 14,500

a2 8 7 12 23 1/4 (8+7+12+23) =12.5 ` 12,500

a3 21 18 12 21 1/4 (21+18+12+21) =18.0 ` 18,000

a4 30 22 19 15 1/4 (30+22+19+15) =21.5 ` 21,500

Since it is a cost minimisation problem, decision a2 would be selected which implicates the lowest cost of
`12,500.
20
Adopted from Chapter 15, Decision Analysis and Games (Operations Research - An Introduction, Tenth Edition, by Hamdy A. Taha)

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iii. The Savage Criterion

This criterion posits the formulation of a regret matrix. The regret matrix is determined by subtracting 5, 7, 12,
and 15 from columns 1 to 4, respectively, and so the following regret matrix is obtained.

s1 s2 s3 s4 Row Max
a1 0 3 6 10 10
a2 3 0 0 8 8  Minimax
a3 16 11 0 6 16
a4 25 15 7 0 25

[Link] Hurwicz Criterion19

The following table summarizes the computation

Alternative Row Min Row Max α (Row Min) + (1-α) (Row Max)
a1 5 25 25 -20α21
a2 7 23 23 -16α
a3 12 21 21 - 9α
a4 15 30 30 -15α

The decision maker will have to decide upon the appropriate α, and thus he can decide upon the optimum
alternative.

21
α(5) + (1-α)(25) = α5+ 25 -25α = 25 -20α, and so forth (for the remaining values in the column).

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Decision Tree 10.4

A
decision tree shows a complete picture of a potential decision and allows a manager to graph alternative
decision paths. Decision trees are a useful way to analyse hiring, marketing, investments, equipment
purchases, pricing, and similar decisions that involve a progression of smaller decisions. Generally,
decision trees are used to evaluate decisions under conditions of risk. Decision making is the core
function of management. New tools for analysis that aid decision making are being developed. One such tool is
the decision tree. It is essentially a visual graph that uses the branching method to map every possible outcome
of a particular decision.
The term decision tree comes from the graphic appearance of the technique that starts with the initial decision
shown as the base. The various alternatives, based upon possible future environmental conditions, and the payoffs
associated with each of the decisions branch from the trunk.
Decision trees force a manager to be explicit in analysing conditions associated with future decisions and in
determining the outcome of different alternatives. The decision tree is a flexible method. It can be used for many
situations in which emphasis can be placed on sequential decisions, the probability of various conditions, or the
highlighting of alternatives.
Decision trees are diagrams which illustrate the choices and possible outcomes of a decision. A decision tree is
a pictorial method of showing a sequence of interrelated decisions and their expected outcomes. Decision trees
can incorporate both the probabilities of, and values of, expected outcomes, and are used in decision-making.
More complex probability questions, although solvable using the basic principles, require a clear logical approach
to ensure that all possible choices and outcomes of a decision are taken into consideration.
Decision trees are a useful means of interpreting such probability problems.
Merits of Decision Trees
 All the possible choices that can be made are shown as branches on the tree.
 All the possible outcomes of each choice are shown as subsidiary branches on the tree.
Constructing a decision tree
There are two stages in preparing a decision tree.
 Drawing the tree itself to show all the choices and outcomes
 Putting in the numbers (the probabilities, outcome values and EVs)
Every decision tree starts from a decision point with the decision options that are currently being considered.
(a) It helps to identify the decision point, and any subsequent decision points in the tree, with a symbol. Here,
we shall use a square shape.

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(b) There should be a line, or branch, for each option or alternative.

It is conventional to draw decision trees from left to right, and so a decision tree will start as follows:
A

B
Decision
Point
C

Figure 10.1 : Conventional decision tree

The square is the decision point, and A, B, C and D represents four alternatives from which a choice must be
made (such as buy a new machine with cash, hire a machine, continue to use existing machine, raise a loan to
buy a machine).
If the outcome from any choice is certain, the branch of the decision tree for that alternative is complete.
If the outcome of a particular choice is uncertain, the various possible outcomes must be shown.
We show the various possible outcomes on a decision tree by inserting an outcome point on the branch of the tree.
Each possible outcome is then shown as a subsidiary branch, coming out from the outcome point. The probability
of each outcome occurring should be written on to the branch of the tree which represents that outcome.
To distinguish decision points from outcome points, a circle will be used as the symbol for an outcome point.
A
Decision 0.6 High Sales
Point
B Outcome
Point
0.4 Low Sales

Figure 10.2 : Decision points and Outcome points

It is assumed that, there are two choices facing the decision-maker, A and B. The outcome if A is chosen is known
with certainty, but if B is chosen, there are two possible outcomes, high sales (0.6 probability) or low sales (0.4
probability).
When several outcomes are possible, it is usually simpler to show two or more stages of outcome points on the
decision tree.
Illustration 10
Several possible outcomes
A company can choose to launch a new product XYZ or not. If the product is launched, expected sales and
expected unit costs might be as follows:
Sales Unit costs
Units Probability ₹ Probability
10,000 0.8 6 0.7
15,000 0.2 8 0.3

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a) The decision tree could be drawn as follows: Cost 6

Sales 10,000 0.7
0.8 Cost 8
0.3
Launch
Cost 6
Sales 15,000 0.7
Don’t launch 0.2 Cost 8
0.3

Figure 10.3 : Drawing of Decision tree

(b) The layout shown above will usually be easier to use than the alternative way of drawing the tree, which is
as follows:
Sales 10,000 Cost 6
0.56 (0.8 × 0.7)
Sales 10,000 Cost 8
Launch 0.24 (0.8 × 0.3)
Sales 15,000 Cost 6
0.14 (0.2 × 0.7)
Sales 15,000 Cost 8
0.06 (0.2 × 0.3)

Don’t Launch

Figure 10.4 : Alternative way of drawing the Decision tree

Sometimes, a decision taken now will lead to other decisions to be taken in the future. When this situation arises,
the decision tree can be drawn as a two-stage tree, as follows:
Decision A
0.7
Decision B
Decision C
nX
isio
Dec Decision D
0.3
Decision
Y

Figure 10.5 :Two-stage Decision tree

In this tree, either a choice between A and B or else a choice between C and D will be made, depending on the
outcome which occurs after choosing X.

The decision tree should be in chronological order from left to right. When there are two-stage decision trees, the
first decision in time should be drawn on the left.

Illustration 11 (Example of Decision Tree)

LT Ltd. owns land in Bangalore and intends to build a project development on the site. The company is deciding
on whether to build a small, medium or large development. Demand is uncertain and fluctuates; demand could
be low, medium or high. Management at LT Ltd. has determined profit payoffs will be:

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(all amounts in ₹ 000s)

Demand
Alternatives Low Medium High
Small d1 1,400 1,400 1,400
Medium d2 1,100 1,600 1,600
Large d3 (1,300) 1,200 2,100
Management has determined the probabilities of demand to be:
Low = P (low) = .20
Medium = P (medium) = .35
High = P (high) = .45
Then Decision Tree Approach can be applied as under:
Solution:
Decision Tree Approach
Payoff table in decision tree format
low
1,400 × .2 = 280
P(low) = 0.20
+
medium 1,400 × .35 = 490
small (d1) P(medium) = 0.35
+
high 1,400 × .45 = 630
P(high) = 0.45
EV = 1,400

low
1,100 × .2 = 220
P(low) = 0.20
+
medium 1,600 × .35 = 560
medium (d2) P(medium) = 0.35
+
high
1,600 × .45 = 720
P(high) = 0.45
EV = 1,500

low
(1,300) × .2 = (260)
P(low) = 0.20
+
medium 1,200 × .35 = 420
large (d3) P(medium) = 0.35
+
high 2,100 × .45 = 945
P(high) = 0.45
EV = 1,105
Figure 10.6 : Payoff table in Decision tree format
Conclusion: Build a medium complex as this alternative provides the highest expected value

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Illustration 12
B Ltd. has a new wonder product, the V, of which it expects great things. At the moment the company has two
courses of action open to it, to test market the product or abandon it.
If the company test markets it, the cost will be ₹ 1,00,000 and the market response could be positive or negative
with probabilities of 0.60 and 0.40.
If the response is positive the company could either abandon the product or market it full scale.
If it markets the V in full scale, the outcome might be low, medium or high demand, and the respective net gains/
(losses) would be (200), 200 or 1,000 in units of ₹1,000 (the result could range from a net loss of ₹ 2,00,000 to a
gain of ₹10,00,000). These outcomes have probabilities of 0.20, 0.50 and 0.30 respectively.
If the result of the test marketing is negative and the company goes ahead and markets the product, estimated
losses would be ₹ 6,00,000.
If, at any point, the company abandons the product, there would be a net gain of ₹ 50,000 from the sale of scrap.
All the financial values have been discounted to the present.
Required
(a) Draw a decision tree.
(b) Include figures for cost, loss or profit on the appropriate branches of the tree.
Solution:
The starting point for the tree is to establish what decision has to be made now. What are the options?
(a) To test market
(b) To abandon
The outcome of the ‘abandon’ option is known with certainty. There are two possible outcomes of the option to
test market, positive response and negative response.
Depending on the outcome of the test marketing, another decision will then be made, to abandon the product or
to go ahead.
High 0.3
● + 1,000
Market Medium 0.5
E ● + 200
Positive Low 0.2
C ● - 200
0.6 Abandon
● + 50
B
Test Negative Market
-100 D ● - 600
0.4 Abandon
A ● + 50

Abandon + 50
●
Figure 10.7 : Decision Making through Decision Tree Approach

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Evaluating decisions by using decision trees has a number of limitations as follows:

(a) The time value of money may not be taken into account.
(b) Decision trees are not very suitable for use in complex situations.
(c) The outcome with the highest EV may have the greatest risks attached to it. Managers may be reluctant to
take risks which may lead to losses.
(d) The probabilities associated with different branches of the ‘tree’ are likely to be estimates, and possibly
unreliable or inaccurate.
Illustration 13 (Problem on Expected Value)
TT Newsagents stocks a weekly health magazine. The owner buys the magazines for ₹ 0.30 each and sells them
at the retail price of ₹0.50 each.
At the end of the week unsold magazines are obsolete and have no value. The estimated probability distribution
for weekly demand is shown below.
Weekly demand in units Probability
20 0.20
30 0.55
40 0.25
1.00
You are required to calculate the following:
(i) What is the expected value of demand?
(ii) If the owner is to order a fixed quantity of magazines per week how many should that be?
Assume no seasonal variations in demand.
Solution
EV of demand (units per week) = (20 × 0.20) + (30 × 0.55) + (40 × 0.25) = 30.5 units per week
The next step is to set up a decision matrix of possible strategies (numbers bought) and possible demand.
The ‘pay-off’ from each combination of action and outcome is then computed.
No sale = Cost of ₹ 0.30 per magazine
Sale = Profit of ₹ 0.20 per magazine (₹0.50 - ₹ 0.30)
Probability Outcome Decision (Profit)
(Numbers demanded) (Numbers bought)
20 30 40
₹ ₹ ₹
0.20 20 4.00 1.00* (2.00)
0.55 30 4.00 6.00 3.00
0.25 40 4.00 6.00 8.00
EV 4.00 5.00** 3.25
* Buy 30 and sell only 20 gives a profit of (20 × ₹0.5) – (30 × ₹0.3) = ₹1
** (0.2 ×1) + (0.55 × 6) + (0.25 × 6) = 5

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The strategy which gives the highest expected pay-off is to stock 30 magazines each week.
Conclusion:

Probability is a numerical measurement of uncertainty. When a probability is based on counting and observed
frequencies, it is objective. When a probability is an expression of whether an event in business will or will not
occur, it may be based on the relative frequency of similar events having occurred in the past, or it may be based
on someone’s judgment. Either way, the determination of probability has strong subjective elements.

Therefore, the concept of probability as it is used in business is a numerical measure of the belief of an individual in
the occurrence or non-occurrence of an event. The probability assigned to an event depends upon the information
and knowledge that the decision-maker has and uses in assessing the probability. As such, probability assessment
is clearly subjective, individual, and dependent upon information. In fact, it has been said that probability does
not exist in any absolute or objective sense.

Thus, these statistical methods of dealing with risk and uncertainty are only means of obtaining a recommended
decision alternative or an optimal strategy for the purpose of planning, budgeting, and decision-making. The
actual results from the implementation of the decision will probably be quite different from the calculated
expected value. The decision-maker’s judgment is the deciding factor.

Illustration 14 (Problem on Probabilistic Budget)

The Profit Budget of ABC Company is given below:
Profit Budget for year ending 31st March 2022
₹
Sales (1,00,000 units @ ₹10) 10,00,000
Variable costs:
Manufacturing (₹ 5 per unit) 5,00,000
Marketing (₹0.50 per unit) 50,000 5,50,000
Contribution: 4,50,000
Fixed costs:
Manufacturing 2,00,000
Marketing 50,000
Administrative 1,00,000 3,50,000
Profit Before Tax 1,00,000
Tax (assumed at 50%) 50,000
Profit after Tax 50,000
Note: Manufacturing variable cost is:

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₹ 5.10 per unit at volume of 80,000 units

₹ 5.00 per unit at volume of 1,00,000 units
₹ 4.80 per unit at volume of 1,10,000 units
The marketing manager has given the sales forecast as follows.
Probability 0.3 - 80,000 units
Probability 0.5 - 1,00,000 units
Probability 0.2 - 1,10,000 units
The production manager has indicated the variable manufacturing cost to be as follows:
Probability 0.2 - ₹ 5.10 per unit
Probability 0.6 - ₹ 5.00 per units
Probability 0.2 - ₹ 4.80 per units
The Management Accountant is to work out the profit Budget taking the above factors into account. All other
costs are as given earlier.

Prepare a Probabilistic Budget.

Solution:
In the table below, a three-way forecast is given:
Description Pessimistic Most Likely Optimistic
₹ ₹ ₹
Sales 8,00,000 10,00,000 11,00,000
Variable Costs:
Manufacturing 4,08,000 5,00,000 5,28,000
Marketing 40,000 50,000 55,000
Contribution 3,52,000 4,50,000 5,17,000
Fixed Costs:
Manufacturing 2,00,000 2,00,000 2,00,000
Marketing 50,000 50,000 50,000
Administration 1,00,000 1,00,000 1,00,000
Profit Before Tax 2,000 1,00,000 1,67,000
Tax (assumed 50%) 1,000 50,000 83,500
Profit after Tax 1,000 50,000 83,500

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The Probabilistic Profit Budget is shown below:

Budget

Volume Variable Cost per unit PAT Joint probability (JP) PAT×JP

80,000

P = 0.3 5.10(P=0.2) 1,000 0.06 60

5.00 (P=0.6) 5,000 0.18 900

4.80 (P=0.2) 13,000 0.06 780

1,00,000

P = 0.5 5.10 (P=0.2) 45,000 0.10 4,500

5.00 (P=0.6) 50,000 0.30 15,000

4.80(P=0.2) 60,000 0.10 6,000

1,10,000

P = 0.2 5.10 (P=0.2) 67,000 0.04 2,680

5.00 (P=0.6) 72,500 0.12 8,700

4.80 (P=0.2) 83,500 0.04 3,340

EV 41,960
Thus, it can be observed that a realistic profit estimate will be ₹ 41,960 and not ₹ 50,000.

Illustration 15 (Statistical Measurements of Cash Flow Variability)

When forecasting cash flows for investment projects, we might make several sets of forecasts for each project
to reflect the various alternative states of the economy that might ensue. If we are comparing two project
proposals, both for one-year projects, we might make several forecasts for the cash flows, as follows:

Project X Project Y

₹ ₹

Economy in a deep recession 2,00,000 1,00,000

Economy in a mild recession 2,50,000 2,00,000

Economy stable 3,00,000 3,00,000

Economy in a minor expansion 3,50,000 4,00,000

Suppose economists forecast that the probability of a deep recession occurring next year is 5%, a mild recession

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is 10%, a stable economy is 50%, a minor expansion is 25%, and a major expansion is 10%. Using these
projections, we can calculate the expected value of the cash flows for both projects:

Probability Project X Project Y

(P) Cash Flow CF x P Cash Flow CF x P

₹ ₹ ₹ ₹

Economy in a deep recession 5% 2,00,000 10,000 1,00,000 5,000

Economy in a mild recession 10% 2,50,000 25,000 2,00,000 20,000

Economy stable 50% 3,00,000 1,50,000 3,00,000 1,50,000

Economy in a minor expansion 25% 3,50,000 87,500 4,00,000 1,00,000

Economy in a major expansion 10% 4,00,000 40,000 5,00,000 50,000

Expected Value 3,12,500 3,25,000

The expected value of the cash flows for each of the two projects is simply a weighted average of the possible
cash flows, with the weights being the probabilities of each occurrence. The expected value of Project Y’s cash
flows is higher than the expected value of Project X’s cash flows.

The expected value is the average value, or mean, of the possible values. According to the data above, if the same
cash flow could be repeated over and over again, 5% of the time the cash flow would be ₹ 2,00,000, 10% of the
time it would be ₹ 2,50,000, and so forth. The weighted average of these potential cash flows is the expected
value.

The problem with using expected value as a forecast for a specific project is that any given project has only one
opportunity to achieve its cash flow for its duration and then the project is complete. The cash flow actually
achieved for Project X could be anywhere from ₹ 2,00,000 to ₹ 4,00,000. Once one of the possible cash flows
has been achieved, we will know that the probability of that cash flow occurring was 100% while the probability
of the other cash flows occurring was zero.

An expected value is a “long-run” average value for a random variable. As a result, an expected value is more
reliable as a long-run average forecast and less reliable as a forecast for the net cash flow for an individual project
at any given moment in time.

Despite not being a reliable forecast, expected value is often used to project future cash flow from individual
projects because it is the best method available for obtaining a forecast.

Illustration 16

A manager is considering whether to make product X or product Y, but only one can be produced. The estimated
sales demand for each product is uncertain. A detailed investigation of the possible sales demand for each product
gives the following probability distribution of the profits for each product.

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Product X probability distribution

Outcome Estimated Probability Weighted Profit (₹)

Profits of ₹6,00,000 0.10 60,000

Profits of ₹7,00,000 0.20 1,40,000

Profits of ₹8,00,000 0.40 3,20,000

Profits of ₹9,00,000 0.20 1,80,000

Profits of ₹10,00,000 0.10 1,00,000

Expected value 8,00,000

Product Y probability distribution

Outcome Estimated probability Weighted Profit (₹)

Profits of ₹ 4,00,000 0.05 20,000

Profits of ₹ 6,00,000 0.10 60,000

Profits of ₹ 8,00,000 0.40 3,20,000

Profits of ₹ 10,00,000 0.25 2,50,000

Profits of ₹12,00,000 0.20 2,40,000

Expected value 8,90,000

Based on the information given, assumed to be perfect, the manger should make Product X, having higher
expected value.

Since decision problems exist in an uncertain environment, it is necessary to consider those uncontrollable
factors that are outside the decision-maker’s control and that may occur for alternative courses of action. These
uncontrollable factors are called events or states of nature. For example, in a product launch situation, possible
states of nature could consist of events such as a similar product being launched by a competitor at a lower price,
at the same price, at a higher price or no similar product being launched at all.

The likelihood that an event or state of nature will occur is known as its probability, and this is normally expressed
in decimal form with a value between 0 and 1. A value of 0 denotes a nil likelihood of occurrence, whereas a value
of 1 signifies absolute certainty – a definite occurrence. A probability of 0.4 means that the event is expected
to occur four times out of ten. The total of the probabilities for events that can possibly occur must sum to 1.0.

For example, if an examiner indicates that the probability of a student passing an examination is 0.7 then this
means that the student has a 60 per cent chance of passing the examination. Given that the pass/fail alternatives
represent an exhaustive listing of all possible outcomes of the event, the probability of not passing the examination
is 0.4.

The information can be presented in a probability distribution. A probability distribution is a list of all possible

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outcomes for an event and the probability that each will occur. The probability distribution for the above example
is as follows:

Outcome Probability
Pass the examination 0.6
Do not pass examination 0.4
Total 1.0
Some probabilities are known as objective probabilities because they can be established mathematically or
compiled from historical data. Tossing a coin and throwing a dice are examples of objective probabilities.
For example, the probability of heads occurring when tossing a coin logically must be 0.5. This can be proved
by tossing the coin many times and observing the results. Similarly, the probability of obtaining number 1 when
a dice is thrown is 0.166 (i.e. one-sixth). This again can be ascertained from logical reasoning or recording the
results obtained from repeated throws of the dice.
It is unlikely that objective probabilities can be established for business decisions, since many past observations
or repeated experiments for particular decisions are not possible; the probabilities will have to be estimated based
on managerial judgement. Probabilities established in this way are known as subjective probabilities because no
two individuals will necessarily assign the same probabilities to a particular outcome. Subjective probabilities
are based on an individual’s expert knowledge, past experience and observations of current variables that are
likely to have an impact on future events. Such probabilities are unlikely to be estimated correctly, but any
estimate of a future uncertain event is bound to be subject to error.
The advantage of this approach is that it provides more meaningful information than stating the most likely
outcome.

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EXERCISE
Theoretical Questions
 Multiple Choice Question
1. A type of decision-making environment is
A Certainty
B. Uncertainty
C. Risk
D. All of these
2. Which of the following criterion is not used for decision-making under uncertainty?
A. Maximin
B. Maximax
C. Minimax
D. Minimize expected loss
3. Decision theory is concerned with
A. Methods of arriving at an optimal decision
B. Selecting optimal decision in a sequential manner
C. Analysis of information that is available
D. All of these
4. Which of the following criterion is not applicable to decision-making under risk?
A. Maximize expected return
B. Maximize return
C. Minimize expect regret
D. Knowledge of likelihood occurrence of each state of nature
5. The minimum expected opportunity loss (EOL) is
A. Equal to EVPI
B. Minimum regret
C. Equal to EMV
D. Both (A) and (B)
6. The expected value of perfect information (EVPI) is
A. Equal to expected regret of the optimal decision under risk

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B. The utility of additional information

C. Maximum expected opportunity loss
D. None of the above
7. The value of the coefficient of optimism (a) is needed while using the criterion of
A. Equally likely
B. Maximin
C. Realism
D. Minimax
8. The decision-maker’s knowledge and experience may influence the decision-making process [Link]
using the criterion of
A. Maximax
B. Maximax regret
C. Realism
D. Maximin
9. The difference between the expected profit under conditions of risk and the expected profit with perfect
information is called
A. The expected value of perfect information
B. Expected marginal loss
C. None of the above
D. Any one of the above
10. A situation in which a decision maker knows all of the possible outcomes of a decision and also knows
the probability associated with each outcome is referred to as
A. Certainty.
B. Risk.
C. Uncertainty.
D. Strategy.
11. Which of the following methods of selecting a strategy is consistent with risk averting behaviour?
A. If two strategies have the same expected profit, select the one with the smaller standard deviation.
B. If two strategies have the same standard deviation, select the one with the smaller expected profit.
C. Select the strategy with the larger coefficient of variation.
D. All of the above are correct.

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12. Which one of the following does not measure risk?

A. Coefficient of variation
B. Standard deviation
C. LPP
D. All of the above are measures of risk.
13. A situation in which a decision maker must choose between strategies that have more than one possible
outcome when the probability of each outcome is unknown is referred to as
A. Diversification.
B.. Certainty.
C. Risk.
D. Uncertainty.
14. If a decision maker is risk averse, then the best strategy to select is the one that yields the
A. Highest expected payoff.
B. Lowest coefficient of variation.
C. Highest expected utility.
D. Lowest standard deviation.
15. Circumstances that influence the profitability of a decision are referred to as
A. Strategies.
B. A payoff matrix.
C. States of nature.
D. the marginal utility of money.
16. A strategy that yields an expected monetary payoff of zero is called a
A. Risk-neutral strategy.
B. Fair game.
C. Zero-sum game.
D. Certainty equivalent
17. A matrix that, for each state of nature and strategy, shows the difference between a strategy’s payoff and
the best strategy’s payoff is called
A. A maximin matrix.
B. A minimax regret matrix.
C. A payoff matrix.
D. An expected utility matrix.

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18. The sequence of possible managerial decisions and their expected outcome under each set of
circumstances can be represented and analysed by using
A. The minimax regret criterion.
B. A decision tree.
C. A payoff matrix.
D. Simulation.
19. The expected value of perfect information is calculated by subtracting:
A. The minimum expected opportunity loss from the expected opportunity loss with perfect information.
B. The maximum EMV from the minimum expected opportunity loss.
C. EVSI from the expected return with perfect information.
D. The maximum EMV from the expected return with perfect information.
20. The maximin criterion is a feature of which of the following?
A. Deterministic model
B. Decision-making under uncertainty
C. Optimization
D. Decision-making under certainty
Answer:
1- D, 2-D, 3-D, 4-B, 5-D, 6- A, 7- C, 8- C, 9- A, 10- B, 11- A, 12- C, 13- D, 14- C, 15-C, 16-B, 17-B, 18-B,
19-A, 20- B.

 State True or False

1. Decision theory provides a method for rational decision making when the consequences are not fully
known.
2. Companies benefit most from considering their risks when they are performing well and when markets
are growing in order to sustain growth and profitability.
3. A decision maker is risk neutral if he is concerned with what will be the most likely outcome.
4. The decision outcome resulting from the same information may vary from manager to manager as a
result of their individual attitude to risk.
5. “Risk” can be defined in many ways. One definition has a negative connotation: “a condition in which
there is a possibility of an adverse deviation from a desired outcome.”
6. The variance and standard deviation both give an idea of the variability of the possible values about the
mean.

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