Risk and uncertainty

Management Accounting deals with making decision about future events. The future is
uncertain and full of risks. Therefore there is the need to evaluate all the risks associated with
any decision to be taken by a management accountant.

Risk involves situations or events which may or may not occur, but whose probability of
occurrence can be calculated statistically and the frequency of their occurrence predicted
from past records. Thus insurance deals with risk.

Uncertain events are those whose outcome cannot be predicted with statistical confidence.

Risk preference

A risk seeker is a decision maker who is interested in the best outcomes no matter how small
the chance that they may occur.

A decision maker is risk neutral if he is concerned with what will be the most likely outcome.

A risk adverse decision maker acts on the assumption that the worst outcome might occur

Accountants are conservatives and prudent hence they are risk averse so the methods they use
to evaluate risk involves estimating outcomes in a conservative manner in order to provide a
built-in safety factor.

Methods of Risk Evaluation

Worst most likely, best outcome estimates

It measures risk from the following standpoints most likely outcome, best possible and worst
possible outcome.

This will show the full range of possible outcomes from a decision and might help managers
to reject certain alternatives because the worst possible outcome might involve an
unacceptable amount of loss. This requires the preparation of pay-off tables. Pay-off tables
identify and record all possible outcomes (or pay-offs) in situations where the action taken
affects the outcomes

Question 1
Omelette 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 N40 N43 N44
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 N200,000 and variable costs of sales are N20 per unit.
Which price should be chosen?

Probabilities and expected values

Expected values indicate what an outcome is likely to be in the long term with repetition.
Fortunately, many business transactions do occur over and over again.
Although the outcome of a decision may not be certain, there is some likelihood that
probabilities could be assigned to the various possible outcomes from an analysis of previous
experience
Expected values
Where probabilities are assigned to different outcomes we can evaluate the worth of a
decision as the expected value, or weighted average, of these outcomes. The principle is that
when there are a number of alternative decisions, each with a range of possible outcomes, the
optimum decision will be the one which gives the highest expected value

Question 2

Suppose a manager has to choose between mutually exclusive options A and B, and the
probable
outcomes of each option are as follows.

Option A Option B
Probability Profit Probability Profit
N N
0.10 3,000 0.10 2,000
0.20 3,500 0.25 3,000
0.40 4,000 0.30 4,000
0.20 4,500 0.25 5,000
0.10 5,000 0.10 6,000

Calculate;
Expected value

Decision rules

The 'play it safe' basis for decision making is referred to as the maximin basis. This is short
for
'maximise the minimum achievable profit'.
.A basis for making decisions by looking for the best outcome is known as the maximax
basis, short for 'maximise the maximum achievable profit' .The ‘opportunity loss’ basis
for decision making is known as minimax regret.
Maximax
The maximax criterion looks at the best possible results. Maximax means 'maximise the
maximum
profit'.

Question 3
Suppose a businessman is trying to decide which of three mutually exclusive projects to
undertake. Each of the projects could lead to varying net profit under three possible scenarios.

Profit
Project
D E F
I 100 80 60
Scenarios II 90 120 85
III (20) 10 85

Maximax rule is followed.

Solution

The maximum profit for D is 100, for E is 120 and for F is 85. Project E would be chosen if
the maximax rule is followed.

Criticisms of maximax
(a) It ignores probabilities.
(b) It is over-optimistic

The maximin decision rule

The maximin decision rule suggests that a decision maker should select the alternative that
offers the least unattractive worst outcome. This would mean choosing the alternative that
maximises the minimum profits.

Solution
The maximin decision rule suggests that he should select the 'smallest worst result' that could
happen. This is the decision criterion that managers should 'play safe' and either minimise
their losses or costs, or else go for the decision which gives the higher minimum profits. If he
selects project D the worst result is a loss of 20. The worst results for E and F are profits of
10 and 60 respectively. The best worst outcome is 60 and project F would therefore be
selected (because this is a better 'worst possible' than either D or E).

Minimax regret rule

The minimax regret rule aims to minimise the regret from making the wrong decision.
Regret is the
opportunity lost through making the wrong decision.

We first consider the extreme to which we might come to regret an action we had chosen.

Regret for any combination of action and circumstances = Profit for best action in those
Circumstances – Profit for the action actually chosen in those circumstances

The minimax regret decision rule is that the decision option selected should be the one which
minimisesthe maximum potential regret for any of the possible outcomes.
Using the example in Section 4.1, a table of regrets can be compiled as follows.

Project
D E F
1 0 20* 40**
Scenario II 30*** 0 35
III 105 75 0
Maximum regret 105 75 40

* 100 – 80 ** 100 – 60 *** 120 – 90

The lowest of maximum regrets is 40 with project F so project F would be selected if the
minimax regret rule is used. * 100 – 80 ** 100 – 60 *** 120 – 90
The lowest of maximum regrets is 40 with project F so project F would be selected if the
minimax regret rule is used.

Question 4

A shop keeper must decide how many boxes of apples he must buy daily. A box of apple
earns contribution of N400 and cost N250. Demand is uncertain and it shall vary from 10
boxes to 30 boxes. Any apple that remains unsold at the end of the day shall be thrown away.
The shop keeper has decided that he will buy 10boxes, 20boxes or 30boxes each day and
these are the only three options he will consider. The following payoff table has been
constructed.

Demand 10boxes Demand 20boxes Demand 30boxes

Course of action N N N
Buy 10boxes 1,500 1,500 1,500
Buy 20boxes (1,000) 3,000 3,000
Buy 30boxes (3,500) 500 4,500

Required;
How many boxes should store keeper purchase if the decision is base on
(a) the maxima decision rule 4marks
(b) the maxim in decision rule 4marks
(c) the minimax decision

Question 5

A company is considering which one of three alternative courses of action, A, B and C to

take. The profit or loss from each choice depends on which one of four economic
circumstances, I, II, III or IV will apply. The possible profits and losses, in thousands of
pounds, are given in the following payoff table. Losses are shown as negative figures

Action
A B C
 I 70 60 70
Circumstance II –10 20 –5
III 80 0 50
IV 60 100 115

Required
State which action would be selected using each of the maximax and maximin criteria.

Solution
(a) The best possible outcomes are as follows.
A (circumstance III): 80
B (circumstance IV): 100
C (circumstance IV): 115
As 115 is the highest of these three figures, action C would be chosen using the maximax
criterion.
(b) The worst possible outcomes are as follows.
A (circumstance II): –10
B (circumstance III): 0
C (circumstance II): –5
The best of these figures is 0 (neither a profit nor a loss), so action B would be chosen using
the
maximin criterion.