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Showing posts with label Decision Making Techniques. Show all posts
Showing posts with label Decision Making Techniques. Show all posts
Saturday, January 2, 2010
Maximin, Maximax and Minimax Regret Decision Criteria/Rules
Decision makers may use any one of the above criteria to make decisions in the following situations:
• Where probabilities are available but the decision maker is not interested in average, long-run values (expected values) but on actual one-off outcomes.
• Where it is not possible to assign meaningful probabilities to alternative courses of action.
The criterion used by the decision maker will be dependent upon his risk attitude:
• Risk seeker management will use maximax rule
• Risk averter management will use maximin rule
• Risk neutral management will use minimax regret rule
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(1) Maximax Rule
It is a strategy which maximizes the maximum gain.
A risk seeker manager using the rule will select the option with the largest payoff based on the assumption that the best possible outcome will occur for all the available options.
(2) Maximin Rule
It is a strategy which maximizes the minimum gain (or minimizes the maximum loss)
A risk averse manager using this rule will select the option with the largest payoff based on the assumption that the worst possible outcome will occur for all the available options.
(3) Minimax Regret Rule
It is a strategy which seeks to minimize the maximum possible regret ie opportunity cost that will be incurred as a result of having made the wrong decision (e.g. contribution/profit/cost savings forgone). The opportunity cost associated with each decision option will be summarized in a regret matrix (opportunity cost table).
A risk neutral manager using this rule will select the option with the lowest regret/opportunity cost based on the assumption that the maximum regret will occur for all the available decision options.
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• Where probabilities are available but the decision maker is not interested in average, long-run values (expected values) but on actual one-off outcomes.
• Where it is not possible to assign meaningful probabilities to alternative courses of action.
The criterion used by the decision maker will be dependent upon his risk attitude:
• Risk seeker management will use maximax rule
• Risk averter management will use maximin rule
• Risk neutral management will use minimax regret rule
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(1) Maximax Rule
It is a strategy which maximizes the maximum gain.
A risk seeker manager using the rule will select the option with the largest payoff based on the assumption that the best possible outcome will occur for all the available options.
(2) Maximin Rule
It is a strategy which maximizes the minimum gain (or minimizes the maximum loss)
A risk averse manager using this rule will select the option with the largest payoff based on the assumption that the worst possible outcome will occur for all the available options.
(3) Minimax Regret Rule
It is a strategy which seeks to minimize the maximum possible regret ie opportunity cost that will be incurred as a result of having made the wrong decision (e.g. contribution/profit/cost savings forgone). The opportunity cost associated with each decision option will be summarized in a regret matrix (opportunity cost table).
A risk neutral manager using this rule will select the option with the lowest regret/opportunity cost based on the assumption that the maximum regret will occur for all the available decision options.
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Saturday, December 26, 2009
Cost-Volume-Profit Analysis (CVPA)
Concepts
CVPA provides a model of the relationships between volume sold, costs incurred and profit realized.
It is a basic business model that seeks to express the cost and revenue structures of a business in the form of mathematical equations.
It involves the identification and quantification of the following variables:
• Product mix
• Sales/demand
• Selling price
• Production efficiency (input and output relationships)
• Variable costs
• Total fixed costs
CVPA requires costs to be analyzed into variable cost and fixed cost to facilitate the prediction of costs and revenues at different activity levels for Decision Making purposes:
1. Variable costs vary in direct proportion with activity
2. Fixed costs remain constant over wide ranges of activity
3. Semi-fixed costs are fixed within specified activity levels, but they eventually increase or decrease by some constant amount at critical activity levels.
4. Semi-variable costs include both a fixed and a variable component (eg telephone charges)
5. Note that the classification of costs depends on the time period involved. In the short term some costs are fixed but in the long term all costs are variable.
Usefulness of CVPA
(a) Facilitates the economic evaluation of short-run decisions.
(b) Facilitates strategic planning – CVPA can be used to determine what market share is needed to breakeven or to achieve a target return with a particular strategy.
(c) Facilitates cost planning in choosing between alternative cost structures – CVPA highlights the risk and returns of alternative fixed-cost/variable-cost structures. A strategy with a high proportion of fixed costs (eg in house manufacture) might be more risky although it promises a higher return. A strategy with a higher proportion of variable costs (eg outsource) can mean more flexibility.
(d) Sensitivity analysis, a what-if technique can be used to examine how the results of the CVPA will change if the original predicted data or if an underlying assumption changes. The sensitivity f operating income/profit to various possible outcomes broadens managers’ perspectives as to what might actually occur before they make cost commitments.
CVPA Equation Method
TR = Total revenue
TVC = Total variable costs
TFC = Total fixed costs
NP = Net profit
USP = Unit selling price
UVC = Unit variable cost
UCM = Unit contribution margin = USP-UVC
CM% (or C/S%) = contribution margin ratio (or contribution to sale ratio) = UCM/USP x 100
NP = TR – TVC – TFC
NP = (USP x Q) – (UVC x Q) – TFC
NP = (UCM x Q) – TFC
(a) Target profit, revenue and costs (NP, USP, Q, UVC, TFC) can be determined by manipulation of the net profit equation.
(b) At breakeven point, NP = 0 i.e. (UCM x Q) = TFC
Therefore, BEQ (units) = TFC/UCM
Breakeven Revenue = TFC / CM% or BEQ (units) x USP
CVPA : Risk and Return Measures
(a) Contribution Margin Ratio (CM%) is a return measure : the higher the CM %, the higher the expected payoff and vice versa.
(b) Breakeven (BE) sales is a risk measure: the lower the breakeven sales, the lower the risk of making losses (due to lower FC) and vice versa.
(c) Margin of safety (MOS) is a risk measure: the lower the MOS, the higher the risk as losses will occur when there is a small drop in sales.
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CVPA provides a model of the relationships between volume sold, costs incurred and profit realized.
It is a basic business model that seeks to express the cost and revenue structures of a business in the form of mathematical equations.
It involves the identification and quantification of the following variables:
• Product mix
• Sales/demand
• Selling price
• Production efficiency (input and output relationships)
• Variable costs
• Total fixed costs
CVPA requires costs to be analyzed into variable cost and fixed cost to facilitate the prediction of costs and revenues at different activity levels for Decision Making purposes:
1. Variable costs vary in direct proportion with activity
2. Fixed costs remain constant over wide ranges of activity
3. Semi-fixed costs are fixed within specified activity levels, but they eventually increase or decrease by some constant amount at critical activity levels.
4. Semi-variable costs include both a fixed and a variable component (eg telephone charges)
5. Note that the classification of costs depends on the time period involved. In the short term some costs are fixed but in the long term all costs are variable.
Usefulness of CVPA
(a) Facilitates the economic evaluation of short-run decisions.
(b) Facilitates strategic planning – CVPA can be used to determine what market share is needed to breakeven or to achieve a target return with a particular strategy.
(c) Facilitates cost planning in choosing between alternative cost structures – CVPA highlights the risk and returns of alternative fixed-cost/variable-cost structures. A strategy with a high proportion of fixed costs (eg in house manufacture) might be more risky although it promises a higher return. A strategy with a higher proportion of variable costs (eg outsource) can mean more flexibility.
(d) Sensitivity analysis, a what-if technique can be used to examine how the results of the CVPA will change if the original predicted data or if an underlying assumption changes. The sensitivity f operating income/profit to various possible outcomes broadens managers’ perspectives as to what might actually occur before they make cost commitments.
CVPA Equation Method
TR = Total revenue
TVC = Total variable costs
TFC = Total fixed costs
NP = Net profit
USP = Unit selling price
UVC = Unit variable cost
UCM = Unit contribution margin = USP-UVC
CM% (or C/S%) = contribution margin ratio (or contribution to sale ratio) = UCM/USP x 100
NP = TR – TVC – TFC
NP = (USP x Q) – (UVC x Q) – TFC
NP = (UCM x Q) – TFC
(a) Target profit, revenue and costs (NP, USP, Q, UVC, TFC) can be determined by manipulation of the net profit equation.
(b) At breakeven point, NP = 0 i.e. (UCM x Q) = TFC
Therefore, BEQ (units) = TFC/UCM
Breakeven Revenue = TFC / CM% or BEQ (units) x USP
CVPA : Risk and Return Measures
(a) Contribution Margin Ratio (CM%) is a return measure : the higher the CM %, the higher the expected payoff and vice versa.
(b) Breakeven (BE) sales is a risk measure: the lower the breakeven sales, the lower the risk of making losses (due to lower FC) and vice versa.
(c) Margin of safety (MOS) is a risk measure: the lower the MOS, the higher the risk as losses will occur when there is a small drop in sales.
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