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Risk and uncertainty 378 Summary
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A summary of manacc378, Risk and uncertainty
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Risk and uncertainty:Decision-making under circumstances of risk and uncertainty:
Up to now single set of information, for example: should the project be discontinued,
R20 000 in fixed overheads will be saved.
What happens if there is a series of possible outcomes with different possibilities?
Example:
Probability distribution (when you see these words it is a hint that the question refers to
risks and uncertainty) for events or “states of nature” (uncontrollable by decision-maker).
Probabilities can either be objective such as tossing a coin or throwing a die, whereas most
business decisions are subjective because no two individuals will assign the same
probabilities to an expected outcome.
35% 45% 20%
POOR AVERAGE GOOD
Product A 1000 1500 2000
Product B 500 750 1000
Contribution per unit A= R50
Contribution per unit B = R40
Total Fixed costs = R80 000
Decision-making under circumstances of risk and uncertainty:
Man Acc 378 purposes – work with EXPECTED VALUE for decision-making
purposes:
o If uncertain or more than one possible outcome, always use the expected
value.
Expected value = ΣpX
p = probability of outcome
x = value of outcome
Decision?
19730
Decision = should this branch be purchased or not? Purchase price is R20 000.
Maybe there is a small loss in year 1, but there was large capital expenditure which
will lead to a larger profit in future years.
Expected profit based on expected values = (1 425 x R50) + (712 x R40) – R80- 000 = R19
730
Risks (mention non-financial factors)
Expected profit based on expected values = R19 730
Best outcome = (2 000 x R50) + (1000 x R40) - R80 000 = 60 000 (20%)
Most probable outcome = (1 500 x R50) + (750 x R40) - R80 000 = 25 000 (45%)
, Worst outcome = (1 000 x R50) + (500 x R40) - R80 000 = -R10 000 (35%)
UNCERTAINTY LEADS TO RISK!
The expected value is R19 730.
Should you buy or not?
o The chances of incurring a loss are 35%
If management are risk adverse, then management will not buy because it is too risky
(they would prefer the less riskier option as most investors would)
But if management are risk takers, although there is a 35% chance of a loss, they also
recognise that there is a 20% chance of making a R60 000 profit (maximum profit)
and will therefore accept such a risk (prefer more riskier option)
If there is not enough information in the question, still address management’s attitude
to risk:
o The higher the risk, the lower the rewards
o The lower the risk, the lower the rewards
Calculate the relevant benefit (cost) should the branch be
discontinued
Decision = should this branch be discontinued or not?
Should this branch be discontinued if there is a 40% probability that 60% of this branch’s
products (in the same ratio as mentioned in the probability distribution) will be sold by other
branches within the entity? There is a 60% probability that none of the products will be sold
by the other branches. If the branch is discontinued, all fixed costs (R80 000) can be saved.
40% chance that there is a 60% contribution (retain)
60% chance that there is a 0% contribution (retain)
Decision-making under circumstances of risk and uncertainty:
BENEFIT IF
CONTINUE DISCONTINUE DISCONTINUED
99 730.00 29 935.2 -75 794.80
Contribution
-80 000 -0.00 80 000.00
Fixed costs
4 205.20
If there is uncertainty – calculate the expected value!!
Expected contribution if continue = (1 425u x R50) + (712u x R40) = R99 730
Expected revenue within the entity should the branch be discontinued:
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