Management Accounting-Decision Management: What Effect Do Risk and Uncertainty Have on Decision-Making? Tim Thompson Considers Some of the Techniques That Can Be Used to Evaluate an Opportunity
Thompson, Tim, Financial Management (UK)
We all have different expectations, aspirations and fears. Some people have an optimistic view of life, whereas others are pessimists. It follows that two people, when faced with the same opportunity, could well arrive at two different decisions about it based upon their different outlooks.
The concepts of risk and uncertainty are based on the recognition that a number of possible outcomes can emerge from a decision. The wider the range of these outcomes, the more risky (or uncertain) the situation. The difference between risk and uncertainty is the extent to which the number, value and likelihood of the outcomes can be confidently quantified.
An example of risk can be derived from a pack of playing cards. If we are presented with a full pack and draw one card at random, we can calculate with confidence the probability that this card will be the ace of spades. We know that 52 outcomes are possible, because there are that many cards in the pack. We also know exactly what these outcomes are, because each card is unique and identifiable. So, we can state with confidence that the probability of drawing the ace of spades is one in 52 or 1.923 per cent.
But the analogy of picking a playing card doesn't really reflect the unpredictable nature of business decision-making. Such decisions are characterised by a high degree of uniqueness. Accordingly, it's difficult to identify every possible outcome and even harder to establish the likelihood of each of these outcomes. This is called uncertainty.
Despite the clear difference between risk and uncertainty, there is a paradox: managers tend to ignore (or at least work around) this distinction for decision-making purposes. To evaluate a business decision involving uncertainty, managers will use their judgment--ie, educated guesswork--to predict as best they can all of the possible outcomes and their associated probabilities. In so doing, they treat an uncertain situation as if it were characterised by risk. In practice, management accounting techniques also usually treat risk and uncertainty as the same thing. From now on, therefore, I will use risk as the blanket term to cover both risk and uncertainty.
One of the models used to describe different individuals' attitudes to risk identifies three classifications as follows:
* Risk-seeking. This term means that an individual seeks risk not as an end itself, but rather as a means to an end. Recognising the established link between risk and return, the individual seeks a very high return and accepts the high level of risk that normally accompanies it. This attitude may, for example, be exhibited by an entrepreneur who plans to set up a new business in the hope of becoming a millionaire. In order to achieve this, he might need to take out a substantial loan and he will willingly risk all of his personal assets as security for his borrowings.
* Risk-averse. This attitude is concerned with limiting risk. At an extreme level, it's where an individual adopts an ultra-cautious approach and eliminates as much risk as possible. In so doing, the individual must accept the tow returns that normally accompany this low risk level. In practice, though, the term is not usually perceived in this extreme way. A less radical interpretation is that risk-aversion describes the way that rational individuals are expected to deal with risk. For a given level of risk, rational decision-makers will seek the highest rate of return. Alternatively, for a given rate of return, they will seek the lowest level of associated risk.
* Risk-neutral. A risk-neutral individual pays no attention to the range of the outcomes that may emerge from a decision. Instead he focuses on a single value that represents the situation facing him. Statistical averages are often used for this, although simply focusing on the most likely outcome would also fall under the risk-neutral classification.
Let's consider a practical example. …