2.2.1 U NDERSTANDINGMANAGEMENT DECISION MAKING AQA Business 2 M ANAGERS, LEADERSHIP AND DECISION MAKING What decisions do managers make: On a day to day basis? In the medium term? In the longer term? In year 1 of A Level Business you learn mainly about tactical decisions made by businesses. In year 2 you will move on to look at strategic decisions. What do you think is the difference between a tactical and a strategic decision? Would you ever flip a coin to make a decision?

2.2.1 U NDERSTANDING MANAGEMENT DECISION MAKING  In this topic you will learn about  The value of decision making based on data (scientific decision making) and on intuition  The use and value of decision trees in decision making  Influences on decision making

O PPORTUNITY COST What do you think is meant by the term opportunity cost? Can you write a definition?

D ECISION MAKING  One role of managers is decision making  Decisions can be scientific i.e. based on data or based on intuition  All decisions have an opportunity cost i.e. the cost of one decision in terms of the next best alternative foregone  All decisions carry risks and rewards as well as being based on uncertainty

R ISK AND UNCERTAINTY  Both risk and uncertainty deal with unknowns  Risks  It is possible to add a probability to quantify the degree of risk  It is measurable  Uncertainties  It is not possible to add a quantifiable probability as the outcome is too unpredictable  It is not measurable  Business decision making involves both risk and uncertainties Further reading on the difference between risk and uncertainty. What is the role of risk and uncertainty in business?

D ECISION MAKING  Think about a big decision you have made recently or will make in the future  Studying A levels or taking an apprenticeship  Going to university or starting a career  Explain the decision making process using the words shown on the left  How difficult is it to know what the actual outcome of these decisions will be? Decision making Scientific Intuition Risk Reward Uncertainty Opportunity cost

D ECISION MAKING ScientificIntuition Supported by quantifiable evidence Encourages logical thought process However: May require expensive data Time consuming Allows for quick decision making Encourages innovation and creativity However: Difficult to justify Reliant on experience and expertise Discussion: Which method of decision making is better in business? Does it depend on the decision to be made?

S CIENTIFIC DECISION MAKING  Scientific decision making involves following a logical series of steps Step 1: Set objectives Step 2: Gather data Step 3: Analyse data Step 4: Make decision Step 5: Implement decision Step 6: Review decision

D ECISION TREES  A simple and visual way of presenting the alternative course of action available when making a decision  A mathematical model based on logic and probability  Decision trees identify:  When a decision has to be made  The choices available  The cost associated with each option  The possible outcomes related to each choice  The likelihood (probability) of each outcome occurring  The estimated financial result of each outcome

D ECISION TREES  Decision trees are drawn using the following tools: A decision node – this is used where a decision has to be made i.e. the option with the lowest financial outcome is discarded at this point and the highest financial outcome shown in the box A chance node - this is used where there are a number of possible outcomes. A calculation is carried out here to work out the expected value A line is used to show the options and the zzzzzpossible outcomes

A CLOTHING MANUFACTURER CAN EITHER IMPORT THEIR RAW MATERIALS FROM ABROAD OR BUY FROM LOCAL SUPPLIERS  What does this tell us?  If the manufacturer chooses to buy their materials from a local supplier it will cost £5000  If this is successful the financial outcome will be £15000, but there is only a 50% chance of success  If this is not successful the financial outcome will only be £6000, there is a 50% chance of failure  Explain what the table tells us about the option to import OptionsCostSuccessFailure ProbabilityFinancial outcome ProbabilityFinancial outcome Buy local£500050%£ %£6000 Import£400070%£ %- £5000

A CLOTHING MANUFACTURER CAN EITHER IMPORT THEIR RAW MATERIALS FROM ABROAD OR BUY FROM LOCAL SUPPLIERS  Why do both probabilities add up to 100%?  What is each probability expressed as a decimal?  50%  70%  30%  Can the probability of an outcome ever be 1? OptionsCostSuccessFailure ProbabilityFinancial outcome ProbabilityFinancial outcome Buy local£500050%£ %£6000 Import£400070%£ %- £5000

D RAWING A DECISION TREE – LEFT TO RIGHT Buy local £5000 Success 0.5 £15000 Failure 0.5 £6000 Success Failure £ £5000 £0 Import £4000 Do nothing Write a set of rules for how to draw a decision tree.

T HE CALCULATIONS  Calculate from right to left  First calculate the expected value  Multiply the financial outcome by the probability for each chance  Add the results together  Buy local  Success = £15000 x 0.5 = £7500  Failure = £6000 x 0.5 = £3000  Expected value =£10500

T HE CALCULATIONS  First calculate the expected value  Multiply the financial outcome by the probability for each chance  Add the results together  Import  Success = £20000 x 0.7 = £14000  Failure = - £5000 x 0.3 = -£1500  Expected value =£12500  The expected values are shown in the chance nodes (the circles)

T HE CALCULATIONS  Second calculate the net gain  Subtract the cost from the expected value  Buy local  Expected value= £10500  Cost= £5000  Net gain= £5500  Import  Expected value = £12500  Cost= £4000  Net gain= £8500  The highest net gain is shown in the decision nodes (the square) and the other options crossed off with a single line

T HE CALCULATIONS  Calculate from right to left  First calculate the expected value  Multiply the financial outcome by the probability for each chance  Add the results together  Second calculate the net gain  Subtract the cost from the expected value Subtract Add Multiply

S HOWING THE CALCULATIONS ON A DECISION TREE Buy local £5000 Success 0.5 £15000 Failure 0.5 £6000 Success Failure £ £5000 £0 Import £4000 Do nothing EV = £12500 EV = £10500 NG = £5500 NG = £8500 Based on the decision tree the business should import the raw materials as the net gain is £8500 which is £3000 higher than if they chose to buy from a local supplier.

Q UANTITATIVE V QUALITATIVE FACTORS  Based on quantitative factors the business should choose to import raw materials rather than buy local  In pairs write a list of qualitative factors that should also be considered To what extent would decision trees have been useful in helping Goodyear make the decision to close the Wolverhampton factory? Should decisions be based on qualitative factors as well as quantitative factors?

Q UESTION TIME  Angus has an objective of growth. Should he sponsor a local hockey team or hire an expert to rebrand his business?  Draw a decision tree based on the table below: OptionsCostHigh growthLow growth ProbabilityFinancial outcome ProbabilityFinancial outcome Sponsorship£ £ £4000 Rebranding£ £ £2000

U SE AND VALUE OF DECISION TREES StrengthsWeaknesses Clearly show the options available Encourages logical thinking Allows structure discussions and comparisons Takes into account risk May raise alternative options Quantifies the outcome of each decision Highlights the likelihood of each outcome Relies heavily on estimates i.e. probabilities and financial outcomes Doesn’t take into account qualitative factors Estimates may be biased May not consider external influences e.g. if the cost of one option is substantially higher will this be affected by interest rates Non dynamic – may be out of date before a decision is reached

U SE AND VALUE OF DECISION TREES  Scientific v intuition – consider the size and legal structure of the business and the need to justify decisions  What is the data based on? Speculation or trends?  Expected value will never actually happen but one of the outcomes might Can game theory and decision trees be used to explain the economic dilemma in Greece?

T EST YOURSELF - 10 MINUTES End 1.What is meant by the term opportunity cost? 2.Explain the difference between a decision node and a chance node. 3.A business has 2 options. Option A will cost £1.2m. There is a 45% chance of success which will result in an outcome of £5m. However if unsuccessful the financial outcome will be -£5m. What is the net gain of option A? 4.State one strength of decision trees. 5.State one weakness of decision trees.

I NFLUENCES ON DECISION MAKING  Influences on decision making include:  Mission – does the decision fit in with the businesses overall purpose?  Objectives – will the decision help the business achieve its goals within the specified time period?  Ethics – is the decision morally right? Are the managers comfortable with the decision i.e. does it meet their own ethical standards?

I NFLUENCES ON DECISION MAKING  Influences on decision making include:  The external environment including competition – how will changes in the external environment e.g. fluctuations in the economy or competitors ’actions influence the financial outcomes and the probabilities? Will this have a major impact on uncertainty in decision making?  Resource constraints – even if a decision looks like the right one is it achievable with the resources available, including: Time Human resources Expertise Finance

2.2.1 U NDERSTANDING MANAGEMENT DECISION MAKING  In this topic you have learnt about  The value of decision making based on data (scientific decision making) and on intuition  The use and value of decision trees in decision making  Influences on decision making