Decision Making Techniques

This page looks at some basic principles of decision making, different categories of problems and then directs you to specific techniques and models

Businesses face many different types of decision ranging from

• strategic choices, such as "should we enter a new market?" to
• tactical ones, such as "should we make a product ourselves or outsource it?" and
• operational decisions, such as "how do we reorganise production to maximise profit when half the workforce are off sick this week?".

Solving such decisions will involve a mixture of quantitative and non-quantitative factors. Here we are mainly concerned with quantitative analysis.

Many different techniques have been developed to assist with decision making. These can be loosely grouped into the following categories:

• Long-term decision making will often involve the use of discounted cash flow techniques
• Short-term decisions often involve looking at contribution
• Decision making with limited or scarce resources
• Incorporating risk and uncertainty 

Objectives

With any decision it is vital to understand what is trying to be achieved in the first place as this will influence the method to be used.

Maximising shareholder wealth

The most common objective in decision making scenarios is to maximise shareholder value. This is because most decisions are made by companies where the directors have a duty to act in the interests of their shareholders.

Research has found that  to develop decision making metrics that maximise shareholder value, the following factors need to be incorporated:

1  Cash is preferable to profit

Cash flows have a higher correlation with shareholder wealth than profits.

2 Exceeding the cost of capital

 The return, however measured, must be sufficient to cover not just the cost of debt (for example by exceeding interest payments), but also the cost of equity. Peter Drucker commented, in a Harvard Business Review article: ‘Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the economy than it devours in resources… until then it does not create wealth; it destroys it.’

3 Managing both long and short-term perspectives

Investors are increasingly looking at long-term value. When valuing a company’s shares, the stock market places a value on the company’s future potential, not just its current profit levels.

Company announcements – about capital expenditure, research and development, or new investments – are often treated as positive rather than negative factors by the market, even though these announcements may have a detrimental effect on short-term profits. New biotechnology companies, for example, clearly have a value despite the fact that many currently have no products.

Taken together, these would suggest the following approaches:

• Net present value (NPV) and other discounted cash flow techniques (IRR, MIRR, etc)
• Economic Value Added (EVA^TM) and market value added (MVA)
• Shareholder value analysis (SVA)

Improving profitability

Despite a poor correlation with shareholder value, many businesses focus on increasing profit. This is due mainly to familiarity and simplicity. Popular profit based measures include the following:

• Return on capital employed 
• Return on investment 
• Residual income 

Other objectives

Many other objectives can be incorporated into decision making. Some are more complex that others. For example:

• Liquidity concerns can be incorporated by setting a target payback period
• Trying to simultaneously maximise return while minimising risk can get very complex!
• Some objectives are very difficult to quantify (e.g. impact on quality of life of local residents when appraising a decision to build a new shopping centre)

Relevant cash flows

From a theoretical standpoint decisions should only consider factors that are directly affected by the decision:

If we consider:

A: the cash position if we accept a project

B: the cash position if we don't

then the key figure is the difference between A and B.

Decisions should thus be based on future net incremental cash flows , also known as "relevant cash flows" or "opportunity cash flows".

There are three elements here:

• Cash flows. To evaluate a decision, actual cash flows should be considered. Noncash items such as depreciation and inter divisional charges should be ignored.
• Future costs and revenues. This means that past costs and revenues are only useful insofar as they provide a guide to the future. Costs already spent, known as sunk costs, are irrelevant for decision making.
• Incremental costs and revenues. Only those costs and revenues that alter as a result of a decision are relevant. Where factors are common to all the alternatives being considered they can be ignored; only the differences are relevant. 

Where this type of analysis can get more subtle is when the cash flow for not accepting a project (B in our example above) is not zero. Rather we consider the next best alternative (if we don't do the project, then what else would we do instead) and consider cash flows avoided or foregone.

• If doing the project means we have avoided a cost, then we have an "opportunity saving",
• if we have revenue foregone, then an "opportunity cost".

Long term investment appraisal

Most methods of long term investment appraisal take into account the "time value of money". This recognises the fact that money paid out or received now is worth more to us than the expectation of the same amount at some future date. this is due to the following:

• Investment opportunities - money received now could be invested and hence grow to a larger sum in the future
• Cost of finance - if we have a loan, then money received sooner could be used to repay it and save interest.(Alternatively, payments made now might increase a loan or overdraft resulting in higher interest payments)
• Inflation - inflation erodes the purchasing power of money. $100 now will buy more than $100 in five years' time.
• Risk - future cash flows are less certain

The implications of this can be very significant, particular for long projects.

The main methods used for longer term investment decisions are the following:

• NPV, IRR, MIRR
• Payback and discounted payback
• ROCE 

Short term decisions

Short term decisions have two characteristics that make them considerably simpler than longer term ones:

• The time value of money can be ignored
• Most fixed costs will be incurred anyway so can be ignored as not relevant

In such cases the main approach is usually to consider relevant cash flows, which may simplify to looking at the impact of the decision on the total contribution.

Methods here include:

• Cost volume profit (CVP) analysis (incorporating break even analysis)
• Key factor analysis 
• Linear programming 

Scarce resources

Some decisions involve scarce resources. For example, this month a large part of the labour force is off sick so how should we allocate the time of the remaining workers? Which products should be made / prioritised?

These scenarios are usually short term and involve maximising contribution.

The method to be used depends on how many scarce resources we have.

Key factor analysis

If we only have one scarce resource, then we can maximise contribution by ranking the different options according to the contribution they generate per unit of scarce resource. In our above example we would calculate the contribution per labour hour to rank products.

Linear programming

If we have two or more scarce resources (constraints), then the more mathematical approach of linear programming is needed.

Incorporating risk and uncertainty

 Estimates of futures costs, revenues and other cash flows always have some degree of uncertainty or risk.

For example, instead of stating that year 1 sales will be £200,000, what if our best estimate gave a range of possibilities with different probabilities as follows:

• probability of 0.2 that sales = £100,000
• probability of 0.5 that sales = £180,000
• probability of 0.3 that sales = £300,000

The average or expected value is 0.2×100 + 0.5×180 + 0.3×300 = £200,000 but the situation is completely different from being guaranteed £200,000.

For example, what if we know our costs will be £120,000? If sales are guaranteed to be £200,000, then we are certain to make a profit. On the other hand with our spread of possibilities above there is now a 20% chance of a loss being incurred. Is this acceptable?

There are a wide range of techniques that can be used to incorporate risk into decision making, including the following:

• Using expected values
• Simulation
• Decision trees     
• Payoff tables    
• Measuring risk using standard deviations
• Increasing the cost of capital used when calculating a NPV
• CAPM    
• Sensitivity analysis     

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Tags:	decision making;relevant cash flows;objectives;risk