A lot of decision-making in business involves some risk or uncertainty. Decisions might be based on what the decision-maker thinks will happen, but there is some possibility that the actual outcome will be different; possibly better or possibly worse than expected.
a. Uncertainty occurs when there is insufficient information about what will happen, or what will probably happen, in the future. It is therefore likely that estimates of future values (estimates of future sales, future costs, and so on) will be inaccurate.
b. Risk occurs when the future outcome from a decision could be any of several different possibilities.
However, it might be possible to assess with reasonable accuracy the probability of each possible outcome. When there are reliable estimates of the probability for each possible outcome, risk can be assessed or analysed statistically.
When there is uncertainty or risk in a business decision, management should consider both:
a. The expected incremental costs, revenues and profits, and also,
b. The risk or uncertainty.
There are several different ways of allowing for risk and uncertainty in decision making.
The approach you take or taken by management will depend to a large extent on your, or their attitude to risk. In other words, to what extent will you or management decision be affected by the risk or uncertainty in the situation?
Risk cannot be removed entirely from a decision, because risk exists in the situation itself. A decision-maker can try to analyse the risk, and must make a decision on the basis of whether the risk is justified or acceptable.
Risk preference describes the attitude of a decision-maker towards risk.
A company or decision-makers might be described as risk averse, risk-seeking or possibly risk neutral.
i. Risk aversive organisation or decision maker considers risk in making a decision, and will not select a course of action that is more risky unless the expected return is higher and so justifies the extra risk. A risk-averse organisation or decision maker does not try to avoid risk as much as possible; however he might want a substantially higher expected return to make any extra risk worth taking.
ii. A risk neutral organisation or decision maker ignores risk entirely in making a decision. The decision of a risk neutral decision maker is to select the course of action with the highest expected return, regardless of risk.
iii. A risk-seeking organisation or decision maker also considers risk in making a decision. A risk seeker, unlike a risk-averse decision-maker, will take extra risks in the hope of earning a higher return.
It is often assumed that managers are risk averse, and so will not select a course of action that has higher risk unless it offers a higher expected return sufficient to justify the risk that is taken.
Reducing risk and uncertainty.
Risk and Uncertainty occurs when there is a lack of reliable information. It can therefore be reduced by obtaining more information on which some reliance can be placed. However, it is doubtful whether risk and uncertainty can be eliminated altogether.
There is often uncertainty about the likely volume of sales demand for a product.
For established products, it might be possible to estimate future sales by taking historical sales figures, and making adjustments for sales growth or decline, and planned changes is the sales price.
For new products, however, estimating sales demand can be very difficult because there is no benchmark on which to base the estimate.
Risk and Uncertainty about future sales demand for a product can be reduced through the use of market research or focus groups.
Market research is research into a particular market, such as the market for a product, for the purpose of obtaining information about the market – such as attitudes and buying intentions of customers in the market.
Market research might be carried out, for example, to test the attitudes of target customers to a prototype of a new product.
In some cases, market research might attempt to obtain an estimate of the likely sales demand for a product.
A focus group is a group of participants who are invited to give their views, opinions and ideas about a product or market to a market research team. The members of a focus group will be selected so as to represent a target audience or target market, and the information provided by the group will therefore be representative of the views of the target market as a whole.
By analysing data obtained from market research surveys or focus groups, an entity might expect to obtain more reliable estimates of the likely sales demand for a product thereby reducing risk and uncertainty in its operation.