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AND COST
ACCOUNTING
SIXTH EDITION
COLIN DRURY
Chapter Twelve:
Decision-making under conditions of risk & uncertainty
3. A probability distribution lists all possible outcomes for an event and the
probability that each will occur:
Student A Student B
probability probability
Outcome:
Pass examination 0.9 0.6
Do not pass 0.1 0.4
1.0 1.0
Example
Estimated Expected
Outcome probability value (EV)
£
Loss of £4 000 0.5 (2 000)
Profit of £22 000 0.5 11 000
9 000
• SD of A = £1 096
• SD of B = £2 142
• SD of C = £13 000
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
12.4b
Example
Possible outcomes A B
Recession 90 0
Normal 100 100
Boom 110 200
Expected value 100 100
The probability of each outcome is 1/3.
2. The two alternatives have the same EV but different levels of risk.
Decision trees
Example
A company is considering whether to develop and market a new product.
Development costs are estimated to be £180 000, and there is a 0.75 probability
that the development effort will be successful and a 0.25 probability that the
development effort will be unsuccessful. If the development is successful, the
product will be marketed, and it is estimated that:
Each of the above profit and loss calculations is after taking into account the
development costs of £180 000. The estimated probabilities of each of the above
events are as follows:
2. With the maximin technique the largest payoff is selected based on the
assumption that the worst possible outcome will occur.
Machine A = £100 000
Machine B = £10 000
Decision = Choose product A
3. With the maximax technique the largest payoff is selected assuming the
best possible outcome will occur.
Machine A = £160 000
Machine B = £200 000
Decision = Choose product B
4. The aim of the regret criterion is to minimize the maximum possible regret.
Regret table
Low High
demand demand
occurs occurs
The maximum regret is £40 000 for A and £90 000 for B.
Therefore,choose A.
Portfolio approach
Example
States of nature Umbrella Ice-cream Combined
manufacturing manufacturing activities
£ £ £
Sunshine –40 000 +60 000 +20 000
Rain +60 000 –40 000 +20 000
2. Each activity is risky on its own, but when the activities are
combined risk is eliminated.