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Risk is used to describe the type of situation in which there are a number of possible states of nature, hence outcomes, but in which the decision maker can reasonably assess the probability of occurrence of each. Thus risk can be expressed in quantitative terms.

 

Under conditions of uncertainty, in contrast, it is recognized that several out-comes are possible, but the decision-maker is unable to attach probabilities to the various states of nature.

 

The liability is usually due to a lack of data on which to base a probability estimate. For instance, in launching a new product, the marketing manager may have an idea of what the sales in year 1 are likely to be, but he must accept that the actual level will be one of many possible levels. However, the marketing manager may be unable to specify the probability of each level being achieved, making it an uncertainty situation.

 

There is also, of course, the situation of complete certainty. This relates to a decision over which the decision-maker has complete control, and is thus likely to be confined to the production sphere. This is so because the existence of external agents in marketing and distribution means that knowledge is incomplete, and the creative aspect of R & D means that outcomes are unknown in advance.

 

In relation to decision-making under conditions of risk and uncertainty, the purpose expressing an opinion about the likelihood of an event occurring is to facilitate the development of decision-making procedures that are explicit and consistent with the decision-maker's beliefs.

 

By convention, probabilities follow certain rules, such as:

• The probability assigned to each possible future event must be a positive number between zero and unity, where zero represents an impossible event and unity represents a certain one.
• If a set of events is mutually exclusive and exhaustive, then the total of the probabilities of the events must add to one.

 

Although analytical methods can be applied to evaluation of risk and uncertainty, management may prefer to take other courses of action to reduce risk and uncertainty. Perhaps the best method is to increase the information available to the decision-maker prior to his making a decision. For instance, marketing research can supply further information prior to new product launches via product testing or trial marketing.

 

Alternatively, the scale of operations may be increased, or product diversification pursued. Product A having a seasonal demand pattern that is the opposite of the pattern of product B.  But in combination they only produce profits. Whereas either product in isolation would result in a loss during part of its demand cycle.

 

Allowing for Risk

 

In investment decision-making, risk generally derives from five sources:

• risk from undertaking insufficient numbers of similar investments;
• risk from misinterpretation of data;
• risk from bias in the data in their assessment;
• risk from a changing external economic environment, invalidating much of the usefulness of past experience; and
• risk from errors of analysis.

 

The pre-requisite to allowing for risks such as these is the establishment of a risk policy. The amount of risk a firm is willing to accept to obtain a given financial return is a general question of values that cannot be rationally determined. A firm may, for instance, opt for a policy of conservatism and require a very high return for risk, or alternatively for a policy of taking greater risks. The major problem is, perhaps, that in pursuing a conservative policy as regards investment, the firm places itself in a risk situation because of its unwillingness to accept risky investments.

 

Once a policy has been determined, it must be translated into specific rate of return requirements for different types of projects. The categories of project may be:

a)                 cost saving investments;

b)                 replacement investments;

c)                 market expansion investments;

d)                 investments required by regulations; and

e)                 welfare amenity investments.

 

Each category will involve different types of risk, and the aim of classifying the various investment proposals by type is to ensure that they all receive equal consideration once due allowance has been made for the differential risk involved.

 

For practical business decisions, agreement on the exact method of incorporating risk into analysis is less important than agreement that varying the discount rate used in evaluating a project is not a good way of accomplishing the objective of taking risk into consideration. (The discount rate is the rate that is used to reduce future income streams to their present value and is the converse of an interest rate).

 

The application of simple risk analysis is best illustrated by means of an example. Let it be assumed that RS Limited has two new products A and B, but only sufficient resources to launch one of these. The relevant states of nature relate to competitive activity; no matter which product is launched, it may be assumed that the competition will:

• do nothing; or
• introduce a comparable product; or
• introduce a superior product.

 

On the basis of past experience and current knowledge, the management of RS Limited attach probabilities of 0.25, 0.5, and 0.25 respectively to these states of nature. In the light of these alternative conditions, the profit of each strategy can be shown in law pay-off matrix.

 

Allowing for Uncertainty

 

Uncertainty arises from a lack of previous experience and knowledge. In a new venture, it is possible for uncertainty to be attached to the following factors:

• date of completion;
• level of capital outlay required;
• level of sales prices;
• level of revenue;
• level of sales volume;
• level of operating costs; and
• taxation rules.

 

Inevitably, decision-making under conditions of uncertainty is more complicated than is the case under risk conditions. In fact there is no single best criterion that should be used in selecting a strategy.  Of the various available techniques, company policy or the decision-marker's attitude will determine that which is selected.