Principles of Management

Dr. Karim Kobeissi Islamic University of Lebanon - 2013

Chapter

Foundations of Decision Making

4-2

Learning Objectives
Describe the decision making process. Explain the three approaches managers can use to make decisions. Describe the types of decisions and decisionmaking conditions managers face. Discuss group decision making. Discuss contemporary issues in managerial decision making.

Introduction
Although everyone makes decisions in an organization, decision making is particularly important to managers and is part of all four managerial functions, as seen in the next slide. Most decision making is routine, such as deciding which employee will work which shift or how to resolve a customers complaint.

The Decision Making Process

Decision making is a basic part of every task a manager is involved, and it can be viewed as an eight-step process that includes:
Step 1: Identification of a problem.

Step 2: Identification of Decision Criteria. Step 3: Allocation of Weights to Criteria. Step 4: Development of Alternatives. Step 5: Analysis of Alternatives.

Step 6: Selection of an Alternative.

Step 7: Implementation of the Alternative. Step 8: Evaluation of Decision Effectiveness.

Step 1 : Identification of a Problem

Problem A discrepancy between an existing and a desired state of affairs. How do managers become aware of such a discrepancy? They have to

compare the current state of affairs with some standard, which can be past
performance, previously set goals, or the performance of another unit within the organization or in another organization. If, for example, a car is no longer worth repairing, then the best decision may be to purchase another car.

Step 2: Identification of Decision Criteria

Once a manager has identified a problem that needs attention, he or she must identify the decision criteria that will be important in solving the problem. In the case of replacing ones car, the cars owner assesses the relevant criteria, which might include: Price Model (two-door or four-door) Size (compact or intermediate) Manufacturer (Japanese, South Korean, German, or American)

Optional equipment (navigation system or side-impact protection)

Fuel economy

Step 3: Allocation of Weights to Criteria

In many decision-making situations, the criteria are not equally important, so its necessary to allocate weights to the items listed in Step 2 to factor their relative priority into the decision.

A simple approach is to give the most important criterion a weight of 10 and then assign weights to the rest of the criteria against that standard to indicate their degree of importance. Thus, a criterion that you gave a 5 is only half as important as the highest-rated criterion.

Step 4: Development of Alternatives

In Step 4, the decision maker lists the alternatives that could resolve the problem. The decision maker only lists the alternatives and does not attempt to appraise them in this step. Lets assume that our subject has identified 12 cars as viable choices: Jeep Compass Ford Focus Hyundai Elantra Ford Fiesta SES Volkswagen Golf Toyota Prius Mazda 3 MT Kia Soul BMW 335 Nissan Cube Toyota Camry Honda Fit Sport MT.

Step 5: Analyze of Alternatives

Once the alternatives have been identified, the decision maker moves to Step 5 that is, critically analyzing each alternative by appraising it against the criteria. The strengths and weaknesses of each alternative become evident when compared with the criteria and weights established in Steps 2 and 3. In Exhibit 4-3 we see the assessed values that the subject put on each of her 12

alternatives after having test-driven each car. Some assessments can be achieved
objectively, such as the best purchase price; however, the assessment of how the car handles is clearly a personal judgment. Most decisions contain judgments and these judgments are reflected in which criteria is chosen in Step 2, the weights given to those criteria, and the evaluation of alternatives.

Step 6: Selection of an Alternative

Step 6 is the critical act of choosing the best alternative from among those assessed. Since we determined all the pertinent factors in the decision, weighted them appropriately, and identified the viable alternatives, we choose the alternative that generates the highest score in Step 5. In our vehicle example (shown in Exhibit 4-4) the decision maker would choose the Toyota Camry. On the basis of the criteria identified, the weights given to the criteria, and the decision makers assessment of each car based on the criteria, the Toyota scored highest with 224 points and thus became the best alternative.

Step 7: Implementation of the Alternative

Although the choice process is now complete, the decision may still

fail if its not implemented properly.

Step 7 involves conveying the decision to those affected and to obtaining their commitment. The people who must carry out a decision are more likely to enthusiastically endorse the outcome if they participate in the decision-making process.

Step 8: Evaluation of Decision Effectiveness

In Step 8, the last step in the decision-making process, managers appraise the result of the decision to see whether the problem was resolved. Did the alternative chosen in Step 6 and implemented in

Step 7 accomplish the desired result? Evaluating the results of a

decision is part of the managerial control process.

Common Errors
When managers make decisions, they not only use their own particular style but also may use rules of thumb or judgmental shortcuts called heuristics to simplify their decision making. Heuristics help make sense of complex, uncertain, and ambiguous information. However, rules of thumb are not necessarily reliable and can lead managers into error while processing and evaluating information.

In Exhibit 4-5, we see 12 common decision errors and biases:

1. Overconfidence occurs when decision makers think they know more than they do
or hold unrealistically positive views of themselves and their performance. 2. Immediate gratification describes decision makers who want immediate rewards but want to avoid immediate costs. For these individuals, decision choices that provide quick payoffs are more appealing than those with payoffs in the future.

Common Errors (con)

3. The anchoring effect describes when decision makers fixate on initial

informationsuch as first impressions, ideas, prices, and estimatesand

then fail to adequately adjust for subsequent information. 4. Selective perception occurs when decision makers organize and interpret

events based on their biased perceptions, which influence the information

they pay attention to, the problems they identify, and the alternatives they develop. 5. Confirmation bias describes decision makers who seek out information that reaffirms their past choices and who discount information that contradicts past judgments. Such people tend to accept, at face value, information that confirms their preconceived views and are critical and skeptical of information that challenges these views.

Common Errors (con)

6. The framing bias occurs when decision makers select and highlight certain

aspects of a situation while excluding others. By drawing attention to specific

aspects of a situation and highlighting them, they downplay or omit other aspects, distort what they see, and create incorrect reference points. 7. The availability bias occurs when decision makers focus on events that are the most recent and vivid in their memory. As a result, their ability to recall events objectively results in distorted judgments and probability estimates. 8. Representation bias describes how decision makers assess the likelihood of an event based on how closely it resembles other events and then draw analogies and see identical situations where they dont necessarily exist. 9. The randomness bias describes when decision makers try to create meaning out of random events.

Common Errors (con)

10. The sunk costs error occurs when decision makers forget that current

choices cant correct the past. They incorrectly fixate on past expenditures of
time, money, or effort rather than on future consequences when they assess choices. 11. Decision makers exhibiting self-serving bias take credit for their successes and blame failures on outside factors. 12. Finally, the hindsight bias is the tendency for decision makers to falsely believe that they would have accurately predicted the outcome of an event once that outcome is actually known. Awareness of these biases helps managers to avoid their negative effects and can encourage them to ask colleagues to identify weaknesses in their decision

making style that the managers can then self-correct.

The Three Approaches Managers Use to making decisions

Managers can use three approaches to making decisions:

1. Rational decision making

2. Bounded rational decision making

3. Intuition

The Rational Model

In a perfect world, being a rational decision maker means being fully objective and logical. The problem to be addressed would be clearcut and the decision maker would have a specific goal and anticipate all possible alternatives and consequences. Ultimately, making decisions rationally would consistently lead to selecting the alternative that maximizes the likelihood of achieving that goal.

Bounded Rationality
Since most decisions that managers make dont fit the assumptions of perfect rationality, a more realistic approach to describing how managers make decisions is the concept of bounded rationality. This means that managers make decisions rationally but are limited (or bounded) by their ability to process information. Because they cant possibly analyze all information on all alternatives, managers satisfice, rather than maximize. That is, they accept solutions that are good enough.

The decision making is also influenced by the organizations culture, internal politics, power considerations, and escalation of commitment, which is an increased commitment to a previous decision despite evidence that it may have been wrong.

Intuition in Decision Making

Intuitive decision making involves making decisions on the basis of experience, feelings, and accumulated judgment, which can complement both rational and bounded rational decision making. Researchers have identified five different aspects of intuition, described in Exhibit 4-7. Accordingly, we have: Affective based decisions Cognitive based decisions Experiences based decisions Subconscious based decisions Ethical or Values based decisions

Types of Problems
Problems can be divided into two categories:

1) Structured problem A straightforward, familiar, and easily

defined problem. Examples include a customer who wants to return an online purchase or a TV news team that has to respond to a fast-breaking event. 2) Unstructured problem A problem that is new or unusual for

which information is ambiguous or incomplete. Entering a new

market segment or deciding to invest in an unproven technology are examples of unstructured problems.

Types of Decisions
As do problems, decisions can also be divided into two categories:

1) Programmed decisions Repetitive decisions that can be handled using a routine approach.
Programmed, or routine, decision making is the most efficient way to handle structured problems. For example, what does a manager do if an auto mechanic damages a customers rim while changing a tire? Because the company probably has a standardized method for handling this type of problem, its considered a programmed decision, which tends to rely heavily on previous solutionssuch as replacing the rim at the companys expense.

Types of Decisions (con)

2) Nonprogrammed decisions Unique and nonrecurring decisions; require a custom-made solution. Nonprogrammed decisions are used to handle unstructured problems. Examples of

nonprogrammed decisions include deciding whether to acquire another organization or to sell off an unprofitable division.

Problems, Decision Types, and Organizational Levels

Exhibit

4-8,

seen

here, the

describes

relationship among types of problems, types of decisions, and ones level in the organization.

Problems, Decision Types, and Organizational Levels (con)

Lower-level managers usually confront familiar and repetitive problems

and typically rely on programmed decisions, such as standard operating

procedures. As managers move up the organizational hierarchy, problems are likely to become less structured.

However, few managerial decisions are either fully programmed or fully nonprogrammed. This means that few programmed decisions eliminate individual judgment completely and even the most unusual situation requiring a nonprogrammed decision can often be helped by programmed routines.

Decision Making Conditions

When making decisions, managers may face three different conditions: certainty, risk, and uncertainty. 1) Certainty - An ideal situation for the decision maker to make accurate decisions because the outcome of every alternative is known. 2) Risk - A situation where the decision maker is able to estimate the likelihood of certain outcomes based on data from past personal experiences or secondary information that lets the manager assign probabilities to different alternatives. 3) Uncertainty A situation where a decision maker has neither certainty

nor reasonable probability estimates available.

How Do Groups Make Decisions?

Many decisions in organizations, especially important decisions that have far-reaching effects on organizational activities and personnel, are typically made in groups such as: Committees Task forces Review panels

Work teams

Group Decision Making: Benefits

Group decision-making have their own sets of strengths such as:

Provides more complete information than an individual can,

bringing diversity of experiences and perspectives to the decision process. Generates more alternatives than a single individual can. Quantities and diversity of information are greatest when group

members represent different specialties.

Increases legitimacy and acceptance of a solution because group decisions may be perceived as more democratic and legitimate than decisions made by a single person.

Group Decision Making: Drawbacks

Alternatively group decision-making have their own sets of weakness such as: Group decisions are time-consuming and the interaction that takes place after the group is organized is frequently inefficient.

Groups are occasionally subject to domination by a minority of members whose rank, experience, knowledge about the problem, influence on other members views, which often leads to inefficient interaction. Groupthink is a response to pressures to conform in groups in which group members withhold deviant, minority, or unpopular views to give the appearance of agreement.
Occasionally group members share responsibility without anyone taking responsibility for the final decision which creates a situation of ambiguous responsibility in case of dissatisfying consequences.

When Are Groups Most Effective?

Whether groups are more effective than individuals depends on the criteria used for defining effectiveness, such as accuracy, speed, creativity, and acceptance. Individuals are faster at decision making.

Groups tend to be more accurate, make better decisions, be more creative, and be more effective in terms of acceptance of the final solution. With few exceptions, group decision making consumes more work hours than individual decision making does.
Ultimately, primary consideration must be given to assessing whether increases in effectiveness outweigh the losses in efficiency.

Contemporary Issues
Research shows that decision-making practices differ from country to country and two examples of decision variables that reflect a countrys national cultural environment are: The way decisions are made, whether by group or team members, participatively (e.g., in Japan), or autocratically by an individual manager (e.g., in Lebanon). The degree of risk a decision maker is willing to take. Decision makers also need creativity: the ability to produce novel and useful ideas. These ideas are different from whats been done before but are also appropriate to the problem or opportunity presented.

Quantitative Module Quantitative Decision-Making Aids

Payoff Matrices
Uncertainty affects decision making by limiting the amount of information available to managers and exploiting their psychological orientation. For instance, the optimistic manager typically follows a maximax choice (that is, maximizing the maximum possible payoff); the pessimist will often pursue a maximin choice (that is, maximizing the minimum possible payoff); and the manager who desires to minimize his regret will opt for a minimax choice. Lets look at these different approaches using an example of a marketing manager promoting the Visa card throughout the northeastern United States who has determined four possible strategies: S1, S2, S3, and S4. He is also aware that one of his major competitors, American Express, has three competitive strategies CA1, CA2, and CA3for promoting its own card in the same region.

Payoff Matrices
We assume that the Visa executive has no previous knowledge that allows him to place probabilities on the success of any of his four strategies. With these facts, the Visa card manager formulates the matrix seen here in Exhibit QM1 to show the various Visa strategies and the resulting profit to Visa, depending on the competitive action chosen by American Express.

1. If our Visa manager is an optimist, hell choose S4 because that could produce the largest possible gain ($28 million), which maximizes the maximum possible gain (that is, the maximax choice). 2. If our manager is a pessimist, hell assume only the worst can occur and the worst outcome for each strategy is as follows: S1, $11 million; S2, $9 million; S3, $15 million; and S4, $14 million. Following the maximin choice, the pessimistic manager would maximize the minimum payoff - in other words, hed select S2.

In the remaining two strategic approaches, managers recognize that once a decision is made it will not necessarily result in the most profitable payoff. What could occur is a regret of profits, as seen in Exhibit QM-2 in the following slide.

Payoff Matrices: Regret Matrix

In the third approach, managers acknowledge a regret of profits given upthat is, regret of the money that could have been made had a different strategy been used. Managers calculate regret by subtracting all possible payoffs in each category from the maximum possible payoff for each givenin this case, for each competitive action. For our Visa manager, the highest payoff, as seen in QM-1, given that American Express engages in CA1, CA2, or CA3, is $24 million, $21 million, or $28 million, respectively (that is, the highest number in each column). Subtracting the payoffs in Exhibit QM1 from these figures produces the results in Exhibit QM2. That means, starting with column CA1, subtract each value for S1, S2, S3, and S4 from $24 million to get the values in column CA1 in the Regret Matrix. For example, CA1 (which is $24 million) S1 (which is $13 million) = $11 million in the Regret Matrix. Likewise, CA1 (which is $24 million) S2 (which is $9 million) = S2 ($15 million), and so on. The maximum regrets are S1 = $17 million; S2 = $15 million; S3 = $13 million; and S4 = $7 million. The minimax choice minimizes the maximum regret, so our Visa manager would choose S4. By making this choice, hell never have a regret of profits forgone of more than $7 million. This result contrasts, for example, with a regret of $15 million had he chosen S2 and American Express had taken CA1.

Decision Trees
Decision trees are useful for analyzing hiring, marketing, investment, equipment purchases, pricing, and similar decisions that involve a progression of decisions. Typical decision trees assign probabilities to each possible outcome and calculate payoffs for each decision path. Exhibit QM3 illustrates a decision facing Becky Harrington, the site selection supervisor for Walden bookstores in the Midwestern region. Becky supervises a small group of specialists who analyze potential locations and make store site recommendations to the regions director. The lease on the companys Winter Park, Florida store is expiring, and the property owner has decided not to renew it. Becky and her group have to make a relocation recommendation. Beckys group has identified an excellent site in a nearby shopping mall in Orlando. The mall owner has offered her two comparable locations: one with 12,000 square feet (the same as she has now) and the other a larger, 20,000-square-foot space. Beckys initial decision concerns whether to recommend renting the larger or smaller location. If she chooses the larger space and the economy is strong, she estimates the store will make a $320,000 profit. However, if the economy is poor, the higher operating costs of the larger store will mean that the profit will be only $50,000. With the smaller store, she estimates the profit at $240,000 with a good economy and $130,000 with a poor one.

Decision Trees (con)

As we can see from Exhibit QM3, the expected value for the larger store is

$239,000that is, [(.70 x 320) + (.30 x 50)]. The expected value for the
smaller store is $207,000that is [(.70 x 240) + (.30 x 130)]. Given these projections, Becky plans to recommend the rental of the larger store space.

If Becky wants to consider the implications of initially renting the smaller space and then expanding if the economy picks up, she can extend the decision tree to include this second decision point. She has calculated three options: no expansion, adding 4,000 square feet, and adding 8,000 square feet. Following the approach used for Decision Point 1, she could calculate the profit potential by extending the branches on the tree and

calculating expected values for the various options.

Break-Even Analysis
Break-even analysis is a widely used technique for helping managers make
profit projections. It points out the relationship among revenues, costs, and profits. To compute the break-even point (BE), the manager needs to know the unit price of the product being sold (P), the variable cost per unit (VC), and the total fixed costs (TFC). An organization breaks even when its total revenue is just enough to equal its total costs. But total cost has two parts: a fixed component and a variable component. Fixed costs are expenses that do not change, regardless of volume, such as insurance premiums and property taxes. Fixed costs, however, are fixed only in the short term because commitments terminate later on and are thus subject to variation. Variable costs change in proportion to output and include raw materials, labor costs, and energy costs. The break-even point can be computed graphically or by using the following formula: BE = [TFC/1P - VC2]

Break-Even Analysis (con)

Lets assume that at Joses Bakersfield Espresso, Jose charges $1.75 for an average cup of coffee. If his fixed costs (salary, insurance, and so on) are $47,000 a year and the variable costs for each cup of espresso are $0.40, Jose can compute his break-even point as follows: $47,000/(1.75 0.40) = 34,815 /52 weeks = about 670 cups

of espresso sold each week, or when annual revenues are

approximately $60,926. This relationship is shown graphically in

Exhibit QM4.

Break-Even Analysis (con)

Break-even analysis also serves as a planning and decision-making tool. As a planning tool, it could help Jose set his sales objective. For example, he could establish the profit he wants and then work backward to determine what sales level is needed to reach that profit. As a decision-making tool, break-even analysis could tell Jose

how much volume has to increase to break even if he is currently

operating at a loss, or how much volume he can afford to lose and

still break even if he is currently operating profitably.

Ratio Analysis
Managers often examine their organizations balance sheet and income statements to analyze key ratios. This means they compare two significant figures from the financial statements and express them as a percentage or ratio. This practice allows managers to compare current financial performance with that of previous periods

which aids managers in deciding their future activities. Some of the

more useful ratios evaluate liquidity, leverage, operations, and

profitability. These ratios are summarized in Exhibit QM5.