Business & Commercial Aw a r e n e s s

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Lecture 6: Decision Making 2 Quantitative

j.a.g.willard@herts.ac.uk
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Learning outcomes
To understand the role played by quantitative techniques in decision making To understand a range of quantitative decision making techniques commonly used in business To be able to use the simpler quantitative techniques which will support decision making

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The role of quantitative decisions

Q UAN T I TAT I V E FAC T O R S

Q UALI TAT I V E FAC T O R S

strategic

tactical

operational

Many complex factors Mix depends on decision Smaller decision scope Non-numerical relationships Good approx. by numerical models Judgment and experience needed Assumptions require qualitative input

ALL decisions are a mix of quantitative and qualitative factors In general the more that decisions deal with the whole business . . . . . . . the greater the input from the qualitative factors Scenario analysis and financial models have wide strategic use Poor decisions often result from inappropriate mix of the 2 types
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How are quantitative tools used?

Collect data
Check data
In many business decisions the quantitative input has errors
The check boxes (in dark grey) are essential to ensure the quality of the decision

Select Model Use Model Check Output

Reality Check Input to Decision

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Quantitative decision tools

Modelling Tool
Break-even analysis Pay-off Period Cost-benefit

Application
Identifies at what point an investment project would move from loss to profit, for instance what volume, price, product mix are required

Financial

Identifies when investment projects would move into profit ie: when up front investment and the ongoing costs are paid back from income Identifies whether an investment project will make a loss or a profit. This can be over the whole lifetime of the investment or over a specified number of years. Some businesses require an investment to return an overall profit over the first X years or they will not invest A forecasting tool which can be used to generate estimates of future business values (eg sales, income). It averages these quantities over the past N months/quarters/years and gives a smoothed forecast A simple but powerful method to forecast a business quantity which is increasing or decreasing over time also called trend analysis The Solution Matrix is an example. It is a pseudo quantitative tool which allows selection of the best alternative when considering qualitative factors and quantitative factors which cannot be aggregated (eg labour availability, proximity to customers, greenness)

Moving averages Linear regression MCDA (Multiple Criteria Decision Analysis)

Forecasting Multi Factor

See weekly reading for descriptions of a wider range of numerical tools commonly used in business
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Break-even or Switchover Analysis

This technique is used if you need to determine a switchover decision point
Imagine 2 investment options, Product Y and Z For each, the more we invest the more profit we create If we can only invest in one, which one? - and how much do we invest?

X W
PROFIT (m)

Product Y Product Z

V X
INVESTMENT (m)

Plot the profit against the cost of investment for each product option Where the 2 lines cross (W-W) is where it becomes better to invest in Product Y Otherwise invest in Z. But if you invest less than V-V you make a loss If you have the available funds invest up to X in Product Y
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Pay-off period
This very simple technique is used if you need to determine when you start to make a cumulative profit on an investment Tabulate cost, income and net position on a monthly, quarterly or yearly basis Where the cumulative net position goes positive is the pay-off period This is important to a business as it is the point at which they will no longer lose money from an investment Business environments are volatile and can quickly reduce investment viability The sooner pay-off occurs, the lower the risk
In k Cost Income Net Cum Net Year 1 745 600 -145 -145 Year 2 797 780 -17 -162 Year 3 995 1,134 +139 -23 Year 4 984 1,160 +176 +153
4000 3000 2000 1000 0 -1000 Year 1 Year 2 Year 3 Year 4

Pay-off does not occur until Year 4 This is a risky investment

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Cost-Benefit
This accounting based technique is used to determine whether an investment will be profitable. It can also be used to vary key inputs to look at the sensitivity of the profit to possible future changes List all the costs and all the incomes Separate these into sub-categories but not too finely divided Identify the spend per time period eg monthly, quarterly, yearly Tabulate, calculate the totals and compare cost and income total Enhancements

Time value of money

Money value reduces over time 1 today buys less in 1 year Driven by inflation & interest rate Reduce money figures by x% (x is the discount rate) In Year 2 reduce by another x% In Year Z it will = value/(1+x)Z

Ratios
2 important ratios Cost/Income: Total cost Total Income Must be < 100% or no profits Profit margin:100% - cost/income % of sales which are profit Can be calculated overall or as a marginal value for one sales unit
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What-if analysis
Build your cost-benefit using a spreadsheet Enter the key variables in cells Change these variables The sensitivity of the investment to changes in key variables can be determined eg:
Price, market share, manufacturing cost, raw material costs etc 8

Cost-Benefit example
Costs (k) Manufacturing Advertising Warehousing Retail costs Overheads TOTAL COSTS (k) Sales volume (k) Price() TOTAL INCOME (k) PROFIT (k) Year 1 400 150 50 15 130 745 100 6.00 600 -145 Year 2 500 100 50 10 137 797 130 6.00 780 -17 Year 3 640 120 75 12 148 995 180 6.30 1,134 +139 Year 4 660 90 75 9 150 984 200 5.80 1,160 +176
Total = 3,674k Total = 3,521k

Cost/Income Years 1-4 = 3521/3674 = 96%. In Year 4 = 984/1160 = 85% Profit margin in Year 1 = -145/600 = -24%. In Year 4 = 176/1160 = 15%
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Forecasting
Business decisions are future orientated. They involve the allocation of resources (time, money, people) to generate an improved performance. It is not possible to know what will happen in the future, so businesses estimate the key variables prices, interest rates, sales, competitor activity

This is called Time Series Forecasting

It can be fairly accurate given: good data + the right method But do not forecast too many months ahead as environments change

There are 4 basic types of Time Series Forecast

to be studied on the module refer to reading list if interested

stationary

trend
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seasonal

cyclical
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Moving average forecasting

USE: If the business variable is changing up and down randomly RESTRICTIONS: Variability should be constant over time Time periods must be of equal length month/quarter/year No trend, seasonal activity or cyclical pattern HOW IT WORKS: Choose a number of time periods over which to average This should usually be in the range 2-6 Collect historical data covering this number of periods Calculate the average of these pieces of data This is the moving average forecast for the future

When you get the next real piece of data do it again

This is a revised forecast replacing the one last you calculated Update your forecast each time you have a new piece of data THE OPTIMUM: Try all averaging over all numbers of periods between 2 and 6 Add the errors (forgetting any minus signs) The best is the one with the lowest average error
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Moving averages example

what is the price forecast for Year 5?
Year 1 Sales volume (k) Price() 100 6.00 Year 2 130 6.00 Year 3 180 6.30 Year 4 200 5.80

Check restrictions: Price varies randomly, variability not increasing Average over 2 years: (6.30 + 5.80) / 2 = 6.050 Average over 3 years: (6.00 + 6.30 + 5.80) / 3 = 6.033 Average over 4 years: (6.00 + 6.00 + 6.30 + 5.80) / 4 = 6.025 Not much difference, any of them will be okay

But maybe the price in year 4 is the best guide as it is the most recent price This is really the Moving Average over 1 period called a Nave Forecast
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Trend forecasts by linear regression

USE: If the business variable is changing steadily over time RESTRICTIONS: Variability should be constant over time Time periods must be of equal length month/quarter/year A seasonal activity or cyclical pattern is okay but this must be modelled separately and the impact added into the trend forecast HOW IT WORKS: To be accurate you need an Excel spreadsheet Plot a line or scatter graph of your business data Right click on the data plot line Select Add Trendline and then the Display equation on Chart box

Your graph shows the equation of the forecast line, eg:

y = 0.75x + 45 or in a more general format y = Ax + B To forecast into the future substitute the value of the time period for x EG: in the above equation, in time period 7 y = 0.75 x 7 + 45 = 50.25

THE OPTIMUM: Excel has done this for you automatically

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Linear regression example

what is the sales volume forecast for Year 5?
Year 1 Sales volume (k) Price() 100 6.00 Year 2 130 6.00 Year 3 180 6.30 Year 4 200 5.80

Check restrictions: Volume is increasing steadily, variability not increasing

Sales Profile Years 1 - 4

250 y = 35x + 65 Sales Volume (000s) 200 150 100 50 0 Year 1 Year 2 Year 3 Year 4

From Excel the equation is y = 35x + 65 or: Sales = 35 time + 65 in Year 5: Sales = 35 x 5 + 65 = 240 (in thousands)

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Multiple criteria decision analysis

USE: Where there are several quantitative decision variables which

cannot be added together as they have different units

eg: costs (), market share (%), distance from supplier (km)
Or where decision variables are qualitative but can be scored out of 10 Or both of the above

HOW IT WORKS: This is the methodology of the Solution Matrix used to evaluate ideas
It will also be seen again when we look at Risk Evaluation Identify the decision criteria Weight their importance to the decision, relative to each other Score each investment option out of 10: good = 10 poor = 1 Multiply the scores by the weights for each option and add them The investment option with the highest score is the best one The scores and weights can be allocated by group decision, by averaging the scores of several decision makers or as the least preferred method, by one person though this is subject to bias
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MCDA - example
Three investment options have been short-listed. The key criteria have been selected by a panel of decision makers. How each of the investment options performs against these criteria is tabulated below.
Which is the best investment option? Criterion Cost Income Labour Availability Pay-off period Environmental impact Investment 1 10m 25m Within 10 miles 3 years Significant Investment 2 12m 27m No skilled labour 3.5 years Low initially but becoming significant Investment 3 15m 32m Within 20 miles 4 years Limited

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MCDA - solution
Criteria Cost Income Labour Pay-off period Weight 10 9 5 6 Investment A Investment B Investment C

Score
8 6 8 7

Utility
80 54 40 42

Score
7 7 2 5

Utility
70 63 10 30

Score
5 8 4 4

Utility
50 72 20 24

Environment
TOTAL

16

20
193

36
202

232

The weights and scores for the options are determined by the decision panel This is best done if each member assesses the score against each criterion These are averaged to give the results saving a lot of debate Weights or scores with large differences are discussed and agreed Above, Investment A is the best . . . . . . . . but if labour supply & cost worsened the decision may be marginal
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Summary
In this lecture we have learned:
Where quantitative decisions are needed in business The process used to obtain quantitative decision inputs The range of commonly used quantitative decision tools How to use some of the simpler but common tools:
Break-even analysis Pay-off period Cost-benefit analysis Forecasting by moving averages and linear regression Multi-criteria decision analysis for: numerical criteria which cannot be added together subjectively assessed qualitative criteria
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