Strategic Decision Making, Risk and Uncertainty
What this domain tests
This domain combines relevant costing with decision-making under risk. The exam tests limiting-factor ranking, make-or-buy and shutdown decisions, expected value, decision trees, and the maximax, maximin and minimax-regret criteria.
Core rules
- Relevant costing: future, incremental, cash; exclude sunk, committed, allocated and notional costs; include opportunity cost.
- With one limiting factor, rank products by contribution per unit of the scarce resource, not by contribution per unit.
- Make-or-buy compares the avoidable cost of making with the buy price; unavoidable fixed costs remain either way.
- Expected value = Σ (probability × outcome). It is a long-run average, ignores risk attitude, and is not a guarantee.
- Decision trees handle sequential decisions: roll back from the right, computing EV at each chance node and choosing the best at each decision node.
- Maximax picks the best of the best (risk seeker); maximin picks the best of the worst (risk averse); minimax regret minimises the maximum opportunity loss.
- Sensitivity analysis asks how far a variable can change before the decision reverses; scenario analysis and simulation handle several variables at once.
Worked example
A project costs Rs. 500,000. Demand is high (0.6) giving Rs. 900,000 inflow, or low (0.4) giving Rs. 300,000. EV of inflows = (0.6 × 900,000) + (0.4 × 300,000) = Rs. 660,000. EV of net benefit = 660,000 − 500,000 = Rs. 160,000, so proceed on an EV basis. Maximin compares worst outcomes: 300,000 − 500,000 = −Rs. 200,000, so reject. The two criteria conflict because they embody different risk attitudes.
Traps
Ranking on contribution per unit when a resource is scarce; including allocated fixed overhead in a shutdown decision; treating EV as a certainty; forgetting to deduct the investment at the decision node; confusing minimax regret with maximin.