3.3 - Decision Making Techniques Flashcards
Extrapolation
Using trends established from historical data to forecast the future
Benefits of using extrapolation
- Simple method of forecasting
- Not much data required
- Quick and cheap
Drawbacks of using extrapolation
- Unreliable if there are significant fluctuations in historical data
- Assumes past trend will continue into the future
- Ignores qualitative factors, like changes in tastes and fashion
Correlation
Looks at the strength of a relationship between two variables
Investment appraisal
Process of analysing the attractiveness of possible future investments
Types of investment appraisal
- Payback period
- Average Rate of Return
- Net Present Value
Average Rate of Return
Assesses the worth of an investment by calculating the average annual profit it generates as a percentage of the initial investment
Formula for Average Rate of Return
(Average annual profit / Initial investment) * 100
Advantages of Average Rate of Return
- Simple to calculate and understand
- Focusses on profitability
- Provides a percentage return which can be compared with a target return or other investments
Disadvantages of Average Rate of Return
- Ignores time value of money
- May encourage short-term thinking
- Ignores risk and external factors
Payback period
Length of time it takes for a firm to get back the initial cost of the investment
Advantages of payback period
- Simple to use and understand
- Emphasises speed of return
- Straightforward to compare projects
Disadvantages of payback period
- Doesn’t consider cash received after the payback period
- Doesn’t consider time value of money
- Ignores long term profitability
Net Present Value
Calculates the monetary value now of a project’s future cash flows using a discount factor
Advantages of Net Present Value
- Takes account time value of money
- Looks at all cash flows involved through the life of the project
- Has a decision making mechanism
Disadvantages of Net Present Value
- Difficult to select the most appropriate discount rate
- Some users may find it difficult to understand
- Sensitive to the initial investment cost
Decision trees
Graphical tool used in business decision-making to assess possible outcomes, probabilities, and financial returns of different choices. It helps businesses evaluate risks and make data-driven decisions
Benefits of decision trees
- Choices are set out in a logical way
- Potential options and choices are considered at the same time
- Use of probabilities enables the risk of options to be assessed
Drawbacks of decision trees
- Probabilities are just estimates
- Uses quantitative data only
- Assignment of probabilities and expected values are prone to bias
Critical path analysis
Project management technique used to plan and schedule tasks in complex projects. It helps businesses identify the longest sequence of dependent tasks (the critical path) and the shortest time needed to complete a project
Critical path
The longest sequence of dependent tasks with zero float, meaning any delay in these tasks will delay the entire project
Float time
The amount of time a task can be delayed without affecting the overall project completion time
Benefits of critical path analysis
- Identifies the exact activities involved
- Identifies activities that can be done simultaneously
- Speeds up processes and allows for Just In Time
- Identifies float time and activities that are critical for success
Drawbacks of critical path analysis
- Projects and strategies often involve multiple factors making calculating the time taken to complete an activity very difficult
- Doesn’t take into account qualitative issues
- Relies on estimations
- Doesn’t take into account unexpected events
