3.3 Decision Making Techniques Flashcards
Define Sales forecast
It provides an estimation of future sales figures using past data and considering predictable external factors
Methods used in quantitative sales forecasting
- Moving Averages
- Extrapolation
- Correlation
Define Extrapolation
The prediction of future sales from past data
Calculating moving averages
Step 1: Calculate the moving total
Step 2: Calculate the centred average
Define Positive correlation
A positive correlation means as one variable increases, so does the other variable
Define Negative correlation
A negative correlation means as one variable increases, the other variable decreases
External factors that may influence the accuracy of the sales forecast
- Seasonality
- Competition
- Publicity
- Market changes
- Changes to legislation
Simple payback period formula
Initial Outlay/ Net Cash Flow per Period = Years/Months
Benefits of the payback period method
It is a simple method to calculate and understand
It is particularly useful for businesses where the cash flow management is vital
Businesses can identify the point at which an investment is paid back and contributing positively to cash flow
It is also useful where new technology is introduced regularly
Businesses purchasing equipment can calculate whether an investment ‘pays back’ before an upgrade is available
Drawbacks of the payback period method
It provides no insight into the profitability of investments
Payback only considers the total length of time to recover an investment
Neither the timing nor the future value of cash inflows is considered
It may encourage a short-termism approach
Potentially lucrative investments may be dismissed as they take longer to pay back than alternatives
Define Average rate of return (ARR)
The Average Rate of Return compares the average profit per year generated by an investment with the value of the initial outlay
ARR formula
Average annual return/ Initial outlay x 100
Adv. of ARR
It considers all of the net cash flows generated by an investment over time
It is easy to understand and compare the percentage returns with each other
Disav. of ARR
As it depends on an average of cash flows, it ignores the timing of those cash flows
The opportunity cost of the investment is ignored as values are nether expressed in real terms nor adjustments made for the impact of interest rates and time
Adv. of Net present value method
It considers the opportunity cost of money
Discount tables are used to calculate forecast future values of net cashflows
Businesses may choose different discount tables (20%, 10%, 5% etc) to adjust the level of risk involved in a project, allowing a range of scenarios to be considered
Disadv. of Net present value
It is more complicated to calculate and interpret than other methods of investment appraisal
One of the primary challenges of using the NPV method is accurately forecasting future cash flows
Selecting an appropriate discount rate can be challenging, and even small changes in the discount rate can significantly impact the calculated NPV
The NPV method only considers the financial costs and benefits of a project and does not account for non-financial benefits or costs, e.g. environmental damage
Limitations of investment appraisal techniques
Each of the investment appraisal techniques relies upon forecasted future cash flows which may lack accuracy
Managers compiling cash flow forecasts may lack experience or may be biased towards a particular investment
Incomplete past data may make forecasting imprecise or mean that confidence in the data used to compile the forecast is limited
Long-term cash flow forecasts can be inaccurate for several reasons
Unexpected increases in costs
The arrival of new competitors
Changes in consumer tastes
Uncertainties due to economic growth or recession
Factors other than the cost of investment and the return on investment are not considered
Business finances and availability of external finance to fund the investment
The overall corporate objectives
Potential for positive public relations or meeting social responsibilities
Limitations of using decision trees
Constructing decision trees that can support effective decision-making requires skill to avoid bias and takes significant amounts of time to gather reliable data
A decision tree is constructed using estimates which rarely take full account of external factors and cannot include all possible eventualities
Qualitative elements such as human resource impacts are not considered, which may affect the probability of success of a decision
The time lag between the construction of a decision tree diagram and the implementation of the decision is likely to further affect the reliability of the expected values
Limitations of using critical path analysis
Very lengthy or complex projects involve a very large number of activities that have numerous dependencies
Network analysis often relies on estimates and forecasts
Significant research is required prior to the completion of network analysis
Close and honest working relationships with suppliers are essential
Network analysis does not guarantee the success of a project
Project managers will need to be highly skilled and will need experience of working with complicated plans
Resources may not prove to be as flexible as hoped when managers identify float periods
