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Cost Benefit or Cost Effectiveness Analysis
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| Cost Benefit or Cost Effectiveness Analysis Cost Benefit Analysis is an improvement on marginal analysis. It enables the decision maker to compare the ratio of costs to benefits of alternative courses of action and to select the alternative that has the best ratio. The best ratio is that which yields the least costly means of achieving an objective or the expenditure that yields greatest value. Decision Trees One of the best ways to analyse a decision is to use the so-called decision tree Decision trees depict, in the form of a tree, the decision points, chance events and probabilities involved in various courses that might be undertaken. We can also define a decision tree as a graphical method of displaying various parts of the decision-making process including courses of action, risks involved and likely outcomes. It enables the decision makers to consider alternative solutions, assign financial values to them, estimate the probability of a given outcome for each alternative, make comparisons and choose the best alternative. 133 Figure 3.2: Decision Tree without probabilities as adapted from Weihrich & Koontz, Management – A Global Perspective, 10 th ed, pp. 209 A common problem occurs in business when anew product is introduced. The manager must decide, among various options, whether to a) Install expensive permanent equipment and ensure production at the lowest possible cost orb) Undertake cheaper technology tooling that will involve a higher manufacturing cost but lower capital investments that will result in smaller losses if the product does not sell as estimated. An example of a decision tree diagram showing the decisions a manager faces in this situation might be similar to that of Figure 6.1. The decision tree approach makes it possible to see at least the major alternatives and the fact that subsequent decisions may depend on events in the future. By incorporating the probabilities of various events in the tree, managers can also comprehend the true probability of a decision leading to the desired results. The best estimate may really turnout to be quite risky. Decision trees and similar techniques (a) replace broad judgments with a focus on important elements in a decision, (b) bring out into the open premises that are often hidden, and (c) disclose the reasoning process by which decisions are made under uncertainty. |