Chapter 7 Risk and Uncertainty
Question 1 – Maximin, Maximax and Minimax Regret Rule
Stow Health Centre specializes in the provision of sports/exercise and medical/dietary
advice to clients. The service is provided on a residential basis and clients stay for
whatever number of days suits their needs.
Budget estimates for the year ended 31 December 2008 are as follows.
(i) The maximum capacity of the center is 50 clients per day for 350 days in the
year.
(ii) Clients will be invoiced at a fee per day. The budgeted occupancy level will vary
with the client fee level per day and is estimated at different percentages of
maximum capacity as follows.
Client fee per day Occupancy level Occupancy as percentage
of maximum capacity
$180 High 90%
$200 Most likely 75%
$220 Low 60%
(iii) Variable costs are also estimated at one of three levels per client day. The high,
most likely and low levels per client day are $95, $85 and $70 respectively.
The range of cost levels reflects only the possible effect of the purchase prices of
goods and services.
Required:
(a) Prepare a summary which shows the budgeted contribution earned by Stow
Health Centre for the year ended 31 December 2008 for each of nine possible
outcomes. (7 marks)
(b) State the client fee strategy for the year to 31 December 2008 which will result
from the use of each of the following decision rules.
(i) Maximax
(ii) Maximin
(iii) Minimax regret
Your answer should explain the basis of operation of each rule. Use the
P. 1
information from your answer to (a) as relevant and show any additional
working calculations as necessary. (12 marks)
(c) The probabilities of variable cost levels occurring at the high, most likely and
low levels provided in the question are estimated as 0.1, 0.6 and 0.3
respectively.
Using the information available, determine the client fee strategy which will be
chosen where maximization of expected value of contribution is used as the
decision basis. (6 marks)
(Total 25 marks)
Question 2 - Maximax, Maximin and Expected Value
Shifters Haulage (SH) is considering changing some of the vans it uses to transport
crates for customers. The new vans come in three sizes; small, medium and large. SH
is unsure about which type to buy. The capacity is 100 crates for the small van, 150
for the medium van and 200 for the large van.
Demand for crates varies and can be either 120 or 190 crates per period, with the
probability of the higher demand figure being 0·6.
The sale price per crate is $10 and the variable cost $4 per crate for all van sizes
subject to the fact that if the capacity of the van is greater than the demand for crates
in a period then the variable cost will be lower by 10% to allow for the fact that the
vans will be partly empty when transporting crates.
SH is concerned that if the demand for crates exceeds the capacity of the vans then
customers will have to be turned away. SH estimates that in this case goodwill of
$100 would be charged against profits per period to allow for lost future sales
regardless of the number of customers that are turned away.
Depreciation charged would be $200 per period for the small, $300 for the medium
and $400 for the large van.
SH has in the past been very aggressive in its decision-making, pressing ahead with
rapid growth strategies. However, its managers have recently grown more cautious as
the business has become more competitive.
Required:
P. 2
(a) Explain the principles behind the maximax, maximin and expected value criteria
that are sometimes used to make decisions in uncertain situations. (4 marks)
(b) Prepare a profits table showing the SIX possible profit figures per period.
(9 marks)
(c) Using your profit table from (b) above discuss which type of van SH should buy
taking into consideration the possible risk attitudes of the managers. (6 marks)
(d) Describe THREE methods other than those mentioned in (a) above, which
businesses can use to analyse and assess the risk that exists in its decision-
making. (6 marks)
(25 marks)
(ACCA F5 Performance Management December 2008 Q2)
Question 3 – Expected Value and Decision Tree
RY Ltd, a transatlantic airline company, has recently launched a low-cost airline
company providing flights within Europe. The market is highly competitive and two
other low-cost airlines, B Ltd and G Ltd, together hold 98% of the market.
RY Ltd commissioned some market research to help with the pricing decision for one
route, London to Paris, which it is thinking of offering. The research identified three
possible market states and the likely number of passengers that would be attracted at
three price levels on this route.
Ticket price £80 £90 £100
Passenger Passenger Passenger
Market Probability seats seats seats
Pessimistic 0.2 80 60 30
Most likely 0.6 100 90 80
Optimistic 0.2 150 150 120
Airport charges are incurred for each customer and these are expected to be either £5
or £6 per customer depending on the negotiations with the airports involved. The
probabilities for the airport charges are 0.6 for an airport charge of £5 per passenger
and 0.4 for an airport charge of £6 per passenger.
The fixed costs of a flight from London to Paris are £4,422.
Required:
P. 3
(a) Use decision tree analysis to advise RY Ltd on the optimum selling price to set.
(10 marks)
(b) (i) Assuming RY Ltd knew that there would be a pessimistic market,
determine the price that it should charge in order to maximize profit.
(3 marks)
(ii) The market research company has now stated that by performance further
analysis, it will be able to accurately predict the state of the market.
Calculate the maximum price that RY Ltd should pay for this further
analysis. (7 marks)
(c) Discuss the limitations of basing this decision on expected value calculations.
(5 marks)
(Total 25 marks)
P. 4
