Conditions of Risk

Risk is defined as a condition in which the results of any decision or course of action are not definitely known but will probably fall within a known range. One describes risk in terms of probability; that is, the "probability of a specific outcome is a fraction between 0 and 1, and if the probability of the specific outcome is 1, it is completely known; if the probability is 0, it is completely unknown." Since under conditions of risk the probability is neither completely known nor completely unknown, it is described as a fraction between the two extremes. If the probability of a batter in a major league baseball game getting a hit is .2 (note that this is point two, or two-tenths), it means that this batter will generally get a hit 20 times out of every 100 he bats. The odds, or probability, of getting a hit in any one time at bat is 20/100, or 1 of 5, or 20 percent. Each of these becomes an expression of the risk involved in the event. Techniques used to make decisions under conditions of probability or risk are listed at the end of this chapter, and in-depth examples are provided in Chapter 20.

An example of making decisions under conditions of risk would be to introduce a redesigned automobile model into the market. There may be a .20 probability of sales of 20,000 cars the first year, a .50 probability of 30,000 sales the first year, and a .30 probability of 25,000 sales the first year. Since there are past sales data on how last year's design for this car did, there is a basis for estimating the probability of success for the new design. Note, however, two aspects of this description: (1) Although the actual results of the decision to introduce a new car model are not known, the general limits of possible probabilities and results are known, and (2) all the probabilities add up to 1. When the probabilities are known, even though the actual results are not, it is possible to use various techniques to estimate the most favorable decision outcome. The techniques for decision-making under conditions of risk are discussed later in this chapter.

This example supposed that we had past data and could estimate the probabilities of specific outcomes, but suppose the new car was something never seen before, a totally new concept for which there were no previous sales data. In this case it would not even be possible to estimate probabilities. In situations in which there is no reliable estimate of probabilities or the potential decision results are unclear or not known, we have conditions of uncertainty.

Conditions of Uncertainty

When a manager cannot predict the outcome of a managerial decision, or if the outcome can be predicted but the probability of that outcome actually happening cannot be predicted, a condition of uncertainty exists. The inability to predict outcome or assign probability may be due to the following factors: (1) too many variables in the situation; (2) few variables in the situation but not enough knowledge about the variables; or (3) both too many variables and not enough knowledge about them. The assignment of probability becomes impossible under these conditions. This is the situation set forth at the end of the last section in which a totally new car was to be introduced into the marketplace. Although the potential results of such a new product introduction are known (failure or success), the probabilities of each possible result are not known. There is no past data upon which to make a prediction. This is why introductions of completely new products are very uncertain events and vast sums of money are lost each year if such managerial actions do not succeed. The single failure of a "new product launch" does not automatically doom a manager's career (although many such failures may destroy a career). Because of the great uncertainty in this management decision-making process, it is understood that some new products, however well conceived, designed, and produced, will fail.

Certainty Risk Uncertainty

Probability

Unknown --------- RESULTS------------ Known

Figure 52. Probability of predicting results of decision-making under conditions

of uncertainty, risk, and certainty.

YOU SHOULD REMEMBER

Managerial decisions made when the potential results of the decisions and the probabilities of occurrence of the results are known are made under conditions of certainty. Decisions made when the potential results are not totally known and probabilities must be assigned are made under conditions of risk. When neither the results nor the probabilities of occurrence of the results are fully known, management is making decisions under conditions of uncertainty. As uncertainty increases, so does the possibility of failure.

Steps in the Decision-Making Process

The first step in the managerial decision-making process is an examination of the current situation to determine if a problem actually exists. This is accomplished by performing a "situational analysis." Once a statement of goals is determined, alternatives are considered and evaluated, performance standards set, and pilot testing begun.

Situational Analysis

The current situation, determined from an examination of available data, is the "what is." It is not always obvious since, as evidenced by the discussion concerning the problem avoider, there are managers who have a stake in the status quo and will resist change. These managers may not see the current situation in an unbiased manner, and their perceptions cannot be relied upon to determine an accurate analysis of "what is." One of the ways in which management can accomplish an accurate analysis of the current situation is to make use of an external consultant. Since outside experts theoretically have no stake in the status quo, they should be able to give an accurate appraisal of the current company situation.

Managers often find it useful, in executing a situational analysis, to focus on the internal organization conditions, the external factors that bear upon the business, and the relationship between the two. The internal analysis, called an organizational audit, consists of listing the organization's strengths and weaknesses. The strengths, what the business does well, are referred to as its "core competencies." But it is not enough to view an organization internally; the situational analysis also requires an understanding of he external reality, the opportunities and threats that are on the horizon. This external analysis is called the environmental scan. Internal audit and environmental scan are collectively referred to as the SWOT analysis (Strengths, Weaknesses, Opportunities, and Threats). Both are necessary for the situational analysis because if an external opportunity exists, there must be an organizational ability to take advantage of that opportunity. If the business is internally weak where such an external opportunity requires strength, the business must either develop that necessary strength, hire experts who bring the necessary skills and abilities to bear, or be unable to pursue the opportunity.

Even so, this may be difficult. What is a realistic goal for the company? If a future goal statement is unrealistic, it will give false directions to the company's management. Goals that are not realistic do not motivate management they only misguide and cause misallocation of organizational resources. Some indication of future directions for management may be gained by examining past company performance and the performance of other companies in the industry. Both of these are indications of what is possible, and management is free to build upon past performance in formulating new goals. The new goals will at least be built upon the foundation of past performance.

I f there is a gap between the ''what is" (current situation) and the "what should be" (desired future), an organizational need is demonstrated and the "what should be" becomes an organizational goal statement. The next step is to formulate performance standards.