uncertainty and risk

uncertainty and risk

Since managers cannot foretell the future, they are forced to guess the most likely outcome of any decision. All such estimates must, by their very nature, be subjective, though some estimates will be better than others depending upon the amount and availability of information.

Uncertainty arises because it is difficult to predict changes and to estimate accurately the likelihood of events, including possible losses. Unfortunately, many management decisions are based on this uncertainty, since circumstances rarely repeat themselves and there is little past data available to act as a guide. Such market uncertainty can only be gauged by managers, when launching a new product, through combining the limited data available with their own judgement and experience. Managers can improve upon their subjective estimates by collecting information from forecasts, market research, feasibility studies, etc., but they need to balance the cost of collecting such information against its value in improving decisions.

The term ‘risk’ rather than uncertainty is used to describe business situations where large amounts of information are available about the extent of possible losses and the likelihood of such losses occurring. For example, an insurance company dealing with fire INSURANCE policies and claims from large numbers of manufacturers will be able to compile detailed statistics about numbers of fires and the amount of damage done by each, and can use this information to predict the likelihood of a business experiencing a fire. This detailed statistical information allows the insurance company to charge manufacturers premiums for indemnifying them against fire losses, and thereby to make a profit. By contrast, a single manufacturer would find it very difficult to predict the likelihood of his premises being damaged by fire and the amount of damage, since such an event would probably be a unique experience for him. Faced with a possibility of fire, the manufacturer can either choose to bear the risk of losses resulting from a serious fire or can avoid the risk of fire damage by paying an insurance company a premium to bear the risk. Again, the manufacturer can take the risk that the prices of its main raw materials will be much higher next year, or it can contract now through a commodity FORWARD MARKET to buy raw materials supplies for future delivery at a fixed price. See DECISION TREE, SALES FORECASTING, DISCOUNTED CASH FLOW, BUSINESS CYCLE, SENSITIVITY ANALYSIS.