Chapter 8:

Business Strategy

A’ Level Business Studies Cambridge

Fyruz Khan
 In simple terms a strategy is ‘how
Corporate Strategy we get from where we are now to
where we want to be in the
future’. A successful business will
have a vision or goal. Its strategy
will be a clear plan and set of
policies that should push it towards
achieving this vision. Before we go
on to assess the role of corporate
strategy, it will help to have some
clear definitions of the terms we
will be using in this unit.
 A longer explanation of corporate

Corporate Strategy strategy is that it is a future, based on an

assessment of the company’s current
position and the external environment,
containing key business objectives and
the decisions needed to achieve these.
Corporate strategy asks the big questions
– such as ‘which markets and products
do we want to be in?’ It also makes the
big decisions – such as ‘can we expand
from manufacturing operations into
retailing too?’ All businesses – indeed all
organizations – need a corporate strategy
to provide integration, direction and focus.
Resources
Available
All business resources are finite. Scarce
resources will force firms to choose
which strategies to proceed with and
which to drop or scale back. A strategy
of launching a new product nationwide
may have to be scaled down because of
lack of resources.
Strengths of the
Businesses
If a business has proven capabilities in certain areas – for example
in researching heart-disease drugs or in converting large
country houses into apartments – it is often wisest to apply these
strengths when devising future strategies. A long-term plan that
takes a business away from a proven field of operation may
require business skills and experience it does not have. In
addition, expansion of the business may be best achieved if some
low-performing areas of the business (or non-core businesses) are
sold off. In this way, the firm will be concentrating on its current
successes to achieve growth. Thus, Pepsi, after it purchased Quaker
Oats, sold off the breakfast cereal division, but kept the so drink
division, which sells the highly successful Gatorade drink in the
USA.
Competitive
Environment
Competitors’ actions are a major constraint or limit on
business strategy. Innovations by competitors may be difficult to
copy or to better. An example is Nintendo’s Wii gaming system,
which was a break from the incremental development of
computer games by Nintendo’s rivals. Major new promotional
campaigns could prove to be very effective. All businesses
operate in a competitive environment to a greater or lesser
degree. Price reductions by supermarkets selling petrol in the
UK forced a change of strategy on to the main petrol retailers.
Esso quickly adopted a ‘price-watch’ strategy, which promised
prices as low as local supermarkets. Would this plan have been
introduced without competitive pressures?
Objectives
Clearly, the objectives of the business will influence
strategy. Increasing shareholder wealth in the short
term might not be best served by investing in extensive
research and development with a payback many years
into the future. In fact, maximizing returns to
shareholders might not be the central objective of the
business – consider the ‘triple bottom line’ approach to
corporate objectives in Unit 1. If a business has a clear
social-responsibility objective, it is likely to pursue
different strategies from those of a business that is
focusing on short-term shareholder returns.
Let’s Play a
Game
• Strategic analysis: where is the
business now?

• Strategic choice: identifying, choosing

and deciding between options

• Strategic implementation: planning

for and managing change
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Strategic Analysis
It is about looking in detail at a business’s current
position, what is happening to it now and what
might happen to it in the future. Then managers
can make sure that their long term plans or
strategy for the business fit in with this external
analysis. Strategic analysis tries to find answers to
three key questions:

1. Where is the business now?

2. How might the business be affected by what

is happening, or likely to happen?

3. How could the business respond to these

changes?
Strategic Choice
After potential strategies have been identified through
strategic analysis, strategic choice, is the next stage.
Strategic choice anlyses the benefits and limitations of
different strategic options and decides between them.

Successful strategic choices have to be challenging

enough to gain competitive advantage. They must
also be achievable and affordable within the resources
available. There are techniques available to assist
managers in making strategic choices, but
judgement, experience and skill are also very
important.
 Without successful strategic implementation, there can be no
effective change with an organisation. Implementing a major
strategic change is a very important cross-functional management
task. It involves ensuring that all thefactors are in place.

• An appropriate organisational structure to deal with the change

Strategic • Adequate resources to make the change happen

Implementation
• Well-motivated staff who want the change to happen successfully

• Leadership style and organisational culture that allow change to

be implemented with wide-ranging support

• Control and review systems to monitor the firm’s progress

towards the desired final objectives
Game Round 2
 Strategic management is the highest level of
managerial activity. It is undertaken by or at least
closely supervised by the chief executive officer

Strategy and approved by the board of directors. In most

large organizations there are several layers of

And management. Under the broad corporate strategy

role of the senior directors there are typically

Tactics business-level competitive strategies and

functional department strategies. These must be
coordinated with the overall corporate strategy to
increase the chances of achieving the
organization's long-term aims.
 Tactics, on the other hand, are concerned
with making smaller-scale decisions aimed
Strategy at reaching more limited and measurable

and goals, which themselves are part of the

longer-term strategic aim. It is important
Tactics to be clear about the distinction between
tactics and strategies.
 If a business did not engage in
strategic management, it would fail to:

The Need For • Plan for the future

Strategic • Respond logically to the changing

Management business environment

• Make effective long-term decisions

based on clear objectives.
Difference Between Strategic And Tactical
Decisions
 Strategic
Management
What is SWOT Analysis?
It is helpful if the information gathered can then be summarised and
presented in a meaningful way. One approach is to use SWOT analysis.
This involves looking at the internal strengths (S) and weaknesses (W)
of a business and the external opportunities (O) and threats (T) that it
faces. It is an analytical tool that can help managers with complex
decisions.

SWOT analysis might be used by senior managers before drawing up a

strategic plan. It helps to give an idea of the advantages and
disadvantages of a particular decision. It might also help to make the
current position of a business easier to understand.
Strengths
Strengths: These could be used as a basis for developing a competitive advantage.
They might include

• A respected, intelligent, inspirational, and a visionary leader

• Experienced management

• An innovative marketing department

• Product patents

• Loyal Workforce

• Good product range.

These factors are identified by undertaking an internal audit of the firm. This is often
undertaken by specialist management consultants who analyze the activeness of the
business and the activeness of each of its departments and major product ranges.
Are We Perfect?
Weaknesses
Weaknesses: These are the negative aspects of a business that may be identified
from the internal audit. Weaknesses are what the business lacks or does poorly; for
example, in relation to its competitors. They are the characteristics that undermine
the performance of a business - perhaps preventing it from growing. They are also
areas for improvement. Examples might include:

• a poorly motivated workforce with a high staff turnover (i.e. the rate at which
workers leave)

• an organisational structure that has too many layers of management

• a product range that is getting out of date

• poor cash flow and growing debt outdated tools and machinery

• a poorly presented and out-of-date website

Opportunities
Opportunities: These are the potential areas for expansion of the business

and future profits. These factors are identified by an external audit of the

market the firm operates in and its major competitors. Examples include:

• New technologies

• A fall in the cost of an essential raw material

• Some difficult regulations being abolished

• The falling of a major rival in the market

• Export markets expanding faster than domestic markets

• Lower rates of interest increasing consumer demand

Threats
Threats: This audit analyses the business and economic environment,
market conditions and the strength of competitors. Examples of threats
are:

• New competitors entering the market

• Globalization driving down prices

• A probable recession

• Changes in the law regarding the sale of the firm’s products

• Changes in government economic policy

• A change in the social attitude towards the business’s key products

 SWOT analysis is often carried out in mind-mapping sessions
before being documented (i.e. officially recorded). It can be a
powerful way of summarising and building upon the results of
internal and external audits. Clearly, it will be a useful tool when
developing a corporate strategy, but it may have other uses. For
example, it might be used to:

• decide which new product to launch

• design a new marketing strategy

• decide whether to outsource a specific business task or

activity, such as IT

• prepare for a completely new business venture plan

• a restructuring of the business.

Finally, by identifying clearly the strengths, weaknesses,

opportunities and threats, it may be possible to improve the
performance of a business. However, this will depend on the

Conclusion action it takes after carrying out the analysis. For example,
performance will only improve if a business acts to remove
known weaknesses.
 • Subjectivity is often a limitation of a
SWOT analysis as no two managers
would necessarily arrive at the same
assessment of the company they
work for.

• It is not a quantitative form of

assessment so the cost of correcting a
weakness cannot be compared with
the potential profit from pursuing
an opportunity.

• SWOT should be used as a

Limitations of SWOT management guide for future

strategies, not a prescription.
TASK
Draw up a SWOT analysis on Fyruz Education
Services (FES)

• FES has been operating for the last 6 years

• It focuses on personal care, innovative teaching

techniques and creates an impactful learning
environment.

• FES has dismissed the entire previous team for

unprofessionalism and hired new experienced
teachers and staff members.

• The business has suffered immensely during the

pandemic.

• FES has built a strong brand image and reputation in

a short span of time.
 This is another form of strategic analysis. It focuses
on analyzing the macro-environment in which a
business operates. The macro-environment means
the wide-ranging and ‘big-picture’ factors that
could influence a firm’s future strategies as opposed

PEST to micro-environmental factors, such as customers

and suppliers. PEST analysis is an acronym for:
Analysis P = Political (and legal) factors

E = Economic factors

S = Social factors

T = Technological factors
 PEST analysis: the strategic analysis of a
firm’s macro- environment, including
political, economic, social and

PEST technological factors.

Analysis PEST is complementary to SWOT, not an

alternative.
 Any significant new business strategy should be
preceded by a detailed analysis of the wider
environment in which the strategy has to operate
and be successful. The use of PEST analysis
formalizes this process, and the results of the
analysis should be an important part of strategic

PEST decision-making.

Evaluation Once completed, PEST analysis cannot just stop. It

may need to be constantly updated and reviewed,
especially in a rapidly changing wider
environment. For multinational businesses – or for
a firm considering foreign expansion for the first
time – it will be important to undertake PEST
analysis for each country being operated in.
PEST Analysis
Porter’s Five Forces
Porter’s Five Forces
Analysis
Michael Porter provided a framework that
models an industry as being influenced by five
forces. It has been suggested that the strategic
business manager, attempting to establish a
competitive advantage over rivals, can use this
model to understand the industry context in
which the business operates.
Barriers To Entry
This means the ease with which other firms can join the industry and
compete with existing businesses. This threat of entry is greatest when:

• Economies of scale are low in the industry

• The technology needed to enter the industry is relatively cheap

• Distribution channels are easy to access, e.g., retail

• Shops are not owned by existing manufacturers in the industry

• There are no legal or patent restrictions on entry

• The importance of product differentiation is low, so

• Extensive advertising may not be required to get established.

 The Power of Buyers
This refers to the power that customers have on the producing industry. For
example, if there are four major supermarket groups that dominate this sector of
retailing, their buyer power over food and other producers will be great. Buyer power
will also be increased when:

• There are many undifferentiated small supplying firms, e.g., many small farmers
supplying milk or chickens to large supermarket businesses

• The cost of switching suppliers is low

• Buyers can realistically and easily buy from other suppliers.

 The Power of Suppliers
Suppliers will be relatively powerful compared with buyers when:

• The cost of switching is high, e.g., from PC computers to Macs

• When the brand being sold is very powerful and well known, e.g., Cadbury’s chocolate or Nike
shoes

• Suppliers could realistically threaten to open their own forward-integration operations, e.g.,
coffee suppliers open their own cafes

• Customers have little bargaining power as they are small

• Firms and fragmented, e.g., dispersed around the country as with independent petrol stations.
The Threat of Substitutes

In Porter’s model, ‘substitute products’ does not mean

alternatives in the same industry, such as Toyota for
Honda cars. It refers to substitute products in other
industries. For instance, the demand for aluminum for
cans is partly affected by the price of glass for bottling
and of plastic for containers. These are substitutes for
aluminum, but they are not rivals in the same industry.
Threats of substitution will exist when:
The Threat Of Substitutes

• New technology makes other options available, such as satellite

TV instead of traditional antenna reception.

• Price competition forces customers to consider alternatives. For

example, lower bus fares might make some travelers switch from
rail transport.

• Any significant new product leads to consumer spending that

results in less being spent on other goods. For example,
increasing spending on mobile (cell) phones by young people
reduces the available cash they must spend on clothes.
Competitive Rivalry
This is the key part of this analysis – it sums up the most
important factors that determine the level of competition or
rivalry in an industry. It is based on the other four forces, which
is why it is often illustrated in the center of the Five Forces
diagram. Competitive rivalry is most likely to be high where:

• It is cheap and easy for new firms to enter an industry

• There is a threat from substitute products

• Suppliers have much power

• Buyers have much power

Competitive Rivalry
There will also be great rivalry between competing firms in an industry
when:

• There are many firms with similar market share

• High fixed costs force firms to try to obtain economies of scale.

• There is slow market growth that forces firms to take a share from
rivals if they wish to increase sales.
Porter’s Five Forces
Porter’s Five Forces As A
Business Strategy
• By analyzing new markets in this way, it helps firms decide whether
to enter or not. It provides an insight into the potential profitability
of markets. Is it better to enter a highly competitive market or not?

• By analyzing the existing markets, a business operates in, decisions

may be taken regarding: ‘Do we stay in these markets in future if
they are becoming more competitive?’ and ‘How could we reduce the
level of competitive rivalry in these markets – and thus increase
potential profitability?’
Porter’s Five Forces As A
Business Strategy
With the knowledge gained and the power of competitive forces, businesses can
develop strategies that might improve their own competitive position. These could
include the following:

• Product differentiation, e.g., Honda hybrid cars with a distinctive appearance.

• Buying out some competitors, e.g., Exxon taking over Shell to reduce rivalry.

• Focus on different segments that might be less competitive, e.g., Nestlé entering
niche confectionery markets such as vegan chocolates.

• Communicate and collude with rivals to reduce competition, e.g., the major
cement producers in the European Union have been accused of this.
Evaluating Porter’s Five
Forces
It is argued that the benefit of Porter’s model is that it enables managers to think about
the current competitive structure of their industry in a structured and logical way.
However, it is sometimes criticized because:

• It analyses an industry at just one moment in time – static analysis – and many
industries are changing very rapidly due to, for example, globalization and
technological changes

• The model can become very complex when trying to use it to analyze many modern
industries with joint ventures, multiple product groups and different market
segments within the same industry – which have their own competitive forces.
Blue Ocean Strategy
The basis of this approach to developing business startegy is to stop competing and start
creating. This means not focussing strategies on existing markets with several or many
competitors.

Instead, it means finding and developing uncontested markets. This involves being creative
and original with strategies that other businesses have not adopted. These uncontested
markets spaces are newly created markets that have no close competitors. They are referred
to as blue oceans. Highly contested markets are referred to as red oceans.

They key to exceptional business success, the theorists suggest, is to redefine the terms of
competition and move into the blue ocean, where you have the water to yourself. The goal of
these strategies is not beat the competition, but to make the competition irrelevant.
Blue Ocean Strategy
The framework asks for four important questions:

• Raise: What factors, such as quality or customer service, could be raised

above the industry’s standard?

• Reduce: What factors, such as costly competitive advertising, were a result

of competiting against othe businesses, and which of these can be reduced?

• Eliminate: Which factors that the business has used to compete against
rivals could be eliminated together?

• Create: Which factors should be created that the industry has bever offerred
before?
Core Competencies And
Strategy
Core Competencies
And Strategy
 Core Competencies
The concept of core competencies was first analyzed in the work of Hamel and Prahalad. They argued that
if a business develops core competencies, then it may gain competitive advantage over other firms in the
same industry.

To be of commercial and profitable benefit to a business, a core competence should:

• provide recognizable benefits to consumers

• not be easy for other firms to copy, e.g., a patented design

• be applicable to a range of different products and markets.

 Core Competencies
Core product: product based on a business’s core competences, but not
necessarily for final consumer or end user.

Core competence: an important business capability that gives a firm competitive

advantage.
 It is important to realize that a business might be
particularly good at a certain activity, it might have
competence in this activity, but this does not necessarily
make it a core competence if it is not exceptional or is
Core easy to copy. So, a computer-assembly business might
Competencies be very efficient and produce computers at low cost, but
if it depends on easily available and cheap bought-in
components from suppliers, this is not a core
competence. It does not make the business very
different from many other computer-assembly firms.
Core Competencies
Developing a core competence, according to Prahalad and Hamel, depends
on integrating multiple technologies and different product skills that
probably already exist in the business. It does not necessarily mean
spending huge amounts on R&D – although patented production
processes, such as Pilkington’s oat-glass process, may give a core
competence. If a management team can effectively bring together and
coordinate designers, production specialists, IT experts and so on into a
team to develop new and different competences, then these may become
differentiated and core competences. Two excellent business examples are
the development of Philips’s expertise in optical media and Sony’s ability
to miniaturize electronic components that has led to many core products.
Core Competencies And
Strategy

Once a core competence has been established, it opens

strategic opportunities for developing core products
and then new ‘end’ products and new markets. For
instance, iOS, iTunes.
Ansoff’s Matrix
Ansoff’s Matrix
Igor Ansoff was an applied mathematician and business strategist. He
developed Ansoff’s Matrix as a strategic tool to help a business achieve
growth. It is a useful decision making tool because it allows the owners of a
business to consider a number of factorsthat will determine its corporate
strategies.

• The level of investment in existing and new products

• The exploitation of different markets

• The growth strategy for the business

• The level of risk the business is willing to accept

Ansoff’s Matrix
Ansoff popularized the idea that long-term business
success was dependent upon establishing business
strategies and planning for their introduction. His best-
known contribution to strategic planning was the
development of the Ansoff’s Matrix, which represented
the different options open to a marketing manager
when considering new opportunities for sales growth.
Ansoff’s Matrix
Ansoff’s matrix: A model used to show the degree
of risk associated with the four growth strategies
of market penetration, market development,
product development and diversification.
Ansoff’s Matrix
He considered that the two main variables in a strategic marketing decision are:
• the market in which the firm was going to operate
• the product(s) intended for sale.

In terms of the market, managers have two options:

• to remain in the existing market
• to enter new ones.

In terms of the product, the two options are:

• selling existing products
• developing new ones.
Market Penetration
In 2013, Samsung reduced the European prices of its range of 4k TVs by up to €1,200. This was in
response to price cuts by other manufacturers – but Samsung’s reductions were larger in an attempt
to increase market share. Market penetration is the least risky of all the four possible strategies in
that there are fewer ‘unknowns’ – the market and product parameters remain the same.

However, it is not risk-free as, if low prices are the method used to penetrate the market, they could
lead to a potentially damaging price war that reduces the profit margins and harm the brand
reputation of all firms in the industry.

Market penetration: achieving higher market shares in existing markets with existing products.
Product Development
It is concerned with marketing new or modified products into new or modified into existing markets.
This might be an appropriate strategy to adopt where the product life cycle is traditionally short or
were trends or technology change quickly. This strategy is associated with product innovation and and
continuous development.

The launch of Diet Pepsi took an existing product, developed it into a slightly different version and
sold it in the soft drinks market where Pepsi was already available. Product development often involves
innovation – as with 4G mobile (cell) phones – and these brand-new products can offer a distinctive
identity to the business.

Product development: the development and sale of new products or new developments of existing
products in existing markets.
Market Development
Involves the marketing of existing products in new markets . The most basic form of the strategy is
entering geographically new markets. This is not always simple, tastes and preferences may be
different in regions of the same country, let alone between countries. Small changes are often made
to suit the market. This might include changing the name or modifying the product.

This could include exporting goods to overseas markets or selling to a new market segment.
Lucozade used to be promoted as a health tonic for people with colds and influenza. It was
successfully repositioned into the sports- drink market, appealing to a new, younger range of
consumers. Dell or HP can use existing business-computer systems and repackage them for
sale to consumer markets.

Market development: the strategy of selling existing products in new markets.

Diversification
The Virgin Group is constantly seeking new areas for growth; the
expansion from a media empire to an airline and then a train operator,
then into finance, is a classic example of diversification, which was
continued with the bid for the National Lottery in the UK. Tata Industries
in India is another classic example of a very diversified business, making a
huge range of products – from steel to tea bags. Related diversification,
e.g., backward and forward vertical integration in the existing industry,
can be less risky than unrelated diversification, which takes the business
into a completely different industry.
Diversification
As the diversification strategy involves new challenges in
both markets and products, it is the riskiest of the four
strategies. It may also be a strategy that is outside the core
competences of the firm. However, diversification may be a
possible option if the high risk is balanced out by the chance
of a high profit. Other advantages of diversification include
the potential to gain a foothold in an expanding industry
and the reduction of overall business-portfolio risk.
Limitations of Ansoff’s Matrix
• It only considers two main factors in the strategic analysis of a business’s options – it is
important to consider SWOT and PEST analysis too in order to give a more complete picture.
Recommendations based purely on Ansoff would tend to lack depth and hard environmental
evidence.

• Management judgment, especially based on experience of the risks and returns from the four
options, may be just as important as any one analytical tool for making the final choice.
Limitations of Ansoff’s Matrix
• The matrix does not suggest – and to be fair to Ansoff , it was never intended to –
actual detailed marketing options. For instance, market development may seem
to be the best option but which market/country and with which of the existing
products produced by the business? Further research and analysis will be needed
to supply answers to these questions.
Conducting A Force
Field Analysis
 Force-field analysis: technique for
identifying and analyzing the
Force Field positive factors that support a
Analysis decision (‘driving forces’) and
Definition negative factors that constrain it
(‘restraining forces’).
Force Field Analysis
This technique, first developed by Kurt Lewin, involves looking at
all of the forces for and against a decision. In effect, it weighs up the
‘pros and cons’ of a decision before a choice is made. The main
purpose of the technique is to allow managers the insight that will
allow them to strengthen the forces supporting a decision and reduce
the forces that oppose it. In business, decisions such as introducing a
new product or service, or implementing a major internal change,
e.g. new IT systems, could be analyzed using this approach.
Conducting A Force Field
Analysis

• Analyze the current situation and the desired situation.

• List all the factors driving change towards the desired situation.

• List all the constraining factors against change towards the

desired situation.

• Allocate a numerical score to each force, indicating the scale or

significance of each force: 1 = extremely weak and 10 =
extremely strong.
Conducting A Force Field
Analysis

• Chart the forces on the diagram with driving forces on the left
and restraining forces on the right.

• Total the scores and establish from this whether the change is
really viable – is it worth going ahead? If yes, then the next
stage is important.

• Discuss how the success of the change or proposed decision

can be affected by decreasing the strength of the restraining
forces and increasing the strength of the driving forces.
 At present the forces against the new IT system are greater than those that are positive towards it
(11:10). Forcing through this decision without responding to this analysis could be very unwise –
people may be uncooperative and resistant if change
is forced through with no attempt to reduce the forces against change.

Evaluation Possible management strategies include:

of Force- • Staff could be trained (increase cost by 1) to help eliminate fear of technology (reduce staff
concern about new technology, −2).

Field • It would be important to show staff that change is necessary for business survival (add a new
force in favor, +2).

Analysis • Staff could be shown that new IT equipment would introduce new skills and interest to their jobs
(add a new force in favor, +1).

• Managers could raise wages to reward staff for higher productivity (increase cost, +1, but
reduce cost by loss of staff , −2).

• IT machines could be selected that are more energy efficient (environmental impact of new
technology, −1).

These changes would swing the balance of the force- eld analysis from the original 11:10 against to
13:8 in favor of the decision.
 This technique is widely used in ‘change situations’ for the reasons
given, yet it has two main limitations as a strategic-choice method:

Evaluation • Unskilled or inexperienced managers could fail to identify all of

of Force- the relevant forces involved in the change process.

Field • The allocation of numerical values to the driving and

Analysis constraining forces is rather subjective – two managers

independently undertaking the same force-field analysis could
arrive at rather different values for the forces and, consequently,
propose very different decisions based on their assessments.
Exercise 1
Example: The manager of an event organizing business has to decide between
holding a fundraising auction indoors or outdoors. The financial success of the
event depends not only on the weather, but also on the decision to hold it indoors
or outdoors.

Table 39.1 shows the expected net financial returns

or ‘economic returns’ from the event for each of these different circumstances.
From past weather records for August, there is a 60% chance of fine weather and a
40% chance of it being poor. The indoor event will cost $2,000 to arrange and the
outdoor event will cost $3,000.
Example 1: The Possible Economic Returns
Example 1
Example 1
More Complex Decision
Trees

The examples used above have been based on straight

forward decisions where only one choice had to be made.
Life is rarely that easy and a more complex decision tree,
which concerns a construction company’s options over a
derelict building that it has owned for some time.
Example 2: More Complex
Example

There are two options facing the business initially:

The building could either be sold now for $1 million or

improved and updated at a cost of $0.5 million. After
renovation, the building could be sold as one house.

However, after renovation, another option is to split the

building into three flats, which will cost a further $0.25
million.
Example 2: More Complex
Example

The pay offs from these options will depend on interest rates at
the time of sale. High rates will reduce the returns in both cases,
as seen in Table 39.2. Based on past economic records, the chance
of interest rates being high during the sale period for the house or
flats is 60% and the chance of low rates is 40%. The decision tree
for these options is shown in Figure 39.5. The important rule of
working from right to left in calculating expected values is still
relevant with these more complex examples.
Example 2
Example 2
Decision Trees
One method of considering all the options available and the chances of them
occurring is known as decision trees. It represents four main features of a
business decision.

• All of the options open to a manager

• The different possible outcomes resulting from these options

• The chances of these outcomes occurring

• The economic returns from these outcomes

Decision tree: a diagram that sets out the options connected with a decision and
the outcomes and economic returns that may result.
Constructing Decision Trees
• It is constructed from left to right.

• Each branch of the tree represents an option together with a range of consequences or
outcomes and the chances of these occurring.

• Decision points are denoted by a square – these are decision nodes.

• A circle shows that a range of outcomes may result from a decision – a chance node.

• Probabilities are shown alongside each of these possible outcomes. These probabilities
are the numerical values of an event occurring – they measure the chance of an outcome
occurring.

• The economic returns are the expected financial gains or losses of a particular outcome.
 • The primary limitation concerns the accuracy of the data used.
Estimated economic returns may be quite accurate when they
concern projects where experience has been gained from similar
decisions. In other cases, they may be based on forecasts of
Limitations market demand or estimates of the most likely financial outcome.

of Decision In these cases, the scope for inaccuracy of the data makes the

Trees results of decision-tree analysis a useful guide, but no more.

• In addition, the probabilities of events occurring may be based

on past data, but circumstances may change. What was a
successful launch of a new store last year may not be repeated in
another location if the competition has opened a shop there first.
 • The conclusion must be that decision trees aid the decision-making
process, but they cannot replace either the consideration of risk or
the impact of non-numerical, qualitative factors on a decision. The
latter could include the impact on the environment, the attitude of the

Limitations workforce and the approach to risk taken by the managers and

Of Decision
owners of the business. There may well be a preference for certain but
low returns, rather than taking risks to earn much greater rewards.
Trees
• Finally, it must not be forgotten that the expected values are average
returns, if the outcomes occur more than once. With any single, one-
off decision, the average will not, in fact, be the result. Decision trees
allow a quantitative consideration of future risks to be made – they do
not eliminate those risks.