Situation → Action Needed for Change
Company Lacks Information → Education and Communication Tactics
In a stodgily run manufacturing company in Salt Lake City, the employees were kept in the dark about corporate profitability. Judging by the expensive cars of the owner, they assumed that all was well. Unfortunately, the company was losing money and layoffs would be inevitable unless productivity rose. In this situation, the employees would need to be informed about the true condition of the company before they gave their full cooperation to work more efficiently.
You Need Information and You Have Little Leverage → Participation and Involvement Tactics
A metal fabrication plant in Kansas City hired a consultant to cure absenteeism. The consultant did not know the people, the personalities, or the town. Because she was an outsider, she had no power to demand cooperation for her investigation. She first had to gain the trust of the workers and begin to talk with them about the problems that prompted so many sick days. She needed their cooperation and involvement to define and solve a problem for the workers as well as for management.
Adjustment Problems → Support and Facilitation Tactics
As offices become computerized across the country, secretarial work has changed. There are no more typewriters. Secretaries are required to use word processor programs on computers. Instead of hiring new help, companies need to retrain their staffs. Companies must hire computer support staff to help with this adjustment.
Your Desired Changes Will Cause Losses and Opponents Have Power to Block You → Negotiation and Agreement Tactics
In the 1980s robotics were introduced in the American auto industry. Japanese imports were taking jobs overseas. GM, Ford, and Chrysler chose to negotiate new agreements with the powerful United Auto Workers union to allow work-rule changes required by the new technology. If the corporations had decided to play hardball and impose their will upon the UAW, the union could have struck, and both parties would have ended up losing. By cooperating both had a chance of surviving.
You Have No Alternatives and No Money for Facilitation → Manipulation (Give No Choices)
In distressed companies there are often no alternatives to layoffs and wage cuts. A manufacturer of electronic switches in Trenton, New Jersey, gave its employees the choice of lower wages or no jobs at all. They took the pay cut, but the company failed anyway.
Speed Is Needed and You Have the Power → Explicit Orders and Coercion Tactics
This situation is most common in the consulting, law, and public accounting professions. The familiar scene begins with a client requesting a project due “yesterday.” The partner calls in a lowly associate and demands that the assignment be completed “the day before yesterday.” The partner says jump and the associate jumps. The partners hold the power. The rub is that employees burn out and leave. Fortunately for the firms, there are legions of eager college graduates to replace their ranks. If you choose coercion tactics, you have to be sure you have the power and are willing to deal with the consequences.
AN OVERVIEW OF ORGANIZATIONAL BEHAVIOR
Above all, MBAs should think before they act. When MBAs need to take action, they should thoroughly analyze the situation, first from the perspective of the individual and then from an organizational vantage point, to create a coordinated and effective action plan. MBAs are not trained to be “organizational experts” by any means, but with a few theories and frameworks, they should have a better chance of acting effectively.
KEY OB TAKEAWAYS
Want Got Gaps—Organizational problems
Causal Chains—The relationship of problems to one another
Action Planning—A specific series of activities to solve an organizational problem
APCFB Model—A human psychology model
Goal Congruence—People with similar goals work better together.
Expectancy Theory—Motivation is a function of how an employee’s actions translate into a reward.
VCM Leadership Model—The vision, commitment, and management aspects of leadership
Active Listening—Listening to gain insight
The Five Forms of Power—Power is derived from more than a title.
The Basic Organizational Model—Strategy, policies, structure, systems, climate, and culture
Structure—The way a company organizes itself
Span of Control—The number of people a manager directly controls
Paradigm—A corporate mind-set or pattern of doing things
Systems Theory—An organization functions much like a body.
The Evolution and Revolution Pattern—Organizations go through a series of growth and crisis periods during their lifetimes.
Day 5
QUANTITATIVE ANALYSIS
Quantitative Analysis Topics
Decision Tree Analysis
Cash Flow Analysis
Net Present Value
Probability Theory
Regression Analysis and Forecasting
Quantitative analysis (QA) is probably the most challenging and most important course in the MBA curriculum. It provides the basic tools principally used in finance, accounting, marketing, and operations. Therefore, these pages are not to be skipped over simply because you are not accustomed to dealing with numbers and statistics. Give it a chance!
Quantitative techniques provide MBAs with a way to distinguish themselves from their non-MBA peers. MBAs can make a splash with their bosses by creating sophisticated charts and graphs and by using impressive language. Hopefully, the conclusions they have to deliver are a welcomed story.
Using QA theories to solve business problems is the MBA’s main job. Quantitative analysis helps MBAs remain objective when solving complicated problems. The theories behind the techniques are inconsequential. Their application to solve real business problems is what is important. Yet it should be noted that no matter how mathematically precise the tools of quantitative may appear, they are no substitute for an MBA’s own best judgment.
“IT’S MY FERVENT HOPE, FERNBAUGH, THAT THESE ARE MEANINGLESS STATISTICS.”
DECISION THEORY
Decision theory teaches how to break complex problems into manageable parts. Without a framework to attack difficult situations, such cases quickly become unmanageable. For example, QA can be used to help a wildcatter decide whether to drill for oil. The inherent risks of oil exploration, however, cannot be eliminated. A decision tree diagram can organize the problem’s alternatives, risks, and uncertainty.
Decision tree analysis consists of the following five steps:
1. Determine all the possible alternatives and risks associated with the situation.
2. Calculate the monetary consequences of each of the alternatives.
3. Determine the uncertainty associated with each alternative.
4. Combine the first three steps into a tree diagram.
5. Determine the best alternative and consider the nonmonetary aspects of the problem.
Decision tree diagrams include activity forks and event forks at the junctures where alternatives are possible. For example, the decision whether to drill for oil represents an activity fork in the tree for an oil wildcatter. It is symbolized on a decision tree by a square. If the different alternatives are subject to uncertainty, that is an event fork. The uncertain outcome of a well producing oil would be considered an event. It is symbolized on a decision tree by a circle.
ACTIVITY FORKS
EVENT FORKS
DECISION TREE EXAMPLE
As an illustration of a situation where the decision tree could be helpful, consider Mr. Sam Houston of Texas. Mr. Houston is about to exercise his option to drill for oil on a promising parcel. Should he drill? If he hits a gusher, there is an estimated $1,000,000 to be gained. When he investigated all of the alternatives, Mr. Houston made the following list:
1. Sam paid $20,000 for the drilling option.
2. Sam could lower his risks if he hired a geologist to perform se
ismic testing ($50,000). That would give him a better indication of success and lower his risk of wasting drilling costs.
3. Should he roll the dice and incur $200,000 in drilling costs without a seismic evaluation to guide him?
4. Sam consulted with oil experts. They believe Sam’s parcel has a 60 percent chance of having oil without the benefit of any tests.
5. It has also been the experts’ experience that if seismic tests are positive for the oil, there is a 90 percent chance there is “some” oil. And conversely, there is a 10 percent chance of failure.
6. If the seismic tests are negative, Sam could still drill but with a 10 percent chance of success and a 90 percent chance of failure.
7. Sam could decide not to drill at all.
Each piece of information above is incorporated into a tree diagram. A tree diagram graphically organizes Mr. Houston’s alternatives.
Before you get too enthusiastic over the drawing of trees, you must determine what information is irrelevant. In this case, the $20,000 Sam paid for his drilling option is extraneous; it is a sunk cost. The money is out the door, sunk down a well. It isn’t coming back no matter what Sam decides. Sunk costs are therefore excluded from decision trees.
DRAWING A DECISION TREE
The first step to drawing the tree is to determine the first decision (or fork of the tree) that needs to be made. Should Sam choose to test first? If seismic testing is chosen, it would precede all of the other activities that follow. It is reflected in the tree as a square at the first fork.
If Sam tests, it could result in a positive event (60 percent chance) or negative event (40 percent). If there are no tests, he can still choose to drill or not (square). Regardless of the results of the seismic report, Sam can still “choose” to drill or not. But once the oil rig is drilling, the existence of oil is an uncontrollable event. Either there will be a lucrative oil event or not.
The next step is to add the monetary consequences—they are like the “leaves to a tree.” If there is oil, there would be a $1,000,000 payday. Drilling costs are $200,000 per well. Testing costs are $50,000 per well.
To know the potential financial outcomes of each decision, multiply the possible dollar outcomes by their probabilities at forks where there is an “event circle.” ([$1,000,000 payday × .90 probability] + [$0 payday × .10 probability] = $900,000.) This gives you the expected monetary value (EMV) of the event, although the actual individual outcomes can be a range of values. At any circle, the probabilities must add up to 100 percent (.90 + .10 = 1.00) to denote that all possibilities are accounted for. Each fork is mutually exclusive of other alternatives, and within that alternative the probability is 100 percent or collectively exhaustive.
THE DECISION TREE OIL DRILLING
At activity squares the decision maker has the ability to choose the best outcome. To determine the best alternative, subtract the applicable cost from the payoff of the alternative. You calculate the monetary consequences by beginning at the far right and working your way to the left. This process is said to be “folding back” or “pruning” the tree to arrive at your best action plan decision. At square forks you should choose the highest dollar alternative. At the circle multiply the possible payoffs by their probabilities.
The decision dictated by the tree is to throw caution to the wind and forgo the seismic tests. The expected monetary value of going ahead with testing is $370,000 (420–50), while the EMV of going ahead without tests is $400,000. You choose the highest expected monetary value (EMV). This relatively simple conceptual framework can be applied to new product development, real estate development, and store inventory level decisions. Whatever the decision to be considered, a decision tree structure forces the decision maker to take a comprehensive view of all the alternatives, to make an evaluation of the uncertainty (you often have to make your best guess about probabilities), and to explicitly calculate the dollar outcomes possible. The tree forces decision makers to state their assumptions explicitly. In this case, you may consider that the probability of oil when there is a test result to be misstated. In that case, using a different assumption, you may get the opposite final answer. Others looking at the same situation could see it otherwise. By comparing trees, analysts can debate specific assumptions in an organized way.
“Draw a tree and get a B” was the saying on exams involving decision trees. The complexity of seemingly simple problems can be seen using decision trees. Therefore, just creating an accurate tree framework was a challenge during a four-hour exam; it takes a lot of practice to become proficient.
THE DECISION TREE OIL DRILLING
(in thousands of dollars)
CASH FLOW ANALYSIS
The term cash flow is often used in connection with leveraged buyouts (LBOs), and it is the basis of financial analysis. Wall Street technicians may ponder briefly the qualitative aspects of their investment decisions, but ultimately, only the cash consequences have any real relevance for them. Cash flow analysis is based on the same information used by the accountant’s Statement of Cash Flows. Cash flow analysis answers the simple question:
What does the investment cost and how much cash will it generate each year?
The cash generated by a company can be used to pay off debt, pay dividends, invest in research, purchase new equipment, or invest in a real estate development. The goal is to determine when and how much cash flows in a given case scenario.
In making an investment there may be several objectives in mind, but cash flow analysis concerns itself only with the dollars. A company’s advertising may create goodwill with the public, for example, but if the benefits cannot be measured in dollars, cash flow analysis is not appropriate.
Cash flow analysis is as relevant to the purchase of a piece of machinery as it is to the acquisition of a corporation. So let us restate the first question asked:
What is the current investment and what are the future benefits?
The steps to answer the question are:
1. Define the value of the investment
2. Calculate the magnitude of the benefits
3. Determine the timing of the benefits
4. Quantify the uncertainty of the benefits
5. Do the benefits justify the wait?
One important issue to consider is that cash flow analysis indicates cash flows, not profits. For example, a successful computer start-up company in Silicon Valley may be making an “accounting” profit of $3 million. But if the company requires a $20 million investment in research and a $30 million outlay to build a factory, the company is actually a net user of cash. In this case the company’s profitability lies in the future.
Accounting profits, as reported in the income statement, are a short-term measurement of an investment in a time frame shorter than the life of the investment, whereas cash flow analysis is a technique used to evaluate individual projects over the life of the project.
The following specific information would be required to quantify the initial cash flows of a project:
Cash Uses
Construction Costs
Initial Inventory Stock
Equipment Purchases
Increases in Accounts Receivable (allowing customers to borrow from you for goods sold to them)
Cash Sources
Sales of Equipment (if disposed of)
Increases in Accounts Payable (borrowing from suppliers on materials purchased)
To determine the cash uses during the life of the project:
Cash Sources
Revenues or Sales
Royalties
Cash Uses
Costs of Goods Sold
Selling Costs
General and Administrative Costs
Taxes
Depreciation, which appears in income statements, is not relevant in cash flow analysis. Depreciation is an accounting allowance that says that if a piece of equipment has a useful life of five years, then one fifth of the cost in each year of use can be deducted from income. In a
cash flow analysis, hard cash is used to buy the machine today, therefore it is shown as a use of cash at the time of purchase. Depreciation is only applicable inasmuch as it is used to reduce “accounting income,” thereby reducing the “cash” out the door for taxes. In the Bob’s Market example in the accounting chapter, the store expensed its cash registers and shopping carts over ten years even though they were paid for at the store’s opening.
A second important point is that financing costs are not included in cash flow analysis. The investment decision is separate from the financing decision. At General Electric there are thousands of projects and many classes of financing—debt (bonds, bank debt) and stock. To match debt with individual projects would be impossible. In reality, the finance department borrows to meet all of its current corporate needs, and it is the capital budgeting department that decides which projects to adopt. If the two decisions were linked, all projects that were financed by debt would look much better than those for which cash is paid up front, even though in substance they are the same.
A CASH FLOW EXAMPLE
Quaker Oats is considering a $100,000 investment in a cereal filling machine for its plant in Kansas City. The fiber craze has spurred the demand for oatmeal to the point of exhausting plant capacity. If the machine is purchased, additional cereal sales of $80,000 could be made each year. The cost of goods sold is only $20,000 and the profits derived would be taxed at 30 percent. The increased sales will also require holding $10,000 in inventory. Quaker will partially offset that use of cash by increasing its payables by $8,000 to farmers for the oats and Smurfit-Stone Container for the boxes to net a $2,000 additional cash investment.
The Ten-Day MBA 4th Ed. Page 15