Introduction to Financial Modelling
Principles of Excel as a Modelling Tool
Essential Operations and Short-Cuts
Introduction to Excel Functions
Building Models: Common Structures and Best Practice Principles
Planning Models for Decision Support

Decision Criteria in Overview

Variables to Evaluate a Decision

In general, decisions may be made using many criteria, ranging from gut feel, qualitative analysis of advantages/disadvantages. In economic and financial analysis, common methods involve the calculation of the profitability, time-to-breakeven, rate-of-return, net present value, and similar methods. (See also the general introductory materials on this site for further discussion and some examples).

It is evident that when quantitative methods are used, then the models used need to be able to calculate or evaluate these items, and therefore the models must also include any input variables and intermediate calculations necessary to do so. One can therefore first establish the decision criteria to be used and then work backwards conceptually to identify the variables required within the model.

Decision Criteria

  • The decision criteria that will be used, and determining the variables that the model will need to evaluate these.
  • The sensitivities and scenario analysis that will be required for decision-making or reporting purposes.

In general, there are many criteria that may be used to make decisions. Broadly speaking, these can be classified into four main groups:

 

Intuitive/Implicit

This involves basing a decision on:

  • Gut feel.
  • Political/motivational factors.
  • Social or moral factors.

Principles Based with Single Criteria

Key examples here include where decisions aim for:

  • Benefit maximization.
  • Cost minimization.
  • Risk minimization.
  • Exploiting limitations e.g. of capacity.

Multi Criteria, Non-Integrated

These are where multiple criteria are considered, but the relationships between the items is not tightly defined, nor quantified, and the trade-offs between them are not aimed to be explicit. The main types are:

  • Advantages-disadvantages lists.
  • Cost-benefit analysis.
  • SWOT assessment (strengths, weaknesses, opportunities and threats).

Multi Criteria, Integrated

These are where multiple criteria are used, and are integrated by using quantitative approaches. Where possible the trade-offs between criteria are explicit in the analysis, or at least are made more transparent than in non-quantitative approaches, for example:

  • Benefit-to-cost maximisation choose the option which maximises this ratio.
  • Target-constraint approaches e.g. choose the decision which minimises cost, as long as the revenue objective is surpassed, or which maximises revenues, as long as a cost target is not exceeded.
  • General optimisation methods: choose a mixture of projects to achieve an objective subject to some constraints.

Importantly, this category includes many approaches used in economic and financial modelling: The quantification of “advantages-disadvantages”, or of “cost-benefit” approached to create integrated approaches are important examples. For example,¬†sales revenue may be considered as a “benefit”, whilst operational expenditure is a “cost”, and these are “integrated” by calculating the profit, and so on.

Scroll to Top
error: Alert: Content is protected !!