Question

Probability and probability distributions are important concepts in applied business statistics. Most of the business decision making processes involve some uncertainty and randomness, which require the use of probability and probability distributions.

What is the importance of probability and probability distributions in a business decision making processes such as scenario analysis, sales forecasting and risk evaluation? Explain your responses by applying specific application examples of probability and probability distributions in business and discuss their implications on business management efficiency.

Answer 1

Probability and probability distributions play a significant and important role in a business decision making process. Businesses regularly use probability and probability distributions for different purposes like scenario analysis, sales forecasting and risk evaluation. For all types of businesses future events are not certain, rather they tend to highly uncertain most of the times. In such a situation probability and probability distributions helps business to remove the element of uncertainty as the tool of probability distribution is used to determine possible outcomes of a particular course of action or a particular event. Business managers make use of scenario analysis in many cases to optimize decision making. A scenario analysis makes use of probability distribution to create several scenarios with regards to the outcome and each scenario has a distinct possibility of its own.

An example will be a business making use of probability and probability distributions to make three scenarios – base case, worst case and best case. The base case is the most likely case; worst case is the pessimistic case while best case is the optimistic case. The worst case scenario will have a value from the lower end of probability distribution while the best case scenario will have a value from the upper end of probability distribution. Base case will have a value towards the middle of the distribution.

An example of risk evaluation will be a hypothetical case in which a company is considering entering a new line of business. The company has done a break even analysis and determined that it will need sales of 100,000 units in next year to break even. The company’s probability distribution tells them that there is a 10% chance that number of units sold will be less than 100,000. This gives the company a good idea of the level of risk it is facing when entering the new line of business. When knowing the risk the level of business management efficiency increases as the managers are able to make informed decisions that are statistically backed.