CHAPTER 1

Decision Trees

T
he analysis of complex decisions with signi cant uncertainty can be confusing
because 1) the consequence that will result from selecting any speci ed decision
alternative cannot be predicted with certainty, 2) there are often a large number
of di erent factors that must be taken into account when making the decision,
3) it may be useful to consider the possibility of reducing the uncertainty in the
decision by collecting additional information, and 4) a decision maker's attitude
toward risk taking can impact the relative desirability of di erent alternatives.
This chapter reviews decision tree analysis procedures for addressing such complexities.

1.1 Decision Trees

To illustrate the analysis approach, a decision tree is used in the following example
to help make a decision.
Example 1.1
Product decision. To absorb some short-term excess production capacity
at its Arizona plant, Special Instrument Products is considering a short manufacturing run for either of two new products, a temperature sensor or a pressure
sensor. The market for each product is known if the products can be successfully developed. However, there is some chance that it will not be possible to
successfully develop them.
Revenue of $1,000,000 would be realized from selling the temperature sensor
and revenue of $400,000 would be realized from selling the pressure sensor. Both
of these amounts are net of production cost but do not include development cost.
If development is unsuccessful for a product, then there will be no sales, and the
development cost will be totally lost. Development cost would be $100,000 for
the temperature sensor and $10,000 for the pressure sensor.

CHAPTER 1 DECISION TREES

Development
Cost

Development
Outcome

Sales
Revenue

Success

$1,000,000

Failure

$0

Success

$400,000

Failure

$0

Net
Profit
$900,000

$100,000
Temperature
Sensor

Pressure
Sensor

-$100,000

$390,000

$10,000
-$10,000

Neither
$0

Figure 1.1

Special Instrument Products decision

Question 1.1: Which, if either, of these products should Special Instrument Products attempt to develop?
To answer Question 1.1 it is useful to represent the decision as shown in Figure
1.1. The tree-like diagram in this gure is read from left to right. At the left,
indicated with a small square, is the decision to select among the three available
alternatives, which are 1) the temperature sensor, 2) the pressure sensor, or 3) neither. The development costs for the \develop temperature sensor" and \develop
pressure sensor" alternatives are shown on the branches for those alternatives.
At the right of the development costs are small circles which represent the uncertainty about whether the development outcome will be a success or a failure. The
branches to the right of each circle show the possible development outcomes. On
the branch representing each possible development outcome, the sales revenue is
shown for the alternative, assuming either success or failure for the development.
Finally, the net pro t is shown at the far right of the tree for each possible combination of development alternative and development outcome. For example, the
topmost result of $900,000 is calculated as $1; 000; 000 $100; 000 = $900; 000.
(Pro ts with negative signs indicate losses.)
The notation used in Figure 1.1 will be discussed in more detail shortly, but
for now concentrate on determining the alternative Special Instrument Products
should select. We can see from Figure 1.1 that developing the temperature sensor
could yield the largest net pro t ($900,000), but it could also yield the largest
loss ($100,000). Developing the pressure sensor could only yield a net pro t

1.1 DECISION TREES

of $390,000, but the possible loss is limited to $10,000. On the other hand,
not developing either of the sensors is risk free in the sense that there is no
possibility of a loss. However, if Special Instrument Products decides not to
attempt to develop one of the sensors, then the company is giving up the potential
opportunity to make either $900,000 or $390,000. Question 1.1 will be answered
in a following example after we discuss the criterion for making such a decision.
You may be thinking that the decision about which alternative is preferred depends on the probabilities that development will be successful for the temperature
or pressure sensors. This is indeed the case, although knowing the probabilities
will not by itself always make the best alternative in a decision immediately clear.
However, if the outcomes are the same for the di erent alternatives, and only the
probabilities di er, then probabilities alone are su cient to determine the best
alternative, as illustrated by Example 1.2.
Example 1.2
Tossing a die. Suppose you are o ered two alternatives, each of which
consists of a single toss of a fair die. With the rst alternative, you will win
$10 if any number greater than 4 is thrown, and lose $5 otherwise. With the
second alternative, you will win $10 if any number greater than 3 is thrown, and
lose $5 otherwise. In this case, since there are 6 faces on a die, the probability
of winning is 2=6 = 1=3 for the rst alternative and 3=6 = 1=2 for the second
alternative. Since the consequences are the same for both alternatives and the
probability of winning is greater for the second alternative, you should select the
second alternative.
However, the possible outcomes are often not the same in realistic business
decisions and this causes additional complexities, as illustrated by further consideration of the Special Instruments Product decision in Example 1.3.
Example 1.3
Product decision. Suppose that in Example 1.1 the probability of development success is 0.5 for the temperature sensor and 0.8 for the pressure sensor.
Figure 1.2 is a diagram with these probabilities shown in parentheses on the
branches representing the possible outcomes for each sensor development e ort.
(While only the probability of success is speci ed for each development e ort,
the probability of failure is determined by the rules of probability since the probabilities of development success and development failure must add up to one.)
A study of Figure 1.2 shows that having the probabilities does not resolve this
decision for us. The gure shows that although the probability of development
success is considerably lower for the temperature sensor than it is for the pressure
sensor (0.5 versus 0.8), the net pro t from successful development of the temperature sensor is considerably higher than the net pro t from successful development

CHAPTER 1 DECISION TREES

Development
Cost

Development
Outcome

Sales
Revenue

Success

$1,000,000

Failure

$0

Success

$400,000

Failure

$0

(0.5)

Net
Profit
$900,000

$100,000
Temperature
Sensor

(0.5)

Pressure
Sensor

(0.8)

-$100,000

$390,000

$10,000
(0.2)

-$10,000

Neither
$0

Figure 1.2

Special Instrument Products decision tree

of the pressure sensor ($900,000 versus $390,000). That is, the alternative with
the higher potential payo has a lower probability that this payo will actually
be realized.
The resolution of this decision dilemma is addressed in the next section, but
before doing this, De nition 1.1 clari es the notation in Figures 1.1 and 1.2.
De nition 1.1: Decision tree notation
A diagram of a decision, as illustrated in Figure 1.2, is called a decision
tree. This diagram is read from left to right. The leftmost node in a
decision tree is called the root node. In Figure 1.2, this is a small
square called a decision node. The branches emanating to the right
from a decision node represent the set of decision alternatives that are
available. One, and only one, of these alternatives can be selected. The
small circles in the tree are called chance nodes. The number shown
in parentheses on each branch of a chance node is the probability that
the outcome shown on that branch will occur at the chance node. The
right end of each path through the tree is called an endpoint, and each
endpoint represents the nal outcome of following a path from the root
node of the decision tree to that endpoint.

1.2 EXPECTED VALUE

Your
Payment

Outcome
of Toss

Payment
to You

Success

$15

Failure

$0

(2/3)
Accept
Offer

Reject
Offer

Figure 1.3

Net
Profit
$6

$9
(1/3)

$0

-$9

$0

Die toss decision tree

1.2 Expected Value

In order to decide which alternative to select in a decision problem, we need
a decision criterion; that is, a rule for making a decision. Expected value is a
criterion for making a decision that takes into account both the possible outcomes
for each decision alternative and the probability that each outcome will occur.
To illustrate the concept of expected value, we consider a simpler decision with
lower stakes than the Special Instrument Products decision.
Example 1.4
Rolling a die. A friend proposes a wager: You will pay her $9.00, and then a
fair die will be rolled. If the die comes up a 3, 4, 5, or 6, then your friend will pay
you $15.00. If the die comes up 1 or 2, she will pay you nothing. Furthermore,
your friend agrees to repeat this game as many times as you wish to play.
Question 1.2: Should you agree to play this game?
If a six-sided die is fair, there is a 1/6 probability that any speci ed side will
come up on a roll. Therefore there is a 4/6 (= 2=3) probability that a 3, 4, 5, or
6 will come up and you will win. Figure 1.3 shows the decision tree for one play
of this game.
At rst glance, this may not look like a good bet since you can lose $9.00,
while you can only win $6.00. However, the probability of winning the $6.00 is
2/3, while the probability of losing the $9.00 is only 1/3. Perhaps this isn't such
a bad bet after all since the probability of winning is greater than the probability
of losing.
The key to logically analyzing this decision is to realize that your friend will let
you play this game as many times as you want. For example, how often would you
expect to win if you play the game 1,500 times? Based on what you have learned

CHAPTER 1 DECISION TREES

about probability, you know that the proportion of games in which you will win
over the long run is approximately equal to the probability of winning a single
game. Thus, out of the 1,500 games, you would expect to win approximately
(2=3) 1; 500 = 1; 000 times. Therefore, over the 1,500 games, you would expect
to win a total of approximately 1; 000 $6 + 500 ( $9) = $1; 500. So this game
looks like a good deal!
Based on this logic, what is each play of the game worth? Well, if 1,500
plays of the game are worth $1,500, then one play of the game should be worth
$1; 500=1; 500 = $1:00. Putting this another way, you will make an average of
$1.00 each time you play the game.
A little thought about the logic of these calculations shows that you can directly determine the average payo from one play of the game by multiplying
each possible payo from the game by the probability of that payo , and then
adding up the results. For the die tossing game, this calculation is (2=3) $6 +
(1=3) ( $9) = $1.
The quantity calculated in the manner illustrated in Example 1.4 is called the
expected value for an alternative, as shown in De nition 1.2. Expected value
is often a good measure of the value of an alternative since over the long run this
is the average amount that you expect to make from selecting the alternative.
De nition 1.2: Expected Value
The expected value for an uncertain alternative is calculated by multiplying each possible outcome of the uncertain alternative by its probability, and summing the results. The expected value decision criterion
selects the alternative that has the best expected value. In situations
involving pro ts where \more is better," the alternative with the highest expected value is best, and in situations involving costs, where \less
is better," the alternative with the lowest expected value is best.

Example 1.5
Product decision. The expected values for the Special Instrument Products decision are designated by \EV" in Figure 1.4. These are determined
as follows: 1) For the temperature sensor alternative, 0:5 $900; 000 + 0:5
( $100; 000) = $400; 000, 2) for the pressure sensor alternative, 0:8 $390; 000 +
0:2 ( $10; 000) = $310; 000, and 3) for doing neither of these $0. Thus, the
alternative with the highest expected value is developing the temperature sensor,
and if the expected value criterion is applied, then the temperature sensor should
be developed.

1.2 EXPECTED VALUE

Development
Cost

Development
Outcome

Sales
Revenue

Success

$1,000,000

(0.5)
$100,000
Temperature
Sensor

Net
Profit
$900,000

EV=$400,000
(0.5)

Failure

$0

Success

$400,000

-$100,000

EV=$400,000
Pressure
Sensor
$10,000

(0.8)

$390,000

EV=$310,000
(0.2)

Failure

$0

-$10,000

Neither
EV=$0

Figure 1.4

$0

Special Instrument Products decision tree, with expected values

Figure 1.4 illustrates some additional notation that is often used in decision
trees. The branches representing the two alternatives that are less preferred are
shown with crosshatching (//) on their branches. The expected value for each
chance node is designated by \EV". Finally, the expected value at the decision
node on the left is shown as equal to the expected value of the selected alternative.

Xanadu Traders
We conclude this section by analyzing a decision involving international commerce. This example will be extended in the remainder of this chapter
Example 1.6
Xanadu Traders. Xanadu Traders, a privately held U.S. metals broker, has
acquired an option to purchase one million kilograms of partially re ned molyzirconium ore from the Zeldavian government for $5.00 per kilogram. Molyzirconium can be processed into several di erent products which are used in semiconductor manufacturing, and George Xanadu, the owner of Xanadu Traders,
estimates that he would be able to sell the ore for $8.00 per kilogram after importing it. However, the U.S. government is currently negotiating with Zeldavia
over alleged \dumping" of certain manufactured goods which that country exports to the United States. As part of these negotiations, the U.S. government
has threatened to ban the import from Zeldavia of a class of materials that includes molyzirconium. If the U.S. government refuses to issue an import license

CHAPTER 1 DECISION TREES

for the molyzirconium after Xanadu has purchased it, then Xanadu will have to
pay a penalty of $1.00 per kilogram to the Zeldavian government to annul the
purchase of the molyzirconium.
Xanadu has used the services of Daniel A. Analyst, a decision analyst, to help
in making decisions of this type in the past, and George Xanadu calls on him to
assist with this analysis. From prior analyses, George Xanadu is well-versed in
decision analysis terminology, and he is able to use decision analysis terms in his
discussion with Analyst.
Analyst: As I understand it, you can buy the one million kilograms of molyzirconium ore for $5.00 a kilogram and sell it for $8.00, which gives a pro t of
($8:00 $5:00) 1; 000; 000 = $3; 000; 000. However, there is some chance that
you cannot obtain an import license, in which case you will have to pay $1.00
per kilogram to annul the purchase contract. In that case, you will not have
to actually take the molyzirconium and pay Zeldavia for it, but you will lose
$1:00 1; 000; 000 = $1; 000; 000 due to the cost of annulling the contract.
Xanadu: Actually, \some chance" may be an understatement. The internal
politics of Zeldavia make it hard for their government to agree to stop selling
their manufactured goods at very low prices here in the United States. The
chances are only fty- fty that I will be able to obtain the import license. As you
know, Xanadu Traders is not a very large company. The $1,000,000 loss would
be serious, although certainly not fatal. On the other hand, making $3,000,000
would help the balance sheet: : :
Question 1.3: Which alternative should Xanadu select? Assume that Xanadu uses expected value as his decision criterion.
To answer this question, construct a decision tree. There are two possible
alternatives, purchase the molyzirconium or don't purchase it. If the molyzirconium is purchased, then there is uncertainty about whether the import license
will be issued or not. The decision tree is shown in Figure 1.5. Starting from the
root node for this tree, it costs $5 million to purchase the molyzirconium, and if
the import license is issued, then the molyzirconium will be sold for $8 million,
yielding a net pro t of $3 million. On the other hand, if the import license is not
issued then Xanadu will recover $4 million of the $5 million that it invested, but
will lose the other $1 million due to the cost of annulling the contract.
The endpoint net pro ts are shown in millions of dollars, and the expected
value for the \purchase" alternative is 0:5 $3 + 0:5 ( $1) = $1, in millions
of dollars. Therefore, if expected value is used as the decision criterion, then the
preferred alternative is to purchase the molyzirconium.

1.3 DEPENDENT UNCERTAINTIES

Cost

Import License
Issued?

Revenue

Yes

$8

No

$4

(0.5)
$5
Purchase

Net
Profit
$3

EV=$1
(0.5)

Don't
Purchase

Figure 1.5

-$1

$0

Xanadu Traders initial decision tree (dollar amounts in millions)

1.3 Dependent Uncertainties

In this section, we consider an additional complexity that often occurs in business
decisions: dependent uncertainties. Speci cally, we will examine a case that
illustrates this complexity of real world decisions, and review a procedure for
analyzing decisions that include dependent uncertainties.
Example 1.7
Xanadu Traders. This is a continuation of Example 1.6. We now consider
an expanded version of the decision that includes dependent uncertainties and
extend the analysis procedure to handle this new issue. We continue to follow the
discussion between Daniel Analyst and George Xanadu that started in Example
1.6.
Analyst: Maybe there is a way to reduce the risk. As I understand it, the
reason you need to make a quick decision is that Zeldavia has also o ered this
deal to other brokers, and one of them may take it before you do. Is that really
very likely? Perhaps you can apply for the import license and wait until you
know whether it is approved before closing the deal with Zeldavia.
Xanadu: That's not very likely. Some of those brokers are pretty big operators,
and dropping $1,000,000 wouldn't make them lose any sleep. I'd say there is a
0.70 probability that someone else will take Zeldavia's o er if I wait until the
import license comes through. Of course, it doesn't cost anything to apply for
an import license, so maybe it is worth waiting to see what happens: : :

10

CHAPTER 1 DECISION TREES

Import License
Issued?

Cost

Still
Cost
Available?

Revenue

Yes

$8

No

$4

(0.5)
$5

(0.5)
Don't
Purchase

(0.3)
Yes
(0.5)
EV=$0.45
(0.5)

Figure 1.6

-$1

$0

Wait
$0

$3

EV=$1

Purchase
EV=$1

Net
Profit

Yes

$5

$8

$3

EV=$0.9
(0.7)

No

No

$0
$0

Xanadu Traders revised decision tree, with expected values

Question 1.4: Should Xanadu Traders wait to see if an import

license is issued before purchasing the molyzirconium?
The decision tree for this revised problem is shown in Figure 1.6. The two
alternatives at the top of this tree (\purchase" and \don't purchase") are the same
as the alternatives shown in Figure 1.5. The third alternative (\wait") considers
the situation where Xanadu waits to see whether it can obtain an import license
before purchasing the molyzirconium. This alternative introduces a new analysis
issue that must be addressed before the expected value for this alternative can
be determined. This new issue concerns the fact that there are two stages of
uncertainty for this alternative. First, the issue of an import license is resolved,
and then there is a further uncertainty about whether the molyzirconium will
still be available.
Question 1.5: What is the expected value for the \wait" alternative?
The process of determining the expected value for this alternative involves two
stages of calculation. In particular, it is necessary to start at the right side of the
decision tree, and carry out successive calculations working toward the root node
of the tree. Speci cally, rst determine the expected value for the alternative
assuming that the import license is issued, and then use this result to calculate

1.4 SEQUENTIAL DECISIONS

11

the expected value for the \wait" alternative prior to learning whether the import
license is issued.
Examine Figure 1.6 to see how this calculation process works. As this gure
shows, if the import license is issued, then there is a 0.3 probability that the
molyzirconium will still be available. In this case, Xanadu will pay $5 million
for the molyzirconium, and sell it for $8 million realizing $3 million in net pro t.
If the molyzirconium is not still available, then Xanadu will not have to pay
anything and will realize no net pro t. Thus, the expected value for the situation
after the uncertainty about the import license has been resolved is 0:3$3+0:7
$0 = $0:9. This expected value is shown next to the lower right chance node on
the decision tree in Figure 1.6.
From the discussion regarding expected value in Section 1.2, it follows that
this $0.9 million is the value of the alternative once the result of the import
license application is known. Hence, this value should be used in the further
expected value calculation needed to determine the overall value of the \wait"
alternative. Thus, the expected value for the \wait" alternative is given by 0:5
$0:9 + 0:5 $0 = $0:45. This expected value is shown next to the lower left
chance node on the decision tree in Figure 1.6. Since the expected value for the
\wait" alternative is less than the $1 million expected value for purchasing the
molyzirconium right now, this alternative is less preferred than purchasing the
molyzirconium right now. Xanadu should not wait, assuming that expected value
is used as the decision criterion.
The process of sequentially determining expected values when there are dependent uncertainties in a decision tree, as demonstrated in Example 1.6, is called
decision tree rollback. This term is de ned in De nition 1.3.
De nition 1.3: Decision Tree Rollback
The process of successively calculating expected values from the endpoints of the decision tree to the root node, as demonstrated in this
section, is called a decision tree rollback.

1.4 Sequential Decisions

In addition to dependent uncertainties, real business decisions often include sequential decisions. This section considers an example that demonstrates how
to address sequential decisions.

12

CHAPTER 1 DECISION TREES

Example 1.8
ABC Computer Company. ABC Computer Company is considering submission of a bid for a government contract to provide 10,000 specialized computers
for use in computer-aided design. There is only one other potential bidder for
this contract, Complex Computers, Inc., and the low bidder will receive the contract. ABC's bidding decision is complicated by the fact that ABC is currently
working on a new process to manufacture the computers. If this process works as
hoped, then it may substantially lower the cost of making the computers. However, there is some chance that the new process will actually be more expensive
than the current manufacturing process. Unfortunately, ABC will not be able to
determine the cost of the new process without actually using it to manufacture
the computers.
If ABC decides to bid, it will make one of three bids: $9,500 per computer,
$8,500 per computer, or $7,500 per computer. Complex Computers is certain
to bid, and it is equally likely that Complex will bid $10,000, $9,000, or $8,000
per computer. If ABC decides to bid, then it will cost $1,000,000 to prepare the
bid due to the requirement that a prototype computer be included with the bid.
This $1,000,000 will be totally lost regardless of whether ABC wins or loses the
bidding competition.
With ABC's current manufacturing process, it is certain to cost $8,000 per
computer to make each computer. With the proposed new manufacturing process,
there is a 0.25 probability that the manufacturing cost will be $5,000 per computer
and a 0.50 probability that the cost will be $7,500 per computer. Unfortunately,
there is also a 0.25 probability that the cost will be $8,500 per computer.
Question 1.6: Should ABC Computer Company submit a bid,
and if so, what should they bid per computer?
A decision tree for this situation is shown in Figure 1.7. First, ABC must
decide whether to bid and how much to bid. If ABC's bid is lower than Complex
Computer's, then ABC must decide which manufacturing process to use. If ABC
uses the proposed new manufacturing process, then the cost of manufacturing
the computers is uncertain. The net pro t gures (in millions of dollars) shown
at the endpoints of the Figure 1.7 tree take into account the cost of preparing
the bid, the cost of manufacturing the computers, and the revenue that ABC will
receive for the computers. For example, examine the topmost endpoint value. It
costs $1 million to prepare the bid, and ABC bids $9,500, which is lower than
Complex Computers' bid of $10,000, and hence ABC wins the contract. Then the
proposed new manufacturing process is used, and it costs $8,500 per computer
to manufacture the 10,000 computers. Therefore, at this endpoint, ABC makes a
net pro t of 1; 000; 000 10; 000 $8; 500 + 10; 000 $9; 500 = $9; 000; 000 = $9

13

1.4 SEQUENTIAL DECISIONS

ABC
Bid

Complex
Bid

Manufacturing
Process

New
$10,000
(1/3)
$9,500
EV=$6.92

(2/3)

EV=$22.75

EV=$22.75

Cost Per
Computer

Net
Profit

$8,500
(1/4)
(1/2) $7,500
(1/4)

$9
$19

$5,000

$44

$8,000

Current

$14

$9,000/$8,000

-$1
$8,500
New

$10,000
/$9,000
EV=$8.17

(2/3)
$8,500
EV=$8.17

(1/3)

EV=$12.75

EV=$12.75

(1/4)
(1/2)

$7,500

(1/4)

$5,000

Current

$9
$34

$8,000

$4

$8,000

-$1
$8,500
New

$7,500

-$1

$10,000/$9,000
/$8,000
EV=$2.75

EV=$2.75
Current

(1/4)
(1/2)

$7,500

(1/4)

$5,000

-$11

$8,000

No Bid

Figure 1.7

-$1
$24
-$6
$0

ABC Computer Company decision tree, with net pro t in millions of dollars
million. Verify the net pro ts shown at the other endpoints so that you better
understand this process.
Calculating the expected values shown on the Figure 1.7 decision tree requires
addressing a new issue, namely what to do when there are multiple decision nodes
in the tree. In this decision, the amount of the bid is the rst decision, and if
this is lower than the Complex Computers bid, then there is a second decision
involving the type of manufacturing process to use. The calculation procedure
for this situation is a straightforward extension of the calculation procedure that
was demonstrated in the preceding section for dependent uncertainties.
This procedure will be illustrated by considering the topmost set of nodes
in the Figure 1.7 tree. Start at the rightmost side of the tree, and calculate
the expected value for the top rightmost chance node. This is determined as

14

CHAPTER 1 DECISION TREES

(1=4) $9 + (1=2) $19 + (1=4) $44 = $22:75. At the top rightmost decision
node, compare the expected values for the two branches. The expected value for
the top branch of this decision node is $22.75, and (since there is no uncertainty
regarding the cost of the current manufacturing process) the expected value for
the bottom branch is $14. Since the top branch has the higher expected value, it
is the preferred branch. That is, the proposed new manufacturing process should
be used. Hence, the expected value for the \manufacturing process" decision
node is equal to the expected value for the proposed new manufacturing process,
which is $22.75.
Now continue back toward the root of the decision tree by calculating the
expected value for the top leftmost chance node in the tree. Since the expected
value of the manufacturing process decision is $22.75, and there is no uncertainty
about the net pro t if ABC loses the bid, the expected value for the top leftmost
chance node is (1=3) $22:75 + (2=3) ( $1) = $6:92.
A similar process is used to calculate the expected values for the other three
branches of the root node, and the results are shown in Figure 1.7. These calculations show that an $8,500 bid has the highest expected value, which is $8.17
million. Hence, if ABC uses expected value as its decision criterion, then it
should bid $8,500. In addition, the calculations also show that ABC should use
the proposed new manufacturing process if it wins the contract. The less preferred branches for each decision node have been indicated on the decision tree
with cross hatching.
The complete speci cation of the alternatives that should be selected at all
decision nodes in a decision tree is called a decision strategy.
De nition 1.5: Decision Strategy
The complete speci cation of all the preferred decisions in a sequential
decision problem is called the decision strategy. The decision strategy
shown in Figure 1.7 can be summarized as follows: Bid $8,500, and if
you win the contract use the proposed new manufacturing process.

1.5 Exercises

1.1

Arthrodax Company has been approached by Ranger Sound with a rush order
o er to purchase 100 units of a customized version of Arthrodax's SoundScreamer
audio mixer at $5,000 per unit, and Arthrodax needs to decide how to respond.
The electronic modi cations of the standard SoundScreamer needed for this customized version are straightforward, but there will be a xed cost of $100,000
to design the modi cations and set up for assembly of the customized SoundScreamers, regardless of the number of units produced. It will cost $2,000 per

1.5 EXERCISES

15

unit to manufacture the circuit boards for the units. Since Arthrodax has some
short term spare manufacturing capacity, the Ranger o er is potentially attractive. However, the circuit boards for the customized units will not t into the
standard SoundScreamer case, and Arthrodax must decide what to do about acquiring cases for the customized units as it decides whether to accept Ranger's
purchase o er. An appropriate case can be purchased at $500 per case, but
Arthrodax could instead purchase an injection molder to make the cases. It will
cost $20,000 to purchase the molder, and there is a 0.6 probability that it will be
possible to successfully make the cases using the molder. If the molder does not
work, then the purchase price for the molder will be totally lost and Arthrodax
must still purchase the cases at $500 per case. If the molder works, then it will
cost $60 per case to make the cases using the molder. Regardless of which case is
used, the cost of assembling the SoundScreamer circuit boards into the case is $20
per unit. Unfortunately, there is no way to test the molder without purchasing
it. Assume that there is no other use for the molder except to make the cases for
the Ranger order.
(i) Draw a decision tree for Arthrodax's decision about whether to accept the
Ranger o er and how to acquire the cases for the customized SoundScreamers.
(ii) Using expected net pro t as the decision criterion, determine the preferred
course of action for Arthrodax.
1.2

This is a continuation of Exercise 1.1. Assume that all information given in that
exercise is still valid, except as discussed in this exercise. Ranger now tells Arthrodax that there is uncertainty about the number of customized SoundScreamers
that will be needed. Speci cally, there is a 0.35 probability that it will need 100
units, and a 0.65 probability that it will need 50 units. If Arthrodax will agree
now to produce either number of units, then Ranger will pay $6,000 per unit if it
ultimately orders 50 units, and will pay $5,000 per unit if it ultimately orders 100
units. The timing is such on this rush order that Arthrodax will have to make a
decision about purchasing the injection molder before it knows how many units
Ranger will take. However, Arthrodax will only need to purchase or manufacture
the number of circuit boards and cases needed for the nal order of either 50 or
100 units.
(i) Draw a decision tree for Arthrodax's decision about whether to accept the
Ranger o er and how to acquire the cases for the customized SoundScreamers. Note that this is a situation with dependent uncertainties, as discussed
in Section 1.3.
(ii) Using expected net pro t as the decision criterion, determine the preferred
course of action for Arthrodax.

1.3

This is a continuation of Exercise 1.2. Assume that all information given in

that exercise is still valid, except as discussed in this exercise. Assume now that
Arthrodax could delay the decision about purchasing the injection molder until
after it knows how many units Ranger will take.

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CHAPTER 1 DECISION TREES

(i) Draw a decision tree for Arthrodax's decision about whether to accept the
Ranger o er and how to acquire the cases for the customized SoundScreamers. Note that this is a situation with sequential decisions, as discussed in
Section 1.4.
(ii) Using expected net pro t as the decision criterion, determine the preferred
course of action for Arthrodax.
1.4

Aba Manufacturing has contracted to provide Zyz Electronics with printed circuit
(\PC") boards under the following terms: (1) 100,000 PC boards will be delivered
to Zyz in one month, and (2) Zyz has an option to take delivery of an additional
100,000 boards in three months by giving Aba 30 days notice. Zyz will pay $5.00
for each board that it purchases. Aba manufactures the PC boards using a batch
process, and manufacturing costs are as follows: (1) there is a xed setup cost
of $250,000 for any manufacturing batch run, regardless of the size of the run,
and (2) there is a marginal manufacturing cost of $2.00 per board regardless of
the size of the batch run. Aba must decide whether to manufacture all 200,000
PC boards now or whether to only manufacture 100,000 now and manufacture
the other 100,000 boards only if Zyz exercises its option to buy those boards. If
Aba manufactures 200,000 now and Zyz does not exercise its option, then the
manufacturing cost of the extra 100,000 boards will be totally lost. Aba believes
there is a 50% chance Zyz will exercise its option to buy the additional 100,000
PC boards.
(i) Explain why it might potentially be more pro table to manufacture all
200,000 boards now.
(ii) Draw a decision tree for the decision that Aba faces.
(iii) Determine the preferred course of action for Aba assuming it uses expected
pro t as its decision criterion.

1.5

Kezo Systems has agreed to supply 500,000 PC FAX systems to Tarja Stores in 90
days at a xed price. A key component in the FAX systems is a programmable
array logic integrated circuit chip (\PAL chip"), one of which is required in
each FAX system. Kezo has bought these chips in the past from an American
chip manufacturer AM Chips. However, Kezo has been approached by a Korean
manufacturer, KEC Electronics, which is o ering a lower price on the chips. This
o er is open for only 10 days, and Kezo must decide whether to buy some or all
of the PAL chips from KEC. Any chips that Kezo does not buy from KEC will be
bought from AM. AM Chips will sell PAL chips to Kezo for $3.00 per chip in any
quantity. KEC will accept orders only in multiples of 250,000 PAL chips, and is
o ering to sell the chips for $2.00 per chip for 250,000 chips, and for $1.50 per chip
in quantities of 500,000 or more chips. However, the situation is complicated by
a dumping charge that has been led by AM Chips against KEC. If this charge
is upheld by the U. S. government, then the KEC chips will be subject to an
antidumping tax. This case will not be resolved until after the point in time
when Kezo must make the purchase decision. If Kezo buys the KEC chips, these
will not be shipped until after the antidumping tax would go into e ect and the
chips would be subject to the tax. Under the terms o ered by KEC, Kezo would
have to pay any antidumping tax that is imposed. Kezo believes there is a 60%

1.5 EXERCISES

17

chance the antidumping tax will be imposed. If it is imposed, then it is equally

likely that the tax will be 50%, 100%, or 200% of the sale price for each PAL
chip.
(i) Draw a decision tree for this decision.
(ii) Using expected value as the decision criterion, determine Kezo's preferred
ordering alternative for the PAL chips.
1.6

Intermodular Semiconductor Systems case. The Special Products Division of Intermodular Semiconductor Systems has received a Request for Quotation from Allied Intercontinental Corporation for 100 deep sea semiconductor
electrotransponders, a specialized instrument used in testing undersea engineered
structures. While Intermodular Semiconductor Systems has never produced deep
sea electrotransponders, they have manufactured subsurface towed transponders,
and it is clear that they could make an electrotransponder that meets Allied's
speci cations. However, the production cost is uncertain due to their lack of
experience with this particular type of transponder. Furthermore, Allied has also
requested a quotation from the Undersea Systems Division of General Electrodevices. Intermodular Semiconductor Systems and General Electrodevices are the
only companies capable of producing the electrotransponders within the time
frame required to meet the construction schedule for Allied's new undersea habitat project.
Mack Reynolds, the Manager of the Special Products Division, must decide whether to bid or not, and if Intermodular Semiconductor Systems does
submit a bid, what the quoted price should be. He has assembled a project team
consisting of Elizabeth Iron from manufacturing and John Traveler from marketing to assist with the analysis. Daniel A. Analyst, a consulting decision analyst,
has also been called in to assist with the analysis.
Analyst: For this preliminary analysis, we have agreed to consider only a
small number of di erent possible bids, production costs, and General Electrodevices bids.
Reynolds: That's correct. We will look at possible per-unit bids of $3,000,
$5,000, and $7,000. We will look at possible production costs of $2,000, $4,000,
and $6,000 per unit, and possible per-unit bids by General Electrodevices of
$4,000, $6,000, and $8,000.
Iron: There is quite a bit of uncertainty about the cost of producing the
electrotransponders. I'd say there is a 50% chance we can produce them in a
volume of 100 units at $4,000 per unit. However, that still leaves a 50% chance
that they will either be $2,000 or $6,000 per unit.
Analyst: Is one of these more likely than the other?
Iron: No. It's equally likely to be either $2,000 or $6,000. We don't have
much experience with deep sea transponders. Our experience with subsurface
towed transponders is relevant, but it may take some e ort to make units that
hold up to the pressure down deep. I'm sure we can do it, but it may be expensive.
Analyst: Could you do some type of cost-plus contract?

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CHAPTER 1 DECISION TREES

Reynolds: No way! This isn't the defense business. Once we commit, we

have to produce at a xed price. Allied would take us to court otherwise. They're
tough cookies, but they pay their bills on time.
Iron: I want to emphasize that there is no problem making the electrotransponders and meeting Allied's schedule. The real issue is what type of
material we have to use to take the pressure. We may be able to use molyaluminum like we do in the subsurface towed units in which case the cost will be
lower. If we have to go to molyzirconium, then it will be more expensive. Most
likely, we will end up using some of each, which will put the price in the middle.
Analyst: What is General Electrodevices likely to bid?
Traveler: They have more experience than we do with this sort of product.
They have never made deep sea electrotransponders, but they have done a variety
of other deep sea products. I spent some time with Elizabeth discussing their
experience, and also reviewed what they did on a couple of recent bids. I'd say
there is a 50% chance they will bid $6,000 per unit. If not, they are more likely
to bid low than high|there is about a 35% percent chance they will bid $4,000
per unit.
Analyst: So that means there is 15% chance they will bid $8,000.
Traveler: Yes.
Reynolds: Suppose we had a better handle on our production costs.
Would that give us more of an idea what General Electrodevices would bid?
Iron: No. They use graphite-based materials to reinforce their transponders. The cost structure for that type of production doesn't have any relationship
to our system using moly alloys.
(i) Draw a decision tree for the decision that Reynolds must make.
(ii) Determine the expected values for each of the alternatives, and specify
which alternative Reynolds should select if he uses expected value as a
decision criterion.