Chapter 1 – Supplement

Operational
Decision -
Making Tools:
Decision Analysis
Vo Thi Xuan Hanh
 Lecture outline
In this chapter, you will learn about:
1. Decision Analysis
2. Sequential Decision Tree
3. Practice

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 What is Decision Analysis?
Decision analysis:  A quantitative method
a set of quantitative
decision-making ■ a tool for operations managers
techniques for decision  A generic technique
situations in which
uncertainly exists. ■ can be applied to a number of different
types of operational decision-making areas
 Example of an uncertain situation
■ demand for a product may vary between 0
and 200 units, depending on the state of
market

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 Decision Making Without Probabilities
 States of nature
■ Events that may occur in the future
■ Examples of states of nature:
 high or low demand for a product
 good or bad economic conditions
 Decision making under risk
■ probabilities can be assigned to the occurrence of states of nature in the
future
 Decision making under uncertainty
■ probabilities can NOT be assigned to the occurrence of states of nature
in the future
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Payoff Table
Payoff: outcome of a decision

States Of Nature
Decision a b
1 Payoff 1a Payoff 1b
2 Payoff 2a Payoff 2b

Supplement 2-5
 Supplement 2-8

Decision Making Criteria Under Uncertainty

 Maximax
■ Choose decision with the maximum of the maximum
payoffs
 Maximin
■ Choose decision with the maximum of the minimum
payoffs
 Minimax regret
■ Choose decision with the minimum of the maximum
regrets for each alternative
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 Supplement 2-9

Decision Making Criteria Under Uncertainty (cont.)

 Hurwicz
■ Choose decision in which decision payoffs are
weighted by a coefficient of optimism, alpha
■ Coefficient of optimism is a measure of a
decision maker’s optimism, from 0 (completely
pessimistic) to 1 (completely optimistic)
 Equal likelihood (La Place)
■ Choose decision in which each state of nature is
weighted equally
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 Maling Manufacturing needs to purchase a new piece of
machining equipment. The two choices are a
conventional (labor-intensive) machine and an
automated (computer-controlled) machine. Profitability
will depend on demand volume. The following data
provide an estimate of profits over the next three years.

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Decision Making with Probabilities
 Risk involves assigning probabilities to states of
nature
 Expected value
■ a weighted average of decision outcomes in which
each future state of nature is assigned a probability
of occurrence

Supplement 2-21
Expected value

EV (x) = n

p(xi)xi 
i =1

where

xi = outcome i
p(xi) = probability of outcome i

Supplement 2-22
 Supplement 2-26

Expected Value of Perfect Information

 EVPI
■ maximum value of perfect information to the
decision maker
 Maximum amount that an investor would pay to
purchase perfect information

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 Supplement 2-27

EVPI Example
 Good conditions will exist 70% of the time
 choose maintain status quo with payoff of $1,300,000
 Poor conditions will exist 30% of the time
 choose expand with payoff of $500,000
 Expected value given perfect information
= $1,300,000 (0.70) + 500,000 (0.30)
= $1,060,000
 Recall that expected value without perfect information was
$865,000 (maintain status quo)

EVPI= $1,060,000 - 865,000 = $195,000

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 Sequential Decision Trees
 A graphical method for analyzing decision situations that require a
sequence of decisions over time
 Decision tree consists of:
■ Square nodes - indicating decision points
1 …
■ Circles nodes - indicating states of nature
2 …
■ Arcs - connecting nodes

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 $2,000,000
0.60 Market growth
2
0.40
$225,000
$3,000,000

0.80
6
0.20 $700,000
1 4

$450,000
0.60
$2,300,000
3
0.40
0.30
7
0.70 $1,000,000
5

Example S1.3/39 $210,000

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 Sequential Decision Trees
Example S1.3/39
Evaluations at Nodes
 Compute EV at nodes 6 & 7
■ EV(node 6)= 0.80($3,000,000) + 0.20($700,000) = $2,540,000
■ EV(node 7)= 0.30($2,300,000) + 0.70($1,000,000)= $1,390,000
 Decision at node 4 is between
$2,540,000 for Expand and
$450,000 for Sell land
 Choose Expand
 Repeat expected value calculations and decisions at remaining
nodes
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 $1,290,000 $2,000,000
0.60 Market growth
2
0.40
$225,000
$2,540,000 $3,000,000

0.80
$1,740,000 6
0.20 $700,000
1 $1,160,000 4

$450,000
0.60
$1,390,000 $2,300,000
3
0.40
0.30
$790,000 7
$1,360,000
0.70 $1,000,000
5

Evaluations at Nodes $210,000

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 Martin’s Service Station is considering investing in a heavy-
duty snowplow this fall. Martin, the owner, has analyzed the
situation carefully and feels that this would be a very profitable
investment if the snowfall is heavy, somewhat profitable if the
snowfall is moderate, and would result in a loss if the snowfall
is light. Specifically, Martin forecasts a profit of $7,000 if
snowfall is heavy and $2,000 if it is moderate, and a $9,000
loss if it is light. From the Weather Bureau’s long-range
forecast, Martin estimates that P(heavy snowfall) 5 .4,
P(moderate snowfall) 5 .3, and P(light snowfall) 5 .3.
a. Prepare a decision tree for Martin’s problem.
b. Using the EV criterion, would you recommend that
Martin invest in the snowplow?
c. Discuss the value of using EV for this situation.
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 The Gorman Manufacturing Company must decide whether to
purchase a component part from a supplier or to manufacture the
component at its own plant. If demand is high, it would be to
Gorman’s advantage to manufacture the component. If demand is
low, however, Gorman’s unit manufacturing cost will be high
because of underutilization of equipment. The projected profit in
thousands of dollars for Gorman’s make-or-buy decision is as
follows:
Demand
Decision Low Medium High
Manufacture component $220 $40 $100
Purchase component 210 45 70
The states of nature have these probabilities: P(low demand) =
.35, P(medium demand) = .35, and P(high demand) = .30. Use a
decision tree to recommend a decision.
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 (6) A firm produces a perishable food product at a
cost of $10 per case. The product sells for $15 per case.
For planning purposes, the company is considering
possible demands of 100, 200, and 300 cases. If the
demand is less than production, the excess production
is discarded. If demand is more than production, the
firm, in an attempt to maintain a good service image, will
satisfy the excess demand with a special production run
at a cost of $18 per case. The product, however, always
sells at $15 per case.
a. Set up the payoff table for this problem.
b. If P(100) = .2, P(200) = .2, and P(300) 5 .6, should
the company produce 100, 200, or 300 cases?
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