Chapter 1 Supplement

Decision Analysis Support

Tools and Processes

Supplement 1-1
 Lecture Outline
• Decision Analysis
• Decision Making without Probabilities
• Decision Analysis with Excel
• Decision Analysis with OM Tools
• Decision Making with Probabilities
• Expected Value of Perfect Information
• Sequential Decision Tree

Copyright 2011 John Wiley & Sons, Inc. Supplement 1-2

 Decision Analysis
• Quantitative methods
• a set of tools for operations manager
• Decision analysis
• a set of quantitative decision-making
techniques for decision situations in which
uncertainty exists
• Example of an uncertain situation
• demand for a product may vary between 0 and 200
units, depending on the state of market

Copyright 2011 John Wiley & Sons, Inc.

Supplement 1-3
 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

Copyright 2011 John Wiley & Sons, Inc.

Supplement 1-4
 Payoff Table
• Payoff table
• method for organizing and illustrating payoffs from
different decisions given various states of nature
• Payoff
• outcome of a decision
States Of Nature
Decision a b
1 Payoff 1a Payoff 1b
2 Payoff 2a Payoff 2b

Copyright 2011 John Wiley & Sons, Inc. Supplement 1-5

 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

Copyright 2011 John Wiley & Sons, Inc. Supplement 1-6

 Decision Making Criteria Under
Uncertainty
• 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

Copyright 2011 John Wiley & Sons, Inc. Supplement 1-7

 Southern Textile Company

Copyright 2011 John Wiley & Sons, Inc. Supplement 1-8

 Maximax Solution

STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions
Expand $ 800,000 $ 500,000
Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000

Expand: $800,000
Status quo: 1,300,000  Maximum
Sell: 320,000
Decision: Maintain status quo

Copyright 2011 John Wiley & Sons, Inc. Supplement 1-9

 Maximin Solution

Expand $ 800,000 $ 500,000

Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000

Expand: $500,000  Maximum

Status quo: -150,000
Sell: 320,000
Decision: Expand

Copyright 2011 John Wiley & Sons, Inc. Supplement 1-10

 Minimax Regret Solution

States of Nature
Good Foreign Poor Foreign
Competitive Conditions
Competitive Conditions
$1,300,000 - 800,000 = 500,000 $500,000 - 500,000 = 0
1,300,000 - 1,300,000 = 0 500,000 - (-150,000)= 650,000
1,300,000 - 320,000 = 980,000 500,000 - 320,000= 180,000

Expand: $500,000  Minimum

Status quo: 650,000
Sell: 980,000
Decision: Expand

Copyright 2011 John Wiley & Sons, Inc. Supplement 1-11

 Hurwicz Criteria

STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions
Expand $ 800,000 $ 500,000
Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000

 = 0.3 1 -  = 0.7

Expand: $800,000(0.3) + 500,000(0.7) = $590,000  Maximum

Status quo: 1,300,000(0.3) -150,000(0.7) = 285,000
Sell: 320,000(0.3) + 320,000(0.7) = 320,000
Decision: Expand

Copyright 2011 John Wiley & Sons, Inc. Supplement 1-12

 Equal Likelihood Criteria

STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions
Expand $ 800,000 $ 500,000
Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000

Two states of nature each weighted 0.50

Expand: $800,000(0.5) + 500,000(0.5) = $650,000  Maximum
Status quo: 1,300,000(0.5) -150,000(0.5) = 575,000
Sell: 320,000(0.5) + 320,000(0.5) = 320,000
Decision: Expand

Copyright 2011 John Wiley & Sons, Inc. Supplement 1-13

 Decision Analysis with Excel

= MAX(C6:D6)

= MIN(C6:D8) = MAX(D6:D8)-F7

= MAX(F6:F8)

= MAX(G7:H7)

= C19*E7+C20*F7)

= .5*E8+.5*F8

Copyright 2011 John Wiley & Sons, Inc. Supplement 1-14

 Decision Analysis with OM
Tools

Copyright 2011 John Wiley & Sons, Inc. Supplement 1-15

 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

Copyright 2011 John Wiley & Sons, Inc.

Supplement 1-16
 Expected Value
n
EV (x) =  p(xi)xi
i =1
where
xi = outcome i
p(xi) = probability of outcome i

Copyright 2011 John Wiley & Sons, Inc.

Supplement 1-17
 Decision Making with Probabilities

Expand $ 800,000 $ 500,000

Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000

p(good) = 0.70 p(poor) = 0.30

EV(expand): $800,000(0.7) + 500,000(0.3) = $710,000
EV(status quo): 1,300,000(0.7) -150,000(0.3) = 865,000  Maximum
EV(sell): 320,000(0.7) + 320,000(0.3) = 320,000

Decision: Status quo

Copyright 2011 John Wiley & Sons, Inc. Supplement 1-18

 Decision Making with Probabilities: Excel

Expected value
computed
in cell D6

Copyright 2011 John Wiley & Sons, Inc. Supplement 1-19

 Expected Value of Perfect
Information
• EVPI
• maximum value of perfect information to the decision
maker
• maximum amount that would be paid to gain
information that would result in a decision better than
the one made without perfect information

Copyright 2011 John Wiley & Sons, Inc. Supplement 1-20

 EVPI

• 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

Copyright 2011 John Wiley & Sons, Inc. Supplement 1-21

 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
• Circles nodes - indicating states of nature
• Arcs - connecting nodes

Copyright 2011 John Wiley & Sons, Inc. Supplement 1-22

 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

Copyright 2011 John Wiley & Sons, Inc. Supplement 1-23

 Decision Tree Analysis
$1,290,000 $2,000,000
0.60 Market growth
2
0.40 N
om
a $225,000
gro rket et
Mark h $3,000,000
0, d
0)

wt h
80 an

$2,540,000
00

t
grow
(-$ Exp

x p and ) 0.80
E 0
$1,740,000 8 00,00 6
(-$ $700,000
0.20
1 $1,160,000 s, 4 No
et r ma
k ea gro rket
ar 3 y f f ) Sell
land wth
M ( o
th pay
Pu (-$

w $450,000
rc 200

o
gr $ 0
ha ,0
se 0 0

0.60 et $2,300,000
Mark
La )

$1,390,000
th
nd

3 e grow
0.40 e h ous ) 0.30
r
$790,000 Wa 00,000
$1,360,000 (-$6 7
gr No 0.70 $1,000,000
ow m
t a 5 No
$0 h (3 rke ma
pa ye t Sell lan grow rket
yo ar d th
ff) s,
$210,000

Copyright 2011 John Wiley & Sons, Inc. Supplement 1-24

 Copyright 2011 John Wiley & Sons, Inc.
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information herein.

Copyright 2011 John Wiley & Sons, Inc. Supplement 1-25