OPERATIONS

MANAGEMENT
MODULE A
DECISION-MAKING TOOLS
 THE DECISION PROCESS
IN OPERATIONS
• Operations managers are not gamblers. But they are decision
makers.
• To achieve the goals of their organizations, managers must
understand how decisions are made and know which
decision-making tools to use.
• The success or failure of both people and companies depends
on the quality of their decisions.
• Overcoming uncertainty is a manager’s challenge.
 DECISION MAKING STEPS
1. Clearly define the problem and the factors that influence it.
2. Develop specific and measurable objectives. SMART
3. Develop a model—that is, a relationship between objectives and
variables (which are measurable quantities).
4. Evaluate each alternative solution based on its merits and
drawbacks.
5. Select the best alternative.
6. Implement and evaluate the decision and then set a timetable for
completion.
 WAYS OF DISPLAYING
A DECISION PROBLEM
• Decision trees
• Decision tables Out-
comes

States of Nature

Alternatives

Decision Problem
 FUNDAMENTALS OF
DECISION THEORY - CONTINUED
Terms:
• Alternative/decision: course of action or choice
• State of nature: an occurrence over which the decision
maker has no control

Symbols used in decision tree:

A decision node from which one of several alternatives
may be selected
A state of nature node out of which one state of nature
will occur
 DECISION TABLE

States of Nature
Alternatives State 1 State 2

Alternative 1 Outcome 1 Outcome 2

Alternative 2 Outcome 3 Outcome 4
 FUNDAMENTALS OF
DECISION THEORY
The three types of decision models:

• Decision making under uncertainty

• Decision making under risk
• Decision making under certainty
 DECISION MAKING UNDER
UNCERTAINTY

• Maximax - Choose the alternative that maximizes the maximum

outcome for every alternative (Optimistic criterion)
• Maximin - Choose the alternative that maximizes the minimum
outcome for every alternative (Pessimistic criterion)
• Equally likely - Choose the alternative with the highest average
outcome.
 DECISION MAKING UNDER
UNCERTAINTY
States of Nature
Alternatives Favorable Unfavorable Maximum Minimum Row
Market Market in Row in Row Average
Construct $200,000 -$180,000 $200,000 -$180,000 $10,000
large plant
Construct $100,000 -$20,000 $100,000 -$20,000 $40,000
small plant
Do Nothing $0 $0 $0 $0 $0
Maximax Maximin Equally
likely
 DECISION MAKING UNDER RISK

• Decision making under risk relies on probabilities.

• Several possible states of nature may occur, each
with an assumed probability.
• The states of nature must be mutually exclusive,
and their probabilities must sum to 1.
• Select alternative with largest expected monetary
value (EMV)
• EMV = Average return for alternative if decision were repeated
many times
 EXPECTED MONETARY
VALUE (EMV)
• EMV (Alternative i) =
(Payoff of 1st state of nature)* (Probability of 1st state of nature)+
(Payoff of 2nd state of nature) * (Probability of 2nd state of nature)
 DECISION MAKING UNDER RISK
(EMV)
(200000X0.5)+(-180000X0.5) = 10000

States of Nature
Alternatives Favorable Unfavorable Expected
Market Market P(0.5) value
P(0.5)
Construct $200,000 -$180,000 $10,000
large plant
Construct $100,000 -$20,000 $40,000 Best choice
small plant
Do nothing $0 $0 $0
 DECISION MAKING UNDER
CERTAINTY-
EXPECTED VALUE OF PERFECT
EVPI INFORMATION (EVPI)
•If a manager were able to determine which state of nature would occur, then he
or she would know which decision to make.
•Once a manager knows which decision to make, the payoff increases because the
payoff is now a certainty, not a probability.
•Because the payoff will increase with knowledge of which state of nature will
occur, this knowledge has value. We now look at how to determine the value of
this information. We call this difference between the payoff under perfect
information and the payoff under risk the expected value of perfect information
(EVPI) .

•EVPI is the expected value with perfect information minus the maximum EMV
EVPI = Expected value with perfect information - Maximum EMV
 EVPI AND EVWPI
• Expected value of perfect information (EVPI)
The difference between the payoff under perfect information and the
payoff under risk.
EVPI = EVwPI - Maximum EMV
• Expected value with perfect information (EVwPI)
The expected (average) return if perfect information is available.
EVwPI) = (Best outcome or consequence for 1st state of nature)*
(Probability of 1st state of nature)
+ (Best outcome for 2nd state of nature)
* (Probability of 2nd state of nature)
 EXPECTED VALUE OF PERFECT
INFORMATION
State of Nature
Alternative Favorable Unfavorable
EMV
Market ($) Market ($)
Construct a 200,000 -$180,000 $10,000
large plant
Construct a small
plant $100,000 -$20,000 $40,000

Do nothing $0 $0 $0
Probabilities 0.50 0.50
 EXPECTED VALUE OF PERFECT
INFORMATION
• If we knew with certainty that a Favorable Market would exist, our
alternative would always be Construct Large Plant.
The outcome would be +$200,000
• If we knew with certainty that an Unfavorable Market would exist,
our alternative would always be Do Nothing.
The outcome would be $0
 EXPECTED VALUE OF PERFECT
INFORMATION
State of Nature
Alternative Favorable Unfavorable
EMV
Market ($) Market ($)
Construct a 200,000
$200,000 -$180,000 $10,000
large plant
Construct a small
plant $100,000 -$20,000 $40,000

Do nothing $0 $0 $0
Probabilities 0.50 0.50
 EXPECTED VALUE OF PERFECT
Best Payoff for
INFORMATION
Favourable
Market Maximum EMV

State of Nature
Alternative Favorable Unfavorable
EMV
Market ($) Market ($)
Construct a $200,000
200,000 -$180,000 $10,000
large plant
Construct a small
plant $100,000 -$20,000 $40,000

Do nothing $0 $0 $0
Best Payoff for
Probabilities 0.50 0.50 Unfavourable
Market
 EXPECTED VALUE OF PERFECT
INFORMATION
• The EVwPI under Certainty would be:
$200,000 x 0.5 + $0 x 0.5 = $100,000
• The EVPI = EVwPI under Certainty – Max EMV under risk
= $100,000 - $40,000
= $60,000
• The value or worth for “perfect information” is $60,000
 DECISION TREES
• A decision tree is a graphic display of the decision process
that indicates decision alternatives, states of nature and their
respective probabilities, and payoffs for each combination of
decision alternative and state of nature.
• Expected monetary value (EMV) is the most commonly used
criterion for decision tree analysis. One of the first steps in
such analysis is to graph the decision tree and to specify the
monetary consequences of all outcomes for a particular
problem.
 ANALYZING PROBLEMS WITH
DECISION TREES
• Define the problem
• Structure or draw the decision tree
• Assign probabilities to the states of nature
• Estimate payoffs for each possible combination of
alternatives and states of nature
• Solve the problem by computing expected monetary values
for each state-of-nature node
• The branch leaving the decision node leading to the state-
of-nature node with the highest EMV will be chosen
 DECISION TREE

State 1
Outcome 1
t ive 1 1 State 2
a Outcome 2
Alt ern
Alte
r nat State 1
ive Outcome 3
2
2 State 2
Outcome 4
Decision
Node
State of Nature Node