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Contents CHAPTERS 1.0 2.0 3.0 4.0 5.0 Agreement Introduction Question review Solution A : Decision based on a decision tree diagram Solution B : Using EVPI to determine whether attempt to obtain a better estimate of demand is required 6.0 Solution C : The probability that the market research report will be favorable 7.0 8.0 Solution D : Optimal decision strategy Solution E : The expected value of the market research information 9.0 Solution F : The efficiency of the information 20 21 23 15 19 10 PAGES 2 3 5 6 7

10.0 Conclusion 11.0 References

CHAPTER

II

INTRODUCTION

Probability is the chance of something happening. For example, this chance could be getting a heads when we toss a coin. Here something is "getting a heads". Probability is expressed as a fractional value between "0" and "1". A "0" probability means something can never happen whereas a "1" probability indicates something always happens.

Decision making is the study of identifying and choosing alternatives based on the values and preferences of the decision maker. Making a decision implies that there are alternative choices to be considered, and in such a case we want not only to identify as many of these alternatives as possible but to choose the one that has the highest probability of success or effectiveness and best fits with our goals, desires, lifestyle, values, and so on.

In mathematics, we have learned about statistic. We were given a problem that needs to solve based on statistic. By using appropriate methods, we have to select the best decision to solve the problem which is given as our program based learning project. The main objective for this project is to revise the study of decision analysis.

The problem given need us to help Gorman Manufacturing Company makes a choice either to manufacture a component part or purchase the component part from a supplier. We are required to decide what the best decision for the company in gaining largest profit. Data on the payoff table and the state-of-nature denotes s.are given.

The problem were given can be categories as difficult problem. So, it requires more knowledge about business. The study on decision making with probabilities and decision analysis with sample information should be well understood in order to solve the question. To make this problem solution easier, we need to form a decision strategy refer from analysis.

In solving this problem, we need more knowledge about engineering as it was so important. The theorem given such as Bayes theorem and conditional probability can be used to calculate the probabilities. Therefore, those methods are very useful to get the best solution for this problem. So, we should study more about decision analysis and expert in this method.

In our report, we will combine these two features which are probability and decision making to purpose the best decision based on the consequences. The analysis consists of Expected Value, Expected Value of Perfect Information, Expected Value of Sample Information and Efficiency of Sample Information. Besides, decision tree diagram is being computed as an overview in decision making.

CHAPTER

III

PBL QUESTION 1 KQ 2014

The Gorman Manufacturing Company is deciding whether to manufacture a component part at its Milan, Michigan plant or purchase the component part from a supplier. The resulting profit is dependent upon the demand of the product. The following payoff table shows the projected profit ( in thousands of dollars)

Question: A) B) Use a decision tree to recommend a decision. Use EVPI to determine whether Gorman should attempt to obtain a better estimate of demand. C) A test market study of the potential demand for the product is expected to report either a favorable (F) or unfavorable (U) condition. The relevant conditional probability is as follow. What is the probability that the market research report will be favorable?

D) E) F)

What is Gormans optimal decision strategy? What is the expected value of the market research information? What is the efficiency of the information?

CHAPTER

IV

Solution A : Decision Based On A Decision Tree Diagram

Expected Value = ( Profit

Profits probability )

1.

EV ( d1 ) =

-20(0.35) + 40(0.35) + 100(0.30) = 37

2.

EV ( d2 ) =

10(0.35) + 45(0.35) + 70(0.30) = 40.25

Since EV ( Node 2 ) < EV ( Node 3 ), The Gorman Manufacturing Company should choose to purchase the component since it gives the highest profit, $ 40,250

CHAPTER

Solution B : Using EVPI To Determine Whether Attempt To Obtain A Better Estimate Of Demand Is Required

EVPI is denoted as Expected Value of Perfect Info EVwPI is denoted as Expected Value with Perfect Info EVw/oPI is denoted as Expected Value without Perfect Info

1.

EVwPI is a better estimation of profit .It sums the profit by selecting the highest profit from manufacturing and purchasing decision for each state of nature.

i.e. If the demand is low, the best decision alternative is to purchase component If the demand is medium, the best decision alternative is to purchase component If the demand is high, the best decision alternative is to manufacture component

2.

EVw/oPI is the highest value of the EV of the decision alternative. It is a rough estimation of profit which takes the highest profit from the decision alternatives without going through the highest value of profit for each state of nature.

3.

EVPI is difference between the payoff under certainty and the payoff under risk It means the extra profit if perfect info is taken to calculate the expected value of profit.

4.

It is would be worth $9000 for the Gorman Manufacturing Company to run a market study before selecting a decision alternative. In other words, the EVPI is $9000 which means that if the company do or buy the market study info, it will earn extra $9000.

5.

Hence the price for buying or doing the market study info should not exceed $9000. If the price of market study info is equal or more than $9000, it is useless because the company spend more than it earns. In this case, the Gorman Manufacturing Company should obtain a better estimate of demand.

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CHAPTER

VI

Solution C : The Probability That The Market Research Report Will Be Favorable

1.0

The Branch Probabilities Based On Favorable Report:

1.1 Using The Conditional Probability Formula To Find The Necessary Information:

1.2 The Given Relevant Conditional Probabilities: P( F | s1 ) = 0.10 P( F | s2 ) = 0.40 P( F | s3 ) = 0.60

1.3 The Calculation of Joint Probabilities: P( Fs1) = P( F | s1 ) P( s1 ) = 0.10 0.35 = 0.035 P( Fs2) = P( F | s2 ) P( s2 ) = 0.40 0.35 = 0.140 P( Fs3) = P( F | s3 ) P( s3 ) = 0.60 0.30 = 0.180

1.4 The Probabilities That The Market Study Report Will Be Favorable: P( F ) = P ( Fsj ) = P ( Fs1) + P ( Fs2 ) + P ( Fs3 ) = 0.035 + 0.140 + 0.180 = 0.355

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1.5 The Posterior Probabilities Associated With Favorable Report:

P(s1 | F )

P ( F s 1 ) 0.035 0.099 P(F) 0.355

P(s 2 | F )

P ( F s 2 ) 0.140 0.394 P(F) 0.355

P ( F s 3 ) 0.180 0.507 P(F) 0.355

P(s 3 | F )

1.6 The Obtained Information based on a Favorable Report:

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2.0

The Branch Probabilities Based On Favorable Report:

2.1 Using The Conditional Probability Formula To Find The Necessary Information.

2.2

The Given Relevant Conditional Probabilities: P( U | s1 ) = 0.90 P( U | s2 ) = 0.60 P( U | s3 ) = 0.40

2.3

The Calculation of Joint Probabilities: P( Us1) = P( U | s1 ) P( s1 ) = 0.90 0.35 = 0.315 P( Us2) = P( U | s2 ) P( s2 ) = 0.60 0.35 = 0.210 P( Us3) = P( U | s3 ) P( s3 ) = 0.40 0.30 = 0.120

2.4 The Probabilities That The Market Study Report Will Be Unfavorable: P( U ) = P ( Usj ) = P ( Us1 ) + P ( Us2 ) + P ( Us3 ) = 0.315 + 0.210 + 0.120 = 0.645

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2.5

The Posterior Probabilities Associated With Favorable Report:

P(s1 | U )

P ( U s1 ) 0.315 0.488 P(U) 0.645

P(s 2 | U )

P ( U s 2 ) 0.210 0.326 P(U) 0.645

P(s 3 | U )

P ( U s 3 ) 0.120 0.186 P(U) 0.645

2.6

The Obtained Information based on a Unfavorable Report:

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3.0 Decision Tree Based On The Test Market Study

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CHAPTER Solution D : Optimal Decision Strategy

VII

Decision Tree Representing The Revised Or Posterior Probabilities

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1.

Starting the backward pass calculations by computing the expected values (EV) at nodes 6 to 9 provides the following results:

EV (Node 6)

= 0.099(-20) + 0.394(40) + 0.507(100) = 64.48

EV (Node 7)

= 0.099(10) + 0.394(45) + 0.507(70) = 54.21

EV (Node 8)

= 0.488(-20) + 0.326(40) + 0.186(100) = 21.88

EV (Node 9)

= 0.488(10) + 0.326(45) + 0.186(70) = 32.57

2.

Now we move to decision nodes 3 and 4. For each of these nodes, we select the decision alternative branch that leads to the best expected value.

3.

At node 3 we have the choice of the decision alternative d 1 with EV 64.48 , the decision alternative d2 with EV (Node7) = 54.21

(Node 6)

4.

Thus we select the decision alternative d1 with the large value and so the expected value at node 3 becomes : EV (Node 3) = 64.48

5.

For node 4, we select the best expected value from nodes 8 and 9. The best decision alternative is d 2 that give EV (Node 9) = 32.57 instead of EV (Node 8) = 21.88

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6.

So the expected value at node 4 becomes : EV (Node 4) = 32.57

7.

The expected value at node 2 can now be computed as follows:

EV (Node 2)

= (0.355)(EVNode 3) + (0.645)(EV Node 4 ) = 0.355(64.48) + 0.645(32.57) = 43.89805

8.

At node 5, the decision alternative d 2 , to purchase the component, with an expected value of 40.25 is the optimal decision..Hence, EV (Node 5) = 40.25.

9.

Finally, the decision can be made at decision node 1 by selecting the best expected values from nodes 2 and 5. This action leads to the decision alternative to conduct the market research study, which provides an overall expected value, EVNode 1 = 43.89805

10. Therefore, the optimal decision strategy for this problem is to go for the market research study before making the final decision .

11. The decision alternative d 1 (manufacture the component part at its plant) is carried out if the study reports a favorable condition.

12. If the study reports an unfavorable condition, the company is best to carry out decision alternative d2 (purchase the component part from a supplier).

13. The expected profit is $43890.5

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14. The overview of the expected value of each node

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

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CHAPTER

VIII

Solution E : The Expected Value Of The Market Research Information

1.

In decision theory, the expected value of sample information (EVSI) is the price that one would be willing to pay in order to gain access to a sample from the distribution about which the prediction has to be made.

2.

Expected Value of Sample Information ( Market Research Information ), EVSI is the difference between the Expected Value best decision with market research information and Expected Value of best decision without market research information.

EVSI = | EV (market study ) = | EV( node2 ) = | 43.89805 = 3.65

EV ( without market study ) |

EV ( node5 ) | 40.25 |

3.

Therefore, conducting the market research study will adds $3650 to the Gorman Manufacturing Company expected value. In other words, the company is suggested pay only up to $3650 to conduct the market study for acquiring the sample information.

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CHAPTER

IX

Solution F : The Efficiency Of The Information

1.

An efficiency measure is to express the value of the market study information.

2.

Low efficiency ratings for sample information might lead the decision maker to look for other types of information.

3.

Whereas, high Efficiency ratings indicate that the sample is almost as good as perfect information.

4.

Efficiency is the ratio between Expected Value of Sample Information, EVSI and Expected Value of Perfect Information, EVPI times with 100 percent.

5.

From the calculation, we conclude that the information from the market study is 40.55% as efficiency as perfect information.

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CHAPTER

CONCLUSION

Initially, the company does not run market study to obtain the component part. From the decision tree diagram, the expected value of profit should be higher if the company decides to purchase the component parts. The expected value of profit for purchasing is $40,250 which is higher than the expected value of profit for manufacturing $37,000.Hence the Gorman Manufacturing Company should decide to purchase the component parts.

Calculating the Expected Value of Perfect Information which shows $9000, the company is willing to pay not more than $9000 to obtain sample information from market study. In this case, the EVPI is $9000 which means that if the company do or buy the market study info, it will earn extra $9000. Hence the price for buying or doing the market study info should not exceed $9000.If the price of market study info is equal or more than $9000,it is useless because the company spend more than it earns.

By using Bayers Theorem, the probability that the market study report will be favorable is 0.355. The probability that the market research report will be unfavorable is 0.645. the company is taking risk since the probability of favorable is lower than unfavorable.

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The optimal decision strategy is to run a market study. If the report is favorable, the company should manufacture the component parts. Otherwise, unfavorable report will lead the company to purchase the component part for better profit. . The company is suggested pay only up to $3650 to conduct the market study for acquiring the sample information. The information from the market study is 40.55% as efficiency as perfect information.

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CHAPTER

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REFERENCES

1.

Douglas C. Montgomery, Geroge C.Runger. Applied Statistics and Probability for Enginners, 4 th edition. John Wiley & Sons ( Asia ) Pte Ltd, 2007

2.

Rachel Brown. Expected Value Method in Decision Making. http://www.freequality.org/sites/www.../Expected%20Value%20Method.ppt November, 2005

3.

Mike Middleton. Value of Information in Decision Trees. http://www.treeplan.com/chapters/19_decan_20071029_1042.pdf October,2007

4.

Kenneth C. Levine. Expected Value of Sample Information. http://www2.gsu.edu/~wwwkcl/MGS3100/MGS3100_Slides8c.ppt August, 2005.