1

INTRODUCTION

We know everyone makes decisions, but not everyone thinks about how
they make those decisions. Decision Analysis can help those who are stuck
with a tough decision and it is a professional practice necessary to address
important decisions in a formal manner.

There are two very basic models used for decision analysis — decision
tables and decision trees. This module contains a model for a general decision
table; a model for entering a decision tree in tabular form; an exciting, new
model with a graphical user interface for decision trees; and a model for
creating a decision table for supply/demand or 1 period inventory situations.

HISTORY AND METHODOLOGY

Graphical representations of decision analysis problems commonly use

framing tools, influence diagrams and decisions trees. Such tools are used to
represent the alternatives available to the decision maker, the uncertainty they
involve, and evaluation measures representing how well objectives would be
achieved in the final outcome. Uncertainties are represents through
probabilities.

Decision analysis advocates choosing that decision whose

consequences have the maximum expected utility (or which maximize the
probability of achieving the uncertain aspiration level). Such decision analytic
methods are used in a wide variety of fields, including business (planning,
marketing, negotiating), environmental remediation, health care, research, and
management, energy, ecxploration, litigation and dispute resolution, etc.
 2

Decision Analysis

 Refers to a systematic, quantitative and interactive approach to

addressing and evaluating important choices confronted by the
organization.

Decision Table Model

 The decision table can be used to find the expected value, the
maximin (minimax), or the maximax (minimin) when several decision
options are available and there are several scenarios that might
occur. Also, the expected value under certainty, the expected value
of perfect information, and the regret (opportunity cost) can be
computed.
 The general framework for decision tables is given by the number of
options (or alternatives) that are available to the decision maker and
the number of scenarios (or states of nature) that might occur. In
addition, the objectives can be set to either maximize profits or to
minimize costs.

Example 1: Decision Table Model

The following example presents three decision options: (1) subcontract,

(2) use overtime, or (3) use part-time help. The possible scenarios (states of
nature) are that demand will be low, normal, or high; or that there will be a
 3

strike or a work slowdown. The table contains profits as indicated. The first row
in the table represents the probability that each of these states will occur.

The remaining three rows represent the profit that we accrue if we make
that decision and the state of nature occurs. For example, if we select to use
overtime and there is high demand, the profit will be 180.

Solution

Expected Values

 The expected values for the options have been computed and
appear in a column labeled “EMV” (Expected Monetary Value), which
has been appended to the right-hand side of the data table.

Row Minimum

 For each row, the minimum element has been found and listed. This
element is used to find the maximin or minimin.

Row Maximum

 For each row, the maximum element in the row has been found and
listed. This number is used for determining the maximax or minimax.
 4

Maximum Expected Value

 Because this is a profit problem finding the maximum values is of

importance. The maximum expected value is the largest number in
the expected value column, which in this example is 124.5.

Maximin

 The maximin is the largest (MAXImum) number in the MINimum

column. In this example, the maximin is 100.

Maximax

 The maximax is the largest value in the table or the largest value in
the maximum column. In this example, it is 190.

A second screen of results presents the computations for the expected

value of perfect information as follows.

Perfect Information

 An extra row labelled “Perfect Information” has been added below

the original data. In this row, the best outcome for each column is
listed. For example, for the low demand scenario the best outcome is
the 120 given by using overtime.
 5

Perfect * Probability (expected value under certainty)

 The expected value under certainty is computed as the sum of the

products of the probabilities multiplied by the best outcomes. This is
the example.

EV (Certainty) = (.2*120) + (.3*150) + (.25*190) + (.15*120) + (.1*130) = 147.50

Expected Value of Perfect Information

 The expected value for perfect information (EVPI) is the difference

between the best expected value (124.5) and the expected value
under certainty (147.5), which in this example is 23.

A third available output display is that of regret or opportunity loss

displayed as follows.

The values in the table are computed for each column as the cell value
subtracted from the best value in the column in the data.

For example, under low demand the best outcome is 120. If you
subcontract and get 100, then the regret is 120 – 100 or 20 but if you use part
time help the regret is 120-105 =15.

The two columns on the right yield two sets of results. In the column
labelled “Maximum regret”, the worst (highest) regret for each decision is
determined and then minimax regret (50) is found by looking at the best
(lowest) of these regrets.
 6

In the column labelled “Expected Regret,” simply multiply the regrets in

each row by the probabilities.

Decision Theory and Probability Analysis

 A matter of selecting a single act among all the alternatives.
 Using quantitative information in analysing alternatives helps in
minimizing mistakes.

• Rationale in using quantitative techniques

Management accountants use quantitative techniques in
developing the necessary information needed by management in
carrying out their functions that include planning, controlling and
decision-making.

• Quantitative Models defined

Real-life decision situations students are modelled mathematically
under certain assumptions in order to achieve a determinable
solution.

• Commonly used quantitative models

• Probability Analysis
• Decision Tree
• Gantt Chart
• PERT CPM
• Linear Programming
• Queuing
• Learning Curves
• Sensitivity Analysis
• Regression Analysis
• Present Values
• Inventory Models
 7

• Elements of a Decision Making Situation

1. Decision Alternative – the courses of action available to the decision
matter. (To issue an unqualified, qualified, adverse opinion).
2. States of Nature – future events which are normally not under the
control of the decicion maker. (Low, moderate, and high-risk).
3. Optimal Decision – best decision alternative.

• Steps in the Decision Theory Approach

1. List all the decision alternatives that must be considered
2. List all the possible state of nature
3. Determine the pay-off associated with each decision alternative and
state of nature combination.
4. Estimate (if possible) the probability of occurrence of each state of
nature.
5. Construct a pay-off or decision tree for the decision situation.

• Methods of Structuring a Decision Situation

1. Pay-off Tables
a. Shows the payoff (profit, cost or any other measure of output)
which would result from each possible combination of decision
alternative and state of nature.

Illustration:
Mr. B. Hon cooks and sells “Pansit in a Box.” Each box of
pansit is sold for P50 during regular hours, that is, from 10am to 8pm. If
every box is sold by 8pm, Mr. B. Hon calls it a day. However, all unsold
boxes by 8pm are sold at half the regular price up to 9pm. The variable
cost per box is P30. The contribution margin per box is as follows:
From 10am to 8pm.
 8

Selling price P 50
Variable cost 30
CM per box P 20

After 8pm Selling price P 25

Variable cost 30
CM per box P 5
Past experience has shown that the daily sales demand (up to 8pm) and
their probabilities are as follows:
Sales per Day Probability
500 boxes 0.20
600 boxes 0.70
700 boxes 0.10

If the sales demand will be the same as in the past, a payoff table
showing the contribution margin (conditional value) for the possible sales
quantities under each production level strategy, as well as the expected value
of such contribution margin can be constructed as follows:

CONTRIBUTION MARGINS FOR POSSIBLE SALES QUANTITIES

PREPARE 500 BOXES: Expected Value of CM
500 boxes (500 x P20) P 10,000
600 boxes (500 x P20) 10,000
700 boxes (500 x P20) 10,000 10,000 (1)
PREPARE 600 BOXES:
500 boxes (500 x P20) – (100 x P5) P 9,500
600 boxes (600 x P20) 12,000
700 boxes (600 x P20) 12,000 11,500 (2)
PREPARE 700 BOXES:
500 boxes (500 x P20) – (200 x P5) P 9,000
600 boxes (600 x P20) – (100 x P5) 11,500
700 boxes (700 x P20) 14,000 11,250 (3)
 9

Probabilities:
500 boxes (500 x P20) P 10,000 9,500 9,000 0.20
600 boxes (500 x P20) 10,000 12,000 11,500 0.70
700 boxes (500 x P20) 10,000 12,000 14,000 0.10

(1) (P10,000x.20) + (P10,000x.70) + (P10,000x.10) = P10,000

(2) (P 9,500x.20) + (P12,000x.70) + (P12,000x.10) = P11,500
(3) (P 9,500x.20) + (P11.500x.70) + (P14,000x.10) = P11,500

Based on the above payoff table, the best course of action is to prepare 600
boxes of “Pansit” per day because it has the highest expected value of
contribution margin of P11,500.

• Methods of Structuring a Decision Situation

2. Decision Tree
 10

P2, 000
P10, 000 P7, 000

P1, 000

P11, 500
P11, 500 P1, 900
P8, 400

P1, 200
P11, 250
P1, 800

P8, 050
P1, 400

Decision: Prepare 600 boxes of Pansit because this quantity has the highest
expected value of contribution margin.

ADVANTAGES OF USING DECISION TREE

1. Decision trees facilitate the evaluation of alternatives by giving the
decision maker a visual presentation of the expected results of each
alternative.
2. Decision trees are useful when sequential decisions are involved.

LIMITATIONS OF DECISION TREE

1. It may difficult to determine all the possible events, outcomes and their
probabilities.
2. A case involving so many events and sequential decisions may result
into a more complex decision tress which may not be that easy to use.

Types of Decision Making Situation

1. Decision making under certainty
a. Expected Value = P(y)
i. Mathematical Expectation
ii. Depends on two factors – probability of an event will occur and
the amount to be receive in relation to such event.
 11

1. Concept of Probability
a. It is a measure of certainty.
b. The value ranges from 0 to 1 – if an event
is certain to happen the probability is 1 or
100% versus if an event is impossible to
happen the probability is zero.
iii. Computation of the Expected Value
1. EV = P(X) wherein P is the probability value and X is
the amount of money.

2. Decision making under uncertainty

a. Criteria for Decision Making
i. Maximin Criterion (Maximum of all minimum)
1. A very pessimistic or conservative approach (assuming
the worst will happen)
ii. Maximax or Minimin Criterion (Maximum of all Maximum)
1. A very optimistic approach
2. Concentrates the attempt to obtain the biggest payoff
possible and it completely neglects possible losses or
low returns.
iii. Minimax Regret Criterion (Minimum of all Maximum
Opportunity Loss)
1. Regret or Opportunity Loss
a. The relative loss resulting from the choice of an
alternative given that a particular state of nature
has occurred, compared with the best alternative
under that state.
b. Highest pay-off less other pay-off for each stated
of nature.
2. Look for the maximum of all the maximum opportunity
loss selected for each decision alternative.
 12

3. Decision making under risk

a. Expected Pay-off Criterion
i. sometimes called as the expected monetary value
ii. the sum of weighted pay-offs for the alternative
iii. choose the alternative with the maximum expected pay-off.
b. Expected Opportunity Loss Criterion
i. Weighted mean of the regret values associated with the
alternative.
ii. Choosing the alternative with the minimum expected
opportunity losss.

 Probability Distribution
• Specifies the values of the variables and their respective
probabilities.

• Probability
• Probability of 0 – the event cannot occur
• Probability of 1 or 100% - the event is certain to occur
• Probability between 0 and 1 - indicated the likelihood of
the event’s occurrence.

• Types of Probabilities
1. Objective Probabilities – calculated from either logic or actual
experience.
2. Subjective Probabilities – estimates of the likelihood of future events are
based on judgment and past experience

Value of the Perfect Information

• Perfect Information – the knowledge that a future state of nature
(event) will occur with certainty.
 13

• The expected value of perfect information is the difference

between the expected value without perfect information and the return if
the best action is taken given perfect information.

Worked Examples
• Expected Value
1. A man buying a raffle ticket can win a first prize of P15,000
or a second prize of P12,000 with probabilities of .002%
and .0015%, respectively.
Determine the fair price to pay for the ticket.
15,000 x .002% = .3
12,000 x .0015% = .18
.48

• Decision Theory
Rex Computers is in the stage of determining the size of computer
system to be used in its computer shops. The pay-off table with the
corresponding decision alternative and state of nature follows:
 14

Rex Computer’s management believes that there is a 20% chance that

consumer acceptance of their computer services will be low; a 50% chance that
it will be moderate, and a 30% chance it will be high.
Required:
1. Show the decision recommendation under each of the following criteria:
a. Maximax = Put up a large system (2,500,000)
b. Maximin = Put up a small system (500,000)
c. Minimax Regret = Put up a medium system
2. What is the decision recommended under the expected payoff criterion?
Put up a medium system
3. What is the expected value of perfect information? Put up a medium
system
SYSTEM

Decision Tables

Data Results
MODERATE HIGH
LOW CONSUMER CONSUMER CONSUMER
Profit ACCEPTANCE ACCEPTANCE ACCEPTANCE EMV Minimum Maximum
Probability 0.2 0.5 0.3
PUT UP A SMALL
500000 700000 1200000 810000 500000 1200000
SYSTEM
PUT UP A MEDIUM
300000 1000000 1600000 1040000 300000 1600000
SYSTEM
PUT UP A LARGE
-200000 -50000 2500000 685000 -200000 2500000
SYSTEM
Maximum 1040000 500000 2500000
The maximum expected monetary value is 1,040,000 given by PUT UP A MEDIUM SYSTEM
THE Maximin is 500,000 given by PUT UP A SMALL SYTEM
THE maximax is 2,500,000 given by PUT UP A LARGE SYSTEM

Expected Value of Perfect Information

Column best 500000 1000000 2500000 1350000 <-Expected value under certainty
1040000 <-Best expected value
310000 <-Expected value of perfect information

Regret
MODERATE HIGH
LOW CONSUMER Expected Maximum
CONSUMER CONSUMER
ACCEPTANCE Regret Regret
ACCEPTANCE ACCEPTANCE
Probability 0.2 0.5 0
PUT UP A SMALL
0 300000 1300000 540000 1300000
SYSTEM
PUT UP A MEDIUM
200000 0 900000 310000 900000
SYSTEM
PUT UP A LARGE
700000 1050000 0 665000 1050000
SYSTEM
Minimax
Regret 310000 900000
 15

POWERPOINT SLIDES
FOR THE THEORY
DISCUSSION
(DECISION ANALYSIS)
16
17
18
19
20
21
 22

CASE ANALYSIS

OHIO EDISION
COMPANY
(DECISION ANALYSIS)
 23

OHIO EDISON COMPANY

Ohio Edison Company is an investor-owned electric utility

headquartered in Northeastern Ohio. Ohio Edison and a Pennsylvania
subsidiary provide electrical service to more than two million people. Most of
this electricity is generated by coal-fired power plants. To meet evolving air
quality standards, Ohio Edison replaced existing particulate control equipment
at most of its generating plants with more efficient equipment with the
continuing need to construct new generating plants with more efficient
equipment. The combination of this program to upgrade air-quality control
equipment with the continuing need to construct new generating plants to meet
future power requirements resulted in a large capital investment program.

Quantitative Methods activities at Ohio Edison are distributed throughout

the company rather than centralized in a specific department, and are more or
less evenly divided among the following areas: fossil and nuclear fuel planning,
environmental studies, capacity planning, large equipment evaluation, and
corporate planning. Applications include decision analysis, optimal ordering
strategies, computer modeling, and simulation.

A Decision Analysis Application

The flue gas emitted by coal-fired power plants contains small ash particles and
sulfur dioxide (SO2). Federal and state regulatory agencies have established
emission limits for both particulates and sulfur dioxide. In the late 1970s, Ohio
Edison developed a plan to comply with new air-quality standards at one of its
largest power plants. This plant, which consists of seven coal-fired units (most
of which were constructed in the 1960s), constitutes about one-third of the
generating capacity of Ohio Edison and its subsidiary company. Although all
the units were initially constructed with particulate emission control equipment,
that equipment was no longer capable of meeting new particulate emission
requirements.

A decision had already been made to burn low-sulfur coal in four of the
smaller units (units 1-4) at the plant in order to meet SO2 emission standards.
 24

Fabric filters were to be installed on these units to control particulate emissions.

Fabric filters, also known as bughouses, use thousands of fabric bags to filter
out the particulars; they function in much the same way as a household
vacuum cleaner.

It was considered likely, although not certain, that the three larger units
(units 5-7) at this plant would burn medium-to-high-sulfur coal. A method of
controlling particulate emission at these units had not yet been selected.
Preliminary studies narrowed the particulate control equipment choice to a
decision between fabric filters and electrostatic precipitations (which remove
particulates suspended in the flue gas by passing the flue gas through strong
electric field). This decision was affected by a number of uncertainties,
including the following:

 Uncertainty in the way some air-quality laws and regulations might be

interpreted.
 Potential requirements that either low-sulfur coal or high-sulfur Ohio coal
(or neither) be burned in units 5-7
 Potential future changes to air quality laws and regulations
 An overall plant reliability improvement program already under way at
this plant
 The outcome of this program itself, which would affect the operating
costs of which would affect the operating costs of whichever pollution
control technology was installed in these units
 Uncertain construction costs of the equipment, particularly since limited
space at the plant site made it necessary to install the equipment on a
massive bridge deck over a four-lane high way immediately adjacent to
the power plant.
 Uncertain costs associated with replacing the electrical power required
to operate the particular control equipment
 Various other factors, including potential accidents and chronic operating
problems that could increase the cost of operating the generating units
(the degree to which each of these factors could affect operating cost
 25

varied with the choice of technology and with the sulfur content of the
coal).

Particulate Control Decision

The air –quality program involved a choice between two types of particulate
control equipment (fabric filters and electrostatic precipitators) for units 5-7.
Because of the complexity of the problem, the high degree of uncertainty
associated with the factors affecting the decision, and the importance (because
of potential reliability and cost impact on Ohio Edison) of the choice, decision
analysis was used in the selection process.

The decision measure used to evaluate the outcomes of the particulate

technology decision analysis was the annual revenue requirements for the
three large units over their remaining lifetime. Revenue requirements are the
monies that would have to collect from the utility customers to recover costs
resulting from the decision. They include not only direct costs but also the cost
of capital and return on investment.

A decision tree was constructed to represent the particulate control

decision and its uncertainties and costs. A simplified version of this decision
tree is shown in Figure 4.15. The decision and state-of-nature nodes are
indicated. Note that to conserve space a type of shorthand notation is used.
The coal sulfur content state-of-nature node should actually be located at the
end of each branch of the capital cost state-of-nature node, as the dashed lines
indicate. Each of the state-of-nature nodes actually represents several
probabilistic cost model are the sum of the revenue requirements for capital
and operating costs, costs associated with these models were obtained from
engineering calculation or estimates. Probabilities we’re obtained from existing
data or the subjective assessments of knowledgeable persons.

Results

A decision tree similar to that shown in Figure 4.15 was used to generate
cumulative probability distribution for the annual revenue requirements
 26

outcomes, calculated for each of two particulate controls alternatives. Careful

study of these results led to the following conclusions;

 The expected value of annual revenue requirements for the electrostatic

precipitator technology was approximately $1 million lower than that for
the fabric filters.
 The fabric filter alternative had a higher upside risk-that is, a higher
probability of high revenue requirements-than did the precipitator
alternative.
 The precipitator technology had nearly an 80% probability of lower
annual revenue requirements than the fabric filters.
 Although the capital cost of the fabric filter equipment (the cost of
installing the equipment) was lower than precipitator, this cost was more
than offset by the higher operating costs as associated with fabric filter.

These result led Ohio Edison to select the electrostatic precipitator

technology for the generating units in question. Had the decision analysis
not been performed the particulate control decision might have been based
chiefly on capital cost, a decision measure that would have favored the
fabric filter equipment. Decision analysis offers a means for effectively
analyzing the uncertainties involved in a decision. Because of this analysis,
the use of decision analysis methodology in this application resulted in a
decision that yielded both lower expected revenue requirements and lower
risk.
 27

Questions

1. Why was decision analysis used in the selection of particulate control

equipment for units 5, 6, and 7?

Decision analysis was used in the selection because it

contains alternatives in which what method of controlling
particulate emissions between fabric filters and electronic
precipitators will be selected. The decision also was affected by a
number of uncertainties that strongly demands the use of decision
analysis. It is a strategy involving a sequence of decisions and
chance outcomes to provide the optimal solution to a decision
problem. This time the decision maker is faced with an uncertain
 28

and risk-filled pattern of future analysis. Because of the

complexity of the problem, the high degree of uncertainty
associated with the factors affecting the decision, and the
importance of the choice.

2. List the decision alternatives for the decision analysis problem

developed by Ohio Edison.

i. Fabric filters were to be installed on these units to control

particulate emissions
ii. Electronic precipitator which removes particulates
suspended in the flue gas by passing the flue gas through
a strong electric field.

3. What were the benefits of using decision analysis in this application?

Using decision analysis in this application, it facilitates the

evaluation of alternatives by giving the decision maker a visual
presentation of the expected results of each alternative. This also
benefits the problem by solving its sequential decisions. This
method offers a mean for effectively analyzing the uncertainties
involved in a decision. It resulted in a decision that yielded both
lower expected revenue requirements and lower risk.
 29

POWERPOINT SLIDES FOR

THE CASE ANALYSIS
OHIO EDISION COMPANY
(DECISION ANALYSIS)
30
31
32
33
34
 35

References

1. https://en.wikipedia.org/wiki/Decision_analysis

2. Howard J. Weiss (2005), Software for Decision Sciences: Quantitative

Methods, Production and Operations Management 6, 74-75.