Table of content 1.0 Question one 1.1 General introduction 1.2 Application of Decision tree 1.

3 Analysis of original scenario 1.4 Sensitivity analysis 1.5 Conclusion Question Two 2.1 Revenue function of the firm 2.2 Profit equation of the firm 2.3 Profit graphs

2.0

3.0 References

1.1

Contemporary businesses operate in a fast changing, highly innovative, dynamic, and global competitive environment. There is no doubt, that advancement in information technology and globalization of financial markets has dramatically changed and reshaped the ways todays businesses are conducted.

Introduction

There has been increasing complexity of the business environment in which firms has to function, the information need of business managers becomes more complex and also demanding on daily basis [see figure 1] resulting from increase competition, improvements in telecommunications, limited managerial time to access and analyze as well as making decisions. Today, the consequences of taking wrong business decisions has become so expensive [ e.g. producing the wrong products, providing inappropriate services or entering a wrong market], all exert serious cost implications to the firm concern. Business managers, and their supporting information systems, must be robust to support fast and appropriate decisions. The role of quantitative method/business models [e.g linear programming, forecasting techniques, simulation, optimization, decision tree etc] in facilitating business decisions has been appreciated in recent times.
Increasing Competition
More complex Business environment More complex Business structures

Changing markets

The manager

Complex information needs & systems Increased uncertainty Reduced reaction time

Changing customer

requirements

Larger error costs

Figure 1 manager and decision-making environment [adapted, Mik Wisniewski, 2006 pp7]
The management reports consist of two parts; while part one deals with decision tree as a quantitative technique for improving managerial decision making process, the second part discusses extensively,

optimization and in relation to strength and weakness of both model as an instrument of policy to assist in business decision-making process.

1.2

Decision tree and business decisions

The popular saying that business is all about risk is basically in recognition of uncertainty in the business environment. To many, appreciating that uncertainty and business environment are closely related is the beginning of wisdom in the world business. One of the fundamental and proven techniques which assist managers in making decisions involving uncertainties is the decision tree. Decision tree widely employed in Oil and gas

industry, investment management, medical field etc to identify the strategy most likely to reach a suitable goal are diagrammatical representations of alternative choices that can be made by a
business. Apart from its simplicity to comprehend, managers find its interpretations straight forward.

1.3 Application of decision tree and Original scenario

As noted in Curwin and Slater,( 2002); Swift and Piff, (2006); Wisniewski, (2002) application of decision tree to business decisions involves three steps. They argued further, that building a decision tree model is the starting step, followed by drawing an inferences1 from the model and finally, making a decision [i.e make predictions] based on inferences. The original decision situation as faced by the chemical manufacturer was analyzed based on past researches, investigations, assumptions listed below and the likely consequences
1

Step (inferences) is usually drawn after performing a forward and backward on the decision tree structure and Emv and payoffs determined.

of each alternative decision outcomes as recommended by the makers of production machinery is presented in table [1] below.

1.4

Assumptions of the original scenario

The assumptions in this particular case study are as follows; [1] The net value contribution to profit for each batch is 20,000 [2] There is assurance of 95% efficiency of output with upgraded [3] There is assurance of 90% efficiency of output with no upgrade [4] 1% deviation in efficiency cost the company 20,000 [5] There is 70% chance of completing before the next set of orders- if decided to upgrade [6] There is 30% chance of not completing the next set of orders-if decided to upgrade [7] If no upgrade, 90% of products undergo reworks and each batch reworked cost 10,000 [8] If no upgrade, 10% of products requires no rework and attracts no further costs [9] There is sufficient demand for more products over and above 100 batches [10] Optimal decision is based on decision with the highest EMV to the firm.

While table below present the probabilities and cash flows from the original scenario,

Probabilities
Upgrade: Complete Upgrade, Not complete No upgrade, rework No upgrade, no rework 0.7 0.3 0.9 0.1

Cash flows
Upgrade, Complete Upgrade, Not complete No upgrade, rework No upgrade, no rework 1.08m 0m 0.9m 0.2m

756,000

Complete

0.7

1,080,000

0.3 Not complete Upgrade 0

830, 000

No upgrade

0.9 Rework

900,000

830, 000

0.1 No rework

200,000

Figure 1: Decision tree of original scenario 1.5 Reasons for the construction of decision tree model
What should a company in this situation do? Clearly this chemical manufacturer faces a range of decisions and possible outcomes, this report note that decision-tree model seems most appropriate as the pattern of decision to be made takes the form of a tree-like approach [i.e from root to stem, stem to branches and so on.

As depicted in the original model [see fig. 1] above, the company faces two distinct options available of either to upgrade the production machinery to latest standard or refit2 (i.e no upgrade) rather than a complete upgrade as the second option suggested by the makers of production process machinery. The construction and application of the decision tree model to this scenario is purely based on the assumptions outlined above. 1.6 Analyzing the decisions situation Starting with the option to upgrade. Should the company decide to upgrade, on the

assumption that only 70% of upgrade will be completed before the next set of orders. The option gives a total of 756,0003 EMV. On the other hand, if the second option of reconditioning the filter system is sanctioned, instead of a complete upgrade but with associated cost of rework for 90% of production, the company would be expected to earn a total of 830,0004 in the form of EMV all in the absence of deviation costs. However, the expectation of earning 756,000 if upgraded still rest on assumption [9] above [i.e sufficient demand] for up to 120 batches and 70% (84 batches) of 120 batches sold.

1.7 Further Analysis with deviation costs Considering the two options in the light of cash flows and taking into accounts cost of reworks and deviation in efficiencies, the tables and figure [2] below indicates the overall cash flow which inform our inferences. While the option of not upgrading offers a higher expected values
2 3
4

To be made fit again or by simply repairing or re-equipping for use again The expected value of 756,000 (i.e. 0.7 x 1,080,000)x( 0.3 x 0) The expected value of 830, 000 (i.e 0.9 x 900,000) x ( 0.1 x 200, 000)

830, 000 EV

in the absence of cost of deviations in production efficiency, a critical consideration of

this variables present the option to upgrade an optimal decision with EV of 686, 000( see figure 2).

Cash flow from option Upgrade 0.7 chance complete (120x 20,000) 0.3 chance complete (120x 0) Less: Cost of upgrade Cost of deviation (5%x 20,000) Net cash flow

1,680,000 (600,000) (100,000) 980,000

Cash flow from option No upgrade 0.9 rework (90 x 20,000) 0.1 No rework (10x 20,000) Less: Cost of rework (90x 10,000) Cost of dev. (10%x 20,000) Net cash flow 1,800,000 200,000 (900,000) (200,000) 900,000

980,000

686,000

0.7 Complete

0.3 Not complete Upgrade 0

686, 000

No upgrade

0.9 Rework

700,000

650,000

0.1 No rework

200,000

Figure 2: Decision tree with considerations for reworks and deviation costs Optimal decision and offers of lower cost of upgrade by makers While the cost and cash flows remain unchanged with no upgrade option, a reduction of upgrade cost from 600,000 to 500,000 has the implications of, first reducing total cost and increase in cash flows as depicted in table 3[a] and [b] below. Cash flow from option Upgrade 0.7 chance complete (120x 20,000) 0.3 chance complete (120x 0) Less: Cost of upgrade Cost of deviation (5%x 20,000) New Net cash flow

1,680,000 (500,000) (100,000) 1,080,000

Cash flow from option No upgrade 0.9 rework (90 x 20,000) 0.1 No rework (10x 20,000) Less: Cost of rework (90x 10,000) Cost of dev. (10%x 20,000) Net cash flow 1,800,000 200,000 (900,000) (200,000) 900,000

Table 3[a] & [b] cash flows from the two options From the analysis of the two options above, it seem logical to infer that putting all variable in consideration that the chemical manufacturer should be advised to upgrade the production machinery as it promises of producing 686, 000 of EV against the 650,000 of no upgrade. Fortunately, should the makers of production machinery offers to upgrade at a cost of 500,000 instead of 600,000, the option to upgrade is convincingly, remains the optimal decision still with higher EV of 756,000 against 650,000 EV of no upgrade.

1.8 Decision tree and Sensitivity analysis

In a perfect world the direct solution above may be right. Unfortunately, business operates in a world full of imperfections, where variables such as market and general economic factors are constantly changing and as so, the solution above may be biased since it is based on original assumptions of the model.

A decision in an environment of uncertain variables requires post-optimality [what-if analysis] to test the strength and weak points of principle and assumptions of our models. The variables analyzed for sensitivity includes; probabilities of outcomes and expected values among others.

1.9 Analyzing a change in expected value

Should the firm expect to earn 686,000 instead of 650,000 in fig. 2 above, at what chance, the probability of expected value of 686,000 is 0.97 with 7.8 % change in probability if the company decide not to upgrade [see appendix for workings]

% change in probability % change = Original probability -new probability Original probability = 0.9- 0.97 x 100 0.9 = 7.8%
The probability of (0.97) brings the chemical manufacturing firm to a Point of indecision, as 0.97 probabilities turns Emv of no upgrade the same with that of to upgrade, as EMV of both are now 686,000. At this point the firm will be face with indecision as to whether to upgrade or not to upgrade.

x 100 1

Conclusion
The usefulness of quantitative techniques particularly application of decision tree model in business decisions is on the increase resulting from the complexity and increase in uncertainties in the contemporary business environment. From our analysis of the decision situation of the

chemical manufacturing company, decision tree once again proved itself as an instrument which facilitates business policy decisions. The management is advised to go ahead with the option of upgrading the production machinery as it offers the highest expected monetary values to the firm .

Question two 2.1 The revenue equation of the firm

Traditionally, the term revenue as it relates to a company, denote the total amount of money received by the company for goods sold or services provided during a certain time period. A mathematical expression establishing a relationship between price [P] of commodities and quantity [Q] sold is called revenue [R] [equation] model. Therefore, a model representing a revenue function [equation] takes the form of [R] = P x Q Revenue [R] = [P] x [Q] In our case we need to determine demand equation since it represents the number of units that can be sold at various prices. On the assumption that demand equation stand for PRICE[ see table below]

Using the data on table 2.1

N 1 2 3 4 5 6 7 8 8
Where:

X 0 1 2 3 4 5 6 7 28

Y 4,500 4,200 3,800 3,520 3,100 2,760 2,500 1,900 26,280

0 4,200 7,600 10,560 12,400 13,800 15,000 13,300 76,860

Xy

0 1 4 9 16 25 36 49 140

n = 8; x =28; y = 26,280; xy = 76, 860; x2 = 140 Demand function (equation y) = a+bx

b = n xy- (x) (y) n (x2 ) (x) 2 = 8(76, 60) (28)(26, 280) 8(140) (28) 2 = 614, 880 735,840 1,120 784 b = -120,960 336 b = -360 Since, y = bx + a Therefore, Demand equation (Price, y) = -360Q+4545

a = y b (x) n n a = 26,280 (-360)(28) 8 8 a = 3,285 (-1,260) a = 4545

The graph below shows profit, demand and cost against quantity of products

[1] Revenue equation = P x Q TR= (-360Q+4545) x Q TR= -360Q2 + 4545Q

[2] The first profit equation of the firm

It is noteworthy, that revenue and profit are not the same, while money received by a firm from the sale of it products defines revenue, business profit is revenues less business expenses. Profit[] is simply a function of total revenue total expenses for a specific period Mathematically, Profit[] = Revenue [R] Cost [C] or Expenses Then, Profit [] = TR -TC Where: TR = -360Q2 + 4545Q TC = 5,000 + 240Q2 - 255Q Substituting in the respective values into the relation yields; Profit equation []= TR TC = (-360Q2 + 4545Q )- (5,000 + 240Q2 - 255Q) []= -600Q2 + 4290Q - 5000 [3] The profit graph of the firm

As a graphical representation, profit graph helps management to visualize how activities or products options strategy may perform over a variety of prices. Shown below is a graph of the companys profit at various units of products sold[ see appendix 2 for workings].

[4] The second profit equation of the firm The assumption with the second profit equation is that cost function remain unchanged and revenue equation given as 4145Q-160Q2. Where; TR = 4145Q-160Q2 TC = 5,000 + 240Q2 - 255Q Inverting the profit model []= TR TC Second Profit equation becomes; [] = (4145Q-160Q2) - (5,000 + 240Q2 - 255Q) = 4145Q-160Q2 - 5,000 + 240Q2 - 255Q [] = 80Q2 + 3,890Q - 5,000

[5] The second profit graph of the firm The graph below presents the relationship of firms profit at various numbers of product sold[ see appendix for computation of table of value]

Q 3 4 5 6

Profit 7,390 11,840 16,450 21,220

Table[ A] table of value

[B] graph of second profit

[6] The equation of best profit

[]= -600Q2 + 4290Q - 5000

d[] =2x (-600)Q2-1 + 4290Q1-1 5000 1,200Q + 4290 At turning point d[] =O
=-

dQ

dQ

1,200Q + 4290 = 0 Substract 4,290 from both sides yields -1,200Q+4290-4290=0-4,290 -1,200Q= -4,290 Q = 4,290/1,200 Q = 3.575 Q = 4 (approx.) From the first graph, Profit is maximized at Q is 4 -

[] = 80Q2 + 3,890Q - 5,000 dQ 160Q + 3,890

d[] =2x 80Q2-1 + 3,890Q1-1 - 5,000 At turning point d[] = 0 dQ

160Q + 3,890 = 0 Substract 3,890 from both sides yields 160Q + 3,890-3,890 = 0-3,890 160Q = 3,890 Q = 3,890/160 Q = 24.3 (profit is maximized at Q =24)
While optimization helps managers to choose the best element from some set of available alternatives, our graphs above indicated that profits are maximized at Q = 4 and 24 for graph one and two respectively.

References

Buglear John, (2006), Quantitative methods for Business: The A-z of QM 2006 Elsevier. Curwin & Slater,(2002),Quantitative Methods for business Decisions,5th Edition ,Singapore, Thomson Swift and Piff, (2006), Quantitative methods for Business, management and Finance, 2nd Ed. Palgrave. University of Sunderland, (2008), Business modeling for decision making, uni. of Sunderland, uk Wisniewski, M(2002),Quantitative methods for decision makers, Financial Times/ prentice Hall Waters, D (2001), Quantitative methods for Business Financial Times/ prentice Hall

Appendices