Operations Management

Supplement:
CHAPTER 5

Decision
Decision Making
Making Tools
Tools pg658
pg658
 The Decision Process in
Operations
1. Clearly define the problems and the
factors that influence it
2. Develop specific and measurable
objectives
3. Develop a model
4. Evaluate each alternative solution
5. Select the best alternative
6. Implement the decision and set a
timetable for completion
 Fundamentals of
Decision Making
1. Terms:
a. Alternative—a course of action or
strategy that may be chosen by the
decision maker
b. State of nature—an occurrence or a
situation over which the decision
maker has little or no control
 Simplest Decision Making Tools:
Decision Table Example

State of Nature
Alternatives Favorable Market Unfavorable Market
Construct large plant $200,000 –$180,000
Construct small plant $100,000 –$ 20,000
Do nothing $ 0 $ 0

Table A.1
 Decision Trees

 Information in decision tables can be

displayed as 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
 Appropriate for showing sequential
decisions
 Fundamentals of
Decision Making- Decision Tree

2. Symbols used in a decision tree:

a.  —decision node from which
one of several alternatives may be
selected
b.  —a state-of-nature node out of
which one state of nature will occur
 Decision Tree Example

A decision node A state of nature node

Favorable market

ct
u Unfavorable market
n str lant
Co ge p
lar Favorable market
Construct
small plant
Do Unfavorable market
no
thi
ng

Figure A.1
Application of Decision Trees
to Product Design
 Particularly useful when there are a
series of decisions and outcomes
which lead to other decisions and
outcomes
Application of Decision Trees
to Product Design
Procedures
 Include all possible alternatives and
states of nature - including “doing
nothing”
 Enter payoffs at end of branch
 Determine the expected value of each
branch and “prune” the tree to find
the alternative with the best expected
value
 Decision Tree Example
(.4)
Purchase CAD
High sales

(.6) Low sales

Hire and train engineers

(.4)
High sales

(.6)
Low sales
Do nothing
Figure 5.14
 Decision Tree Example
$2,500,000 Revenue
(.4) - 1,000,000 Mfg cost ($40 x 25,000)
Purchase CAD - 500,000 CAD cost
High sales
$1,000,000 Net

$800,000 Revenue
(.6) Low sales - 320,000 Mfg cost ($40 x 8,000)
- 500,000 CAD cost
Hire and train engineers - $20,000 Net loss

(.4)
High sales
EMV (purchase CAD system) = (.4)($1,000,000) + (.6)(- $20,000)

(.6)
Low sales
Do nothing
Figure 5.14
 Decision Tree Example
$2,500,000 Revenue
(.4) - 1,000,000 Mfg cost ($40 x 25,000)
Purchase CAD - 500,000 CAD cost
$388,000 High sales
$1,000,000 Net

$800,000 Revenue
(.6) Low sales - 320,000 Mfg cost ($40 x 8,000)
- 500,000 CAD cost
Hire and train engineers - $20,000 Net loss

(.4)
High sales
EMV (purchase CAD system) = (.4)($1,000,000) + (.6)(- $20,000)
= $388,000
(.6)
Low sales
Do nothing
Figure 5.14
 Decision Tree Example
$2,500,000 Revenue
(.4) - 1,000,000 Mfg cost ($40 x 25,000)
Purchase CAD - 500,000 CAD cost
$388,000 High sales
$1,000,000 Net

$800,000 Revenue
(.6) Low sales - 320,000 Mfg cost ($40 x 8,000)
- 500,000 CAD cost
Hire and train engineers - $20,000 Net loss
$365,000
$2,500,000 Revenue
(.4) - 1,250,000 Mfg cost ($50 x 25,000)
- 375,000 CAD cost
High sales
$875,000 Net

$800,000 Revenue
(.6) - 400,000 Mfg cost ($50 x 8,000)
- 375,000 CAD cost
Low sales
Do nothing $0 $25,000 Net

$0 Net Figure 5.14

 Decision-Making
Environments
 Decision making under uncertainty
 Complete uncertainty as to which
state of nature may occur
 Decision making under risk
 Several states of nature may occur
 Each has a probability of occurring
 Decision making under certainty
 State of nature is known
 Uncertainty

1. Maximax
 Find the alternative that maximizes
the maximum outcome for every
alternative
 Pick the outcome with the maximum
number
 Highest possible gain
 Uncertainty

2. Maximin
 Find the alternative that maximizes
the minimum outcome for every
alternative
 Pick the outcome with the minimum
number
 Least possible loss
 Uncertainty

3. Equally likely
 Find the alternative with the highest
average outcome
 Pick the outcome with the maximum
number
 Assumes each state of nature is
equally likely to occur
 Risk

 Each possible state of nature has an

assumed probability
 States of nature are mutually exclusive
 Probabilities must sum to 1
 Determine the expected monetary value
(EMV) for each alternative
Expected Monetary Value

EMV (Alternative i) =(Payoff of 1st state of nature) x

(Probability of 1st state of
nature)
+(Payoff of 2nd state of nature) x
(Probability of 2nd state of
nature)
+…+(Payoff of last state of nature)
x (Probability of last state of
nature)
 Uncertainty Example
States of Nature
Favorable Unfavorable Maximum Minimum Row
Alternatives Market Market in Row in Row Average
Construct
large plant $200,000 -$180,000 $200,000 -$180,000 $10,000
Construct
small plant $100,000 -$20,000 $100,000 -$20,000 $40,000
Do nothing $0 $0 $0 $0 $0
Maximax Maximin Equally
likely

1. Maximax choice is to construct a large plant

2. Maximin choice is to do nothing
3. Equally likely choice is to construct a small plant
 EMV Example
Table A.3
States of Nature
Favorable Unfavorable
Alternatives Market Market
Construct large plant (A1) $200,000 -$180,000
Construct small plant (A2) $100,000 -$20,000
Do nothing (A3) $0 $0
Probabilities .50 .50

1. EMV(A1) = (.5)($200,000) + (.5)($180,000) = $10,000

2. EMV(A2) = (.5)($100,000) + (.5)($20,000) = $40,000
3. EMV(A3) = (.5)($0) + (.5)($0) = $0
 EMV Example
Table A.3
States of Nature
Favorable Unfavorable
Alternatives Market Market
Construct large plant (A1) $200,000 -$180,000
Construct small plant (A2) $100,000 -$20,000
Do nothing (A3) $0 $0
Probabilities .50 .50

1. EMV(A1) = (.5)($200,000) + (.5)($180,000) = $10,000

2. EMV(A2) = (.5)($100,000) + (.5)($20,000) = $40,000
3. EMV(A3) = (.5)($0) + (.5)($0) = $0 Best Option
 Decision Tree Example

EMV for node 1

= $10,000 = (.5)($200,000) + (.5)(-$180,000)

Payoffs
Favorable market (.5)
$200,000
t 1
pl an Unfavorable market (.5)
ge -$180,000
t l ar
c
s t ru Favorable market (.5)
n $100,000
Co
Construct
small plant
2
Unfavorable market (.5)
Do -$20,000
no
th
in EMV for node 2
g
= $40,000 = (.5)($100,000) + (.5)(-$20,000)

Figure A.2
$0
 Decision Trees in Ethical
Decision Making

 Maximize shareholder value and

behave ethically
 Technique can be applied to any
action a company contemplates
 Decision Trees in Ethical
Decision Making
Yes Do it
Is it ethical? (Weigh the
affect on employees,
customers, suppliers,
Yes community against
shareholder benefit) No Don’t
Does action do it
maximize
Yes company
returns? Don’t
Yes
Is Is it ethical not to take do it
action No action? (Weigh the
legal? harm to shareholders
vs. the benefits to other Do it,
No stakeholders) but notify
No appropriate
parties

Figure A.4 Don’t

do it
 Certainty

 Is the cost of perfect information

worth it?
 Determine the expected value of
perfect information (EVPI)
 Expected Value of
Perfect Information
EVPI is the difference between the payoff
under certainty and the payoff under risk
Expected value Maximum
EVPI = under certainty – EMV

Expected value . (Best outcome or consequence for 1st state of

under certainty =nature) x (Probability of 1st state of nature)

+Best outcome for 2nd state of nature)

x (Probability of 2nd state of nature)
+ … +Best outcome for last state of nature)
x (Probability of last state of nature)
 EVPI Example

1. The best outcome for the state of nature

“favorable market” is “build a large
facility” with a payoff of $200,000. The
best outcome for “unfavorable” is “do
nothing” with a payoff of $0.

Expected value
under certainty = ($200,000)(.50) + ($0)(.50) = $100,000
 EVPI Example

2. The maximum EMV is $40,000, which is

the expected outcome without perfect
information. Thus:

Expected value Maximum

EVPI = under certainty – EMV

= $100,000 – $40,000 = $60,000

The most the company should pay for

perfect information is $60,000