3. Decision Analysis

8/6/2019 3. Decision Analysis

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OPERATIONSOPERATIONS

MANAGEMENTMANAGEMENT

O MPDECISION ANALYSIS

By:By: --HAKEEMHAKEEMURURREHMANREHMAN

PCBAPCBAUCPUCP


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DECISION ANALYSIS / DECISIONTHEORY

QUANTITATIVE METHODSQUANTITATIVE METHODS

A set of tools for operations managerA set of tools for operations manager

DECISION ANALYSISDECISION ANALYSIS

a set of quantitative decisiona set of quantitative decision--makingmaking

techniques for decision situations intechniques for decision situations inwhich uncertainty existswhich uncertainty exists


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DECISION PROCESS

Fundamental process of management involves 6Fundamental process of management involves 6steps:steps:

1.1. Specify objectives and the criteria for decisionSpecify objectives and the criteria for decision

making.making.2.2. Develop Alternatives.Develop Alternatives.

3.3. Analyze and compare alternatives.Analyze and compare alternatives.

4.4. Select the best alternativeSelect the best alternative5.5. Implement the chosen alternativeImplement the chosen alternative

6.6. Monitor the results to ensure that the desiredMonitor the results to ensure that the desiredresults are achieved.results are achieved.


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DECISION ENVIRONMENTSDECISION ENVIRONMENTS

There are three scenarios which refer toThere are three scenarios which refer to CERTAINTY,CERTAINTY,RISK & UNCERTAINTYRISK & UNCERTAINTY..

Certainty:Certainty: You have an order for 3000 units (Demand = 3000 units).You have an order for 3000 units (Demand = 3000 units). Profit per unit is RS. 30Profit per unit is RS. 30

Risk:Risk: probabilities can be assigned to the occurrence of states ofprobabilities can be assigned to the occurrence of states of

nature in the futurenature in the future

There is a 25% chance of 2000 units, 50% chance of 1000 unitsThere is a 25% chance of 2000 units, 50% chance of 1000 units& 25% chance of an order of 500 units.& 25% chance of an order of 500 units.

Uncertainty:Uncertainty: probabilities can NOT be assigned to the occurrence of states ofprobabilities can NOT be assigned to the occurrence of states of

nature in the future.nature in the future.


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STATES OF NATURE:STATES OF NATURE:

Events that may occur in the futureEvents that may occur in the future

Examples of states of nature:Examples of states of nature:

high or low demand for a producthigh or low demand for a product

good or bad economic conditionsgood or bad economic conditions

PAYOFF:PAYOFF: Outcome of a decisionOutcome of a decision

DECISION ENVIRONMENTSDECISION ENVIRONMENTS ------

CONT.CONT.


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Payoff table: a method for organizing andPayoff table: a method for organizing andillustrating the payoffs from differentillustrating the payoffs from differentdecisions given various states of nature.decisions given various states of nature.

States Of NatureStates Of Nature

DecisionDecision aa bb

11 Payoff 1aPayoff 1a Payoff 1bPayoff 1b

22 Payoff 2aPayoff 2a Payoff 2bPayoff 2b

PAYOFF TABLEPAYOFF TABLE


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DECISION MAKING CRITERIADECISION MAKING CRITERIA

UNDER UNCERTAINTYUNDER UNCERTAINTY

Maximax Maximin

Minimax regret

Equal likelihood


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EXAMPLE:EXAMPLE:SOUTHERN TEXTILE COMPANYSOUTHERN TEXTILE COMPANY

STATES OF NATURESTATES OF NATURE

Good ForeignGood Foreign Poor ForeignPoor Foreign

DECISIONDECISION Competitive ConditionsCompetitive Conditions Competitive ConditionsCompetitive Conditions

ExpandExpand $ 800,000$ 800,000 $ 500,000$ 500,000

Maintain status quoMaintain status quo 1,300,0001,300,000 --150,000150,000Sell nowSell now 320,000320,000 320,000320,000


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MAXIMAXMAXIMAX SOLUTIONSOLUTION


Good ForeignGood Foreign Poor ForeignPoor ForeignDECISIONDECISION Competitive ConditionsCompetitive Conditions Competitive ConditionsCompetitive Conditions

ExpandExpand $ 800,000$ 800,000 $ 500,000$ 500,000

Maintain status quoMaintain status quo 1,300,0001,300,000 --150,000150,000

Sell nowSell now 320,000320,000 320,000320,000

Expand: $800,000

Status quo: 1,300,000 n Maximum

Sell: 320,000

Decision: Maintain status quo

MaximaxMaximax (the maximum of the maxima) criterion is very optimistic.(the maximum of the maxima) criterion is very optimistic.

Choose decision with the maximum of the maximum payoffsChoose decision with the maximum of the maximum payoffs

MaximaxMaximax determines the best possible outcomedetermines the best possible outcome


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MAXIMIN SOLUTION


Good ForeignGood Foreign Poor ForeignPoor ForeignDECISIONDECISION Competitive ConditionsCompetitive Conditions Competitive ConditionsCompetitive Conditions

ExpandExpand $ 800,000$ 800,000 $ 500,000$ 500,000


Sell nowSell now 320,000320,000 320,000320,000

Expand: $500,000 n

Maximum Status quo: -150,000

Sell: 320,000

Decision: Expand

TheThe maximinmaximin (the maximum of minima)(the maximum of minima) criterion is pessimisticcriterion is pessimistic

Choose decision with the maximum of the minimum payoffsChoose decision with the maximum of the minimum payoffs MaximinMaximin determines the worst payoff for each alternative; the operations managerdetermines the worst payoff for each alternative; the operations manager

chooses the best worst alternative. Meaning the least (best) of the worstchooses the best worst alternative. Meaning the least (best) of the worst..


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MINIMAX REGRETMINIMAX REGRET

SOLUTIONSOLUTIONGood Foreign Poor Foreign

Competitive Conditions Competitive Conditions

$1,300,000 - 800,000 = 500,000 $500,000 - 500,000 = 0

1,300,000 - 1,300,000 = 0 500,000 - (-150,000)= 650,000

1,300,000 - 320,000 = 980,000 500,000 - 320,000= 180,000

Expand: $500,000 n Minimum

Status quo: 650,000

Sell: 980,000

Decision: Expand

Choose decision with the minimum of the maximum regrets for eachChoose decision with the minimum of the maximum regrets for eachalternativealternative


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EQUAL LIKELIHOOD CRITERIAEQUAL LIKELIHOOD CRITERIA




ExpandExpand $ 800,000$ 800,000 $ 500,000$ 500,000


Sell nowSell now 320,000320,000 320,000320,000

Two states of nature each weighted 0.50Expand: $800,000(0.5) + 500,000(0.5) = $650,000 n Maximum

Status quo: 1,300,000(0.5) -150,000(0.5) = 575,000

Sell: 320,000(0.5) + 320,000(0.5) = 320,000

Decision: Expand

Choose decision in which each state of nature isChoose decision in which each state of nature isweighted equallyweighted equally


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DECISION ENVIRONMENTSDECISION ENVIRONMENTS

There are three scenarios which refer toThere are three scenarios which refer to CERTAINTY,CERTAINTY,RISK & UNCERTAINTYRISK & UNCERTAINTY..

Certainty:Certainty: You have an order for 3000 units (Demand = 3000 units).You have an order for 3000 units (Demand = 3000 units). Profit per unit is RS. 30Profit per unit is RS. 30

Risk:Risk: probabilities can be assigned to the occurrence of states ofprobabilities can be assigned to the occurrence of states of

nature in the futurenature in the future

There is a 25% chance of 2000 units, 50% chance of 1000 unitsThere is a 25% chance of 2000 units, 50% chance of 1000 units& 25% chance of an order of 500 units.& 25% chance of an order of 500 units.

Uncertainty:Uncertainty: probabilities can NOT be assigned to the occurrence of states ofprobabilities can NOT be assigned to the occurrence of states of

nature in the future.nature in the future.


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DECISION MAKING WITHDECISION MAKING WITHPROBABILITIES (RISK)PROBABILITIES (RISK)

Risk involves assigning probabilities to states ofRisk involves assigning probabilities to states ofnaturenature

Expected valueExpected value

a weighted average of decision outcomes ina weighted average of decision outcomes inwhich each future state of nature is assignedwhich each future state of nature is assigneda probability of occurrencea probability of occurrence

EV (EV (xx) =) = pp((xxii))xxii

nn

ii=1=1

xxii = outcome= outcome ii

pp((xxii)) = probability of outcome= probability of outcome ii

wherewhere


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DECISION MAKING WITHDECISION MAKING WITH

PROBABILITIES: EXAMPLEPROBABILITIES: EXAMPLESTATES OF NATURESTATES OF NATURE



ExpandExpand $ 800,000$ 800,000 $ 500,000$ 500,000


Sell nowSell now 320,000320,000 320,000320,000

p(good) = 0.70 p(poor) = 0.30

EV(expand): $800,000(0.7) + 500,000(0.3) = $710,000EV(status quo): 1,300,000(0.7) -150,000(0.3) = 865,000 nMaximum

EV(sell): 320,000(0.7) + 320,000(0.3) = 320,000

Decision: Status quo


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SEQUENTIALSEQUENTIALDECISION TREESDECISION TREES

A graphical method for analyzing decisionA graphical method for analyzing decision

situations that require a sequence ofsituations that require a sequence ofdecisions over timedecisions over time Decision tree consists ofDecision tree consists of

Square nodesSquare nodes -- indicating decision pointsindicating decision points

Circles nodesCircles nodes -- indicating states of natureindicating states of nature ArcsArcs -- connecting nodesconnecting nodes


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EXAMPLE:EXAMPLE: (How to Develop A Decision Tree?)(How to Develop A Decision Tree?)A firm that plans to expand its product line must decide whetherA firm that plans to expand its product line must decide whether

to build a small or a large facility to produce the new products.to build a small or a large facility to produce the new products.If it builds a small facility and demand is low, the net presentIf it builds a small facility and demand is low, the net presentvalue after deducting for building costs will be $400,000. Ifvalue after deducting for building costs will be $400,000. Ifdemand is high, the firm can either maintain the small facilitydemand is high, the firm can either maintain the small facility

or expand it. Expansion would have a net present value ofor expand it. Expansion would have a net present value of$450,000 and maintaining the small facility would have a net$450,000 and maintaining the small facility would have a netpresent value of $50,000.present value of $50,000.

If a large facility is built and demand is high, the estimated netIf a large facility is built and demand is high, the estimated netpresent value is $800,000. If demand turns out to be low, thepresent value is $800,000. If demand turns out to be low, the

net present value will benet present value will be --$10,000.$10,000.

The probability that demand will be high is estimated to be 0.60,The probability that demand will be high is estimated to be 0.60,and the probability of low demand is estimated to be 0.40.and the probability of low demand is estimated to be 0.40.

Analyze using a tree diagram.Analyze using a tree diagram.


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1

2

Demand High (0.6)

Demand Low (0.4)

$400,000

$50,000

$450,000

$10,000

$800,000


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QUESTIONSQUESTIONS

3. Decision Analysis

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