GYAAN KOSH

TERM 2
Learning and
Development Council,
CAC

Decision Models and Optimization

This document covers the basic concepts of Decision Models
and Optimization covered in Term 2. The document only
summarizes the main concepts and is not intended to be an
instructive material on the subject.

Also note that since this is a Quantitative Subject, only concepts

that you might need to know for tackling an interview are
included here along with some sample problems. For details of
solving problems, please refer to the detailed notes.

Gyaan Kosh Term 2

DMOP

Learning & Development Council, CAC

CONTENTS
1. The Optimization Tree and Taxonomy of Decision Models
2. Linear Programming
i) Basic LP Assumptions
ii) Gaining Insights through LP Model
iii) What does it mean to spot patterns in an LP solution
iv) LP Geometry Basics
v) LP States
vi) Sensitivity Analysis Shadow Price and Reduced Costs
3. The Dual Formulation
4. Introduction to Network Models
i) Terminology and Applications
ii) The General Min-Cost Network Flow (MCNF) Formulations
5. Modeling Business Logic
6. Newsvendor problem and Auctions

Gyaan Kosh Term 2

DMOP

Learning & Development Council, CAC

The Optimization Tree and Taxonomy of Decision Models

Taxonomy of Decision Models

Gyaan Kosh Term 2

DMOP

Learning & Development Council, CAC

Basic LP Assumptions
Proportionality:
Contribution from a decision variable is proportional to the decision variable.
Additivity:
Contribution to objective from one decision variable is independent of another decision variable
Divisibility:
Each variable is allowed to assume fractional values.
Data certainty:
Coefficients are not random variables.

Gaining Insights through LP Model

The optimal solution tells a story about a pattern of economic priorities, and its the recognition of these
priorities that provides insight.
When we know the pattern, we can explain the solution more convincingly than when we simply read the
algorithms output.
When we know the pattern, we can also anticipate some of the answers to what if questions. In short,
the pattern provides a level of understanding that enhances decision making.

What does it mean to spot patterns in an LP Solution

Spotting a pattern involves observations about both variables and constraints. In the optimal solution we
should ask ourselves, which constraints are binding and which are not? Which variables are positive and
which are zero?
Grasping the pattern of binding constraints and positive variables allows us to reconstruct the solution in a
sequential fashion.
This allows us an opportunity to discern an economic imperative at the heart of the situation depicted in
the model.

Gyaan Kosh Term 2

DMOP

Learning & Development Council, CAC

LP Geometry Basics
The number of decision variables determines the problem spaces dimensionality
Two-variable problems can be plotted on a 2-D graph
Pick an axis for each variable
The constraints define the set of feasible solutions
Each inequality defines a feasible half-plane
The problems feasible region is the intersection of the half-planes
To draw a constraint: calculate the two intercepts; draw a line between them
An optimal solution can always be found at a vertex (corner point)
Pick an arbitrary objective function and draw test iso-profit line using intercepts
Find the improving direction for the objective function, locate candidate optimal vertices
Calculate the solution corresponding to each candidate vertex by solving the simultaneous
equations of the vertexs binding constraints
Compare the objective function value by plugging solution coordinates into the objective function

Example of Graphical Representation of a LP

LP States
1. An LP can be in one of these three states
Unbounded
Infeasible
Bounded, feasible with an optimal solution (at least one corner-point solution)

Gyaan Kosh Term 2

DMOP

Learning & Development Council, CAC

2. An LP can have many optimal solutions

3. An LP can have redundant constraints
This happens when a constraint can be expressed as a linear combination of other constraints
4. An LP can have a degenerate vertex
When one or more basic variables are zero at a particular vertex
Think of an over-defined vertex (though degeneracy cannot always be depicted graphically)
A 2-D LP never has a degenerate vertex.

Sensitivity Analysis Shadow Price and Reduced Costs

Shadow prices and validity range
Relaxing the right-hand side (RHS) of a binding constraint improves the optimal objective function value
Relaxing the constraint enlarges the feasible region
As the optimal vertex moves, its objective function value improves
The marginal improvement in the objective function value caused by relaxing the RHS one unit is called
the constraints shadow price
Shadow prices are also called dual variables.
Computing the validity-range of a shadow price
The shadow price is valid when the RHS changes within an interval, if all other data remains the same (one
change at a time.)
In 2 dimensions, this means that the shadow price is valid when the RHS is in an interval in which the same
corner point solution remains.
In multiple dimensions, it means that the shadow price is valid when the RHS changes so long as the
optimal basic variables remain optimal.
Perturbing the objective function
The optimal solution remains unchanged as long as the objective function lies between the slopes of the
constraints.

Gyaan Kosh Term 2

DMOP

Learning & Development Council, CAC

A large enough change in an objective function coefficient can cause the optimal solution to change
A change in one coefficient causes the objective function to rotate.
With a sufficiently large change, the objective function becomes parallel to one of the binding constraints,
creating multiple optimal solutions
If the coefficient continues to change, the optimal solution jumps to an adjoining vertex
The amount a coefficient can increase or decrease before the optimal vertex changes is called the
coefficients allowable increase / decrease
The reduced cost of a variable
The reduced cost associated with the non-negativity constraint for each variable is the shadow price of that
constraint, i.e., the corresponding change in the objective function per unit increase in the lower bound of
the variable
The reduced cost for all decision variables can be directly computed from the shadow prices on the
structural constraints and the objective coefficient
In this view, the shadow prices are thought of as the opportunity costs associated with diverting resources
away from the optimal production mix.
Computing the reduced cost
The operation of computing the reduced cost from shadow prices is called pricing-out. If yi is the shadow
price of the ith constraint (there are m constraints), cj is the objective coefficient of the jth activity, and aij is
the amount of the ith resource consumed by the jth activity, then the reduced cost for the jth activity is
computed as

Quick Summary
Shadow price of a constraint
Defines the price you are willing to pay to relax the RHS by one unit, or the price you must be paid to
tighten the RHS by one unit.

Gyaan Kosh Term 2

DMOP

Learning & Development Council, CAC

Non-binding constraints have 0 shadow price; i.e. either the constraint has a slack (surplus)with zero
shadow price or the shadow price is non-zero and the constraint is tight.
Reduced Cost of a decision variable
Indicates how much more attractive (i.e., higher in profit or lower in cost) its coefficient in the objective
function must be before this variable is worth using.
Ignore the sign. Sign conventions differ across different LP solvers; just remember that the objective
coefficient must be made more attractive by this magnitude.
Unless the problem is degenerate basic variables are positive and their reduced costs are 0.

Gyaan Kosh Term 2

DMOP

Learning & Development Council, CAC

The Dual formulation

Every constraint of an LP is associated with a shadow price (or dual variable).
For every LP formulation, we can write another LP formulation, called the Dual using the original problemdata and the shadow prices (or dual values) as decision variables. The original formulation is typically
referred to as the Primal LP.
The Dual problem can be solved like a regular LP (it is an LP!).
The decision variables of the primal problem (original LP) are dual variables (shadow prices) corresponding
to the constraints of the dual LP.
The Dual of the Dual LP is the Primal LP (original problem).

Rules to write the dual of an LP

Gyaan Kosh Term 2

DMOP

Learning & Development Council, CAC

The Primal Dual Combinations

A Quick Example

Gyaan Kosh Term 2

DMOP

Network Terminologies

Application Areas

Learning & Development Council, CAC

Gyaan Kosh Term 2

DMOP

MCNF
Generalized Min-Cost Flow

The LP Formulation:

Learning & Development Council, CAC

Gyaan Kosh Term 2

DMOP

Learning & Development Council, CAC

Special Cases of MCNF Problems:

Sample Transportation Problem and Its LP Formulation

LP Formulation

Gyaan Kosh Term 2

DMOP

Learning & Development Council, CAC

Special Cases of MCNF Problems:

Max Flow Problem and Its LP Formulation

LP Formulation:

Applications:
Military applications
Deployment of material
City water piping system to maximize flow to residential areas
Currency arbitrage problem

Gyaan Kosh Term 2

DMOP

Learning & Development Council, CAC

Special Cases of MCNF Problems:

Shortest Path Problem and Its LP Formulation

LP Formulation:

Gyaan Kosh Term 2

DMOP

Learning & Development Council, CAC

Modeling Business Logic

Why Integer Programming
Advantages of restricting variables to take on integer values:
1. More realistic (economic indivisibilities)
2. More flexibility (use of binary variables, logical constraints)
Disadvantages
1. More difficult to model
2. Can be much more difficult to solve

Binary Integer Variables

Binary variables can take values of 0 or 1; This is also equivalent to 0 Xj 1
Binary variables are very useful in modeling several business situations:
1. Logical constraints (e.g., if-then-else, go-no/go decisions)
2. Application areas include supply-chain optimization models (transportation, facility location), financial
models (budget models), and many more

Types of Integer Programming

All integer programs have linear equalities and inequalities and some or all of the variables are required to
be integer
If all variables are required to be integer, then it is usually called a pure integer program
If all variables are required to be 0 or 1, it is called a binary integer program, or a 0-1 integer Program
If some variables can be fractional and others are required to be integers, it is called a mixed linear integer
program (MILP)

Gyaan Kosh Term 2

DMOP

Learning & Development Council, CAC

Examples of Application: Fixed Charge Problems

Modeling the Fixed Charge Problem:

Modeling the discrete choice of keeping a facility open:

Gyaan Kosh Term 2

The Constraints:
Demand Side Constraints:

Supply Side Constraints:

DMOP

Learning & Development Council, CAC

Gyaan Kosh Term 2

DMOP

Indicator Variables

Logical Constraints

Learning & Development Council, CAC

Gyaan Kosh Term 2

DMOP

Learning & Development Council, CAC

The Newspaper Vendor Problem

The newsvendor sells newspapers:
Buys them for $0.25 each
Sells them for $0.50 each
Returns unsold papers for $0.10 each
Has to place the order, q, for papers the night before. Next days demand, D, is uncertain. Demand
estimate is based on past data is Approximated by N(98,312)
How many papers to order?

System Mechanics

Gyaan Kosh Term 2

DMOP

Learning & Development Council, CAC

Simulation approach to find optimal order quantity

1. Choose a value of q:
a. A lower bound for q is zero
b. A reasonable upper bound is, say, the mean demand plus 3 standard deviations
c. So might consider order quantities in the set {0, 1, , 190}
2. Simulate some number, say n, random demands: D1, D2,, Dn
3. Compute simulated profits: profit(q, D1), profit(q, D2), ,profit(q, Dn)
4. Evaluate results E[profit(q,D)] = 1/n(profit(q, D1) + +profit(q, Dn))
5. Repeat steps for another value of q! (brute force)

Expected profit as a function of order quantity, q

Other Measures of Interest Could Include:

1. Variability in Profit
2. Percentage of Unsatisfied Demand
3. Expected Utility

Gyaan Kosh Term 2

DMOP

Learning & Development Council, CAC

AUCTIONS
(Please refer to class notes for details of problems)
1. Sealed bid first price auction:
Each bidder submits a sealed bid of how much they are willing to pay for the contract
Bidders submit bids independently and unobserved by others
After all the bids have been collected, the contract is awarded to the highest bidder at a price equal
to the amount bid by the highest bidder
2. Sealed bid second price auction
Identical to first price auction, except that the winner (highest bidder) only has to pay the second
highest bid to the auctioneer

Gyaan Kosh Term 2

DMOP

Learning & Development Council, CAC

Articles on DMOP Available in the LMS:

File

Industry

Functional Area

Company/ Organization

Modeling
Technique

Air Products and Chemicals.pdf

Chemicals,
industrial gases

Distribution logistics,
routing and
transportation

Air Products and

Chemicals

Optimization: IP

Applying OR Techniques to
Financial Markets 2003.pdf

Financial Services

Finance

Various

Optimization,
simulation

Asset and Liability Management

System at Towers Perrin
Interfaces 2000.pdf

Consulting,
insurance

Australian Sugar Mills Optimize

Harvester Rosters 2003.pdf

Agriculture, farm
machinery

integer programming,
algorithms, heuristics

Australian sugar mills

IP, algorithms,
heuristics

Call Center Simulation

Interfaces 2003.pdf

Customer Services

Call Center Operations

Major Software Company

Simulation

Deciding Order Quantites and

Markdowns for Fashion Goods
Interfaces 2001.pdf

Retail

Logistic, pricing,
decision support
system

Large retail chain

Stochastic
Dynamic
Programming

Heery's Model for Assigning

Managers.pdf

Construction

Project Management

Heery International

Optimization: IP

Optimization,
simulation

Asset liability matching,

employee benefits,
Towers Perrin-Tillinghast
pension

Optimization,
simulation

Brief description
Award-winning application of optimization
techniques to make vehicle scheduling,
dispatching, and inventory decisions for the
distribution of industrial gases to customers.
A survey of OR models used in the financial
services industry.
Towers Perrin-Tillinghast employs a stochastic
asset-and-liability management system for helping
its pension plan and insurance clients understand
the risks and opportunities related to capital market
investments and other major decisions.
An IP based model is developed to optimize the
rosters of sugarcane mills given a large number of
users (sugarcane harvesters) and tight capacities
in the transportation facilities
Simulation modeling of a customer-focused
software company's call center operations to
determine how a fee-based technical support
program would deliver a high service level with a
waiting time of less than one minute.
A stochastic DP model-based decision support
system to help retailers of fashion goods decide on
optimal order quantities and markdown prices.
A spreadsheet based optimization model for
minimizing the total cost of assigning managers to
various projects, while striving to maintain a
balanced workload for different managers
Dell launched e-commerce and manufacturing
initiatives with its supplier to lower supply chain
inventory costs by reducing revolver by 40 percent.
This reduction would raise inventory turns by 67%
leading to a potential $43 million saving.

Year of
Publication
1983

2003

2000

2002

2001

2001

2000

Inventory Decision in Dell's

Supply Chain

Computers

Inventory Planning

Dell Inc.

The Kellog Company Optimizes

Production, Inventory and
Distribution

Cereal, Food

Inventory, Production
and Distribution

The Kellog Company

Menlo Worldwide Forwarding

Optmizes its Network Routing

Logistics,
Transportation

Optimize Transportation
Network

Menlo Worldwide

Mount Sinai Hospital uses

Integer Programming to Allocate
Operating Room Time

Health Care

Effectively manage
Operating room time

Mount Sinai Hospital

Optimization using
IP

Optimally allocated opertaing room time to five

surgical divisions.

2002

Optimizing Customer Mail

Streams at Fingerhut Interfaces
2001.pdf

Internet Retailing

Catalog Mailing

Fingerhut/IBM

Optimization: LP

Customers (7 million) keep receiving redundant

mails and catalogs frequently. With IBM, Fingerhut
developed a optimization program to select the
most profitable mail stream for each customer.

2001

Optimization of Reusable
Containers at Canada Post.pdf

Container
Transportation

Match constrained
supply to demand

Canada Post

Nu-kote's LP Models for

Optimizing Transportation
Interfaces 2004.pdf

Imaging supplies
manufacturer

Supply Chain Shipment

planning

Nu-kote

Newsvendors Tackle
Newsvendor Problem 2003.pdf

Print
Media/Magazines

Supply Chain
Distribution

Time Inc./Mckinsey

Pricing Analysis for Merrill

Lynch Integrated Choice.pdf

Financial Services

Finance

Merrill Lynch

Simulation

Merrill Lynch faced challenges from new discount

brokerages and evaluated alternative service
structures and pricing using simulation based
models

2002

Machinary

Route scheduling and

planning

Schindler Elevator

Optimization:
Heuristics

Environmental Systems Research Institute (ESRI)

developed a automated routing scheduling and
planning system for Schindler Elevator to support
maintenance and repair. The system saves over $1
million annually.

2003

Optimizaing Maintenance
Operations at Schindler
Elevators

Used its planning system to guide production and

Optimization using
distribution decisions for its cereal and convenience
LP
foods business
Maximize use of its network capacity to increase
Optimization using
profitability and reduce operating costs while
IP: assignment
maintaining high service levels. In 2002 alone, the
problem,
company reduced operating cost by 21%,
transportation
increased operating margin by 41% and improved
network, etc
financial results by $80 million in the North
American aircraft transportation operation.

Canada Post detected a imbalance in inventory

between the supply locations and demand
locations. They developed a planning and control
model to prevent this disequilibrium
Nu-kote uses this LP program to identify improved
Decision
shipments to customers, saving 1 millions dollars
Support/Optimizati
annually and reduce custoimer waiting time by two
on: LP
days on average
Mckinsey reviewed the three tier supply chain of
Simulation, Integer Time, Inc and revised its distribution policy for the
programming
major magazines and allocation procedures across
all regions, wholesalers and newsstands.
Optimization:
LP/Network
Optimization

2004

2001

2004

2001

2004

2003

Gyaan Kosh Term 2

DMOP

Learning & Development Council, CAC

Optimizing Pilot Planning and

Training for Continential Airlines

Airline

Decision support
systems

Continental Airlines

Optiimization: LP
and MIP

The Crew-ResourceSolver decision support system

determines optimal pilot transitions and
allocates/schedules training resources. Savings of
over $10 million annually.

2004

The Quebec Ministry of Natural

Resources Uses Linear
Programming to Understand the
Wood-Fiber Market

Government,
Forestry

Decision support
systems

The Quebec Ministry of

Natural Resources

Optimization: LP

In 1996, The Quebec Ministry of Natural Resources

began using descriptive mathemtaical programming
model to support various negotiations in the woodfiber markets.

2000

Optimization Models for

Restructuring BASF North
America's Distribution System

Chemicals

Distribution planning

BASF North America

Optimization: LP

BASF North America formulated and implemented

a distribution planning system that explores tradeoff between customer service and operating costs.

2001

Blending OR/MS, Judgment and

GIS: Restructuring P&G Supply
Chain.pdf

Pharmaceutical

Supply Chain Design

Interfaces

Revenue Management Saves

National Car Rental.pdf

Transportation

Revenue management

Interfaces

Strategic Service Network

Design for DHL Hong Kong

Transportation

Service network design

Interfaces

Visteons Sterling Plant Uses

Simulation-Based Decision
Support in Training, Operations,
and Planning

Machinery

Decision support
systems

Interfaces

Simulation Helps Maxager

Shorten Sales Cycle Interfaces
2004.pdf

IT, Manufacturing

Decision support
systems

Maxager

Strategic and operational

management at Tata Steel.pdf

Steel

Resource and capacity

management

Tata Steel

Supply-Chain Management at
IBM .pdf

IT

Supply Chain
Management

IBM

Targeted Advertising on the

Web with Inventory
Management 2003.pdf

Internet Retailing

Advertising, Inventory
management

Microsoft

UPS Optimizes Air Network

Interfaces 2004.pdf

Transportation;
Shipping; Network
Models

UPS

P&G North America supply chain was analysed

using the combination of GIS(geo-information
Optimization:
system) and network optimization. As a result of
Mixed Integer LP ths study, P&G is reducing number of plants in US
by 20%, saving over 200 millions in pretax costs
per year
In 1993, National Car rental faced liquidation
prospects. The company initiated a comprehensive
revenue management program targeted at
Optimization:
improving capatity, pricing and reservation
Mixed Inteteger LP
decisions improvements. As an immediate result,
company was able to become profitable within a
year.
The model for optimizing service network for DHL
was created. At first, the model finds the least cost
network using optimization approach. After that,
Network
various network parameters can be analysed using
Optimization/Simul
simulation. DHL decision makers can now examine
ation
trade offs between coverage and reliability by
adjusting workforce, changing cut off time or
redesigning the service network

Simulation

Visteons Sterling plant uses a strategic decision

support system (DSS) that integrates plant-floor
information systems and simulation for three
related, mutually reinforcing purposes: productivity
training, productivity improvement in operations,
and design of new operations. As a result of new
system, productivity improved by 30 percent.
Visteon used the DSS in designing a new line with
higher productivity and $5.5 million cost savings.

In order to increase efficiency in the sales cycle of

Maxager's manufacturing decision support
systems, a simulation technique is developed that
Simulation
uses both real and simulated customer data to
provide the customer with an estimate of the
impact of the decision analysis systems. Sales
cycles are shortened from 12 to 6 months.
A MILP is developed to maximize profits at Tata
Steel while considering marketing constraints,
Optimization:
capacities, yields, profitability, routs, energy, and
Mixed Integer LP
oxygen balances of different grades of product.
Profitability increased by $73 million in the first
year of use.
Description of a comprehensive supply chain
analysis tool that incorporates graphical process
modeling, analytical performance optimization,
simulation, activity based costing, and enterprise
Optimization,
database connectivity used by IBM to study
simulation
inventory budgets, turnover objective, customerservice targets, and new product introductions.
Savings amounted to $750 million in the first year
of use.
Development of an internet advertising delivery
system that uses predictive segments and an LP
Optimization: LP to perform a constrained optimization to maximize
click-through-rates subject to inventory
management constraints.
OR specialists at UPS and the Massachusetts
Institute of Technology (MIT) developed a system to
optimize design of service networks and delivering
Optimization: LP/ express packages. The system jointly determines
Network
aircraft routes, fleet assignments and package
routings to ensure overnight delivery at minimal
Optimization
cost. A novel composite-variable technique is
employed to reduce the size of the network
formulation, and solve the LP

1997

1997

2001

2000

2004

1995

2000

2003

2004