Decision-Making Tools

Heizer, Render and Munson, 2017

 Analytic Decision Making Process in
Operations
1. Clearly define the problem and the factors that influence it.
2. Develop specific and measurable objectives.
3. Develop a model—that is, a relationship between objectives and variables (which are
measurable quantities).
4. Evaluate each alternative solution based on its merits and drawbacks.
5. Select the best alternative.
6. Implement and evaluate the decision and then set a timetable for completion.
Types of 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
 Decision Making Terms

• Alternative —A course of action or strategy that may be chosen by

a decision maker (e.g., not carrying an umbrella tomorrow).
• State of nature —An occurrence or a situation over which the
decision maker has little or no control (e.g., tomorrow’s weather).
 Decision Tree

• Symbols used in a decision tree:

• Decision node from which one of
several alternatives may be selected.
• A state-of-nature node out of which
one state of nature will occur.
 Decision Table
• Decision or payoff table
• Define its alternatives
• Define its consequence or outcome
• Express in conditional value
• Getz Products now wishes to organize the following information into a table. With a favorable
market, a large facility will give Getz Products a net profit of $200,000. If the market is
unfavorable, a $180,000 net loss will occur. A small plant will result in a net profit of $100,000 in a
favorable market, but a net loss of $20,000 will be encountered if the market is unfavorable.
 Uncertainty: Maximax
• Find the alternative that maximizes the
maximum outcome for every alternative
• Pick the outcome with the
maximum number
• Highest possible gain
• This is viewed as an optimistic approach
 Uncertainty: Maximin
• Find the alternative that maximizes the
minimum outcome for every alternative
• Pick the outcome with the minimum number
• Least possible loss
• This is viewed as a pessimistic approach
 Uncertainty: Equally Likely (Laplace)
▪
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
 Uncertainty Example

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
Uncertainty: Criterion of Realism (Hurwicz)

A weighted average compromise between

optimistic and pessimistic

Select a coefficient of realism

Coefficient is between 0 and 1

A value of 1 is 100% optimistic

Compute the weighted averages for each alternative

Select the alternative with the highest value

Weighted average = (maximum in row) + (1 – )(minimum in row)

 Uncertainty: Criterion of Realism
(Hurwicz)
Example

For the large plant alternative using = 0.8 (0.8)
(200,000) + (1 – 0.8)(–180,000) = 124,000

For the small plant alternative using = 0.8 (0.8)
(100,000) + (1 – 0.8)(–20,000) = 76,000

STATE OF NATURE
CRITERION
FAVORABLE UNFAVORABLE OF REALISM
ALTERNATIVE MARKET ($) MARKET ($) ( = 0.8)$
Construct a large 200,000 –180,000 124,000
plant
Construct a small Realism
100,000 –20,000 76,000
plant
Do nothing 0 0 0
 Decision Making Under 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
Risk: Expected Monetary Value
st
EMV (Alternative i) = (Payoff of 1 state of
nature) x (Probability of
st
1 state of nature)
nd
+ (Payoff of 2 state of
nature) x (Probability of
nd
2 state of nature)
+…+ (Payoff of last state of
nature) x (Probability of
last state of nature)
 EMV Example
Getz Products’ operations manager believes that the probability of a favorable market
is 0.6, and that of an unfavorable market is 0.4. He can now determine the EMV for
each alternative

1. EMV(A1) = (.6)($200,000) + (.4)(-$180,000) = $48,000

2. EMV(A2) = (.6)($100,000) + (.4)(-$20,000) = $52,000
3. EMV(A3) = (.6)($0) + (.4)($0) = $0
Best Option
 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

EVPI = Expected value with perfect information - Maximum EMV

Expected value with = (Best outcome or consequence for 1 st state of nature) x (Probability of 1 st state of
nature)
perfect information
(EVwPI)
nd nd
+ Best outcome for 2 state of nature) x (Probability of 2 state of nature)

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

The Getz operations manager would like to calculate the

maximum that he would pay for information—that is,
the expected value of perfect information, or EVPI.
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 with perfect information (EVwPI) = ($200,000)(.60) + ($0)(0.6) = $120,000

2. The maximum EMV is $52,000. Thus:

EVPI = EVwPI- Maximum EMV = $120,000 - $52,000 = $ $68,000
 Sensitivity Analysis

Sensitivity analysis examines how our decision might change
with different input data

For the Getz Products’ example

p = probability of a favorable market

(1 – p) = probability of an unfavorable market

 Sensitivity Analysis
EMV(Large Plant) = $200,000p – $180,000)(1 – p)
= $200,000p – $180,000 + $180,000P
= $380,000p – $180,000
EMV(Small Plant) = $100,000p – $20,000)(1 – p)
= $100,000p – $20,000 + $20,000P
= $120,000p – $20,000
EMV(Do Nothing) = $0P + 0(1 – p)
= $0
Sensitivity Analysis

BEST RANGE OF p
ALTERNATIVE VALUES
Do nothing Less than 0.167
Construct a small plant 0.167 – 0.615
Construct a large plant Greater than 0.615
 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
 Decision Trees
1. Define the problem
2. Structure or draw the decision tree
3. Assign probabilities to the states of nature
4. Estimate payoffs for each possible
combination of decision alternatives
and states of nature
5. Solve the problem by working backward
through the tree computing the EMV for
each state-of-nature node
Decision Tree Example
EMV for node 1
= (.6)($200,000) + (.4)(-$180,000)
= $48,000

Payoffs
Favorable market (.6)
$200,000
1
Unfavorable market (.4)
-$180,000
Favorable market (.6)
$100,000
Construct 2
small plant Unfavorable market (.4)
-$20,000
EMV for node = (.6)($100,000) + (.4)(-$20,000)
2 = $52,000

$0
 Complex
Decision Tree
Example
(Imperfect
Information)
 Complex Decision Tree Example
1. Given favorable survey results:
EMV (node 2) = (.78) ($190,000) + (.22) (- $190,000) = $106,400
EMV (node 3) = (.78) ($90,000) + (.22) (- $30,000) = $63,600
The EMV of no plant in this case is -$10,000.
Thus, if the survey results are favorable, a large plant should be built.
2. Given negative survey results:
EMV (node 4) = (.27) ($190,000) + (.73) (-$190,000) = -$87,400
EMV (node 5) = (.27) ($90,000) + (.73) (-$30,000) = $2,400 The
EMV of no plant is again -$10,000 for this branch.
Thus, given a negative survey result, Getz should build a small plant
with an expected value of $2,400.
3. Continuing on the upper part of the tree and moving backward,
we compute the expected value of conducting the market
survey: EMV (node 1) = (.45) ($106,400) + (.55) ($2,400) = $49,200
 Complex Decision Tree Example
4. If the market survey is not conducted:
EMV (node 6) = (.6) ($200,000) + (.4) (-$180,000) = $48,000
EMV (node 7) = (.6) ($100,000) + (.4) (-$20,000) = $52,000
The EMV of no plant is $0.
Thus, building a small plant is the best choice, given the
marketing research is not performed.
5. Because the expected monetary value of not conducting the survey
is $52,000—vs. an EMV of $49,200 for conducting the study—the
best choice is to not seek marketing information . Getz should build
the small plant.