Spreadsheet Modeling & Decision Analysis

A Practical Introduction to Management Science

5th edition

Cliff T. Ragsdale

Chapter 1
Introduction to Modeling & Problem Solving

Introduction
We face numerous decisions in life & business. We can use computers to analyze the potential outcomes of decision alternatives. Spreadsheets are the tool of choice for todays managers.

What is Management Science?

A field of study that uses computers, statistics, and mathematics to solve business problems. Also known as:
Operations research Decision science

Home Runs in Management Science

Motorola
Procurement of goods and services account for 50% of its costs Developed an Internet-based auction system for negotiations with suppliers The system optimized multi-product, multivendor contract awards Benefits:
$600 million in savings

Home Runs in Management Science

Waste Management
Leading waste collection company in North America 26,000 vehicles service 20 million residential & 2 million commercial customers Developed vehicle routing optimization system Benefits:
Eliminated 1,000 routes Annual savings of $44 million

Home Runs in Management Science

Hong Kong International Terminals
Busiest container terminal in the world 122 yard cranes serve 125 ships per week Thousands of trucks move containers in & out of storage yard Used DSS to optimize operational decisions involving trucks, cranes & storage locations Benefits:
35% reduction in container handling costs 50% increase in throughput 30% improvement in vessel turnaround time

Home Runs in Management Science

John Deere Company
2500 dealers sell lawn equipment & tractors with support of 5 warehouses Each dealer stocks 100 products, creating 250,000 product-stocking locations Demand is highly seasonal and erratic Developed inventory system to optimize stocking levels over a 26-week horizon Benefits:
$1 billion in reduced inventory Improved customer-service levels

What is a Computer Model?

A set of mathematical relationships and logical assumptions implemented in a computer as an abstract representation of a real-world object of phenomenon. Spreadsheets provide the most convenient way for business people to build computer models.

The Modeling Approach to Decision Making

Everyone uses models to make decisions. Types of models:
Mental (arranging furniture) Visual (blueprints, road maps) Physical/Scale (aerodynamics, buildings) Mathematical (what well be studying)

Characteristics of Models
Models are usually simplified versions of the things they represent A valid model accurately represents the relevant characteristics of the object or decision being studied

Benefits of Modeling
Economy - It is often less costly to analyze decision problems using models. Timeliness - Models often deliver needed information more quickly than their real-world counterparts. Feasibility - Models can be used to do things that would be impossible. Models give us insight & understanding that improves decision making.

Example of a Mathematical Model

Profit = Revenue - Expenses
or Profit = f(Revenue, Expenses)

or
Y = f(X1, X2)

A Generic Mathematical Model

Y = f(X1, X2, , Xn)
Where:

Y = dependent variable

(aka bottom-line performance measure)

Xi = independent variables (inputs having an impact on Y) f(.) = function defining the relationship between the Xi & Y

Mathematical Models & Spreadsheets

Most spreadsheet models are very similar to our generic mathematical model:

Y = f(X1, X2, , Xn)

Most spreadsheets have input cells (representing Xi) to which mathematical functions ( f(.)) are applied to compute a bottom-line performance measure (or Y).

Categories of Mathematical Models

Model Category Form of f(.) Independent Variables OR/MS Techniques

Prescriptive

known, well-defined

known or under decision makers control known or under decision makers control unknown or well-defined

LP, Networks, IP, CPM, EOQ, NLP, GP, MOLP Regression Analysis, Time Series Analysis, Discriminant Analysis Simulation, PERT, uncertain

Predictive

unknown, ill-defined

Descriptive

known,

Queueing, Inventory Models

The Problem Solving Process

Identify Problem

Formulate & Implement Model

Analyze Model

Test Results

Implement Solution

unsatisfactory results

The Psychology of Decision Making

Models can be used for structurable aspects of decision problems. Other aspects cannot be structured easily, requiring intuition and judgment. Caution: Human judgment and intuition is not always rational!

Anchoring Effects
Arise when trivial factors influence initial thinking about a problem. Decision-makers usually under-adjust from their initial anchor. Example:
What is 1x2x3x4x5x6x7x8 ? What is 8x7x6x5x4x3x2x1 ?

Framing Effects
Refers to how decision-makers view a problem from a win-loss perspective. The way a problem is framed often influences choices in irrational ways Suppose youve been given $1000 and must choose between:
A. Receive $500 more immediately B. Flip a coin and receive $1000 more if heads occurs or $0 more if tails occurs

Framing Effects (Example)

Now suppose youve been given $2000 and must choose between:
A. Give back $500 immediately B. Flip a coin and give back $0 if heads occurs or give back $1000 if tails occurs

A Decision Tree for Both Examples

Payoffs Alternative A $1,500

Initial state
Heads (50%) $2,000 $1,000

Alternative B (Flip coin)

Tails (50%)

Good Decisions vs. Good Outcomes

Good decisions do not always lead to good outcomes...

A structured, modeling approach to decision making helps us make good decisions, but cant guarantee good outcomes.

End of Chapter 1