Decsion Making Powerpoint

Supplement A
Decision Making
Copyright 2013 Pearson Education, Inc. publishing as Prentice Hall A - 01
Decision Making Tools
Break-even analysis
Analysis to compare processes by finding the volume at which
two processes have equal total costs.
Preference matrix
Table that allows managers to rate alternatives based on several
performance criteria.
Decision theory
Approach when outcomes associated with alternatives are
in doubt.
Decision Tree
Model to compare alternatives and their possible
consequences.
Break-even analysis notation
Variable cost (c)-
The portion of the total cost that varies directly with
volume of output.
Fixed cost (F)
The portion of the total cost that remains constant
regardless of changes in levels of output.
Quantity (Q)
The number of customers served or units produced per
year.
Break-Even Analysis
By setting revenue equal to total cost
pQ = F + cQ
Q =
F
p - c
Total cost = F + cQ
Total revenue = pQ
Example A.1
A hospital is considering a new procedure to be offered at
$200 per patient. The fixed cost per year would be $100,000
with total variable costs of $100 per patient. What is the
break-even quantity for this service? Use both algebraic and
graphic approaches to get the answer.

The formula for the break-even quantity yields
Q =
F
p - c
= 1,000 patients =
100,000
200 100
Example A.1

The following table shows the results for Q = 0 and Q = 2,000
Quantity
(patients)
(Q)
Total Annual Cost ($)
(100,000 + 100Q)
Total Annual Revenue ($)
(200Q)
0 100,000 0
2,000 300,000 400,000
Example A.1
Total annual costs
Fixed costs
Break-even quantity
Profits
Loss
Patients (Q)
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400
300
200
100
0
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500 1000 1500 2000
(2000, 300)
Total annual revenues
The two lines
intersect at
1,000
patients, the
break-even
quantity
(2000, 400)
Application A.1
The Denver Zoo must decide whether to move twin polar bears to Sea
World or build a special exhibit for them and the zoo. The expected
increase in attendance is 200,000 patrons. The data are:
Revenues per Patron for Exhibit
Gate receipts $4
Concessions $5
Licensed apparel $15

Estimated Fixed Costs
Exhibit construction $2,400,000
Salaries $220,000
Food $30,000

Estimated Variable Costs per Person
Concessions $2
Licensed apparel $9
Is the predicted
increase in
attendance
sufficient to
break even?
Copyright 2013 Pearson Education, Inc. publishing as Prentice Hall A -08
Application A.1
Q TR = pQ TC = F + cQ
0 $0 $2,650,000
250,000 $6,000,000 $5,400,000
7
6
5
4
3
2
1
0
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50 100 150 200 250
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Q (thousands of patrons)
Where
p = 4 + 5 + 15 = $24
F = 2,400,000 + 220,000 + 30,000
= $2,650,000
c = 2 + 9 = $11
Application A.1
Q

TR = pQ

TC = F + cQ
0 $0 $2,650,000
250,000 $6,000,000 $5,400,000
Where
p = 4 + 5 + 15 = $24
F = 2,400,000 + 220,000 + 30,000
= $2,650,000
c = 2 + 9 = $11
Algebraic solution of Denver Zoo problem
pQ = F + cQ
24Q = 2,650,000 + 11Q
13Q = 2,650,000
Q = 203,846
Example A.2
If the most pessimistic sales forecast for the proposed
service from Example 1 was 1,500 patients, what would be
the procedures total contribution to profit and overhead per
year?

200(1,500) [100,000 + 100(1,500)] pQ (F + cQ) =
= $50,000
Make-or-buy decision notation
F
b

The fixed cost (per year) of the buy option
F
m

The fixed cost of the make option
c
b

The variable cost (per unit) of the buy option
c
m

The variable cost of the make option

Make-or-buy decision
Total cost to buy
F
b
+ c
b
Q
Total cost to make
F
m
+ c
m
Q
F
b
+ c
b
Q = F
m
+ c
m
Q
Q =
F
m
F
b
c
b
c
m
Example A.3
A fast-food restaurant featuring hamburgers is adding
salads to the menu
The price to the customer will be the same
Fixed costs are estimated at $12,000 and variable costs
totaling $1.50 per salad
Preassembled salads could be purchased from a local
supplier at $2.00 per salad
Preassembled salads would require additional
refrigeration with an annual fixed cost of $2,400
Expected demand is 25,000 salads per year
What is the break-even quantity?
The formula for the break-even quantity yields the
following:
Q =
F
m
F
b
c
b
c
m
= 19,200 salads =
12,000 2,400
2.0 1.5
Example A.3
Application A.2
At what volume should the Denver Zoo be
indifferent between buying special sweatshirts from
a supplier or have zoo employees make them?


Buy Make
Fixed costs $0 $300,000
Variable costs $9 $7
Q =
F
m
F
b
c
b
c
m
Q =
300,000 0

9 7

Q = 150,000
Preference Matrix
A Preference Matrix is a table that allows you to
rate an alternative according to several
performance criteria.
The criteria can be scored on any scale as long as the same
scale is applied to all the alternatives being compared.
Each score is weighted according to its perceived
importance, with the total weights typically
equaling 100.
The total score is the sum of the weighted scores (weight
score) for all the criteria and compared against scores for
alternatives.
The following table shows the performance criteria, weights,
and scores (1 = worst, 10 = best) for a new thermal storage air
conditioner. If management wants to introduce just one new
product and the highest total score of any of the other product
ideas is 800, should the firm pursue making the air conditioner?
Example A.4
Performance Criterion Weight (A) Score (B) Weighted Score (A B)
Market potential
30 8 240
Unit profit margin
20 10 200
Operations compatibility
20 6 120
Competitive advantage
15 10 150
Investment requirements
10 2 20
Project risk
5 4 20
Weighted score = 750
Because the sum of the weighted scores is 750, it falls short
of the score of 800 for another product. This result is
confirmed by the output from OM Explorers Preference
Matrix Solver below
Example A.4
Total 750
Application A.3
The following table shows the performance criteria, weights, and
scores (1 = worst, 10 = best) for a new thermal storage air
conditioner. If management wants to introduce just one new
product and the highest total score of any of the other product
ideas is 800, should the firm pursue making the air conditioner?

Performance Criterion Weight (A) Score (B) Weighted Score (A B)
Market potential 10 5 50
Unit profit margin 30 8 240
Operations compatibility 20 10 200
Competitive advantage 25 7 175
Investment
requirements
10 3 30
Project risk 5 4 20
Weighted score = 715
No.
Because
715 >800
Decision Theory Steps
List a reasonable number of feasible alternatives
List the events (states of nature)
Calculate the payoff table showing the payoff for
each alternative in each event
Estimate the probability of occurrence for each
event
Select the decision rule to evaluate the alternatives

Example A.5
A manager is deciding whether to build a small or a large
facility
Much depends on the future demand
Demand may be small or large
Payoffs for each alternative are known with certainty
What is the best choice if future demand will be low?
Possible Future Demand
Alternative Low High
Small facility 200 270
Large facility 160 800
Do nothing 0 0
Example A.5
The best choice is the one with the highest payoff
For low future demand, the company should build a small
facility and enjoy a payoff of $200,000
Under these conditions, the larger facility has a payoff of
only $160,000
Possible Future Demand
Alternative Low High
Do nothing 0 0
Decision Making under Uncertainty
Maximin
Maximax
Laplace
Minimax Regret

Example A.6
Reconsider the payoff matrix in Example 5. What is the best
alternative for each decision rule?
a. Maximin. An alternatives worst payoff is the lowest
number in its row of the payoff matrix, because the
payoffs are profits. The worst payoffs ($000) are
Alternative Worst Payoff
Small facility 200
Large facility 160
The best of these worst numbers is $200,000, so the
pessimist would build a small facility.
Example A.6
b. Maximax. An alternatives best payoff ($000) is the
highest number in its row of the payoff matrix, or
Alternative Best Payoff
Small facility 270
Large facility 800
The best of these best numbers is $800,000, so the
optimist would build a large facility.
Example A.6
c. Laplace. With two events, we assign each a probability
of 0.5. Thus, the weighted payoffs ($000) are
The best of these weighted payoffs is $480,000, so
the realist would build a large facility.
0.5(200) + 0.5(270) = 235
0.5(160) + 0.5(800) = 480
Alternative Weighted Payoff
Small facility
Large facility
Example A.6
d. Minimax Regret. If demand turns out to be low, the best
alternative is a small facility and its regret is 0 (or 200
200). If a large facility is built when demand turns out to
be low, the regret is 40 (or 200 160).
Regret
Alternative Low Demand High Demand
Maximum
Regret
Small facility 200 200 = 0 800 270 =530 530
Large facility 200 160 = 40 800 800 = 0 40
The column on the right shows the worst regret for each
alternative. To minimize the maximum regret, pick a
large facility. The biggest regret is associated with having
only a small facility and high demand.
Application A.4
Fletcher (a realist), Cooper (a pessimist), and Wainwright (an
optimist) are joint owners in a company. They must decide
whether to make Arrows, Barrels, or Wagons. The government
is about to issue a policy and recommendation on pioneer
travel that depends on whether certain treaties are obtained.
The policy is expected to affect demand for the products;
however it is impossible at this time to assess the probability
of these policy events. The following data are available:

Payoffs (Profits)
Alternative
Land Routes
No treaty
Land Routes
Treaty
Sea Routes
Only
Arrows $840,000 $440,000 $190,000
Barrels $370,000 $220,000 $670,000
Wagons $25,000 $1,150,000 ($25,000)
Application A.4
Which product would be favored by Fletcher (realist)?
Fletcher (realist Laplace) would choose arrows

Which product would be favored by Cooper (pessimist)?
Cooper (pessimist Maximin) would choose barrels

Which product would be favored by Wainwright (optimist)?
Wainwright (optimist Maximax) would choose wagons

What is the minimax regret solution?
The Minimax Regret solution is arrows

A - 30 Copyright 2013 Pearson Education, Inc. publishing as Prentice Hall
Decision Making Under Risk
Use the expected value rule

Weigh each payoff with associated probability
and add the weighted payoff scores.

Choose the alternative with the best expected
value.

Example A.7
Reconsider the payoff matrix in Example 5. For the expected
value decision rule, which is the best alternative if the
probability of small demand is estimated to be 0.4 and the
probability of large demand is estimated to be 0.6?
The expected value for each
alternative is as follows:
Possible Future
Demand
Alternative Small Large
0.4(200) + 0.6(270) = 242
0.4(160) + 0.6(800) = 544
Alternative Expected Value
Small facility
Large facility
The large
facility is
the best
alternative.
For Fletcher, Cooper, and Wainwright, find the best decision
using the expected value rule. The probabilities for the events
are given below.

What alternative has the best expected results?

Alternative
Land routes,
No Treaty
(0.50)
Land Routes,
Treaty Only
(0.30)
Sea routes,
Only (0.20)
Arrows 840,000 440,000 190,000
Barrels 370,000 220,000 670,000
Wagons 25,000 1,150,000 -25,000
Application A.5
Application A.5
A - 34
Alternative
Land routes, No
Treaty
(0.50)
Land Routes,
Treaty Only
(0.30)
Sea routes
Only (0.20)
Expected Value
Arrows (.50) * 840,000` + (.30)* 440,000 + (.20) * 190,000 590,000
Barrels (.50) * 370,000` + (.30)* 220,000 + (.20) * 670,000 385,000
Wagons (.50) * 25,000` + (.30)* 1,150,000 + (.20) * -25,000 352,500
Copyright 2013 Pearson Education, Inc. publishing as Prentice Hall
Arrows is the
best alternative.
Payoff 1
Payoff 2
Payoff 3
Alternative 3
Alternative 4
Alternative 5
Payoff 1
Payoff 2
Payoff 3
E
1
& Probability
E
2
& Probability
E
3
& Probability
E
2
& Probability
E
3
& Probability
Payoff 1
Payoff 2
1st
decision
1
Possible
2nd decision
2
Decision Trees
= Event node
= Decision node
E
i
= Event i
P(E
i
) = Probability of event i
Example A.8
A retailer will build a small or a large facility at a new location
Demand can be either small or large, with probabilities
estimated to be 0.4 and 0.6, respectively
For a small facility and high demand, not expanding will have a
payoff of $223,000 and a payoff of $270,000 with expansion
For a small facility and low demand the payoff is $200,000
For a large facility and low demand, doing nothing has a payoff
of $40,000
The response to advertising may be either modest or sizable,
with their probabilities estimated to be 0.3 and 0.7, respectively
For a modest response the payoff is $20,000 and $220,000 if the
response is sizable
For a large facility and high demand the payoff is $800,000
Example A.8
$200

$223

$270

$40

$800
$20

$220
Dont expand
Expand
Low demand [0.4]
2
High demand [0.6]
3
Do nothing
Advertise
Modest response [0.3]

Sizable response [0.7]
1
Example A.8
$200

$223

$270

$40

$800
$20

$220
Dont expand
Expand
Low demand [0.4]
2
High demand [0.6]
3
Do nothing
Advertise

1
0.3 x $20 = $6
0.7 x $220 = $154
$6 + $154 = $160
Example A.8
$200

$223

$270

$40

$800
$20

$220
Dont expand
Expand
Low demand [0.4]
2
High demand [0.6]
3
Do nothing
Advertise

1
$160
$160
Example A.8
$200

$223

$270

$40

$800
$20

$220
Dont expand
Expand
Low demand [0.4]
2
High demand [0.6]
3
Do nothing
Advertise

1
$160
$160
$270
Example A.8
$200

$223

$270

$40

$800
$20

$220
Dont expand
Expand
Low demand [0.4]
2
High demand [0.6]
3
Do nothing
Advertise

1
$160
$160
$270
x 0.4 = $80
x 0.6 = $162
$80 + $162 = $242
Example A.8
$200

$223

$270

$40

$800
$20

$220
Dont expand
Expand
Low demand [0.4]
2
High demand [0.6]
3
Do nothing
Advertise

1
$160
$160
$270
$242
x 0.6 = $480
0.4 x $160 = $64
$544
Example A.8
$200

$223

$270

$40

$800
$20

$220
Dont expand
Expand
Low demand [0.4]
2
High demand [0.6]
3
Do nothing
Advertise

1
$160
$160
$270
$242
$544
$544
Application A.6
a. Draw the decision tree for the Fletcher, Cooper, and
Wainwright Application 5
b. What is the expected payoff for the best alternative
in the decision tree below?

Alternative
Land routes,
No Treaty
(0.50)
Land Routes,
Treaty Only
(0.30)
Sea routes, Only
(0.20)
Arrows 840,000 440,000 190,000
Barrels 370,000 220,000 670,000
Wagons 25,000 1,150,000 -25,000
Application A.6
Solved Problem 1
A small manufacturing business has patented a new
device for washing dishes and cleaning dirty kitchen sinks
The owner wants reasonable assurance of success
Variable costs are estimated at $7 per unit produced and
sold
Fixed costs are about $56,000 per year
a. If the selling price is set at $25, how many units must be
produced and sold to break even? Use both algebraic and
graphic approaches.
b. Forecasted sales for the first year are 10,000 units if the
price is reduced to $15. With this pricing strategy, what
would be the products total contribution to profits in the
first year?
Solved Problem 1

a. Beginning with the algebraic approach, we get
Q =
F
p c
= 3,111 units
=
56,000
25 7
Using the graphic approach, shown in Figure A.6, we first draw
two lines:
The two lines intersect at Q = 3,111 units, the break-even
quantity
Total revenue =
Total cost =
25Q
56,000 + 7Q
Total costs
Break-even
quantity
250
200
150
100
50
0
Units (in thousands)
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1 2 3 4 5 6 7 8
Total revenues
3.1
$77.7
Solved Problem 1
Solved Problem 1
b. Total profit contribution = Total revenue Total cost
= pQ (F + cQ)
= 15(10,000) [56,000 + 7(10,000)]
= $24,000
Solved Problem 2
Herron Company is screening three new product idea: A, B, and C.
Resource constraints allow only one of them to be commercialized. The
performance criteria and ratings, on a scale of 1 (worst) to 10 (best),
are shown in the following table. The Herron managers give equal
weights to the performance criteria. Which is the best alternative, as
indicated by the preference matrix method?
Rating
Performance Criteria Product A Product B Product C
1. Demand uncertainty and project risk 3 9 2
2. Similarity to present products 7 8 6
3. Expected return on investment (ROI) 10 4 8
4. Compatibility with current
manufacturing process
4 7 6
5. Competitive Strategy 4 6 5
Solved Problem 2
Each of the five criteria receives a weight of
1/5 or 0.20
The best choice is product B as Products A and C are well behind in
terms of total weighted score
(0.20 3) + (0.20 7) + (0.20 10) +
(0.20 4) + (0.20 4)
= 5.6
(0.20 9) + (0.20 8) + (0.20 4) +
(0.20 7) + (0.20 6)
= 6.8
(0.20 2) + (0.20 6) + (0.20 8) +
(0.20 6) + (0.20 5)
= 5.4
Product Calculation Total Score
A
B
C
Solved Problem 3
Adele Weiss manages the campus flower shop. Flowers must
be ordered three days in advance from her supplier in Mexico.
Although Valentines Day is fast approaching, sales are almost
entirely last-minute, impulse purchases. Advance sales are so
small that Weiss has no way to estimate the probability of low
(25 dozen), medium (60 dozen), or high (130 dozen) demand for
red roses on the big day. She buys roses for $15 per dozen and
sells them for $40 per dozen. Construct a payoff table. Which
decision is indicated by each of the following decision criteria?

a. Maximin
b. Maximax
c. Laplace
d. Minimax regret
Solved Problem 3
The payoff table for this problem is
Demand for Red Roses
Alternative
Low
(25 dozen)
Medium
(60 dozen)
High
(130 dozen)
Order 25 dozen $625 $625 $625
Order 60 dozen $100 $1,500 $1,500
Order 130 dozen ($950) $450 $3,250
Do nothing $0 $0 $0
Solved Problem 3
a. Under the Maximin criteria, Weiss should order 25 dozen, because
if demand is low, Weisss profits are $625, the best of the worst
payoffs.
b. Under the Maximax criteria, Weiss should order 130 dozen. The
greatest possible payoff, $3,250, is associated with the largest
order.
c. Under the Laplace criteria, Weiss should order 60 dozen. Equally
weighted payoffs for ordering 25, 60, and 130 dozen are about
$625, $1,033, and $917, respectively.
d. Under the Minimax regret criteria, Weiss should order 130 dozen.
The maximum regret of ordering 25 dozen occurs if demand is
high: $3,250 $625 = $2,625. The maximum regret of ordering 60
dozen occurs if demand is high: $3,250 $1,500 = $1,750. The
maximum regret of ordering 130 dozen occurs if demand is low:
$625 ($950) = $1,575.
Copyright 2013 Pearson Education, Inc. publishing as Prentice Hall
A - 54
Solved Problem 4
White Valley Ski Resort is planning the ski lift operation for its
new ski resort and wants to determine if one or two lifts will
be necessary. Each lift can accommodate 250 people per day
and skiing occurs 7 days per week in the 14-week season and
lift tickets cost $20 per customer per day. The table below
shows all the costs and probabilities for each alternative and
condition. Should the resort purchase one lift or two?
Alternatives Conditions Utilization Installation Operation
One lift Bad times (0.3) 0.9 $50,000 $200,000
Normal times (0.5) 1.0 $50,000 $200,000
Good times (0.2) 1.0 $50,000 $200,000
Two lifts Bad times (0.3) 0.9 $90,000 $200,000
Normal times (0.5) 1.5 $90,000 $400,000
Good times (0.2) 1.9 $90,000 $400,000
Solved Problem 4
The decision tree is shown on the following slide. The payoff
($000) for each alternative-event branch is shown in the
following table. The total revenues from one lift operating at
100 percent capacity are $490,000 (or 250 customers 98 days
$20/customer-day).
0.9(490) (50 + 200) = 191
1.0(490) (50 + 200) = 240
1.0(490) (50 + 200) = 240
0.9(490) (90 + 200) = 151
1.5(490) (90 + 400) = 245
1.9(490) (90 + 400) = 441
Alternatives Economic Conditions Payoff Calculation (Revenue Cost)
One lift Bad times
Normal times
Good times
Two lifts Bad times
Normal times
Good times
Bad times [0.3]
Normal times [0.5]
Good times [0.2]
$191
$240
$240
Bad times [0.3]
Normal times [0.5]
Good times [0.2]
$151
$245
$441
One lift
Two lifts
$256.0
$225.3
$256.0
Solved Problem 4
0.3(191) + 0.5(240) +
0.2(240) = 225.3
0.3(151) + 0.5(245) +
0.2(441) = 256.0
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otherwise, without the prior written permission of the publisher.
Printed in the United States of America.

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