Decision Analysis

Decision Analysis

• Quantitative methods
• a set of tools for operations manager
• Decision analysis
• a set of quantitative decision-making techniques for
decision situations in which uncertainty exists
• Example of an uncertain situation
• demand for a product may vary between 0 and 200
units, depending on the state of market
 Decision Making Without Probabilities

• States of nature
• Events that may occur in the future
• Examples of states of nature:
• high or low demand for a product
• good or bad economic conditions
• Decision making under risk
• probabilities can be assigned to the occurrence of states of
nature in the future
• Decision making under uncertainty
• probabilities can NOT be assigned to the occurrence of states
of nature in the future
 Payoff Table

• Payoff table
• method for organizing and illustrating payoffs from
different decisions given various states of nature
• Payoff
• outcome of a decision
States Of Nature
Decision a b
1 Payoff 1a Payoff 1b
2 Payoff 2a Payoff 2b
 Decision Making Criteria Under
Uncertainty
• Maximax
• choose decision with the maximum of the
maximum payoffs
• Maximin
• choose decision with the maximum of the
minimum payoffs
• Minimax regret
• choose decision with the minimum of the
maximum regrets for each alternative
 Decision Making Criteria Under
Uncertainty
• Hurwicz
• choose decision in which decision payoffs are
weighted by a coefficient of optimism, alpha
• coefficient of optimism is a measure of a
decision maker’s optimism, from 0 (completely
pessimistic) to 1 (completely optimistic)
• Equal likelihood (La Place)
• choose decision in which each state of nature is
weighted equally
Example

C3-7
 Southern Textile Company

STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions
Expand $ 800,000 $ 500,000
Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000
 Maximax Solution

STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions
Expand $ 800,000 $ 500,000
Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000

Expand: $800,000
Status quo: 1,300,000  Maximum
Sell: 320,000
Decision: Maintain status quo
 Maximin Solution

STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions
Expand $ 800,000 $ 500,000
Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000

Expand: $500,000  Maximum

Status quo: -150,000
Sell: 320,000
Decision: Expand
 Minimax Regret Solution

States of Nature
Good 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  Minimum

Status quo: 650,000
Sell: 980,000
Decision: Expand
 Hurwicz Criteria

STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions
Expand $ 800,000 $ 500,000
Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000

 = 0.3 1 -  = 0.7

Expand: $800,000(0.3) + 500,000(0.7) = $590,000  Maximum

Status quo: 1,300,000(0.3) -150,000(0.7) = 285,000
Sell: 320,000(0.3) + 320,000(0.7) = 320,000
Decision: Expand
 Equal Likelihood Criteria

STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions
Expand $ 800,000 $ 500,000
Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000

Two states of nature each weighted 0.50

Expand: $800,000(0.5) + 500,000(0.5) = $650,000  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
 Decision Making with Probabilities

• Risk involves assigning probabilities to states of

nature
• Expected value
• a weighted average of decision outcomes in which
each future state of nature is assigned a probability
of occurrence
 Expected Value
n
EV (x) =  p(xi)xi
i =1
where
xi = outcome i
p(xi) = probability of outcome i
 Decision Making with Probabilities

STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions
Expand $ 800,000 $ 500,000
Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000

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

EV(expand): $800,000(0.7) + 500,000(0.3) = $710,000
EV(status quo): 1,300,000(0.7) -150,000(0.3) = 865,000  Maximum
EV(sell): 320,000(0.7) + 320,000(0.3) = 320,000

Decision: Status quo

 Sequential Decision Trees

• A graphical method for analyzing decision

situations that require a sequence of decisions
over time
• Decision tree consists of
• Square nodes - indicating decision points
• Circles nodes - indicating states of nature
• Arcs - connecting nodes

© 2014 John Wiley & Sons, Inc. - Russell and Taylor 8e Supplement 1-20
 Evaluations at Nodes

• Compute EV at nodes 6 & 7

• EV(node 6)= 0.80($3,000,000) + 0.20($700,000) = $2,540,000
• EV(node 7)= 0.30($2,300,000) + 0.70($1,000,000)= $1,390,000
• Decision at node 4 is between
$2,540,000 for Expand and
$450,000 for Sell land
• Choose Expand
• Repeat expected value calculations and decisions at
remaining nodes
 Decision Tree Analysis
$1,290,000 $2,000,000
0.60 Market growth
2
0.40
$225,000
$3,000,000
$2,540,000
0.80
$1,740,000 6
$700,000
0.20
1 $1,160,000 4

$450,000
0.60 $2,300,000
$1,390,000
3
0.40
0.30
$790,000 7
$1,360,000
0.70 $1,000,000
5

$210,000
 Example

Determine the best decision using the following

decision criteria.
1. Maximax
2. Maximin

© 2014 John Wiley & Sons, Inc. - Russell and Taylor 8e C3-23