Decision Making

Sales Price Relationship Analysis

A workshop making lampshades finds that the number it

can sell varies depending on selling price.

It can sell 10 per week if the price is set at Rs. 80, but 50 per week if the price is reduced to Rs. 40. The cost of production is Rs. 20 for each lampshade and there are overheads of Rs. 60 per week. Assume linear relationship between price and sales. What should be the price to maximize his profit.

Sales Price Relationship Analysis

2500 2000
Rupees

1500 1000 500 0 0 20 40

Sales

60

80

Revenue

Cost

Profit

Inverse Costs
Maintenance department of a foundry wants to plan its annual expenditure on equipment maintenance. Currently it has a crew of 10 people. It costs the company

Rs. 20000 per month per crew member.

If department increases its crew size, it can make maintenance operations more efficient. As a result

breakdown costs will come down.

Data analysis showed that size of maintenance crew and breakdown loss have a inverse relation as follows.

Inverse Costs
Crew size Ependiture 10 2400000 11 2640000 12 2880000 4000000 6880000 13 3120000 3000000 6120000 14 3360000 2400000 5760000 15 3600000 2000000 5600000

Breakdown loss 12000000 6000000 Total cost 14400000 8640000

Crew size Ependiture Breakdown loss Total cost

16 3840000 1900000 5740000

17 4080000 1800000 5880000

18 4320000 1700000 6020000

19 4560000 1600000 6160000

20 4800000 1500000 6300000

Inverse Costs
16000000 14000000 12000000
Cost

10000000 8000000 6000000 4000000 2000000 0 8 9 10 11 12 13 14 15 16 17 18 19 20 21

Crew size

Expenditure

Breakdown loss

Total cost

Inventory Costs

Total cost = HC + OC Annual cost

Holding cost (HC) Ordering (setup) cost (OC)

Lot Size (Q)

Replacement Decisions

Depreciation
Any equipment we use at work reduces in value year by year, which is called as depreciation. Calculation of depreciation is needed for many decision

making situations and one of them is replacement

analysis. There are two basic methods of depreciation calculation. 1. Straight line analysis 2. Declining Balance method

Depreciation and Replacement Analysis

A machine tool costs Rs. 300,000 when new. Lets calculate the written down value after 1,2 and 3 years using

1. Straight line method with annual depreciation of Rs. 50,000

2. By declining Balance method with annual depreciation of 20 %

Approach 1: Straight line method

Capital cost = 3,00,000 Annual depreciation = 50,000

Value after 1st year = 2,50,000

Value after 2nd year = 2,00,000 Value after 3rd year = 1,50,000

Depreciation and Replacement Analysis

A machine tool costs Rs. 300,000 when new. Lets calculate the written down value after 1,2 and 3 years using

1. Straight line method with annual depreciation of Rs. 50,000

2. By declining Balance method with annual depreciation of 20 %

Approach 2: Declining balance method

Capital cost = 3,00,000 Annual depreciation = 20%

Value after 1st year = 30,00,000 - 0.2 x 3,00,000 = 2,40,000

Value after 2nd year = 2,40,000 0.2 x 2,40,000 = 1,92,000 Value after 3rd year = 1,92,000 0.2 x 1,92,000 = 1,53,600

Equipment Replacement Decisions

Suppose a factory has a permanent need for an
equipment, that wears out over a period of several years. In the initial period of use, the depreciation is likely to be high but maintenance costs will be low. Towards the end of its useful life, the rate of depreciation may be slow but maintenance costs will be high. When will it be better to sell off the existing equipment

and purchase a new one ?

Equipment Replacement Decisions

Year 1 2 3 4 5 6 7 8

maintenance Depreciation Cost 50000 6000 45000 7500 40000 12000 35000 20000 30000 34000 25000 50000 20000 70000 15000 90000

When will it be better to sell off the existing equipment and purchase a new one ?

Equipment Replacement Decisions

120000 100000 80000

Rupees

60000 40000 20000 0 0 Depreciation 2 4 6 Year Maintenence 8 Total Cost 10

Decision making Under Uncertainty

Decision making Under Uncertainty

A set of quantitative decision-making techniques for decision situations where uncertainty exists

States of nature

events that may occur in the future decision maker is uncertain which state of nature will occur

decision maker has no control over the states of

nature

Payoff Table

A method of organizing & illustrating the payoffs

from different decisions given various states of nature

A payoff is the outcome of the decision

Payoff Table

States Of Nature Decision a b 1 Payoff 1a Payoff 1b 2 Payoff 2a Payoff 2b

Decision making Criteria

Maximax criterion (optimistic)

choose decision with the maximum of the maximum

payoffs

Maximin criterion (Pessimist)

choose decision with the maximum of the minimum payoffs

Minimax regret criterion

choose decision with the minimum of the maximum

regrets for each alternative

Decision making Criteria

Hurwicz criterion

choose decision in which decision payoffs are

weighted by a coefficient of optimism,

coefficient of optimism () is a measure of a decision makers optimism, from 0 (completely pessimistic) to 1

(completely optimistic)

Equal likelihood (Laplace) criterion

choose decision in which each state of nature is weighted equally

Decision Making Example

Alternative X Y Z Pay-Offs in Thousands of rupees A 8 -4 14 B 0 12 6 C -10 18 0 D 6 -2 8

Alternative X Y Z

Minimum Pay-off -10 -4 0

Maximum Pay-off 8 18 14

Decision Making Example

Alternative X Y Z Pay-Offs in Thousands of rupees A 8 -4 14 B 0 12 6 C -10 18 0 D 6 -2 8

Alternative X Y Z

Minimum Pay-off Maximum Pay-off -10 -4 0 8 18 14

Maximin

Maximax

Minimax Regret Example

Strategic Altenatives S1 S2 S3 Events and Pay-offs A 700 500 300 B 300 450 300 C 150 200 100

Strategic Altenatives S1 S2 S3

Events and Regrets A 0 200 400 B 150 0 150 C 50 0 100

Minimax Regret Example

Strategic Altenatives S1 S2 S3 Events and Pay-offs A 700 500 300 B 300 450 300 C 150 200 100

Strategic Altenatives S1 S2 S3

Events and Regrets A 0 200 400 B 150 0 150 C 50 0 100

Maximum Regret 150 200 400

Minimax Regret Example

Strategic Altenatives S1 S2 S3 Events and Pay-offs A 700 500 300 B 300 450 300 C 150 200 100

Strategic Altenatives S1 S2 S3

Events and Regrets A 0 200 400 B 150 0 150 C 50 0 100

Maximum Regret 150 200 400

Hurwicz Criterion
Step 1: Choose alfa and (1-alfa) Step 2: Determine for each alternative, h = (alfa) (max pay off) + (1-alfa) (minimum pay off) Step 3: Select the alternative with maximum value of h alfa is the coefficient of optimism. It is a measure of a decision makers optimism, from 0 to 1 (completely optimistic)

(1-alfa) is the degree of pessimism

Hurwicz Criterion Example

Take degree of optimism as 0.6

Strategic Altenativ S1 S2 S3

Events and Pay-offs A B C 8000 4500 2000 3500 4500 5000 5000 5000 4000

For alternative S1,

h = 0.6(8000)+0.4(2000) = 5600

Hurwicz Criterion Example

Take degree of optimism as 0.6

Strategic Altenative S1 S2 S3

Events and Pay-offs A B C 8000 4500 2000 3500 4500 5000 5000 5000 4000

h 5600 4400 4600

Hurwicz Criterion Example

Take degree of optimism as 0.6

Strategic Altenativ S1 S2 S3

Events and Pay-offs A B C 8000 4500 2000 3500 4500 5000 5000 5000 4000

h 5600 4400 4600

Laplace Criterion Example

In this method we each state of nature is weighted equally. In other words, likelihood of occurrence of events is considered to be equal.

Step 1: Assign equal weights to each pay off of an alternative or strategy. Step 2: Estimate the expected pay off for each alternative Step 3: Select the alternative which has the maximum expected pay off

Laplace Criterion Example

Events and Pay offs Alternative A 1 2 3 4 -2 7 B 0 6 3 C -5 9 2 D 3 1 4

Expected Pay off for Alternative 1: 0.25 (4) + 0.25 (0) +0.25 (-5) + 0.25 (3) = 0.5

Laplace Criterion Example

Events and Pay offs Alternative A 1 2 3 4 -2 7 B 0 6 3 C -5 9 2 D 3 1 4

Expected Pay off 0.5 3.5 4.0

Expected Pay off for Alternative 1: 0.25 (4) + 0.25 (0) +0.25 (-5) + 0.25 (3) = 0.5

Laplace Criterion Example

Events and Pay offs Alternative A 1 2 3 4 -2 7 B 0 6 3 C -5 9 2 D 3 1 4

Expected Pay off 0.5 3.5 4.0

Expected Pay off for Alternative 1: 0.25 (4) + 0.25 (0) +0.25 (-5) + 0.25 (3) = 0.5

Decision making With Probabilities

Decision making With Probabilities

Probabilities need to be assigned to events

Expected Value is a weighted average of decision outcomes.
n EV( x) p xi xi i1 where xi outcome i

p xi probability of outcome i

Expected payoff Criterion

A store keeper stocks a perishable item. Shelf life of this item is one month. Store keeper wants to determine the number of items he should stock at the beginning of the month. He buys the item for Rs. 30 and sells at Rs. 50.

He analyzes the trend for last two years i.e. 24 months. The following table gives the sales during last 24 months.

Sales Frequency

10 3

11 5

12 10

13 6

Expected payoff Criterion

Sales Frequency Probability

10 3 0.125

11 5 0.208

12 10 0.417

13 6 0.250

Expected payoff Criterion

Stock Demand 10 10 11 12 13 200 200 200 200 11 170 220 220 220 12 140 190 240 240 13 110 160 210 260

Expected Demand is derived from the sales of the past

Expected payoff Criterion

Stock and conditional pay off Demand 10 10 11 12 13 EMV 25.00 41.67 83.33 50.00 200.00 11 21.25 45.83 91.67 55.00 213.75 12 17.50 39.58 100.00 60.00 217.08 13 13.75 33.33 87.50 65.00 199.58

EMV = Expected Monetary Value

Expected payoff Criterion

Stock and conditional pay off Demand 10 10 11 12 13 EMV 25.00 41.67 83.33 50.00 200.00 11 21.25 45.83 91.67 55.00 213.75 12 17.50 39.58 100.00 60.00 217.08 13 13.75 33.33 87.50 65.00 199.58

Expected Regret Criterion

Stock and Regret Demand 10 10 11 12 13 0 20 40 60 11 30 0 20 40 12 60 30 0 20 13 90 60 30 0

Stock and Conditional Regret Demand 10 10 11 12 13 ER 0.00 4.17 16.67 15.00 35.83 11 3.75 0.00 8.33 10.00 22.08 12 7.50 6.25 0.00 5.00 18.75 13 11.25 12.50 12.50 0.00 36.25

Decision Trees

Decision Trees
Bharat Oil Company (BOC) owns a land that may contain oil. Geologist report shows a 25% chance of oil Another company is offering to buy the land for Rs. 90 Cr If BOC decides to drill, it will earn a profit of Rs. 700 Cr if oil is found. However, it will incur a loss of Rs. 100 Cr if oil is not found. Should BOC drill or sell ?

Decision Trees

(0.25) Oil

700 Cr Expected pay off is 100 Cr -100 Cr

Drill (0.75) Dry

decision

(0.25) Oil

90 Cr Expected pay off is 90 Cr

Sell
(0.75) Dry 90 Cr

Value of Perfect Information

In many decision making exercises it is possible to get more or extra information about the events or state of nature.
But it will cost extra money. Question : Is additional information worth the cost ?

Value of Perfect Information

Continuing with the previous example,

A sesmic survey can tell whether the land is fairly likely or fairly unlikely to have oil. Cost of the survey is Rs. 30 Cr Should BOC do the survey ?

Value of Perfect Information

Expected pay off with perfect information is

= 0.25 (700) + 0.75 (90) = 242.5 Cr

Expected value of perfect information is = Expected pay off with perfect information - Expected pay off without perfect information = 242.5 100 = 142.5 Cr. If EVPI is less than the cost of survey, then dont do the survey. Its not worth it. In this case, 142.5 Cr. >> 30 Cr. It is worthwhile doing the survey.

Decision Trees
A firm is adding a new product line and must build a new plant. Demand will either be favourable or unfavourable, with probabilities of 0.6 and 0.4,

respectively. If a large plant is built and demand is favourable the pay off is
estimated to be Rs. 1520 Cr. If the demand is unfavourable, the loss with larger plant will be Rs. 20 Cr If a medium sized plant is built and demand is unfavourable, the pay off is Rs. 760 Cr. If the demand proves to be favourable, the firm can maintain the medium sized facility or expand it. Maintaining medium sized facility will result in to a pay off of Rs. 950 Cr and expanding it will give a pay off of Rs 570 Cr in the next period. Draw a decision tree for this problem What should the management do to achieve the highest expected pay off ?

Decision Trees
(0.6) Fav 1520 Cr

Large (0.4) Un Fav -20 Cr Expand 570 Cr

decision
Small

(0.6) Fav
Continue (0.4) Un Fav 760 Cr 950 Cr

0.6 (1520) 0.4 (20) = 904 Cr 0.6 (950) + 0.4 (760) = 874 Cr

Build a large Plant