OM6 | SUPPLEMENTARY CHAPTER

E Decision Analysis
LEARNING Objectives
After studying this chapter, you should be able to:

E-1 Describe types of management decisions where decision analysis techniques are useful
and describe the basic elements of a decision problem.

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E-2 Explain how to evaluate risk in making decisions, and how to apply decision criteria to select

Photo Credit Here

an ­appropriate decision alternative.

E-3 Describe how to construct simple decision trees and use them to select optimal expected-value
decisions.

“What do you think we should do? We’re down by
10 with five minutes left—plenty of time to get
the ball back,” pondered Ken Kendall, head coach
of West High, in talking to offensive coach Craig
Russell. West was facing fourth down and short
yardage for another first down from their opponent’s
9-yard line. “Should we try for the first down or go
for the field goal?” Craig noted that, statistically, a
run is better than a field-goal attempt inside the
10-yard line. Ken wasn’t so sure, trying to weigh the
risk of not getting the first down or a touchdown
instead of an almost sure field goal.

What do you think?

Describe a situation in your personal or work life where you need to make an important decision. What criteria
will you use? How will you make the decision?

Decision analysis is the formal study of how people make require the manufacturer to make a production-quantity
decisions, particularly when faced with uncertain information, as decision before the actual demand is known. Most deci-
well as a collection of techniques to support the analysis of deci- sions that we face in business and in our personal lives
sion problems. For example, the manufacturer of a new require a choice in the face of an uncertain future.
style or line of seasonal clothing would like to manufac- Decision analysis has many applications in product
ture large quantities of selection, facility capacity expansion and location, inven-
Decision analysis is the formal the product if consumer tory analysis, technology and process selection, and other
study of how people make decisions, acceptance and, conse- areas of operations management. The opening scenario
particularly when faced with uncertain quently, demand for the provides one example. In fact, Virgil Carter, a former
information, as well as a ­collection of
product are going to be NFL quarterback, and Robert Machol applied decision
techniques to support the analysis of
­decision problems. high. Unfortunately, the analysis to evaluate football strategies. They found, for
seasonal clothing items example, that the expected value of having the ball with
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 One former NFL quarterback has applied decision
analysis to evaluate football strategies.

first down and 10 yards to go varies by field position. If 5 yards to go. These results were contrary to practice,
the ball is close to one’s own goal line, then the team’s but many coaches continued to employ the field goal far
expected scoring value is 21.64, indicating that the op- more than the analysis indicated.1
ponent is more likely to score as a result of getting the
ball back in good field position. As field position moves
closer to the opponent’s goal line, the expected value E-1 Applying Decision
becomes positive and increases. A further analysis of
field-goal attempts showed that, inside the 30-yard line, Analysis Tools
the run is preferred to the field-goal attempt if there are
1 or 2 yards to go, and possibly 3. Inside the 10-yard line, Decision analysis tools should not be used in every
the run is preferred to the field-goal attempt with up to decision situation. Characteristics of management de-
cisions where decision analysis techniques apply are
summarized as follows:2
1. They must be important. Decision analysis
techniques would not be appropriate for minor
decisions where the consequences of a mistake
are so small that it is not worth our time to study
the situation carefully. The consequences of
© Ahmet Misirligul/Shutterstock.com

many decisions, such as building a major facility,

are not felt immediately but may cover a long
time period.
2. They are probably unique. Decisions that recur
can be programmed and then delegated. But the
ones that are unusual and perhaps occur only one
time cannot be handled this way.
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 3. They allow some time for study. For example, capital investment and continuation of research over
decision analysis techniques would not be useful in the long development cycle do not lend themselves
making a decision in the emergency department or to traditional financial analysis.3
when a jet fighter flames out during takeoff.
4. They are complex. Practical decision problems involve E-1a  Structuring Decision Problems
multiple objectives, requiring the evaluation of trade- To illustrate the process of defining a decision problem, we
offs among the objectives. For example, in evaluating present an example of a medium-size producer of industrial
routes for proposed pipelines, a decision maker would chemical products, Commonwealth Chemicals Company,
want to minimize environmental impact, minimize that is facing a decision about capacity expansion. The com-
health and safety hazards, maximize economic pany has recently developed a new, synthetic, industrial lu-
benefit, and maximize social impact. Decisions bricant that will increase tool life for machining operations
involve many intangibles, such as the goodwill of a in metal-fabrication industries. A new factory would be
client, employee morale, and necessary to produce the lubricant
governmental regulations, on a large scale, but expanding
and may involve several Practical decision the existing facilities would allow
stakeholders. For instance, production on a smaller scale.
to build a plant in a new
problems involve
Managers are uncertain
area, corporate management multiple objectives, which decision to choose. Clearly,
may require approval from requiring the the best decision depends on fu-
stockholders, regulatory ture demand. If the demand for
agencies, community evaluation of the product is high, the expan-
zoning boards, and perhaps trade-offs among sion alternative will not provide
even the courts. Finally, enough capacity to meet all the
most decisions are closely
the objectives.
demand, and profits will be lost.
allied with other decisions. If demand is low, and a new fac-
Choices today affect both the alternatives available in tory is built, the excess capacity will substantially reduce the
the future and the desirability of those alternatives. return on investment. With an unstable economy, it is dif-
Thus, a sequence of decisions must often be made. ficult to predict actual demand for the product.
5. They involve uncertainty and risk. Uncertainty The first step in structuring a decision problem is to
refers to not knowing what will happen in the future. An define the decision alternatives. Decision alternatives
advertising campaign may fail, a reservoir may represent the choices that a decision maker can make . In this
break, or a new product may be a complete failure. case, the alternatives are whether to expand the existing
Uncertainty is further complicated when little or no plant or to build a new factory. Let
data are available, or some data are very expensive d1 5 decision to expand the existing plant
or time-consuming to obtain. Faced with such
d2 5 decision to build a new plant
uncertainties, different people view the same set of
information in different ways. Risk is the uncertainty The second step is to define the events that might oc-
associated with an cur after a decision is made. Events represent the future
undesirable outcome, such as outcomes that can occur after a decision is made and that are not
Uncertainty refers to not knowing financial loss. To appreciate under the control of the decision maker. For each combination
what will happen in the future.
the importance of risk, of production-volume decision and subsequent event,
Risk is the uncertainty associated consider the fact that a payoff can be computed. For instance, if the manu-
with an undesirable outcome, such
it takes hundreds of facturer decides to produce 10,000 units, but demand
as financial loss.
millions of dollars and is low, the manufacturer will incur the cost of producing
Decision alternatives represent about 10 years for a the 10,000 units but will receive revenue for sales of only
the choices that a decision maker
pharmaceutical company 5,000; the remaining units will have to be disposed of at
can make.
to bring a drug to market. a loss. On the other hand, if sales are medium or high, all
Events represent the future outcomes Once there, 7 of 10 10,000 units will be sold, and the net profit can be com-
that can occur after a decision is made
and that are not under the control of the
products fail to return the puted. The payoff would be the net profit.
decision maker. company’s cost of capital. For instance, in deciding to expand an existing plant
Decisions involving or build a new one, Commonwealth Chemicals needs to

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 consider the future demand for
the product. Different possible
levels of demand represent Environmental Decisions
the events. Demand might
be expressed quantitatively Electric utilities face decisions that can have important impacts on the
in sales units or dollars. In environment. The impacts stem from the by-products of combustion and other
this example, events might be chemicals, equipment, and processes that utilities use to produce electricity. For
designated as “high demand,” example, utilities use large boilers to boil water and make steam to generate
“medium demand,” and “low electricity. The cleaning process results in a waste solution that may be
demand.” Alternatively, they hazardous. Whether or not the waste stream will be hazardous is uncertain, as
might be quantified as “de- are the costs and effects of the various management strategies. Several courses
mand estimated as 15,000 of action—choice of cleaning agent; whether or not to include a prerinse stage;
units,” “demand estimated as treatment and disposal method; and cleaning frequency—are available. Using
10,000 units,” and “demand techniques of decision analysis, the consulting firm Decision Focus ­Incorporated
estimated as 5,000 units.” If developed a strategy that would save a utility $119,000 for one boiler over a
you are planning a vacation to 20-year horizon.4
­Florida in March, you might
define events as the weather
that you might encounter.
Uncertain weather-related outcomes might be defined occurrence of events helps assess risk when making a
qualitatively, for example, sunny and warm, sunny and cold, decision. In some cases, however, event probabilities
rainy and warm, or rainy and cold. For the Commonwealth may not be available or appropriate to try to assess. We
Chemicals decision problem, we will define the events as will provide examples of both situations in the follow-
ing sections.
s1 5 low product demand
In summary, the elements of a decision problem are
s2 5 high product demand (1) decision alternatives, (2) events, (3) estimated payoffs
Next, we need well-defined decision criteria on which for each combination of decision alternatives and events,
to evaluate potential options. Decision criteria might and possibly (4) probabilities of the events.
be net profit, customer service, cost, social benefits, or
any other measure of output that may be appropriate for E-2 Selecting Decision
the particular situation being analyzed. A numerical value
associated with a decision coupled with some event is called a Alternatives
payoff. Using the best information available, the man-
agers of Commonwealth Chemicals have estimated the Making decisions with uncertain future consequences
payoffs, expressed as profits, as shown in Exhibit E.1. A is often quite frustrating and a source of anxiety for
table of this form is referred to as a payoff table. The individuals and managers alike. We run the risk that
notation we use for the entries in the payoff table is V(di, any decision we choose may result in undesirable con-
sj), which denotes the payoff, V, associated with decision sequences once we see what the future holds in store.
alternative di and event sj. Using this notation, we see There are two principal ways of viewing a decision strat-
that V(d2, s1) 5 $100,000. egy, and these depend on the frequency with which the
In many decision problems, the probabilities of decision will be made. For one-time decisions, managers
events can be estimated, either from historical data or must take into account the risk associated with making
managerial judgment. Knowing the likelihood of the the wrong decision. However, for decisions that are re-
peated over and over, man-
agers can choose decisions
EXHIBIT E.1 Payoff Table for Commonwealth Chemicals based on the expected pay-
offs that might occur.
Possible Future Events
Decision Alternative Low Product Demand (s1) High Product Demand (s2) A numerical value associated with a
Expand existing plant (d1) $200,000 $300,000 decision coupled with some event is
Build new plant (d2) $100,000 $450,000
called a payoff.

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 One-Time Decisions
E-2a 
Without Event Probabilities
The Commonwealth Chemicals decision is clearly a one-
time decision. So how should the choice be made? Dif-
ferent criteria can be used to reflect different attitudes
toward risk, and they may result in different decision
recommendations. For a problem in which the payoff is
profit, as it is in the Commonwealth Chemicals problem,
three common criteria are
1. Maximax—choose the decision that will maximize
the maximum possible profit among all events.
This is an aggressive, or risk-taking, approach.
2. Maximin—choose the decision that will maximize
the minimum possible profit among all events. This
is a conservative, or risk-averse, approach.
3. Minimax regret—choose the decision that will
minimize the maximum opportunity loss associated
with the events. Opportunity loss represents the
regret, or ill-feeling, that people often have after
making a nonoptimal decision (“I should have
bought that stock years ago . . .”). This approach is
neither aggressive nor conservative, but focuses on
not erring too much in either direction.
We will apply these criteria for the Commonwealth Chem-
icals problem. For the maximax criterion, we see that if d1
is selected, the maximum payoff is $300,000, and it occurs
for s2. If d2 is selected, the maximum payoff is $450,000,
also for s2. The decision maker should choose d2, build a
new plant, as it results in the largest possible payoff.
For the maximin criterion, we see that if d1 is cho-
sen, the minimum payoff is $200,000, whereas if d2 is
selected, the minimum payoff is $100,000. Thus, to max-
imize the minimum payoff, the decision maker should
choose d1, expand the existing plant.
To apply the minimax-regret criterion, we must first
construct a regret or opportunity-loss matrix. The op-
portunity loss associated with a particular decision, di,
and state of nature, sj, is the difference between the best
payoff that the decision maker can receive by making the
optimal decision d* corresponding to sj, V(d*, sj), and the
payoff for choosing any arbitrary decision di and having
sj occur, V(di, sj). For example, if we know that s1 will
EXHIBIT E.2 Opportunity-Loss Matrix for Commonwealth Chemicals
The expected-value approach Decision
is to select the decision alternative Expand existing plant (d1)
with the best expected payoff.
Build new plant (d2)
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64791_Supp_E_ptg01.indd 6
occur, the best decision is to choose d* 5 d1 and receive
a payoff of $200,000; the opportunity loss will be zero.
If we choose d2, we will receive only $100,000 and will
lose the opportunity to receive $200,000 2 $100,000 5
$100,000. Similarly, if we know that s2 will occur, the best
decision is d* 5 d2; an opportunity loss of $450,000 2
$300,000 5 $150,000 will occur if we choose d1.
Exhibit E.2 shows the complete opportunity-loss matrix
for this situation. We see that the smallest maximum op-
portunity loss occurs for d2, so using this criterion, Com-
monwealth should build the new plant.
We see that different criteria can result in different
decisions; which to use is purely a judgment call on the
part of the decision maker and reflects the person’s val-
ues and attitudes toward risk.
For problems in which the payoff is cost, the crite-
ria change somewhat. The aggressive decision criterion
is minimin—minimize the minimum possible payoff
over all events. The conservative decision is minimax—
minimize the maximum possible payoff over all events.
Finally, the minimax-regret criterion does not change,
as opportunity loss is always a cost. However, care is
needed in computing the opportunity loss correctly. It
is still the difference between the best possible payoff
(received by making the optimal decision) and the pay-
off of any other decision. The only difference when the
output measure is cost is that the “best” payoff is the
lowest cost, not the highest profit. The difference must
be viewed as an absolute value—that is, the savings in
cost—because it does not make sense for opportunity
losses to be negative. The Excel Decision Analysis tem-
plate provides the capability of solving decision prob-
lems involving cost criteria.
E-2b  Repeated Decisions
with Event Probabilities
If an individual or business faces the same decision prob-
lem repeatedly, then, over the long run, the decision can
be made based on expected value. The expected-value
approach is to select the decision alternative with the best ex-
pected payoff. The expected-value (EV) criterion requires
probability estimates for the events. In many situations,
Low Product High Product Maximum
Demand (s1) Demand (s2) Opportunity Loss
0 $150,000 $150,000
$100,000 0 $100,000
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 Solved Problem E.1
Maling Manufacturing needs to purchase a new
piece of machining equipment. The two choices are
a conventional (labor-intensive) machine and an
automated (computer-controlled) machine. Profitability
will depend on demand volume. The following data
provide an estimate of profits over the next three years.
Demand Volume
Decision Low (s1) High (s2)
Conventional machine (d1) $15,000 $21,000
Automated machine (d2 ) $  9,000 $35,000
Exhibit E.3 shows the Excel Decision Analysis template that can be used to perform these calculations.
EXHIBIT E.3 Portion of Spreadsheet from Excel Decision Analysis Template
good probability estimates can be developed from his-
torical data or judgmentally. Let
P(sj) 5 probability of occurrence for event sj
N 5 number of events
Because one and only one of the N states of nature can
occur, the associated probabilities must satisfy these two
conditions:
P(sj )  0  for all j
P(sj ) 5 P(s1) 1 P(s2) . . . P(sN) 5 1
The expected value for decision alternative di is given by
EV(di) 5 SjP(sj)V(di, sj)[E.1]
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64791_Supp_E_ptg01.indd 7
Solution
Decision Maximum Profit Minimum Profit
Conventional (d1) $21,000 $15,000
Automated (d2) $35,000 $  9,000
Maximax decision 5 d2 Maximin decision 5 d1
Opportunity-Loss Matrix
Decision Low High Maximum
Conventional (d1) 0 $14,000 $14,000
Automated (d2) $6,000 0 $  6,000
Minimax-regret decision 5 d2
The EV criterion is used in revenue management
applications (see Chapter  10). Most airlines, for ex-
ample, offer discount fares for advanced purchase.
Assume that only two fares are available: full and dis-
count. The airline must make the decision of whether
or not to accept the next request for a discount seat.
If it accepts the discount request, the revenue it earns
is the discount fare. If it rejects the discount request,
two outcomes are possible. First, the seat may remain
empty, and the airline will not realize additional rev-
enue. Alternatively, the remaining seat may be filled
by a full-fare passenger, either because full-fare pas-
senger demand is sufficient to fill the seats or because
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EXHIBIT E.4 Airline Discount-Fare Request Decision
Events
Do Not Sell
Decision Sell Full-Fare Ticket Full-Fare Ticket
Reject request $560
Accept request $400
Probability .75
of event
discount-fare passengers choose to pay full fare when
told the discount fare is not available.
This decision situation is illustrated by an example
in Exhibit E.4. Suppose that a full-fare ticket is $560
and the discount fare is $400. The decision depends on
the probability, p, of getting a full-fare request when a
discount request is rejected. The expected value of re-
jecting the discount seat request is p times the full-fare
value. Thus, if p 5 .75, the expected value of rejecting
the discount request is .25(0) 1 .75($560) 5 $420. Be-
cause this is higher than the discount fare, the discount
request should be rejected. Because an airline makes
hundreds or thousands of such decisions each day, the
EV criterion is appropriate.
E-2c  Expected Value of Perfect Information
By perfect information, we mean knowing in advance
what state of nature will occur. Although we never have
Then clearly the best decision
would be to accept the discount
request and receive revenue of
$400. On the other hand, if it
knows that it can sell the full-fare
Expected Value
ticket, then obviously it should
$0 $560 3 .75 5 $420
reject the request and receive
$400 $400
$560. However, on average, we
.25 know that only 75 percent of
customers will buy the full-fare
ticket if the request is rejected,
and 25 percent will not. So the expected value of having
perfect information would be
(.75)(560) 1 (.25)(400) 5 $520
Recall that without the perfect information, the best
decision is to always choose d 1, which has an expected
value of $420. By having perfect information about
what a particular customer might do, we see that the
value of the expected payoff can be increased by
$520 2 420 5 $100
This difference is the expected value of perfect informa-
tion (EVPI), and it represents the maximum amount the
company should be willing to pay for any information
about the events, no matter how good it is. In this case,
we might interpret it as the maximum incentive that the
airline might give to a customer who is unwilling to pur-
chase the full-fare ticket.

E-3 Decision Trees

perfect information in practice, it is worth knowing how
much we could improve the value of our decision if we
had such information. This is called the expected value
of perfect information, or EVPI, which is the difference be- Decision problems can be depicted graphically using a de-
tween the expected payoff under perfect information and the ex- cision tree. A decision tree is a schematic of the logical order
pected payoff of the optimal decision without perfect information. with which decisions are made and events occur. In the terminol-
We compute EVPI by asking the following question: If ogy associated with decision trees, nodes refer to the intersec-
each event occurs, what would be the best decision and tions, or junction points, of the tree. Arcs are the connectors between
payoff? Then we weight
Expected value of perfect these payoffs by the EXHIBIT E.5 Airline Discount-Fare Request Decision
information, or EVPI, is the probabilities associated
difference between the expected Decision Event Payoff
with the events to obtain
payoff under perfect information and
the expected payoff of the optimal
the expected payoff un- Sell full fare
der perfect information. $560
decision without perfect information. p 5 0.75
Suppose the airline
A decision tree is a schematic of Reject request
the logical order with which decisions somehow knew in ad-
are made and events occur. vance that it could not
Nodes refer to the intersections, or sell the full-fare ticket Do not sell
junction points, of the tree. to a particular customer $0
1 2 p 5 .25
(perhaps based on demo-
Arcs are the connectors between the Accept request
nodes. graphic profiles and anal- $400
ysis of past behavior).
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 EXHIBIT E.6 New Product Introduction Decision Tree
Decisions States of nature Decisions States of nature

High response

Introduce
nationally
Low response
Remain regional
High
response
High regional Market nationally
response
Low
Drop project response
Introduce
regionally Remain regional
High
Low regional response
Market nationally
response
Low
Drop project response

the nodes. Arcs are sometimes called branches. When the Expected-value calculations can be made directly on
branches leaving a given node are decision branches, we the tree to arrive at the best decision strategy. Working
refer to the node as a decision node. Decision nodes are backward through the decision tree, we first compute the
usually denoted by squares. Similarly, when the branches expected monetary value of each event node by weight-
leaving a given node are event branches, we refer to the ing the possible payoffs by their chances of occurrence. In
node as an event node. Event nodes are denoted by circles. the airline fare example, the expected value for the event
The number at each endpoint of the tree represents the node corresponding to the reject request decision is
payoff associated with a particular chain of events.
EV 5 .75(560) 1 .25(0) 5 $420
Exhibit E.5 is a decision tree of the airline fare request
decision. Note that the tree shows the natural, or logical, shown in the box in Exhibit E.7. We continue backward
progression of the decision-making process. First, the firm through the tree to the decision node. At this point we
must make its decision (d1 or d2); then, once the decision compare the expected value for rejecting the request
is implemented, an event (s1 or s2) occurs. Note that in this with the value of the branch associated with accepting
case, if the request is accepted it does not matter if the air- the request. Because the value for rejecting the request
line could have sold the full fare or not, so we do not have is higher, it corresponds to the best decision.
to include event branches for this decision.
Decision trees are useful for more
complex business decisions. For exam- EXHIBIT E.7 Calculation of Optimal Decision Strategy
ple, a nationwide restaurant franchise
Decision Event Payoff
that frequently introduces new items
might develop the decision tree shown in Sell full fare
Exhibit  E.6 to help make a decision on $560
p 5 0.75
how to best market the products. Even if
the tree is not used analytically to evaluate Reject request
$420
expected payoffs, it can be of substantial
benefit in helping decision makers to logi- Do not sell
$420
cally determine what decisions need to be $0
1 2 p 5 .25
made, and how to react to external forces
Accept request
such as competitor strategies or economic $400
changes beyond their control.
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 Collegiate Athletic Drug Testing
The athletic board of Santa Clara University had to decide whether to recommend implementing a drug-testing
program for intercollegiate athletes. One of the board members, a management science professor, developed
a simple decision model to address the question of whether or not to test a single individual for the presence
of drugs. The model focused on the key issue of the reliability of the testing procedures, consequences of
testing errors, and the benefits of identifying a drug user compared with the costs of false accusations and
nonidentification of users.
Exhibit E.8 shows the decision tree developed for testing an individual for drug use. The two main alternatives
are “test” or “don’t test.” The model evaluates the expected cost of testing for drug use compared with that of
not testing. If testing is chosen, the test is given and the result, positive or negative, is observed. If the result is
positive, action is taken. Because not all those who test positively are actually users, there is some chance of a
false accusation, which costs an amount C1. If the result is negative, then some drug users are not identified,
which costs C2. Nonusers who test negatively might be expected to experience some cost, C3, perhaps based
on invasion of privacy. Following the lower path of the tree, if the alternative “don’t test” were selected, the
expected cost is just the cost of an unidentified user, C2, multiplied by the prior probability that an individual
is a drug user.
The model’s results surprised many board members. For instance, the model showed that if a test that is 95 percent
reliable is applied to a population of 5 percent drug users, only 50 percent of all those who tested positively will actually
be drug users. Most board members had read about the reliability of drug tests in various publications and agreed
that 95 percent reliability was a representative value. As a result, the board concluded that a false accusation was more
serious than not identifying drug users, and it rejected the proposal. The university administration later accepted this
recommendation.5

EXHIBIT E.8 Decision Tree for Drug-Use Testing

Decision node Outcome Cost
Event node Uses drugs
User identified 0
Act
1 Does not
False accusation C1
Result Do nothing use drugs
Test
Act
2 Uses drugs
Unidentified user C2
Result Do nothing
Does not C3
use drugs
Uses drugs
Unidentified user C2
Do not
test Does not use drugs
0

Source: Charles D. Feinstein, “Deciding Whether to Test Student Athletes for Drug Use,” Interfaces 20, 3, May–June 1990, pp. 80–87. The Institute for Operations Research
and the Management Sciences (INFORMS), 7240 Parkway Drive, Suite 300, Hanover, MD 21076 USA.

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 Solved Problem E.2

Martin’s Service Station is considering investing in a Solution

heavy-duty snowplow this fall. Martin, the owner, has a. Exhibit E.9 is the decision tree and the variables are
analyzed the situation carefully and feels that this would defined as follows: d1 5 invest, d2 5 do not invest, s1 5
be a very profitable investment if the snowfall is heavy, heavy, s2 5 moderate, s3 5 light, P(s1) 5 .4, P(s2) 5 .3,
somewhat profitable if the snowfall is ­moderate, and and P(s3) 5 .3.
would result in a loss if the snowfall is light. ­Specifically,
b. Recommended decision: d1(invest) because EV(d1) 5
Martin forecasts a profit of $7,000 if snowfall is heavy
.4(7,000) 1 .3(2,000) 1 .3(29,000) 5 $700 and EV(d2) 5 0.
and $2,000 if it is moderate, and a $9,000 loss if it is
light. From the Weather Bureau’s long-range forecast, c. Although the decision tree helps structure the prob-
Martin estimates that P(heavy snowfall) 5 .4, P(moderate lem, the fact remains that this is a one-time decision.
snowfall) 5 .3, and P(light snowfall) 5 .3. The expected-value criterion does not incorporate
risk into the decision.
a. Prepare a decision tree for Martin’s problem.
b. Using the EV criterion, would you recommend that
Martin invest in the snowplow?
c. Discuss the value of using EV for this situation.

EXHIBIT E.9 Decision Tree for Solved Problem

s1
7,000
.4

d1 s2
2 2,000
.3

s3
29,000
.3
1
s1
0
.4

d2 s2
3 0
.3

s3
0
.3

OM6  Supplementary Chapter E: Decision Analysis E11

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 Problems, Activities, and Discussions
Note: An asterisk denotes problems for which a template in the OM6 Spreadsheet Templates at OM6 Online
may be used.
 1.* Suppose a decision maker faced with four decision a. Construct a decision tree for this problem and
alternatives and four states of nature develops the determine the best decisions using the maximax,
profit-payoff table shown as follows: maximin, and minimax-regret decision criteria.

State of Nature
b. Assume that the best estimate of the probability of
low long-run demand is .20, of medium long-run
Decision s1 s2 s3 s4
demand is .15, and of high long-run demand is .65.
d1 14  9 10  5
What is the best decision using the EV criterion?
d2 11 10  8  7
d3  9 10 10 11  4.* McHuffter Condominiums, Inc., of Pensacola,
d4  8 10 11 13 Florida, recently purchased land near the Gulf of
Mexico and is attempting to determine the size of
a. If the decision maker knows nothing about the the condominium development it should build there.
chances or probability of occurrence of the four Three sizes of developments are being considered:
states of nature, what decision would be indicated small, d1, medium, d2, and large, d3. At the same time,
by the maximax, maximin, and minimax-regret an uncertain economy makes it difficult to ascertain
criteria? the demand for the new condominiums. McHuffter’s
managers realize that a large development followed
b. Which decision criterion do you prefer? Explain.
by a low demand could be very costly to the company.
Should the decision maker establish the most
However, if McHuffter makes a conservative, small-
appropriate decision criterion before analyzing the
development decision and then finds high demand,
problem? Explain.
the firm’s profits will be lower than they might have
c. Assume the payoff table provides cost, rather than been. With the three levels of demand—low, medium,
profit, payoffs. What is the recommended decision and high—McHuffter’s managers prepared the payoff
using the optimistic, conservative, and minimax- table as follows:
regret decision criteria?
Demand (in thousands of dollars)
 2.* Suppose the decision maker in problem 1 obtains
Decision Low Medium High
information that enables these probability estimates to
Small $400 $400 $400
be made:
Medium  100  600  600
P(s1) 5 .4, P(s2) 5 .3, P(s3) 5 .2, P(s4) 5 .1. Large –300  300  900

a. Use the expected-value (EV) criterion to If P(low) 5 .50, P(medium) 5 .35, and P(high) 5 .15,
determine the optimal decision. what decision is recommended by the EV criterion?
b. Assuming the entries in the payoff table are costs,  5.* The Gorman Manufacturing Company must decide
use the EV criterion to determine the minimum- whether to purchase a component part from a
cost solution. supplier or manufacture the component at its own
plant. If demand is high, it would be to Gorman’s
3. Southland Corporation’s decision to produce a new
advantage to manufacture the component. If demand
line of recreational products has resulted in the
is low, however, Gorman’s unit manufacturing cost
need to construct either a small plant or a large
will be high because of underutilization of equipment.
plant. The decision as to which size to select
The projected profit in thousands of dollars for
depends on the marketplace reaction to the new
Gorman’s make-or-buy decision is as follows:
product line. To conduct an analysis, marketing
managers have decided to view the possible long- Demand
run demand as low, medium, or high. The payoff Decision Low Medium High
table gives the projected profits in millions of Manufacture component $220 $40 $100
dollars as follows: Purchase component  210  45  70

Long-Run Demand The states of nature have these probabilities:

Decision Low Medium High P(low demand) 5 .35, P(medium demand) 5 .35,
Small plant $150 $200 $200 and P(high demand) 5 .30. Use a decision tree to
Large plant   50  200  500 recommend a decision.
E12 OM6: Supplementary Chapters

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  6.* A firm produces a perishable food product at a cost
of $10 per case. The product sells for $15 per case.
For planning purposes, the company is considering
possible demands of 100, 200, and 300 cases. If the
demand is less than production, the excess production
is discarded. If demand is more than production,
the firm, in an attempt to maintain a good service
image, will satisfy the excess demand with a special
production run at a cost of $18 per case. The product,
however, always sells at $15 per case.
a. Set up the payoff table for this problem.
b. If P(100) 5 .2, P(200) 5 .2, and P(300) 5 .6, should
the company produce 100, 200, or 300 cases?
 7.* Sealcoat, Inc., has a contract with one of its customers
to supply a unique, liquid chemical product used in
the manufacture of a lubricant for airplane engines.
Because of the chemical process Sealcoat uses,
batch sizes for the product must be 1,000 pounds.
The customer has agreed to adjust manufacturing to
the full-batch quantities and will order either one,
two, or three batches every three months. Because
production includes a one-month aging process,
Sealcoat must make its production decision (how much
to make) before the customer places an order. Thus,
the product demand alternatives are 1,000, 2,000, and
3,000 pounds, but the exact demand is unknown.
Sealcoat’s manufacturing costs are $150 per pound,
and the product sells at the fixed contract price of $200
per pound. If the customer orders more than Sealcoat
has produced, Sealcoat has agreed to absorb the added
cost of filling the order by purchasing a higher-quality,
substitute product from another chemical firm. The
substitute product, including transportation expenses,
will cost Sealcoat $240 per pound. Because the product
cannot be stored more than two months without
spoilage, Sealcoat cannot inventory excess production
until the customer’s next three-month order. Therefore,
if the customer’s current order is less than Sealcoat has
produced, the excess production will be reprocessed and
will then be valued at $50 per pound.
The decision in this problem is: How much
should Sealcoat produce given the costs and the
possible demands of 1,000, 2,000, and 3,000 pounds?
From historical data and analysis of the customer’s
future demands, Sealcoat has developed the
probability distribution for demand as follows
Demand Probability
1,000 .3
2,000 .5
3,000 .2
a. Develop a payoff table for the problem.
b. How many batches should Sealcoat produce every
three months?
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64791_Supp_E_ptg01.indd 13
8. A quality control procedure involves 100 percent
inspection of parts received from a supplier. Historical
records show the observed defect rates as follows:
Percent Defective Probability
0 .15
1 .45
2 .25
3 .15
The cost to inspect 100 percent of the parts
received is $250 for each shipment of 500 parts. If the
­shipment is not 100 percent inspected, defective parts
will cause rework problems later in the production
process. The rework cost is $35 per each defective part.
a. Complete the payoff table shown here, in which
entries represent the total cost of inspection and
reworking.
Percent Defective
Decision 0 1 2 3
100% inspection $250 $250 $250 $250
No inspection ? ? ? ?
b. The plant manager is considering eliminating the
inspection process to save the $250 inspection cost
per shipment. Do you support this action? Use EV
to justify your answer.
c. Show the decision tree for this problem.
9. The research and development (R&D) manager of
the Beck Company is trying to decide whether or
not to fund a project to develop a new lubricant.
It is assumed that the project will be a major
technical success, a minor technical success, or a
failure. The company estimates the value of a major
technical success as $150,000, as the lubricant could
be used in a number of products the company is
making. If the project is a minor technical success,
its value is estimated as $10,000, as Beck feels
the knowledge gained will benefit other ongoing
projects. If the project is a failure, it will cost the
company $100,000. Based on the opinion of the
scientists involved and the manager’s own subjective
assessment, the following probabilities are assigned:
P(major success) 5 .15
P(minor success) 5 .45
P(failure) 5 .40
a. According to the EV criterion, should the project
be funded?
b. Suppose a group of expert scientists from a
research institute could be hired as consultants to
study the project and make a recommendation.
If this study would cost $30,000, should the Beck
Company hire the consultants?
OM6  Supplementary Chapter E: Decision Analysis E13
02/09/16 6:42 PM
 10. Consider again the problem faced by the Beck
Company R&D manager (problem 9). Suppose an
experiment can be conducted to shed some light on
the technical feasibility of the project. There are three
possible outcomes of the experiment:
I1 5 prototype lubricant works well at all
temperatures
Trendy’s Pies Case Study
Trendy’s is a national chain specializing in selling
pies, either whole or by the slice, from small
facilities with drive-through
capabilities. Trendy’s corpo-
rate kitchen staff has devel-
oped a new type of pie and
needs to make a decision on
whether to introduce it nation-
ally across the chain or to try a
regional test market first. Tina
Trendy, the franchise founder,
and her staff sketched out the
decision tree described earlier
in the chapter in ­Exhibit E.6.
Based on various research
reports and industry knowl-
edge, and judgment, Trendy Trendy’s sells pies, either whole or by the slice.
and her staff came up with the
following financial estimates and risk probabilities. If
they decide to roll the product out nationally, they would
incur costs of $200,000. A high consumer response would
result in expected revenues of $700,000, with a .6 prob-
ability; whereas a low consumer response would result in
only $150,000 of revenue, with a .4 probability. If they
first introduce the product in a regional test market, they
would incur $30,000 in costs and expect a 70 percent
chance of a high regional response and a 30 percent
chance of a low regional response. Regardless of the
outcome, they still have to make a decision on whether
to remain regional with the product (thereby avoiding
potential risks of national failure), market the product
nationally, or drop the idea. If the regional response is
Endnotes
1.  William E. Balson, Justin L. Welsh, and Donald S. Wilson, “Using Decision
Analysis and Risk Analysis to Manage Utility Environmental Risk,” Interfaces,
22, 6, November–December 1992, pp. 126–139.
2.  Virgil Carter and Robert E. Machol, “Optimal Strategies on Fourth
Down,” Management Science, 24, 16, December 1978, pp. 1758–1762.
3.  Bruce F. Baird, Managerial Decisions Under Uncertainty, New York: John
Wiley & Sons, 1989, p. 6; and Ralph L. Keeney, “Decision Analysis:
E14 OM6: Supplementary Chapters
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64791_Supp_E_ptg01.indd 14
I2 5 prototype lubricant works well only at
temperatures above 10ºF
I3 5 prototype lubricant does not work well at any
temperature
How would the decision tree be modified to include
this information?
high, they anticipate that remaining regional would re-
sult in revenues of $200,000; remaining regional
with a low regional response would
result in revenues of only $100,000.
If they decide to market nationally
after a high regional test-market re-
sponse, Trendy estimates that there
is a .9 probability of a high national
response that would result in reve-
nues of $700,000, and a .1 probabil-
ity of a low national response with
© RusGri/Shutterstock.com
revenues of $150,000. If they mar-
ket nationally after a low regional
test-market response, the probabil-
ity of a high national response is only
.05; the probability of a low national
response would be .95 (revenue es-
timates would remain the same).
Case Questions for Discussion
1. Use these cost, revenue, and probability estimates
along with the decision tree to identify the best
decision strategy for Trendy’s Pies.
2. Suppose that Trendy is concerned about her
probability estimates of the consumer response to the
regional test market. Although her estimates are .7 for
a high response and .3 for a low response, she is not
very confident of these values. Determine how the
decision strategy would change if the probability of a
high response varies from .1 to .9 in increments of .1.
How sensitive is the best strategy in part a to this
probability assumption?
An Overview,” Operations Research, 30, 5, September–October 1982,
pp. 803–838.
4.  Nancy A. Nichols, “Scientific Management at Merck: An Interview with CFO
Judy Lewent,” Harvard Business Review, January–February 1994, pp. 89–99.
5.  Adapted from Charles D. Feinstein, “Deciding Whether to Test Student
Athletes for Drug Use,” Interfaces, 20, 3, May–June 1990, pp. 80–87.
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