Decision

Theory and
Decision
Trees

Decision-
Making Tools

1
 Introduction
• At the Operational level hundreds of decisions
are made in
order to achieve local outcomes that contribute to the

achievement of the company’s overall strategic goal.

Achieving good results for local outcomes is an

important
objective for individual operational units and individual

operations managers. However, all these decisions are

interrelated and must be coordinated for the purpose of

attaining the overall company goals.

• Decision making is analogous to a great stage pay in

which
all the actors, the costumes, the music, the orchestra,

and
the script must be choreographed and staged by the
2

 Decision Theory
Decision Theory represents a general


approach to decision making which

uses quantitative methods suitable
for a wide range of operations
management decisions, including:
• Capacity planning
• Location planning
• Product and service design
• Equipment selection
3
 Decision Theory Process
• Identify possible future conditions
called states
of nature. Future states of nature may be

high
demand or low demand for a product or

good
economic conditions or bad economic

conditions etc.
• Develop a list of possible alternatives,

one of
which may be to do nothing
4
 Decision Theory Process
• A payoff table is a means of
organising and
illustrating the payoffs from the

different
alternative decisions, given the

various states of
nature. Payoff’s are typically

expressed in
terms of profit, revenues.

5

 Decision Theory Process
(Cont’d)
• If possible, determine the likelihood
of each
possible future condition

• Evaluate alternatives according to

some
decision criterion and select the best

alternative

6
 Decision Environments
• Uncertainty - Environment in which it
is impossible to assess the
likelihood or the probabilities of
various future events (Or
probability are not assigned to
states of nature)
• Risk - Environment in which certain
future
events have probable outcomes i.e.

probability are assigned to the states

of 7
 Decision Making under
Uncertainty
• Maximin – (Pessimistic nature) Choose the
alternative
with the best of the worst possible payoffs

• Maximax – (Optimistic nature) Choose the

alternative
with the best possible payoff. The decision

maker
chooses the most favorable states of nature

for each
alternative decision.

• Laplace - Choose the alternative with the

best average
payoff of any of the alternatives
8
 Example
• A food products company is contemplating the introduction of a
revolutionary new product with new packaging or replace the
existing product at much higher price or a moderate change in
the composition of the existing product with a new packaging
at a small increase in price or a small change in the
composition of the existing product except the word ‘New’ with
a negligible increase in price. The three possible states of
nature or events are: i) high increase in sales, ii) no change in
sales and iii) decrease in sales. The marketing department of
the company worked out the payoffs in terms of yearly net
profits for each of the strategies of three events (expected
sales). This is represented in the following table:
 Which strategy should the concerned executive choose on the
States
basis of of Nature
 i) MaximinN1
Strategies Criterion ii) N2
Maximax criterion
N3 iii) Minimax regret
criterion iv) Laplace criterion?

S1 7,00,000 3,00,000 1,50,000
S2 5,00,000 4,50,000 0
S3 3,00,000 3,00,000 3,00,000
9
 Decision Making under Risk
Expected Monetary Value (EMV).
Expected value is computed by

multiplying each
outcome by the probability of its

occurrence and then

summing these products according to the

formulae:
EMV(x) = ∑ p(xi)*xi

Where xi = ith outcome

p(xi) = probability of ith outcome

The decision maker selects the decision

that has 10
 Decision Making under Risk
Expected value of perfect information: Occasionally
additional information is available, or can be purchased,

regarding
future events, enabling the decision maker to make a better

decision. For example, a company could hire an economic

forecaster to determine more accurately the economic

conditions
that will occur in the future. However, it would be foolish to

pay
more for the information than it stands to gain in extra profit

from
having the information. The information has some maximum

value
that is the limit of what the decision maker would be willing to

spend. This value of information can be computed as an

expected 11
 Example
A glass factory specializing in crystal is
experiencing a
substantial backlog, and the firm's

management is
considering three courses of action:

A) Arrange for subcontracting,

B) Construct new facilities.

C) Do nothing (no change)

The correct choice depends largely upon

demand,
which may be low, medium, or high. By

consensus,
management estimates the respective
12
 Example
The management also estimates the profits when
choosing from the three alternatives (A, B, and C)

under the differing probable levels of demand.

These costs, in thousands of dollars are

presented in the table below:

13
 Solution
Probability are assigned to the states of Nature
(Low, medium and high) hence we use decision
criterion under Risk (EV & EVPI). Further it is
find the best decision out of A, B or C
Expected Values

10*0.1+ 50*.5 + 90*.4 = 62

-120*.1 + 25*.5 +200*.4 =80.5

20*.1 + 40*.5 + 60*.4 = 46

Decision: B

EVPI = (Best outcome for 1st state of

nature) * p(x1) + (Best outcome of 2nd

state of nature) * p(x2) + (Best outcome
for 3rd state of nature)* p(x3) – EMV under
risk
14
= (20*0.1) + (50*0.5) + (200*0.4) -80.5 =26.5