COLLEGE OF ENGINEERING, ARCHITECTURE, AND TECHNOLOGY

Subject: Quantitative
Production Systems
Management
Topic: Introduction
Decision Theory
to Operations Research/LP (Graphical Method)
Lecturer: Engr.
Engr.Ma.
Maria
Estrella
Socorro
Natalie
M. Bunda
B. Pineda

Decision Theory
 COLLEGE OF ENGINEERING, ARCHITECTURE, AND TECHNOLOGY

Topic: Decision Theory

Lecturer: Engr. Maria Lourdes H. Parcero

Desicion Theory - represents a general approach to

decision making. It is suitable for a wide range of
operations management decision

Decision Analysis – is a generic technique that can be

applied to a number of different types of operational
decision making areas. It is a set of quantitative decsion
–making dealing to aid the decision maker in dealing
with a decision situation which there is uncertainty
• Decision making is an integral part of movement
planning , organizing , controlling and motivation
processes. The decision maker selects one strategy
(course of action ) over others depending on some
criteria , like utility , sales , cost or rate of return

• Is used whenever an organization or an individual

faces a problem of decision making or dissatisfied
with the existing decisions or when alternative
selection is specified
 Types of Decisions
• Strategic Decision
– Concerned with external environment of the organization

• Administrative Decision
– Concerned with structuring and acquisition of the organization’s
resources so as to optimize the performance of the organization.

• Operating Decision
– Concerned with day to day operations of the organization such as
pricing , production , scheduling , inventory levels etc.
 Reasons for Poor Decisions

1. Mistakes made in the decision process/

2. Bounded rationality – it is the limits imposed
on decision making by costs, human abilities ,
time , technology and the availability of
information
3. Typically departmentalized decision
• Sub- optimization – is a result of different
departments attempting to reach a solution
that is optimum for each department .
Unfortunately what is optimal for one
department may not be optimal for the
organization as a whole
 Steps in Decision Making

1. Identify the problem

2. Specify objectives and the decision criteria for
choosing a solution
3. Develop alternatives
4. Analyze and compare alternatives
5. Select the best alternative
6. Implement the chosen alternative
7. Monitor the result to ensure that the derived
results are achieved.
 General approach to decision making are:

1. Use of models
2. Quantitative methods – Linear programming
(used for optimum allocation of scarce
resources )
3. Analysis of trade- offs
4. System analysis
 3 basic categories in decision making

1. Certainty – means that relevant parameters

such as costs , capacity and demand have
known values
2. Risk – means that certain parameters have
probabilistic outcomes
3. Uncertainty – means that it is possible to
asses the likelihood of various possible future
events
 4 Possible decision criteria under
uncertainty
1. Maximin- determine the worst possible pay off for each
alternatives and choose the alternative that has the “best
worst”. The maximum approach is essentially a
pessimistic one because it takes into account only the
worst possible outcome for each alternative . The actual
outcome may not be as bad as that, but this approach
establishes a “guaranteed minimum”
2. Maximax – determine the best possible payoff and
choose the alternative with the payoff. The maximax
approach is an optimistic , “go for it” strategy . It does not
take into account any proof other that best .
3. Laplace – determine the average payoff for each
alternative and choose the alternative with the
best average. The Laplace approach treats the
states of nature as equally likely.
4. Minimax regret – determine the worst regret for
each alternative and choose the alternative with
the “best worst”. This approach seeks to minimize
the difference between the payoff that is realized
and he best payoff for each states of nature .
• Pay off table – is a table showing the expected
pay offs for each alternative in every possible
states of nature. They are typically expressed
in terms of profit , revenues or cost .
 Example # 1
Without Probabilities
In Growing the best payoff is 70, In Stable the best payoff is 45, In
Declining the best payoff is 5.
 Example # 2
Without Probabilities
Cost example

In this example the payoff is cost, therefore the smaller the better
In this example the payoff is cost, therefore the smaller the better
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08/28/2021 27
The approach in determining the best alternative is exactly the same
for profit and cost problems
 Problem solving #1 :
The Southern Textile Company is contemplating the future of one of its
plants located in South Carolina . 3 alternative decisions are being
considered. 1) Expand the “plant and produce lightweight , durable
materials for possible sale to the military , a market with little foreign
competition ; 2) maintain the status quo at the plant , continuing production
of textile goods that are subject to heavy foreign competition; or 3) sell the
plant now. If one of the first two alternatives is chosen , the plant will still
be sold at the end of the year . The amount of profit that could be earned
by selling the plaint in a year depends on foreign market conditions ,
including the status of a trade embargo bill in Congress .

Determine the best decision using each of the decision criteria:

a.Maximax
b.Maximin
c.Minimax regret
d.Laplace
 Problem Solving #2
• A food product company is contemplating introduction of
revolutionary new product with new packaging to replace the
existing product at much price (S1) or moderate change in the
composition of the existing product with a new packaging at a
small increase in price (S2) or small change in the composition of
the existing except the word “new” with a negligible increase in
price (s3) . The three possible states of nature of events :
(i) High increase in sales(N1) ; (ii) no change in sales (N2) ; or (iii)
decrease in sales(N3)
The marketing department of the company worked out the
payoffs in term of yearly net profit for each course for these
events (expected sales)
 Decision Making with Probabilities
• Expected Value
- is the most widely used decsion – making
criterion under risk.
- a weighted average of decision outcomes in
which each future state of nature is a probability
of occurrence
- computed by multiplying each outcome by the
probability of its occurrence and then summing
these products according to the following formula
 Expected Value of Perfect Information
- it is the maximum value of perfect
information to the decision maker

EVPI = Expected value given perfect

information – Expected value without perfect
information
 Example # 1
Assume that it is now possible for the
Southern Textile Company to estimate the
probability of 0.70 that good foreign
competitive conditions will exist and a
probability of 0.30 that poor conditions will
exist in the future. Determine the best
decision using expected value .
 DECISION TREE

• Is a visual tool that can represent the key elements

in a model for decision making under uncertainty
and help organize those elements by
distinguishing between decision and random
events
• Is a specialized model for recognizing the role of
uncertainties in a decision-making situation.
• Decision Trees are commonly used in
Operations Research, specifically in decision
analysis, to help identify a strategy most likely
to reach a goal.
• It is a descriptive means for calculating
conditional probabilities
 Representing Decision Trees

- decisions or controllable variables

- chance events or uncontrollable variables

- End nodes or results

Note: A decision tree has only bust nodes and have

no converging paths
 Importance of Decision Trees
• It helps us distinguish between random
events.
• Sort out the sequence in which they occur
• Provide us with an opportunity to consider the
possible states in a random environment
when there are several resources of
uncertainty, and they become components of
decision trees
 Advantages of Decision Trees

• Are simple to understand and interpret

• Have value even with little hard data
• Use a white box model
• Can be combined with other decision
techniques
 How to Draw a Decision Tree
1. Start a decision you need to make.
2. Draw a small square to represent this towards the left of where
you draw it
3. Draw a line from this box towards the right with each having a
possible solution and write the solution along the line
4. At the end of each line, consider the results. If the result of
taking that decision leads to another decision, draw another box
and if it leads to uncertainty, draw a circle then write the decision
or factor above the box or circle
5. Keep on doing this until you have drawn as many of the possible
outcomes and decisions as you can see leading on from original
decisions.
 Example 1

Clarke Coffee operates a chain of five luxury coffee shops in

Chesire. It is looking at two options to increase revenues across
the chain. It can either launch a loyalty card or cut prices. If there
is high sales on the launch of loyalty card, the company will earn
£1,000,000 or if there is low sales, the company will earn
£750,000 with a probability of 0.6 and 0.4 respectively. On the
other hand, if the company cut prices while high and results to
high on sales, the company will earn £800,000 and £500,000 if
low on sales and with a probability of 0.8 and 0.2 respectively.
Decision Tree
 Low Sales High Sales
Launch a Loyalty Card £750,000 £1,000,000
Cut Prices £500,000 £800,000

EV (launch) = 750,000 (0.4) + 1,000,000 (0.6) = 900,000

EV (cut price) = 500,000 (0.2) + 800,000 (0.8) = 740,000

Decision Outcome: 750,000 (0.4) + 1,000,000 (0.6) = 900,000

EVPI= 900,000-900,000= 0
 Example 2

Jenny Lind is a writer of romance novels. A movie company and a

TV network both want exclusive rights to one of her more
popular works. If she signs with the network, she will receive a
single lump sum, but if she signs with the movie company, the
amount she will receive depends on the market response to her
movie. The probabilities of a small, medium and big box office
are 0.3, 0.6, and 0.1 respectively. What should she do?
 Decision Tree
Small Box Office
200,000
Sign with Movie Company
Medium Box Office
1,000,000
Big Box Office
3,000,000

Small Box Office

900,000
Sign with TV network Medium Box Office
900,000
Big Box Office
900,000
 Small Box Office Medium Box Office Big Box Office

Sign with Movie

company $200,000 $1,000,000 $3,000,000
Sign with TV
network $900,000 $900,000 $900,000

EV (movie)= 200,000 (0.3) + 1,000,000 (0.6) + 3,000,000 (0.1) = 960,000

EV (tv network)= 900,000 (0.3) + 900,000 (0.6) + 900,000 (0.1) = 900,000

Decision Outcome: 900,000 (0.3) + 1,000,000 (0.6) + 3,000,000 (0.1) = 1,170,000

EVPI= 1,170,000- 960,000 = 210,000
 Example 3
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 demand probabilities as 0.1, 0.5, and 0.4.
 Given Pay off Table

0.1 0.5 0.4

Low Medium High
Arrange for subcontracting $10,000 50,000 90,000
Construct new facility -120,000 25,000 200,000
Do nothing 20,000 40,000 60,000
 Small
10,000
Arrange for subcontracting Medium
50,000
High 90,000
Small
-120,000
Construct a new facility Medium
25,000
High 200,000
Small
20,000
Do nothing Medium
40,000
High
60,000
• EV (arrange) = 10,000 (0.1) + 50,000 (0.5) + 90,000 (0.4) = 62,000
EV (construct) = -120,000 (0.1) + 25,000 (0.5) +200,000 (0.4) =80,500
EV (do nothing) = 20,000 (0.1) + 40,000 (0.5) + 60,000 (0.4) = 46,000
•
Decision Outcome: 20,000 (0.1) + 50,000 (0.5) + 200,000 (0.4)= 107,000
EVPI= 107,000- 80,500= 26,500