Supplement 5

Decision Theory

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Supplement 5: Learning Objectives
• You should be able to:
– Describe the different environments under which operations are
made
– Describe and use techniques that apply to decision making
under uncertainty
– Describe and use the expected value approach
– Construct a decision tree and use it to analyze a problem
– Compute the expected value of perfect information
– Conduct sensitivity analysis on a simple decision problem

5S-2
Expected Value of Perfect Information

• Expected value of perfect information (EVPI)

– The difference between the expected payoff with perfect
information and the expected payoff under risk
– Two methods for calculating EVPI
• EVPI = expected payoff under certainty – expected payoff under risk
• EVPI = minimum expected regret

5S-3
In-House or Outsourcing
Outsource: obtain a good or service
from an external provider

1. Available capacity
2. Expertise
3. Quality considerations
4. Nature of demand
5. Cost
6. Risk

5S-4
5-4
 Developing Capacity Alternatives

1.Design flexibility into systems

2.Take stage of life cycle into account
3.Take a “big picture” approach to capacity
changes

5S-5
5-5
 Bottleneck Operation

10/hr Bottleneck operation: An operation

Machine
Machine #1
#1 in a sequence of operations whose
capacity is lower than that of the
other operations
10/hr
Machine
Machine #2
#2 Bottleneck
Bottleneck 30/hr
Operation
Operation
Machine
Machine #3
#3 10/hr

Machine
Machine #4
#4 10/hr
Figure 5.2

5S-6
5-6
Bottleneck Operation

Bottleneck

Operation 1 Operation 2 Operation 3

10/hr.
20/hr. 10/hr. 15/hr.

Maximum output rate

limited by bottleneck

5S-7
5-7
Developing Capacity Alternatives
4. Prepare to deal with capacity “chunks”
5. Attempt to smooth out capacity requirements
6. Identify the optimal operating level (next 3 slides)

5S-8
5-8
Optimal Operating Level

Optimal
Output
Rate

5S-9
Economies and Diseconomies of Scale

• Economies of Scale
– If output rate is less than the optimal level, increasing
the output rate results in decreasing average per unit
costs
• Diseconomies of Scale
– If the output rate is more than the optimal level,
increasing the output rate results in increasing
average per unit costs

5S-10
 Economies of Scale
Figure 5.5
Minimum cost & optimal operating rate are
functions of size of production unit.
Average cost per unit

Small
plant Medium
plant Large
plant

0 Output rate

5S-11
5-11
Evaluating Alternatives
• Cost-volume analysis
– Break-even point
• Financial analysis
– Cash flow
– Present value
• Decision theory
• Waiting-line analysis

5S-12
5-12
Decision Theory
• A general approach to decision making that is
suitable to a wide range of operations
management decisions
– Capacity planning
– Product and service design
– Equipment selection
– Location planning

5S-13
Characteristics of Suitable Problems
• Characteristics of decisions that are suitable for
using decision theory
– A set of possible future conditions that will have a
bearing on the results of the decision
– A list of alternatives from which to choose
– A known payoff for each alternative under each
possible future condition

5S-14
Process for Using Decision Theory
1. Identify the possible future states of nature
2. Develop a list of possible alternatives
3. Estimate the payoff for each alternative for each
possible future state of nature
4. If possible, estimate the likelihood of each possible
future state of nature
5. Evaluate alternatives according to some decision
criterion and select the best alternative

5S-15
Causes of Poor Decisions
• Decisions occasionally turn out poorly due to
unforeseeable circumstances; however, this is
not the norm.
• More frequently poor decisions are the result of
a combination of
– Mistakes in the decision process
– Bounded rationality
– Suboptimization

5S-16
Decision Process
• Steps:
1. Identify the problem
2. Specify objectives and criteria for a solution
3. Develop suitable alternatives
4. Analyze and compare alternatives
5. Select the best alternative
6. Implement the solution
7. Monitor to see that the desired result is achieved
• Errors
– Failure to recognize the importance of each step
– Skipping a step
– Failure to admit mistakes

5S-17
Bounded Rationality & Suboptimization

• Bounded rationality
– The limitations on decision making caused by costs,
human abilities, time, technology, and availability of
information
• Suboptimization
– The results of different departments each attempting
to reach a solution that is optimum for that
department

5S-18
Decision Environments
• There are three general environment categories:
– Certainty
• Environment in which relevant parameters have known
values
– Risk
• Environment in which certain future events have probable
outcomes
– Uncertainty
• Environment in which it is impossible to assess the likelihood
of various future events

5S-19
Decision Making under Uncertainty
Maximin - Choose the alternative with the best
of the worst possible payoffs

Maximax - Choose the alternative with the best

possible payoff

Laplace - Choose the alternative with the best

average payoff of any of the alternatives

Minimax Regret - Choose the alternative that

has the least of the worst regrets

5S-20
5S-20
5S-21
Decision Making Under Risk
• Risk: The probability of occurrence for each
state of nature is known
• Risk lies between the extremes of uncertainty
and certainty
• Expected monetary value (EMV) criterion:
– The best expected value among alternatives
– Determine the expected payoff of each alternative, and
choose the alternative with the best expected payoff

5S-22
5S-22
30% low, 50% moderate, 20% high

5S-23
Decision Tree
– Composed of
• Nodes
– Decisions – represented by square nodes
– Chance events – represented by circular nodes
• Branches
– Alternatives– branches leaving a square node
– Chance events– branches leaving a circular node
– Analyze from right to left
• For each decision, choose the alternative that will yield the greatest return
• If chance events follow a decision, choose the alternative that has the
highest expected monetary value (or lowest expected cost)

5S-24
Format of a Decision Tree

5S-25
Decision Trees
• Decision tree: a Schematic representation of
the available alternatives and their possible
consequences.
• Useful for analyzing situations that involve
sequential decisions
• See Figure 5S.1

5S-26
5S-26
 Format of a Decision Tree
Figure 5S.1
1
f n a t u re Payoff 1
o
Decision Point State
Chance Event eA ’1 Payoff 2
’ C hoos
A St a t e
se o f n at 2
o o u re 2
h C h o o se Payoff 3
C A’2
B
1
e A’ 3 Payoff 4
1 C hoos
a t u re
C

o f n 2
ho

State
os

C h o o se Payoff 5
e

A’4
A
’2

St a t e
o f n at Payoff 6
u re 2

5S-27
5S-27
5S-28
 Cost-Volume Relationships
Figure 5.6a

FC
+
Amount ($)

VC C)
=t t (V
co
s
cos
tal e l
o ab
T ari
l v
o ta
T
Fixed cost (FC)

0
Q (volume in units)

5S-29
5-29
 Cost-Volume Relationships
Figure 5.6b

ue
en
Amount ($)
ev
r
t al
To

0
Q (volume in units)

5S-30
5-30
Cost-Volume Relationships

u e
e n f i t
Amount ($)

e v r o
r P
al t
t o s
To t a l c
To

0 BEP units
Q (volume in units)
Figure 5.6c
5S-31
5-31
Break-Even Problem with Step
Fixed Costs
C =
+ V
FC
C TC
C =T
+V
FC 3 machines
T C
C =
V
+ 2 machines
FC

1 machine
Quantity
Step fixed costs and variable costs.
Figure 5.7a
5S-32
5-32
Break-Even Problem with Step
Fixed Costs
$
BEP
3
TC
BEP2
TC
3
TC
2
TR 1
Quantity
Multiple break-even points
Figure 5.7b
5S-33
5-33