Faculty of Management & Finance

University of Colombo

Masters in Business Administration (MBA) : 2017-2019 - Trimester VI

MBAMK 5222 / MBAAI 5224 / MBA 5238 : Supply Chain Development & Integration

Name of Lecturer: M. Prasad F. Jayasuriya

Lecture No. 7 : 15-February-2020 Hand Out No. 7

PROBABILITY CONCEPTS, EXPECTED VALUES & BUSINESS DECISION MAKING

Introduction
Business decisions are always made under conditions of uncertainty like many other decisions
relating to the future. The most certain thing is that the future is uncertain. If all business
decisions can be taken under conditions of certainty, the only valid justification for a poor
decision would be the failure to consider all relevant facts. Certainty here means an ability to
make a correct forecast in to the future. No body under any circumstances can ever operate in a
world of absolute certainty. The businessmen are forced to make decisions when they are very
uncertain as to what will happen after their decision. In this uncertain situation the mathematical
theory of probability, first expounded in France in 1654 affords a helping hand to the decision
maker.

Definition of Probability
Probability is a branch of mathematics that calculates the likelihood of a given event occurring,
and is often expressed as a number between 0 and 1. It can also be expressed as a proportion or
as a percentage. If an event has a probability of 1 it can be considered a certainty; An event with
a probability of 0 can be considered as impossibility.

Accordingly we can define the probability of an event, denoted by P (event) as below;

P (Event) = Total number of outcomes which constitute the event

Total number of possible outcomes

This is known as ‘Exact’ probability because it involves having a complete list of all possible
outcomes and counting the exact number that constitute the event. An example will be the
throwing of an unbiased coin.

However, this definition is not always practical for business purposes, as you can rarely state all
the possible outcomes. Thus we introduce two more types of probabilities;

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 (1) Empirical Probability - Finding exact probability necessitates obtaining a list of the
possible outcomes, as well as the outcomes which make the given event. In certain
situations it is clearly impossible to keep such a detailed record of every possibility and
hence an alternative, feasible approach is to take a sample of components. The
probabilities produced in this way are known as empirical and are essentially
approximations to the true, but unobtainable, exact probabilities. Example – Probability
of a light failing within 1 year after installation.

(2) Subjective Probability - There are many practical instances in which a suitable sample
is unavailable; so an empirical probability too cannot be found. In such cases a subjective
probability could be estimated, based on judgement and experience. Although such
estimates are not entirely reliable, they can often be useful for business decision making.
In the case of subjective interpretations, historical information may not be available and
instead of objective evidence, personal experience often become the basis of the
probability assignment. For business decision making purposes the subjective
interpretation is frequently required since reliable objective evidence may not be
available. Example – We have a 10% chance of making profits next year.

Independent Events - Events may be either independent or dependent. If two events are
statistically independent, the occurrence of one event will not have an effect or impact on the
occurrence of the second event.

Mutually Exclusive Events - Two events are said to be Mutually Exclusive, if the occurrence of
one event exclude the possibility of occurrence of the second event.

BASIC Rules of PROBABILITY

1. If two events A and B are mutually exclusive and together cover all possibilities then
P(A) + P(B) = 1

2. In a set of mutually exclusive events (i.e. only one of the events can occur on any one
trial), the probabilities of these events can be added to obtain the probability that at least
one of these events will occur in any one trial.

3. P (A is not true) = 1 - P (A is true); This is in practice a remarkably useful rule. It. often
happens that it is easier to calculate the probability of the very opposite of the event you
are interested in. It is certainly always worth thinking about if you are not sure how to
proceed.

4. Addition Rule of Probability; P(A or B) = P (A U B) = P(A) + P(B) – P (A & B)

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 5. Special Addition Rule of Probability for mutually exclusive events ; P(A or B) = P (A U
B) = P(A) + P(B) ; where P (A & B) = 0

6. Multiplication Rule of Probability ; P(A & B) = P (A ∩ B) = P(A) x P(B│A)

Where P(B│A) means the probability of event B, subject to the condition that event A
has already occurred or is certain to occur. In other words it denotes the CONDITIONAL
probability of event B, subject to the condition that event A has already occurred or is
certain to occur.

7. Special Multiplication Rule of Probability for Independent events ; P(A & B) = P (A ∩

B) = P(A) x P(B) ; where P(B│A) = P(B)

Example 1

Company has three offices in Colombo, Kandy and Matara with 60, 40 and 30 employees
respectively. The professionally qualified employees in these three offices are 60%, 25% and
40% respectively. What is the probability that a randomly selected employee,
(i) Work in Colombo or Matara ?
(ii) Work at Colombo or professionally qualified or both ?
(iii)Work at Kandy and not professionally qualified ?

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EXPECTED VALUE & DECISION MAKING

Now we consider the application of probability concepts to business decisions which must be
made under conditions of uncertainty. We shall attempt to develop a means of making consistent
decisions and of estimating the cost of uncertainty. We shall discuss the Expected Monetary
Value as the appropriate criterion for decision making.

Expected Monetary Value of an event x can be defined as below; EMV (x) = Σ x.P(x)

Example
Suppose a grocer is faced with the problem of how many cases of milk to stock to meet
tomorrow’s demand. Assume any milk that is left over at the end of the day has to be discarded.
Assume also that any unsatisfied demand carries no cost except the profit from the lost sale.

Suppose the grocer has maintained records of past sales as shown below.

Number of days
Total demand per day
each demand level was recorded

25 Cases 20

26 Cases 60

27 Cases 100

28 Cases 20

TOTAL 200

Suppose the purchase price is Rs. 80/- per case and the selling price is Rs. 100/- per case.

Conditional profit table or ‘Pay off’ table

Possible actions

Event
Stock 25 Stock 26 Stock 27 Stock 28
(Demand)
25 cases Rs. 500 Rs. 420 Rs. 340 Rs. 260

26 cases 500 520 440 360

27 cases 500 520 540 460

28 cases 500 520 540 560

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EXPECTED MONETARY VALUE
The expected monetary value is calculated by multiplying the conditional values of each event in
the conditional value table by the probability of the event occurring and adding the products.
The resulting number is the EXPECTED MONETARY VALUE for the act.
The optimum act is the one with the highest expected monetary value.

Probability of
Event
event Stock 25 Stock 26 Stock 27 Stock 28
(Demand)
.

Expected Expected Expected Expected

Value Value Value Value

25 0.10 Rs. 50 Rs. 42 Rs. 34 Rs. 26

26 0.30 150 156 132 108

27 0.50 250 260 270 230

28 0.10 50 52 54 56

1.00 Rs.500 Rs.Rs.510 Rs.490 Rs.420

SAME DECISION USING THE EXPECTED OPPORTUNITY LOSS

The grocer can also choose the optimal action by minimising the expected opportunity loss.

Opportunity loss can be defined in general as the amount of profit foregone by not choosing
the best act for each event.

Conditional Opportunity loss table

Event
Stock 25 Stock 26 Stock 27 Stock 28
(Demand in Cases)
25 0 80 160 240

26 20 0 80 160

27 40 20 0 80

28 60 40 20 0

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Calculation of Expected Opportunity losses

Probability of
Event
event Stock 25 Stock 26 Stock 27 Stock 28
(Demand)
.

Expected Expected Expected Expected

Opportunity Opportunity Opportunity Opportunity
loss loss loss loss
25 0.10 Rs. 0 Rs. 8 Rs. 16 Rs. 24

26 0.30 6 0 24 48

27 0.50 20 10 0 40

28 0.10 6 4 2 0

1.00 Rs. 32 Rs.22 Rs.42 Rs.112

Problem No. 1

Assume the following conditional value table applies to a decision.

Event Probability of event Act 1 Act 2 Act 3

A 0.35 4 3 2

B 0.45 4 6 5

C 0.20 4 6 8

Present a table of expected monetary values and determine the optimal act.

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Problem No. 2

A storeholder has to decide how many units of a perishable commodity X to buy each day. Past
demand has followed the distribution:

Demand (units) Probability

1 0.2
2 0.4
3 0.4

Each unit is bought for Rs.100 and sold for Rs.200, and at the end of each day, any unsold units
can be sold for Rs.50 per unit to another party.

Using the EV criterion, how many units should be bought daily ?

Problem No. 3

Nimesh Garments produces specialty T-shirts that are primarily sold at special events. They are
trying to decide how many to produce for an upcoming event. During the event itself, which lasts
one day, they can sell T-shirts for Rs.750 apiece. However, when the event ends, any unsold T-
shirts are sold for at Rs.400 apiece. It costs them Rs.500 to make a specialty T-shirt.

Assuming the demand to be as follows, how many T-shirts should they produce for the
upcoming event?

Demand Probability

300 0.05

400 0.10

500 0.40

600 0.30

700 0.10

800 0.05

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 Probability & Decision Making Practice Problem

A yoghurt distributor is in the process of determining the purchase order quantity for
the coming week. Based on the demand indications given by the retailers, he has
developed the following table;

Weekly Demand (Yoghurt cups) Probability

28,000 0.20
31,000 0.45
34,000 0.25
36,000 0.10

24 hours before the delivery, retailers can adjust their final order quantity up to +/- 12%
of the weekly indications given. The distributor buys a yoghurt cup at Rs.15.00 from Pio
Yoghurt (Pvt) Ltd. and sells them to retailers at Rs. 19.00.

The total costs of the distributor operation, which includes transport and other overheads
and also freezer storing capacity for 5000 yoghurts is Rs. 80,000.00 per week. This also
includes the costs of a safety stock of 4000 yoghurts which the distributor maintains in
his freezer store to satisfy short terms demands that can come up during the week. If he
needs extra freezer capacity for storing yoghurts, he will have to pay additional Rs.2 per
week per yoghurt.

With this information help the distributor to determine the optimal weekly order quantity
to raise the purchase order, using ‘Expected Monetary Value’ as the decision criteria, if
there were exactly 4000 yoghurts in the distributor freezer store at the time of ordering.

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