QUATECH DR. E.

SARREAL

MANAGERS USE QUANTITATIVE APPROACHES IN DECISION MAKING WHEN: 1. 2. 3. 4. 5. The problem is complex The problem involves variables There are data which describe the decision environment There are data which describe the value of utility of the different possible alternatives The goals of the decisionmaker or her organization can be described in quantitative terms/the goal is quantifiable 6. Workable models are available for these situations SIX BASIC STEPS IN DECISION MAKING 1. 2. 3. 4. 5. State the problem State the objective Identify all viable alternatives Identify all future events that will possibly affect the decision Compute the pay off (return/profit/benefit that accrues from a possible combination of alternatives and state of nature) of each alternative and construct pay off table 6. Make the decision for the best alternative THREE DIFFERENT ENVIRONMENTS: 1. UNDER CERTAINTY - 1 future event is assumed to happen 2. UNDER UNCERTAINTY - 2 or more events are assumed to happen and the probability cannot be determined 3. UNDER RISK - 2 or more future events are assumed to happen and the probability can be determined p. 194/4-4 Alternatives State of Nature High Moderate Low Failure Overhaul (O) $30,000 10,000 -5,000 -50,000 Expand (E) $60,000 20,000 -10,000 -70,000 Buy (B) $50,000 15,000 -20,000 -60,000 Do Nothing (DN) $3,000 2,000 -1,000 -5,000

CRITERIA UNDER UNCERTAINTY a. MAXIMAX CRITERION (criterion of optimism) 1. Determine the max pay off of each alternative O E B 2. Select the highest of these max pay offs. Decision: ________________ b. MAXIMIN CRITERION (criterion of pessimism) 1. Determine the min pay off of each alternative O E

DN

DN

2. Select the highest of these min pay offs. Decision: ________________

QUATECH DR. E. SARREAL

c. MINIMAX REGRET CRITERION 1. Construct the regret table. REGRET VALUE: maximum value of future event or state of nature minus pay off of the alternatives of this event Regret Table Alternatives Overhaul (O) Expand (E) Buy (B) Do Nothing Max value of (DN) each event State of Nature High Moderate Low Failure 2. Determine the maximum regret value of each alternative O E B DN 3. Select the lowest of these max alternative. Decision: ______________ d. Criterion of realism 1. Assign a weight for optimism and 1- for pessimism. Thus, if = 80% 2. Compute for the measure of realism (MR) for each alternative MR = (max pay off) + (1-) (min pay off) MRO = MRE = MRB = MRDN = 3. Select the highest MR. Decision: _____________________________ CRITERIA UNDER RISK Alternatives State of Nature High Moderate Low Failure Overhaul (O) $30,000 10,000 -5,000 -50,000 Expand (E) $60,000 20,000 -10,000 -70,000 Buy (B) $50,000 15,000 -20,000 -60,000 Do Nothing (DN) $3,000 2,000 -1,000 -5,000 Probability (p) 1- = 20%

a. EXPECTED VALUE CRITERION (EV) 1. Compute EV of each alternative m EV = pi xi i=1 EVO = EVE = EVB = EVDN = 2. Select the alternative with highest EV. Decision: _________________ b. MAXIMUM LIKELIHOOD CRITERION 1. Identify the future event which is most likely to occur: _________ 2. Select the alternative which has the highest pay off for this event. Decision: _______________________________________________

QUATECH DR. E. SARREAL

c. CRITERION OF RATIONALITY 1. Assign equal probability for each event. P of each event = 1/# of events 2. Compute for the EV for each m EV = pi xi i=1 EVO = EVE = EVB = EVDN = 3. Select the alternative with the highest EV. Decision: ______________ DECISION MAKING UNDER RISK (DEMAND IS DISCRETE RANDOM VARIABLE) MAXIMIZE EXPECTED PROFIT (VALUE) 1. Marginal Profit = SP per unit - VC per unit 2. Compute for probabilities Daily Demand No. of days demanded 10 11 12 13 18 36 27 9

Probability of each level of demand

3. Conditional Profit Table MP per case= $5 ML per case = $3 To Stock 10 11 To Sell 10 11 12 13 4. Compute for EV m EV = pi xi i=1 EV10 = EV11 = EV12 = EV13 =

12

13

5. Select the alternative with the highest EV. Decision: ______________ 6. Identify EV with perfect information 7. Compute for EV with perfect information (EVPI) EVPI = pi (max profit of the event) EVPI =

QUATECH DR. E. SARREAL

8. Compute for worth of perfect information (WPI) WPI = EVPI - max EV WPI = MINIMIZE EXPECTED LOSSES 1. Obsolescence losses (demand < stock) vs Opportunity losses (demand > stock) 2. Construct conditional loss table To Stock 10 11 12 To Sell 10 11 12 13 3. Compute for EL m EL = pi xi i=1 EL10 = EL11 = EL12 = EL13 = 4. Select the alternative with the lowest EL. Decision: ______________ MARGINAL ANALYSIS APPROACH 1. Compute for Marginal Probability ML P = = MP + ML 2. Compute for cumulative probability of each event To Stock 10 11 12 13 To Sell 10 11 12 13

13

Cumulative P

3. Select the alternative whose cumulative probability is immediately greater than the marginal probability 4. Compute the EV of this alternative CONDITIONAL PROFIT TABLE WITH SALVAGE VALUE

QUATECH DR. E. SARREAL 1.

Compute for Marginal Profit with Salvage Value (MPS) MPS= Profit per event - cost of unsold + salvage value per case If salvage value is $2 per case, To Stock 10 11 12

13

To Sell 10 11 12 13 2. Determine EVPI EVPI = pi (max profit of the event) EVPI = 3. Determine WPI WPI = EVPI - max EV WPI = CONDITIONAL LOSS TABLE WITH SALVAGE VALUE USING MARGINAL ANALYSIS APPROACH 1. Compute for Marginal Probability ML P = = MP + ML 2. Compute for cumulative probability of each event To Stock Cumulative 10 11 12 13 p P To Sell 10 11 12 13 3. Select the alternative whose cumulative probability is immediately greater than the marginal probability 4. Compute for EL m EL = pi xi i=1 EL10 = EL11 = EL12 = EL13 = 5. Select the alternative with the lowest EL. Decision: ______________

QUATECH DR. E. SARREAL