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2011 Lew Hofmann

Decision Making
2011 Lew Hofmann
Overview
Break-Even Analysis

Preference Matrices

Payoff Tables (Decision Tables)

Decision Trees
2011 Lew Hofmann
Break-Even Analysis
Break-even analysis is used to compare processes
by finding the volume at which two different
processes have equal total costs.
Break-even point is the volume at which total
revenues equal total costs.
Variable costs (c) are costs that vary directly with
the volume of output. (EG: material costs, labor, etc.)
Fixed costs (F) are those costs that remain constant
with changes in output level. (EG: Insurance, rent,
property taxes, etc.)
2011 Lew Hofmann
Break-Even Analysis
Gives you a comparison of Revenues and
Total Costs over a range of operations/output.
Assumes all changes are linear
Fixed Costs (F) are assumed to be level and
constant as output changes.
Variable Costs (c) are assumed to change linearly
with output.
Revenues are assumed to change linearly with
output.
In reality, no changes are linear, but the
technique can still be helpful.
2011 Lew Hofmann
Break-Even Graph
D
o
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l
a
r
s

Volume of Output (Q)
Fixed Costs
Total Costs
Total Revenues
Break-Even Point
2011 Lew Hofmann
Break-Even Analysis
in the real world.
Fixed costs increase incrementally as output
capacity increases.
As capacity increases, periodic expansion of plant
and equipment is required, insurance cost and
taxes increase
Variable Cost increase is curvilinear as
output production increases.
As you purchase greater quantities of materials,
you usually get quantity discounts.
Revenue increase is curvilinear as output
increases.
Quantity discounts are given to larger sales.
2011 Lew Hofmann
The Complications of
Non-linearity
D
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l
a
r
s

Volume of Output (Q)
Fixed Costs
Variable Costs
2011 Lew Hofmann
Q is the volume in units
c is the variable cost per unit
F is the total fixed costs
p is the revenue per unit
cQ is the total variable cost.
(Variable cost per unit x Volume)
Total cost = F + cQ (Fixed costs + total Variable costs)
Total revenue = pQ (Revenue per unit x Volume)
Break even is where Total Revenue = Total
costs: pQ = F + cQ

Break-Even Analysis
(You dont need the formula for exams.)
2011 Lew Hofmann
Break-Even Analysis
can tell you
...if a forecast sales volume is sufficient to make
a profit, or at least cover your costs.
...how low your variable cost per unit must be to
break even, given current product price and
sales-volume forecast.
...what the fixed cost need to be to break even.
...how price levels affect the break-even volume.
2011 Lew Hofmann
Hospital Example
A hospital is considering a new procedure to be offered,
billed at $200 per patient. The fixed cost (F) per year is

$100,000, with variable costs at $100 per patient.

How many patients do they need to cover their costs?
(I.E. what is the break-even level for this service?)
Q = F / (p - c) = 100,000 / (200-100) = 1,000 patients
Where Q = total # of patients; F = fixed costs; p = revenue per unit;
c = variable costs per patient
2011 Lew Hofmann
Using Excel Solver
Select the Break-Even solver model on the L-Drive
(under my name)





Select MGT 360

2011 Lew Hofmann
Using Excel Solver cont.
Select Excel Solver Models





Select the Break-Even
Analysis model.

2011 Lew Hofmann
Enabling the Macros
Mac
PC
2011 Lew Hofmann
Running The Model
You will get this screen whether you enable the
macros or not, but your answer wont be correct if
you dont enable them.


2011 Lew Hofmann
Total Costs
Total Revenue
Using the Excel Solver,
enter the data requested
in the yellow blocks, and
the answer will appear in
the green block, along
with the chart.
2011 Lew Hofmann
Patients (Q)
D
o
l
l
a
r
s

| | | |
500 1000 1500 2000
Quantity Total Annual Total Annual
(patients) Cost ($) Revenue ($)
(Q) (100,000 + 100Q) (200Q)
0 100,000 0
2000 300,000 400,000
Hospital Example
(solved using graphical method)
40,000
30,000
20,000
10,000
0
2011 Lew Hofmann
40,000
30,000
20,000
10,000
0
Patients (Q)
D
O
L
L
A
R
S

| | | |
500 1000 1500 2000
(2000, 40,000)
Total annual revenues
Quantity Total Annual Total Annual
(patients) Cost ($) Revenue ($)
(Q) (100,000 + 100Q) (200Q)
0 100,000 0
2000 300,000 400,000
2011 Lew Hofmann
Quantity Total Annual Total Annual
(patients) Cost ($) Revenue ($)
(Q) (100,000 + 100Q) (200Q)
0 100,000 0
2000 300,000
400,000
Total annual costs
Patients (Q)
D
O
L
L
A
R
S

| | | |
500 1000 1500 2000
Fixed costs
(2000, 40,000)
(2000, 30,000)
Total annual revenues
40,000
30,000
20,000
10,000
0
2011 Lew Hofmann
Total annual revenues
Total annual costs
Patients (Q)
| | | |
500 1000 1500 2000
Fixed costs
Break-even quantity is 1000 patients
(2000, 40,000)
(2000, 30,000)
Profits
Loss
Quantity Total Annual Total Annual
(patients) Cost ($) Revenue ($)
(Q) (100,000 + 100Q) (200Q)
0 100,000 0
2000 300,000 400,000
D
O
L
L
A
R
S

40,000
30,000
20,000
10,000
0
2011 Lew Hofmann
40,000
30,000
20,000
10,000
0
Total annual revenues
Total annual costs
Patients (Q)
| | | |
500 1000 1500 2000
Fixed costs
Profits
Loss
Sensitivity Analysis
Forecast (Q) = 1,500
pQ (F + cQ)

200(1500) [100,000 + 100(1500)]

= $5,000 profit
Per-patient cost of the
procedure.
D
O
L
L
A
R
S

2011 Lew Hofmann
Two Processes and
Make-or-Buy Decisions
Breakeven analysis can be used to choose
between two different processes
Also can be used to decide between using an
internal process or outsourcing that process
service.
The solution finds the point at which the total
costs of each of the two processes are equal.
A forecast of sales (volume level) is then
applied to see which alternative (process)
has the lowest cost for that volume.
2011 Lew Hofmann
Two-Process Example
Process #1 fixed costs for making
widgets is $12,000, and the variable
cost is $1.50 per unit.
Process #2 fixed costs for making
widgets is $2400 and the variable cost
is $2.00 per unit.
If expected demand is 25,000 widgets,
which process is less expensive?
2011 Lew Hofmann
Breakeven for
Two Processes
For any volume above 19,200
units, Process #1 should be
used.
2011 Lew Hofmann
Q =
F
m
F
b

c
b
c
m

Q =
12,000 2,400
2.0 1.5
Breakeven for
Two Processes
Q = 19,200
2011 Lew Hofmann
An analysis that allows you to rate alternatives by
quantifying tangible and/or intangible criteria.
Criteria are ranked and weighted for each
alternative being evaluated.
Each score is weighted according to its perceived
importance to you, with the total weights typically
equaling 100.
Thus it measures your preference.
Alternative with highest sum of the weighted
scores is the one you most prefer.
Preference Matrix
2011 Lew Hofmann
Using the
Preference Matrix
(A hypothetical example)
Problem: Where to go to dinner.
Possible Criteria:
Price
Quality
Distance
Atmosphere
Type of food
2011 Lew Hofmann
Weighting the Criteria
Criteria
Price
Quality
Distance
Atmosphere
Type of food
Weight
4
1
3
1
1
These are the criteria I selected, and the weights are how
important each criteria is relative to the other criteria.

I used a scale of 1-10 (1 being 10% of the weight), but any
scale can be used.
2011 Lew Hofmann
Evaluating
McDonalds
Criteria Weight
(w)
Eval.
(e)
Score
(w)(e)
Price 4 10 40
Quality 1 2 2
Distance 3 8 24
Atmosphere 1 2 2
Type of food 1 5 5
73


For simplicity, the valuation scale should be the same as the one for the
weights. Evaluations are subjective, and can be individual preference or
group-consensus.

The score of 73 is used to compare with the scores from other options.
2011 Lew Hofmann
Performance Weights Scores Weighted Scores
Criterion (A) (B) (A x B)
Market potential
Unit profit margin
Operations compatibility
Competitive advantage
Investment requirement
Project risk


Threshold score = 800
Preference Matrix
(New product evaluation)
Management decides that a product
evaluation must have a total score of at
least 800 to be acceptable.
2011 Lew Hofmann
Threshold score = 800
Preference Matrix
Establishing the criteria weights
Performance Weights Scores Weighted Scores
Criterion (A) (B) (A x B)
Market potential 30
Unit profit margin 20
Operations compatibility 20
Competitive advantage 15
Investment requirement 10
Project risk 5
In this example,
the most weight
is given to a
products market
potential.
2011 Lew Hofmann
Threshold score = 800
Preference Matrix
Rating a product
Performance Weight Score Weighted Score
Criterion (A) (B) (A x B)
Market potential 30 8
Unit profit margin 20 10
Operations compatibility 20 6
Competitive advantage 15 10
Investment requirement 10 2
Project risk 5 4
These are the ratings for one of
the products being considered.
2011 Lew Hofmann
Threshold score = 800
Preference Matrix
Performance Weight Score Weighted Score
Criterion (A) (B) (A x B)
Total weighted score = 750
Market potential 30 8 240
Unit profit margin 20 10 200
Operations compatibility 20 6 120
Competitive advantage 15 10 150
Investment requirement 10 2 20
Project risk 5 4 20
2011 Lew Hofmann
Threshold score = 800
Preference Matrix
Performance Weight Score Weighted Score
Criterion (A) (B) (A x B)
Weighted score = 750
Score does not meet the
threshold and is rejected.
Market potential 30 8 240
Unit profit margin 20 10 200
Operations compatibility 20 6 120
Competitive advantage 15 10 150
Investment requirement 10 2 20
Project risk 5 4 20
2011 Lew Hofmann
2011 Lew Hofmann
Decision-Making
Terminology
Alternatives
Possible solutions or alternatives to a problem.
States of Nature (Chance Events)
Events effecting the outcome, but which the
decision-maker cannot control.
EG: What the stock market is going to do.
Payoffs
Profits, losses, costs, etc. that result from
implementing an alternative.
2011 Lew Hofmann
Decision-Making
Contexts
Certainty
Only one state of nature can occur.
You have complete knowledge about the outcome.
(Break-even analysis is decision making under certainty.)
Risk
Two or more states of nature
You know the probabilities of their occurrence
(Expected-value analysis is decision making under risk.)
Uncertainty
The number of states of nature may be unknown.
Probabilities of occurrence are unknown.
(Payoff tables are a good example.)

2011 Lew Hofmann
A Continuum of
Awareness
Decreasing Knowledge about the problem situation
Certainty
Risk
Uncertainty
Only 1 state
of nature
More than one
state of nature
with known
probabilities
States of nature
may be unknown,
or a least their
probabilities are
unknown.
2011 Lew Hofmann
Payoff Tables
Under Uncertainty

Bear
Market
Level
Market
Bull
Market

Stock A 400 500 600
Stock B 200 400 1100
Stock C 100 500 900


With uncertainty, you dont know the probabilities for the states of nature.
States of Nature
Alternatives
2011 Lew Hofmann
Payoff Tables
Under Uncertainty
Maximax
The optimists approach
Maximin
The pessimists approach
Minimax Regret
Another pessimistic approach
2011 Lew Hofmann
Maximax Approach
Pick the best of the best payoffs
Bear
Market
Level
Market
Bull
Market

Stock A 400 500 600
Stock B 200 400 1100
Stock C 100 500 900


2011 Lew Hofmann
Maximin Approach
Pick the Best of the Worst payoffs
Bear
Market
Level
Market
Bull
Market

Stock A 400 500 600
Stock B 200 400 1100
Stock C 100 500 900


2011 Lew Hofmann
Minimax Regret Approach
Minimizes the regret you would have from making the wrong choice.
Bear
Market
Level
Market
Bull
Market

Stock A 400 500 600
Stock B 200 400 1100
Stock C 100 500 900


Determine the maximum regret, if any, you could have for each payoff.
0 0
0
0
500
200 100
300 200
2011 Lew Hofmann
Regret Matrix
Compute total regrets for each alternative
and select the one with the smallest total regret.
Bear
Market
Level
Market
Bull
Market

Stock A 0 0 500
Stock B 200 100 0
Stock C 300 0 200


500
300
500
Add across each row to get the total regret for each alternative.
Pick the alternative that has the LEAST regret.
2011 Lew Hofmann
Expected Value Analysis
Decision Making Under Risk!
Bear
Market
Level
Market
Bull
Market
Probabilities
.2 .6 .2
Stock A 400 500 600
Stock B 200 400 1100
Stock C 100 500 900


2011 Lew Hofmann
Expected Value Analysis
Computing Expected Values
Bear
Market
Level
Market
Bull
Market
EV
Probabilities
.2 .6 .2
Stock A 400x.2 500x.6 600x.2

=80 =300 =120 500
Stock B 200x.2 400x.6 1100x.2

=40 =240 =220 500
Stock C 100x.2 500x.6 900x.2

=20 =300 =180 500

2011 Lew Hofmann
Expected Value Analysis
using the Excel Solver
Why does the solver model pick stock A?
(All three have the same expected value!)
2011 Lew Hofmann
Probability Distributions
as a measure of risk.
Probabilities
Expected Payoffs 100 200 300 400 500 600 700 800 900 1000 1100
.1
.2
.3
.4
.5
.6
C
B
A
Probability
distributions for
the alternatives
C
C
B
B
B A
A
C A
2011 Lew Hofmann
Standard Deviation
as a measure of risk
Alternative

Stock A

Stock B

Stock C
Standard Deviation

63.25

316.93

252.98
The lower the standard deviation,
the less likely it is that payoffs will deviate from the mean.
2011 Lew Hofmann
Coefficient of Variation
Standard Deviation only works as a measure
of risk when the expected values you obtain
are relatively similar.

Coefficient of Variation must be used to
measure risk when the expected values are
widely different.


2011 Lew Hofmann
Using Coefficient of Variation

Std. Dev.
Expected
Value
Coeff. Of
Variation
Stock A 63.25 500 0.1265
Stock B 316.93 500 0.63386
Stock C 252.98 500 0.50596


Coefficient of Variation =
Standard Deviation
Expected Value
Since the expected values are the same in this example, there is no need to use Coefficient of Variation.
2011 Lew Hofmann
Using Coefficient of Variation

Expected
Value
R.O.I
Standard
Deviation
Coefficient
of Variation
X 100 15% 23.5 .235
Y 100,000 15% 12,600 .126

Smaller coefficient of variation indicates less risk!
In this example the Expected Values of the alternatives are widely different, so we need to
use Coefficient of Variation to make our comparison.
2011 Lew Hofmann
Alternatives Low High
Small facility 200 270
Large facility 160 800
Do nothing 0 0
Events
(Uncertain Demand)
MaxiMin Decision
(another example)
1. Look at the payoffs for each alternative and identify the
lowest payoff for each.
2. Choose the alternative that has the highest of these.
(the maximum of the minimums)
2011 Lew Hofmann
Events
(Uncertain Demand)
MaxiMax Decision
1. Look at the payoffs for each alternative and identify the
highest payoff for each.
2. Choose the alternative that has the highest of these.
(the maximum of the maximums)
Alternatives Low High
Small facility 200 270
Large facility 160 800
Do nothing 0 0
2011 Lew Hofmann
MiniMax Regret
Events
(Uncertain Demand)
Look at each payoff and ask yourself, If I end up here, do
I have any regrets?
Your regret, if any, is the difference between that payoff
and the best choice you could have made with a different
alternative, given the same state of nature (event).
Alternatives Low High
Small facility 200 270
Large facility 160 800
Do nothing 0 0
2011 Lew Hofmann
MiniMax Regret
Events
(Uncertain Demand)
If you chose a small
facility and demand is
low, you have zero
regret. You could not
have done better with
a different alternative.
If you chose a large facility and
demand is low, you regret you didnt
build a small facility. Your regret is
40, which is the difference between
the 160 you got and the 200 you
could have gotten.
Alternatives Low High
Small facility 200 270
Large facility 160 800
Do nothing 0 0
2011 Lew Hofmann
MiniMax Regret
Events
(Uncertain Demand)
Alternatives Low High

Small facility 0 530
Large facility 40 0
Do nothing 200 800
Events
Total
Regrets
530
40
1000
Regret Matrix
Building a large
facility offers the
least regret.
Alternatives Low High
Small facility 200 270
Large facility 160 800
Do nothing 0 0
If you chose a small
facility and demand is
high, you forgo the
higher payoff of 800,
and thus have a
regret of 530.
2011 Lew Hofmann
Expected Value
Decision Making under Risk
Events
200*0.4 + 270*0.6 = 242
160*0.4 + 800*0.6 = 544
Multiply each payoff times the probability of
occurrence its associated event.
Select the alternative with the highest weighted payoff.
Alternatives Low High
(0.4) (0.6)
Small facility 200 270
Large facility 160 800
Do nothing 0 0
2011 Lew Hofmann
Decision Trees are schematic models
of alternatives available along with their
possible consequences.
They are used in sequential decision
situations.
Decision points are represented by
squares.
Event points (states of nature) are
represented by circles.
Decision Trees
2011 Lew Hofmann
= Event node
= Decision node
1st
decision
Possible
2nd decision
Payoff 1
Payoff 2
Payoff 3
Alternative 3
Alternative 4
Alternative 5
Payoff 1
Payoff 2
Payoff 3
E
1
& Probability
E
2
& Probability
E
3
& Probability
E
2
& Probability
E
3
& Probability
Payoff 1
Payoff 2
1 2
Decision Trees
2011 Lew Hofmann
Buy stock A
Buy stock B
Buy stock C
Bear Market
Bear Market
Bear Market
Level Market
Level Market
Level Market
Bull Market
Bull Market
Bull Market
$400 x .2 = $80
$500 x .6 = $300
$600 x .2 = $120
$200 x .2 = $40
$400 x .6 = $240
$1100 x .2 = $220
$100 x .2 = $20
$500 x .6 = $300
$900 x .2 = $180
.2
.6
.2
.2
.6
.2
.2
.6
.2
$500
$500
$500
2011 Lew Hofmann
Decision Trees
After drawing a decision tree, we solve it by working
from right to left, starting with decisions furthest to the
right, and calculating the expected payoff for each of
its possible paths.

We pick the alternative for that decision that has the
best expected payoff.

We saw off, or prune, the branches not chosen by
marking two short lines through them.

The decision nodes expected payoff is the one
associated with the single remaining branch.
2011 Lew Hofmann
Sample Problem
A retailer must decide whether to build a small or a large facility at a new
location. Demand can either be low or high, with the probabilities
estimated to be 0.4 and 0.6 respectively.

If a small facility is built and demand is high, the manager may choose
not to expand (payoff = $223,000) or expand (payoff = $270,000) However,
if demand is low, there is no reason to expand. (payoff = $200,000)

If a large facility is built and demand is low, the retailer can do nothing
($40,000) or stimulate demand by advertising. Advertising is estimated to
have a 0.3 chance of a modest response ($20,000) and a 0.7 chance of a
large response ($220,000).

If a large facility is built and demand is high, the payoff is $800,000.
2011 Lew Hofmann
1
Drawing the Tree
There are two choices:
Build a small facility or
build a large facility.
A retailer must decide whether to build
a small or a large facility at a new
location.
2011 Lew Hofmann
Low demand [0.4]
Dont expand
Expand

$200





$223


$270



1
2
Drawing the Tree
The event (state of
nature) in this example
is demand. It can be
either high or low.
Demand can either be small or large, with the
probabilities estimated to be 0.4 and 0.6 respectively.
If a small facility is built and demand is high, the
manager may choose not to expand (payoff =
$223,000) or expand (payoff = $270,000) However, if
demand is low, there is no reason to expand. (payoff
= $200,000)
2011 Lew Hofmann
1
Low demand [0.4]
Dont expand
Expand
Do nothing
Advertise
$200





$223


$270


$40








$800
Modest response [0.3]

Sizable response [0.7]
$20

$220
High demand [0.6]
2
3
Completed Drawing
This is the completed tree.
Now we start pruning it
from the right. We will
begin with decision #3.
The state of nature for
the 3
rd
decision is the
possible response to the
advertising
If a large facility is built
and demand is high, the
payoff is $800,000.
If a large facility is built and
demand is low, the retailer can do
nothing ($40,000) or stimulate
demand by advertising.
Advertising is estimated to have a
0.3 chance of a modest response
($20,000) and a 0.7 chance of a
large response ($220,000).
2011 Lew Hofmann
Solving Decision #3
Low demand [0.4]
Dont expand
Expand
Do nothing
Advertise
$200





$223


$270


$40








$800
Modest response [0.3]

Sizable response [0.7]
$20

$220
High demand [0.6]
1
2
3
0.3 x $20 =$6
0.7 x $220 =$154
$6 + $154 =$160
The 40% probability
of low demand is not
yet considered since
it is the same for
both advertising
states of nature.
2011 Lew Hofmann
Dont expand
Expand
Do nothing
Advertise
$200





$223


$270


$40








$800
$160
Low demand [0.4]
Modest response [0.3]

Sizable response [0.7]
$20

$220
High demand [0.6]
1
2
3
Solving Decision #3
$160
We eliminate the do
nothing option since it has a
lower payoff than does
advertising.
2011 Lew Hofmann
$160
Modest response [0.3]

Sizable response [0.7]
$20

$220
Solving Decision #2
$160
Low demand [0.4]
Dont expand
Expand
Do nothing
Advertise
$200





$223


$270


$40








$800
High demand [0.6]
1
2
3
$270
Here there is no state of
nature involved with
expanding or not expanding.
They are simply choices if we
end up with high demand.
Expanding has a
higher expected
value than not
expanding.
2011 Lew Hofmann
$242
x 0.4 = $80
x 0.6 = $162
$242
$160
$270
$160
Low demand [0.4]
Dont expand
Expand
Do nothing
Advertise
$200





$223


$270


$40








$800
Modest response [0.3]

Sizable response [0.7]
$20

$220
High demand [0.6]
1
2
3
Solving Decision #1
Low demand expected value of
$80 is added to the high
demand expected value of $162
2011 Lew Hofmann
Solving Decision #1
$242
$160
$270
$160
Low demand [0.4]
Dont expand
Expand
Do nothing
Advertise
$200





$223


$270


$40








$800
Modest response [0.3]

Sizable response [0.7]
$20

$220
High demand [0.6]
1
2
3
x 0.6 = $480
0.4 x $160 =$64
$544
The expected value of
high demand for the large
facility ($480) is added to
the expected value of low
demand for the large
facility ($64).
2011 Lew Hofmann
$160
$270
$160
$242
$544
Low demand [0.4]
Dont expand
Expand
Do nothing
Advertise
$200





$223


$270


$40








$800
Modest response [0.3]

Sizable response [0.7]
$20

$220
High demand [0.6]
1
2
3
Solving Decision #1
$544
The expected value of
building a small facility
can now be compared to
the expected value of
building a large facility.
2011 Lew Hofmann
Advantages of
Decision Trees
Gives structure to a problem situation
Visual representation of the options
Forces management to consider each
alternative and compare them
Optimum courses of action are apparent.
The only technique for dealing with multiple
(sequential) decisions.

2011 Lew Hofmann
Disadvantages of
Decision Trees
Many problems are too complex for
visual display
Complex trees are only computational
Subject to estimation errors
(As with any probabilistic decision tool)
Only as good as the data used.
(True with any model.)
2011 Lew Hofmann
Homework Assignment #1
Six problems: Due in class next week this time.
1. Breakeven
2. Two Processes
Recommend using the Excel Solver for the above problems.
3. Preference Matrix
4. Payoff Table
5. Decision-Tree problem #1 (a,b)
6. Decision-Tree problem #2 (a,b)
Do these manually. On the exam you will not have the use of the
computer program for analyzing preference matrices, payoff tables or
decision trees. Doing these problems on the computer may NOT adequately
prepare you for doing the problems on the exams.
2011 Lew Hofmann
1. Break Even Analysis
Mary Williams, owner of Williams Products, is evaluating whether to
introduce a new product line. After thinking through the production
process and the costs of raw materials and equipment, she estimates the
variable costs of each unit produced and sold to be $6 and the fixed costs
per year at $60,000. (Solver wont provide answers to b, c, or d.)

a. If the selling price is set at $18 each, how many units must be
produced and sold for Williams to break even?
b. Williams forecasts sales of 10,000 units for the first year if the selling
price is $14 each. What would be the total contribution to profits from
this new product during the first year?
c. If the selling price is set at $12.50, forecast sales is 15,000 units.
Which pricing strategy ($14 or $12.50) would result in the greater total
contribution to profits?
d. What other considerations would be crucial to the final decision about
making and marketing the new product?
2011 Lew Hofmann
2. Two Processes
Use Excel Solver
Gabriel Manufacturing must implement a manufacturing process
that reduces the amount of toxic by-products. Two processes
have been identified that provide the same level of toxic by-
product reduction. The first process would incur $300,000 of
fixed costs and $600 per unit of variable costs. The second
process has fixed costs of $120,000 and variable costs of $900
per unit.

a. What is the break-even quantity beyond which the first
process is more attractive?
b. What is the difference in total cost if the quantity produced
is 800 units? (You can either estimate this from the solver
solution graph, or use the formula given in slide #21.)
2011 Lew Hofmann
3. Preference Matrix
You can use the Solver software or do it on a spreadsheet.
Axel Express, Inc. collected the following information on two possible
locations for a new warehouse (1 = poor, 10 = excellent).
a. Which location, A or B, should be chosen on the basis of the total
weighted score?
b. If the factors were weighted equally, would the choice change?
2011 Lew Hofmann
4. Payoff Table
You can use the Solver software or do it on a spreadsheet, but you
will need to know how to solve it manually on the test.
Build-Rite Construction has received favorable publicity from guest
appearances on a public TV home improvement program. Public TV
programming decisions seem to be unpredictable, so Build-Rite cannot
estimate the probability of continued benefits from its relationship with
the show. Demand for home improvements next year may be either low
or high. But they must decide now whether to hire more employees, do
nothing, or develop subcontracts with other home improvement
contractors. Build-Rite has developed the following payoff table.
Alternative Low Moderate High
Hire ($250,000) $100,000 $625,000
Subcontract $100,000 $150,000 $415,000
Do Nothing $ 50,000 $ 80,000 $300,000
Which alternative is best, according to each of the following criteria?
a. Maximin b. Maximax c. Minimax regret
2011 Lew Hofmann
5. Decision Tree #1
A manager is trying to decide whether to buy one machine or two. If
only one is purchased, and demand proves to be excessive, the second
machine can be purchased later. Some sales will be lost, however,
because the lead time for producing this type of machine is six months. In
addition, the cost per machine will be lower if both are purchased at the
same time. The probability of low demand is estimated to be 0.20. The
after-tax net present value of the benefits from purchasing the two
machines together is $90,000 if demand is low, and $180,000 if demand is
high.
If one machine is purchased and demand is low, the net present value
is $120,000. If demand is high, the manager has three options. Doing
nothing has a net present value of $120,000; subcontracting, $160,000;
and buying the second machine, $140,000.
a. Draw a decision tree for this problem.
b. How many machines should the company buy initially, and what is
the expected payoff for this alternative?
Do this manually (no computer).
2011 Lew Hofmann
6. Decision Tree Problem #2
Do this manually (no computer).
A manager is trying to decide whether to build a small, medium, or large
facility. Demand can be low, average, or high, with the estimated probabilities
being 0.25, 0.40, and 0.35 respectively.
A small facility is expected to earn an after-tax, net-present value of
$18,000 if demand is low, and $75,000 if demand is medium or high.
Expanding a small facility to medium size after demand is established as
medium or high will only yield an after-tax net profit of $60,000. Expanding it
to a large facility if demand is high, nets $125,000.
Initially building a medium-sized facility and not expanding it would result
in a $25,000 loss if demand is low, but net $140,000 in medium demand and
$150,000 in high demand. Expanding to a large facility at that point would
only net $145,000.
Building a large facility will net $220,000 if demand is high; $125,000 if
demand is medium, and is expected to lose $60,000 if demand is low.
a. Draw an analyze a decision tree for this problem.
b. What should management do to achieve the highest expected payoff?

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