D.

PLANNING AND DESIGNING OF PRODUCTION &/or OPERATIONS SYSTEMS

Process Selection
It refers to the way an organization chooses to produce its goods or provide its services. Essentially
it involves choice of technology and related issues, and it has implications for capacity planning,
layout of facilities, equipment, and design of work system.
Make or Buy. A number of factors are
usually considered.
1.
2.
3.
4.
5.

Available capacity.
Expertise
Quality considerations
The nature of demand
Cost

Figure 7. Process selection and system design

Types of Processing
1. Continuous processing system produces large volume of one highly standardized item. There is
little or no processing variety. Sugar is produced by a continuous processing system.
2. Repetitive/assembly operations can be thought of as semi-continuous because they tend to involve
long runs of one or few similar items. The output of these operations is fairly standard, involving
very little processing variety.
3. Batch processing is sometimes referred to as an intermittent processing system processing system
because many jobs are performed with frequent shifting from one job to another. Intermittent
system tends to have a high to moderate processing variety range.
4. Job shops are also considered as intermittent processing system because small quantities are
produced.
5. Projects are special casea type of processing that is employed to handle a non-routine job
encompassing a complex set of activities.

Operation Strategy
Management of technology is where managers must work with technical experts, asking questions and
increasing their understanding of the benefits and limitations of sophisticated processing equipment
and technology, and ultimately make decisions themselves.

Capacity Planning
The capacity of an operating unit is an important piece of information for planning purposes. It
enables managers to quantify production capability in terms of inputs or output, and thereby make
other decisions or plan related to those quantities.
Capacity refers to an upper limit or ceiling on the load that an operating unit can handle.

Importance of Capacity Decisions

1.
2.
3.
4.

relates to the potential impact on the ability of the organization to meet future demand.
stems from the relationship between capacity and operating cost.
also lies in the initial cost involved, of which capacity is usually a major determinant.
stems from the often required long-term commitment of resources and the fact that, once they are
implemented, it may be difficult or impossible to modify those decisions without incurring major
cost.

Defining and Measuring Capacity

Defining capacity:
1. Design capacity: the maximum output that can possibly be attained.
2. Effective capacity: the maximum possible output given a product mix, scheduling difficulties,
machine maintenance, quality factors, ad so on.
3. Actual output; the rate of output actually achieved. It cannot exceed effective capacity and is often
less than effective capacity due to breakdowns, defective output, shortages of materials, and similar
factors.

Measures of capacity
Business

Inputs

Outputs

Auto manufacturing
Steel mill
Oil refinery
Farming

Labor hours, machine hours

Furnace size
Refinery size
Number of acres, number of cows

Restaurant
Theater
Retail Sales

Number of tables, seating capacity

Number of seats
Square feet of floor space

Number of car per shift

Tons of steel per day
Gallons of fuel per day
Bushels of grain per acre per year, gallons of
milk per day
Number of meals served per day
Number of tickets sold per performance
Revenue generated per day

Measures of system effectiveness

1. Efficiency is the ratio of actual output to effective capacity.
Actual output
Efficiency =
Effective capacity

2. Utilization is the ratio of actual output to design capacity.

Actual output
Utilization =
Design capacity
Example Problem
Given the information below, compute for the efficiency and the utilization of the vehicle repair
department.
Design capacity =
Effective capacity =
Actual output =

50 trucks per day

40 trucks per day
36 trucks per day

Actual output
Efficiency =

36 units per day

= 90 %

Effective capacity =

40 units per day

Actual output

36 units per
day

Utilization =

=
Design capacity

= 72 %
50 units per
day

Thus, compared with the effective capacity of 40 units per day, 36 per day looks pretty good. However,
compared with the design capacity of 50 units per day, 36 units per day is much less impressive
although probably more meaningful.
Determinants of Effective Capacity
1. Facilities factors such as design of facilities, including size and provision for expansion,
transportation cost, distance to market, labor supply, energy sources, room for expansion, likewise,
layout of the working area and environmental factors such as heating, lighting, and ventilation.
2. Product/Service Factors can have a tremendous influence on capacity. The particular mix of
products or service rendered must also be considered since different items will have different rates
of output.
3. Process factors. The quantity capability of a process is an obvious determinant of capacity. A subtler
determinant is the influence of output quality.
4. Human Factor. The task that make up a job, the variety of activities involved, and the training,
skills, and experience required to perform a job all have an impact on the potential and actual
output. Employee motivation has a very basic relationship to capacity, as do absenteeism and labor
turnover.
5. Operations Factors. Scheduling problems may occur when an organization has differences in
equipment capabilities among alternatives pieces of equipment or differences in job requirements.
Inventory stocking decisions, late deliveries, acceptability of purchased materials and parts, and
quality inspection and control procedures also can have an impact on effective capacity.

6. External factors. Product standards, especially minimum quality and performance standards can
restrict managements options for increasing and using capacity. Thus, pollution standard on
products and equipments often reduce-effective capacity, as does paperwork required by
government regulatory agencies by engaging employees in nonproductive activities.
A. Facilities
1. Design
2. Location
3. Layout
4. Environment
B. Product or Service
1. Design
2. Product and Service Mix
C. Process
1. Quantity capabilities
2. Quality capabilities
D. Human Factors
1. Job content
2. Job design
3. Training and experience

4.
5.
6.
7.

Motivation
Compensation
Learning rates
Absenteeism and labor turnover
E. Operational
1. Scheduling
2. Materials management
3. Quality assurance
4. Maintenance policy
5. Equipment breakdown
F. External Factors
1. Product standards
2. Safety regulations
3. Unions
4. Pollution control standards

Table 2. Factors that determine effective capacity

Determining Capacity Requirements

1. Long term considerations relate to overall level of capacity, such as facility size;
2. Short-term considerations relate to probable variations in capacity requirement created by such
thing as seasonal, random, and irregular fluctuations in demand.
Developing Capacity Alternatives
1.
2.
3.
4.
5.

Design flexibility into systems.

Take a big picture approach to capacity changes.
Prepare to deal with capacity chunks.
Attempt to smooth out capacity requirements.
Identify the optimal operating level.

Evaluating Alternatives

1. Calculating Processing Requirement

example:
A department works one 8-hour shift, 250 days a year, and has these figures for usage of a
machine that is currently being considered:
Product

Annual Demand
#1
#2
#3

400
300
700

Standard processing Processing time needed

time per unit (hour)
(hour)
5.0
8.0
2.0

2,000
2,400
1,400
-------5,800

Working one 8-hour shift, 250 hours a year provides an annual capacity of 8 x 250 = 2,000
hours per year. We can see that three of these machines would be needed to handle the required
volume.
5,800 hours
2,000 hours/machine

= 2.90 machines

2. Cost-Volume Analysis
Cost-volume analysis focuses on a relationship between cost, revenue, and volume of output. The
purpose of cost-volume analysis is to estimate the income of an organization under different operating
conditions. It is particularly useful as a tool for comparing capacity alternatives.

a. Fixed costs tend to remain constant regardless of volume of output. (Examples include rental
costs, property taxes, equipment costs, heating and cooling expenses, and certain administrative
costs).
b. Variable costs vary directly with volume of output. The major components of variable costs are
generally materials and labor costs.
c. Break-even point is the volume of output at which total costs and total revenue are equal.
d. Step costs are costs that increase stepwise as potential volume increases.
e. Formulas:
TC =
TR =
P=
=

FC + VC x Q
RxQ
TR TC
R x Q (FC + VC x Q)

(2-1)
(2-2)
(2-3)

Volume =

SP + FC
R - VC

(2-5)

QBEP =

FC
R - VC

(2-6)

FC = Fixed cost
VC = Variable cost per unit
TC = Total cost
TR = Total revenue
R = Revenue
Table 3. Cost-volume symbol

Q = Quantity or volume of output

QBEP = Break-even quantity
P = Profit
SP = Specified profit

Example:
The owner of Old-Fashioned Berry Pies, S. Simon, is contemplating adding a new line of pies,
which will be require leasing new equipment for a monthly payment of $6,000. Variable cost would be
$2.00 per pie, and pies would retail for $7.00 each.
a.
b.
c.

How many pies must be sold in order to break even?

What would the profit (loss) be if 1,000 pies are made and sold in a month?
How many pies must be sold to realize a profit of $4,000?

FC = $6,000, VC = $2 per pie, Rev = $7 per pie

a.

Break-even quantity
QBEP =

b.

FC
Rev - VC

Quantity
For Q = 1,000,

$6,000
$7 - $2

= 1,200 pies/month

P = rev x Q (FC + VC X Q)
= $7 x 1,000 ($6,000 + $2 X 1,000) = -$1,000

c.

Break-even profit
P = $4,000 solve for Q in the preceding equation:
$4,000 = $7Q ($6,000 + $20)
Rearranging terms, we obtain
$50Q = $10,000 Q = 2,000 pies

3. Financial Analysis
a. Cash flow refers to the difference between the cash-received from sales (of goods or services)
and other sources (e.g., sale of old equipment) and the cash outflow for labor, materials,
overhead, and taxes.
b. Present value expresses in current value the sum of all future cash flow of an investment
proposal
c. Payback is a crude but widely used method that focuses on the length of time it will take for an
investment to return its original cost.
d. Present value (PV) method summarizes the initial cost of an investment, its estimated annual
cash flows, and any expected salvage value in a single value called the equivalent current value,
taking into account the time vale of money (i.e., interest rates)

e. Internal rate of return (IRR) summarizes the initial costs, expected annual cash flows, and
estimated future salvage value of an investment proposal in an equivalent interest rate. In other
words, this method identifies the rate of return that equates the estimated future returns and
the initial cost.
4. Decision Theory is a helpful tool for financial comparison of alternatives under condition of risk or
uncertainty.
5. Waiting-line analysis. Analysis of waiting lines is often useful for designing service systems.
Waiting lines have a tendency to form in a wide variety of service systems (e.g., airport ticket
counters, telephone calls to a cable television company, and hospital emergency rooms). The lines
are symptoms of bottlenecks operations. Analysis is useful in helping managers choose a capacity
level that will be cost-effective through balancing the cost of having customer wait with the cost of
providing additional capacity. It can aid in the determination of expected costs for various levels of
service capacity.
Problem Solving on Break Even Analysis
1. Make or buy. A firms manager must decide whether to make or buy a certain item use in the
production of vending machines. Cost and volume estimates are as follows:
Make
Annual fixed cost
P6,750,000
Variable cost per unit
P2,700
Annual volume (units)
12,000
a. Given these data, should the firm buy or make this item?
b. There is a possibility that volume could change in the
manager be indifferent between making and buying?

Buy
None
P 3,600
12,000
future. At what volume would the

2. A publishing company for a textbook found out that their monthly expenses are P200, 000.00 and
P100.00 on every textbook. If each textbook is sold at P 160.00
a. Formulate the cost function, revenue function, and profit function.
b. Find the break-even volume, cost, and profit.
c. Show the break-even graph and interpret.
d. If the company produce and sell 1,000 books, do they have a gain or a loss? How much?
e. If they could sell 20,000 books, how much is the gain or loss?
f. If the company forecast revenue of P 3,000,000.00 for the next month, how much will be the
profit.
3. An important process in the economic progress of a country is the replacement of human effort
with machines. If it cost P15 to move one cubic yard of soil for building a dam by human effort
while P5 to do the same job with a machine plus a fixed cost of P1,000. a) Find the cost function
for human and machine effort. b) Sketch the break-even graph and interpret. c) Find the minimum
number of cubic yard of soil required for replacing human effort with a machine.
4. Arianna is the finance director of Jollibee Foods Corporation and she wants to determine the
breakeven point of the companys monthly sales. The fixed cost per month is $2, 850 and the
company has five all time favorite products. The price per unit of Chickenjoy is $2.85, Yumburger
is $1.75, French fries is $0.85, pineapple juice is $0.60, and tuna pie is $1.30. The cost per unit of
Chickenjoy is $1.40, Yumburger is 0.95, French fries is $0.40, pineapple juice is $0.25, and tuna
pie $0.70. the monthly volume forecast for Chickenjoy is 2,130 units, Yumburger is 3,500, French
fries is 2,500, pineapple juice is 3,050, and tuna pie is 1,500. What is the breakeven point in total
amount? What is the breakeven point in units for every product served in the menu?

DECISION MAKING

A. The Decision Process

a. Cause of Poor Decisions
b. Decision Environments
B. Decision Theory
a. Decision Making Under Certainty

b.
c.
d.
e.
f.

Decision Making Under Uncertainty

Decision Making Under Risk
Decision Trees
Expected Value of Perfect Information
Sensitivity Analysis

The Decision Process

Most successful decision making follows a process that consists of these steps:
1. Identify the problem. The focal point of the process, unless done carefully, the remaining steps can
be misdirected. It may be directed towards removing the symptoms of the problem rather than the
actual problem, allowing the problem to resurface later. Solutions may address the basic problem,

not the symptoms.

2. Specify objectives and the criteria for choosing a solution. The decision maker must identify the
criteria by which proposed solutions will be judged. Common criteria often relates to costs, profits,
return on investment, increased productivity, risk, common image, impact on demand, or similar
variables.
3. Develop alternatives. In the search for alternatives, there is always the danger that one or more
potentially superior alternatives will be overlooked. Consequently, the optimal alternative may turn
out to be less than optimum. As a general rule, efforts expended n carefully identifying alternatives
can yield substantial dividends in terms of the overall decision.
4. Analyze and compare alternatives is often enhanced by the use of mathematical or statistical
techniques.
5. Select the best alternative will depend on the objectives of the decision maker and the criteria that
are being used to evaluate alternatives.

6. Implement the chosen alternative (solution) simply means carrying out the actions indicated by the
chosen alternatives. Many decision makers use this approach by default: By the time they get
around to making a decision, its too late!
7. Monitor the results to ensure that desired results are achieved. Effective decision making requires
that the results of the decision be monitored to make sure that the desired consequences have been
achieved. If they have not, the decision maker may have to repeat the entire process; or perhaps a
review of the situation may reveal an error in implementation, an error in calculations, or a wrong
assumption that will allow the situation to be remedied quickly.
The decision process is not always completed in a sequential manner. Instead, there is usually a certain
amount of backtracking and feedback, especially in terms of developing and analyzing alternatives.
Cause of Poor Decisions
1. failures can be traced to some combination of mistakes in the decision process;
2. bounded rationality (the limitation on decision making caused by costs, human abilities, time,
technology, and availability of information); and
3. suboptimization (the result of different departments each attempting to reach a solution that is
optimum for that department).
Decision Environments

Certainty means that relevant parameters such as costs, capacity, and demand have known values.
Example, profit per unit is P5. You have an order for 200 units. How much profit will you make?

Risk means that certain parameters have probabilistic outcomes. Example, profit is P5 per unit. Based
on previous experience, there is a 50 percent chance of an order for 100 units and a 50 percent
chance of an order for 200 units. What is the expected profit?

Uncertainty means that it is impossible to assess the likelihood of various possible future events.
Example, profit is P5 per unit; the probabilities of potential demands are unknown.
Decision Theory
Decision theory represents a general approach to decision making. Decisions that lend themselves to a
decision theory approach tend to be characterized by these elements:

1. A set of possible future conditions exist that will have a bearing on the results of the decision.
2. A list of alternatives for the manager to choose from.
3. A known payoff for each alternative under each possible future condition.
In order to use this approach, a decision maker would employ this process;
1. Identify the possible future conditions (e.g., demand will be low, medium, or high; the number of
contracts awarded will be one, two, or three; the competitor will or will not introduce a new
product). These are called states of nature.
2. Develop a list of possible alternatives, one of which may be to do nothing.
3. Determine or estimate the payoff associated with each alternative for every possible future
condition.
4. If possible, estimate the likelihood of each possible future condition.
5. Evaluate alternatives according to some decision criterion (e.g., maximize expected profit), and
select the best alternative

Payoff table is a table showing the expected payoffs for each alternative in every possible state of nature.
Alternatives
Small facility
Medium facility
Large facility
* Present value in P million

Low
10
7
(4)

Possible future demand

Moderate
10
12
2

High
10
12
16

Decision Making Under Certainty

When it is known for certain which of the possible future conditions will actually happen the decision
is usually relatively straightforward: Simply choose the alternative that has the best payoff under that
state of nature. This is illustrated in the following example.
Determine the best alternative in the preceding payoff table, if it is known with certainty that demand
will be: (a) low, (b) moderate, (c) high.
Choose the alternative with the highest payoff. Thus, if we know demand will be low, we would elect to
build the small facility and realize a payoff of P10 million. If we know demand will be moderate, a
medium facility would yield the highest payoff (P12 million versus either P10 million or P2 million).
For high demand, a large facility would provide the highest payoff.

Decision Making Under Uncertainty

At the opposite extreme is complete uncertainty: no information is available on how likely the various
state of nature are. Under those conditions, four possible decision criteria are maximin, maximax, La
Place, and minimax regret. These approaches can be defined as follows:

Maximin Determine the worst possible payoff for each alternative, and choose the alternative that has
the best worst. The maximin 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.
Maximax Determine the best possible payoff, and choose the alternative with that payoff. The
maximax approach is an optimistic, go for it strategy; it does not take into account any payoff other
than the best.

La Place Determine the average payoff for each alternative, and choose the alterative with the best
average. The La Place approach treats the states of nature as equally likely.

Maximax regret Determine the worst regret for each alternative, and choose the alternative with the
best worst.
The main weakness of these approaches (except for La Place) is that they do not take into account all of
the payoffs. Instead, they focus on the worst or best, and so they lose some information. The weakness
of La Place is that it treats all states of nature as equally likely. Still, for a given set of circumstances,
each has certain merits that can be helpful to a decision maker.
Referring to the preceding payoff table, determine which alternative would be chosen under each of
these strategies: (a) maximin, (b) maximax, (c) laplace.
Alternatives

Possible future demand

Low Moderate
High
Small facility
10
10
10
Medium facility
7
12
12
Large facility
(4)
2
16
* Present value in P million

Row total
(in P million)
30
31
14

Row average
(in P million)
10.00
10.33
4.67

Solution:
1. The worst payoffs for the alternatives are shown at the table. Hence, since P10 million is the best,
choose to build the small facility using the maximin strategy.
2. The best payoffs are shown at the table. The best overall payoff is the P16 million in the third row.
Hence, the maximax criterion leads to building a large facility.
3. For the La Place criterion, first find the row totals, and then divide each of these amount by the
number of states of nature (three in this case). Since the medium facility has the highest average, it
would be chose under the La Place criterion.
Determine which alternative would be chosen using a maximax regret approach to the capacity
planning program.
The first step in this approach is to prepare a table of opportunity losses, or regrets (the difference
between a given payoff and the best payoff in the same column). To do this, subtract every pay off in
each column from the largest possible payoff in that column. For instance, in the first column the
largest possible payoff is 10, so each of the three numbers in that column must be subtracted from 10.
Going down to the column, the regrets will be 10 10 = 0, 10 7 = 3, 10 (-4) = 14. In the second
column, the largest positive payoff is 12. Subtracting each pay of from 12 yields the following; 2, 0, and
10. In the third column, 16 is the largest payoff. The regrets are 6, 4, and 0. These are summarized in a
regret table:
Alternatives
Small facility
Medium facility
Large facility

Possible future demand

Low Moderate High
10
10
10
7
12
12
(4)
2
16

Low
0
3
14

Regrets (in P millions)

Moderate High Worst
2
6
6
0
4
4
10
0
12

The second step is to identify the worst regret for each alternative. For the first alternative, the worst is
6; for the second, the worst is 4; and for the third, the worst is 14.
The best of these worst would be chosen using minimax regret. The lowest regret is 4, which is for
a medium facility. Hence, that alternative would be chosen.

Decision Making Under Risk

Between the two extreme of certainty and uncertainty lies the case of risk. The probability of
occurrence for each state of nature can be estimated. (Note that because the states are mutually
exclusive and collectively exhaustive, these probabilities must add to 1.00) A widely used approach
under such circumstances is the expected monetary value criterion. The expected value is computed for
each alternative, and one with the highest expected value is selected. The expected value is the payoffs
for an alternative where each pay is weighted by the probability for the relevant state of nature. Thus,
the approach is:

Expected monetary value criterion (EMV) Determine the expected payoff of each alternative, and
choose the alternative that has the best expected payoff.
Using the expected monetary value criterion, identify the best alternative for the previous payoff table
for these probabilities: Low = 0.30, moderate = 0.50 and high = 0.20.
To find the expected value of each alternative by multiplying the probability of occurrence for each
state of nature by the payoff for that state of nature and summing them:
EV small = 0.30 (P10) + 0.50 (P10) + 0.20 (P10) = P10
EV medium = 0.30 (P7) + 0.50 (P12) + 0.20 (P12) = P10.50
EV large = 0.30 (P-4) + 0.50 (P2) + 0.20 (P16) = $ 3

Decision Trees
A decision tree is a schematic representation of the
alternatives available to a decision maker and their possible
consequences.

Example of a Decision Trees

Exercise: Try making a decision tree for your college plans in
the next five years or so.

Expected Value of Perfect Information

In certain situations, it is possible to ascertain which state of nature will actually occur in the future.
The question to consider is whether the cost of the option will be less than the expected gain due to
delaying the decision (e.g., the expected payoff above the expected value). The expected gain is the
expected value of perfect information, or EVPI, which is the difference between the expected pay under
certainty and the expected payoff under risk.
One possible ways of obtaining perfect information depend somewhat on the nature of the decision
being made. For example, information about consumer preferences might come from market research,
additional information about a product could come from product testing, legal experts might be called
on.
There are two ways to determine the EVPI. One is to compute the expected payoff under certainty and
subtract the expected payoff under risk. That is<
Expected value of perfect information

Expected payoff under certainty

Expected payoff under risk

A second approach is to use the regret table to compute the EVPI. To do this, find expected regret for
each alternative. The minimum expected regret is equal to the EVPI

Sensitivity Analysis
Sensitive analysis provides a range of probability over which the choice of alternative would remain the
same. The approach illustrated here is useful when there are two states of nature. It involves
constructing a graph and then using algebra to determine a range of probabilities for which a given
solution is best. In effect, the graph provides a visual indication of the range of probability over which
the various alternatives are optimal, and the algebra provides exact values of the endpoints of the
ranges.
Given the following table, determine the range of probability for state of nature #2, that is, P(2), for
which each alternative is optimal under the expected-value approach.
#2
#1
Alternative

State of
Nature

12
4
A

2
16
B

8
12
C

First, plot each alternative to P(2). To do this, plot #1 value on the left side of the graph and the #2
value on the right side. For instance, for alternative A, plot 4 on the left side of the graph and 12 on the
right side. Then connect these two points with a straight line. The three alternatives are plotted on the
graph shown below.

Payoff #1

16

16

14

14

12

12

10

10

B best

A best

C best

Payoff #2

2
0

0.2

0.4

0.6

0.8

1.0

P (2)

The slope and equations are:

A
B
C

#1
4
16
12

#2
12
2
8

Slope
12 4 = +8
2 16 = -14
8 12 = -4

Equation
4 + 8P(2)
16 14P(2)
12 4P(2)

If 16 14P(2) = 12 4P92); then 4 = 10P(2). Solving, you obtain P(2) = 0.40. Thus, alternative B is
best from P(2) = 0 up to P(2) = 0.40. B and C are equivalent at P(2) = 0.40
Alternative C is best from that point until its line intersects alternative As line. To find that
intersection set those two equations equal and solve for P(2). Thus, 4 + 8P(2) = 12 4P(2).
Rearranging terms, you have 12P(2) = 8. Solving, you obtain P(2) = 0.67. Thus, alternative C is best
from P(2) > 0.40 up to P(2) = 0.67, where A and C are equivalent . For values P(2) greater than 0.67
up to P(2) = 1.0, A is best.
Note: if a problem calls for ranges with respect to P(1), find the P(2) range as above, and then
subtract each P(2) from 1.00 (e.g., 0.40 becomes 0.60, and 0,67 becomes 0.33)

Problem Set for Decision Making:

1. Assume the payoffs represent profits.
Alternative locations for new
warehouse
New bridge built
No new bridge

1
14

2
10

4
6

a. Determine the alternative that would be chosen under each of these decision criteria: maximin,
maximax, and laplace
b. Using graphical sensitivity analysis, determine the probability for new bridge for which each
alternative would be optimal.
c. Using the information in the payoff table, develop a table of regrets, and then: a) determine the
alternative that would be chosen under minimax regret, and b) determine the expected value of
perfect information using the regret table, assuming that the probability of a new bridge being built is
0.60.
d. Using the probabilities of 0.60 for a new bridge and 0.40 for no new bridge, compute the expected
value of each alternative in the payoff table, and identify the alternative that would be selected under
the expected-value approach.
e. Suppose that the values in the payoff table represent cost instead of profits.
i. Determine the choice that you would make under each of these strategies: maximin, minimin, and
La Place.
ii. Develop the regret table, and identify the alternative chosen using each alternative the EVPI if P(new
bridge) = 0.60
iii. Using sensitivity analysis, determine the range of P(no new bridge) for which each alternative
would be optimal.
iv. If P(new bridge) = 0.60 and P(no new bridge) = 0.40, find the alternative chosen to minimize
expected cost.
2. A small building contractor has recently experienced two successive years in which work opportunities
exceeded the firms capacity. The contractor must now make a decision on capacity for the next year. He
has estimated profits under each of the two states of nature he believes might occur, as shown in the
table below.
High
Next years
demand
Low
Alternative
* Profit in P millions

P60*
50
Do nothing

P80
20
Expand

P70
40
Subcontract

a. Which alternative should be selected if the decision criterion is: Maximax, maximin, La Place, and
minimax regret
b. Suppose after a certain amount of discussion with an accountant, the contractor is able to subjectively
assess the probabilities of low and high demand: P(low) = 0.30 and P(high) = 0.70.
i. Determine the expected profit of each alternative. Which alternative is best? Why?
ii. Analyze the problem using a decision tree. Show the expected profit of each alternative on the tree.
iii. Computer for the expected value of perfect information. How could the contractor use this
knowledge?
c. Subsequently, construct a graph that will enable you to perform sensitivity analysis on the problem.
Over what range of P(high) would the alternative of doing nothing be best? Expand? Subcontract?
3. A researcher of a marketing agency has assemble the following payoff table of estimated profits:
Receive
P10*
P8
P5
P0
Contract
Not receive
-2
3
5
7
Alternative
MP1
MP2
MP3
MP4
* Cost in millions of Peso.
Relative to the probability of not receiving the contract, determine the range of probability for each of the
proposal would maximize expected profit.

10

PLANNING & DESIGNING OF P/O SYSTEM - Part I: FORECASTING

Pedagogical Objectives: By the end of this topic discussion, the student should be able to:
1. Define forecasting;
2. Discuss why demand forecasting is important in managing the P/O system;
3. Identify the basic types of forecasting models and describe some forecasting techniques under
each model;
4. Forecast using quantitative techniques; and
5. Evaluate the effectiveness of a forecasting technique.

Definition
Forecasting is the art and science of predicting future situations. It may involve taking historical
data and projecting them into the future with sort of mathematical model. It may be a
_______________ or intuitive prediction of the future. It may involve combination of these, that is, a
mathematical model adjusted by a managers ______________ _______________.

Types of Forecasts
Organizations use three types of forecasts in planning and anticipating the future of their operations.
1. _______________ forecasts address the business cycle by predicting inflation rates, money
supplies, housing starts, and other planning indicators.
2. _______________ forecasts are concerned with rates of technological progress, which can
result in the birth of exciting new products, requiring new plants and equipment.
3. _______________ forecasts are projections of demand for a companys product or services.
These forecasts, also called sales forecasts, drive a companys production capacity and
scheduling systems and serve as inputs to financial, marketing, and human resource planning.

Why Forecast Demand?

1. To plan for the system in terms of product design, process design, capacity planning and
equipment investment and replacement.
2. To plan the use of the system which includes _______________ requirements for materials,
products and services; and _______________ schedules and varying labor and materials?

Forecasting Time Horizons

1. ________________ forecast. This forecast has a time span of up to one year, but is generally
less than three months; it is used for planning, purchasing, job scheduling, workforce levels, job
assignments, and production levels.
2. ________________ forecast. An intermediate forecast generally spans for three months up to
three years. It is used in sales planning and budgeting, cash budgeting and analyzing various
operating plans.
3. ________________ forecast. Generally three years or more in time span, these forecasts are
used in planning for new products, capital expenditures, facility location or operation
expansion, and research and development.

The Influence of Product Life Cycle

Another factor to consider when developing sales forecasts, especially longer ones, is the products life
cycle. Products, and even services, do not sell at a constant level throughout their span of life. Most
successful products pass through four stages: (1) introduction, (2) growth, (3) maturity, and (4)
decline.
Products in the first two stages of their life cycle need longer forecasts than those in the
maturity and decline stages. Forecasts are useful in projecting different staffing levels, inventory levels,
and factory capacity as the product passes from the first to the last stage.

Types of Forecasting Models

1. _________________ Models
a. _________________. This method solicits input from customers or potential customers
regarding their future purchasing plans. It can help not only in preparing a forecast,
but also in improving product design and planning new products.

11

b. __________________. In this approach, each sales person estimates what sales will be
in his or her region or sales territory. These forecasts are then reviewed to ensure the
realistic and then combined at the district and national levels to reach an overall
forecast estimates.
c. __________________. Under this method, the opinions of a group of high-level
managers, often in combination with statistical models, are pooled to arrive at a group
estimate of demand.
d. __________________. There are three different types of participants in the Delphi
method: decision-makers, staff personnel, and respondents. The decision-makers
usually consist of a group of five (5) to ten (10) experts who will be making the actual
forecast. The staff personnel assist the decision-makers by preparing, distributing,
collecting, tabulating, and summarizing a series of questionnaires and survey results.
The respondents are a group of people, often located in different places, whose
judgments are valued and are being sought. This group provides inputs to the decisionmakers before the forecast is made.
2. _________________ Models
a. __________________ Models. Time-series models predict on the assumption that the
future is a function of the past. In other words, they look at what happened over a
period of time and use a series of past data to make a forecast.
Nave forecast
Moving averages
Simple moving average
Weighted average
Exponential smoothing
b. __________________ Models. Causal models, such linear regression, incorporate the
variables or factors that might influence the quantity being forecast. For example, a
causal model for appliance sales might include factors such as new housing starts,
advertising budget, and competitors price.
Simple regression
Multiple regression

Mean Absolute Deviation is a measure used to evaluate the accuracy of a forecasting model.
Associative or Causal Models
Regression Analysis is a forecasting technique that establishes a relationship between variables In
this discussion, we consider only:
1. Two variables; say, x and y
2. A linear relationship between them
where:

y = dependent variable, e.g., Demand, Sales

x = independent variable, e.g., Time, Advertising, Price,
Unemployment, etc.,

Slope-intercept form of a line

y = a + bx

y = a + bx
where:
a = y-intercept
b = slope of the line; rate of change of y with
respect to x

nxy - xy
nx2 (x)2

b=

b=
a

y - bx

a=

N.B.: Linear regression may be applied only when the relationship between two variables is linear or
nearly so. In other words, the regression line: y = a + bx may be used to forecast values of y for any
given value of x only if there is a significant relationship, i.e., high correlation, between x and y .
Question: But how do we know if the linear relationship between x and y is significant
Answer: By calculating the correlation coefficient, r.
nxy - xy
r=
[nx2 (x)2] [ny2 (y)2]

12

If |r| is
0.90 1.00
0.70 0.89
0.40 0.69
0.20 0.39
0.00 0.19

Then
very high correlation
high correlation
moderate correlation
low correlation
slight correlation

Thus, for our purposes, the regression line: y = a + bx may be

used to forecast values of y for any given value of x only
when |r| is greater than or equal to 0.70.

NAVE APPROACH

Ft
At 1

Ft = At 1

SIMPLE MOVING AVERAGE

Ai
Wi

Ft =

= the demand forecast for period t

= the actual demand for period t 1
= the average period
= the actual demand for period i
= the weight to be multiplied to the
actual demand for period i
= the exponential smoothing constant
= the demand forecast for period t - 1

i=1

WEIGHTED MOVING AVERAGE

Ft 1

Ft =

W A , where 0 W
i

1 and

i=1

W = 1.00

MEAN ABSOLUTE DEVIATION (MAD)

EXPONENTIAL SMOOTHING

MAD =

|A

i -

Fi|

i=1

Ft = Ft 1 + (At 1 - Ft 1), where 0 1

FORECASTING Time Series

The following data show the number of liters of gasoline sold by Petron in Baguio City
for the past 12 weeks.
Forecast*
Week

Actual
Demand*

17

21

19

23

18

16

20

18

22

10

20

11

15

12

22

Nave

|A - F|

SMA

|A - F|

WMA

|A - F|

ES, = 0.30

Linear trend

|A - F|

13
MAD
* 1,000 liters
1. Forecast demand using the nave approach.
2. Forecast demand using 3-week simple moving average model.
3. Using a weight of 0.40 for the most recent observation, 0.30 for the second most recent, 0.20
for the third most recent, and 0.10 for the fourth most recent, forecast demand using 4-week
weighted moving average model.
4. Forecast demand using exponential smoothing model with = 0.30.
5. Forecast demand using linear trend analysis.
6. Calculate the MAD for each of the above forecasting models. Which forecasting model would
you recommend to Petrons manager? Why?
7. What demand forecast would you recommend for week 13?

13

|A - F|

FORECASTING Linear Regression

Don Henricos Pizza is interested in establishing the relationship between its advertising and
sales on the following data:

Quarter
1
2
3
4
5
6
7
8
9
10

Advertising

Sales

(P100,000)
4
10
15
12
8
16
5
7
9
10

(PMillion)
1
4
5
4
3
4
2
1
4
2

1. Can Don Henricos Pizza use linear regression analysis to forecast its future sales given a
planned advertising expenditure?
2. Determine the estimated equation of the regression line that defines the relationship between
sales and advertising.
3. If Don Henricos Pizza advertising expense is expected to be P1,100,000.00, what would be the
corresponding sales forecast?
4. If Don Henricos Pizza spends five percent of sales on pizza boxes, how much boxes, in peso
volume, should its operations manager order for the next quarter?

Quantitative Forecasting
The following table represents sales data for palm oil ( in hundred gallons) sold by a grocery
store.

Month

Sales

1
2
3
4
5
6
7
8
9
10

40
48
40
45
50
49
46
57
54
62

14

1. Given a choice on whether to use the nave approach; a 5-month

SMA model; a WMA model with weights 0.20, 0.30, and 0.50; and
an ES model with = 0.60 and a forecast of 3,600 galloons in the
first month; which model would you use? Why?
2. Based on your decision in item 1, what should be the forecast for
month 11?
3. Would you recommend using linear regression forecasting model
for this time series data? Why?
4. If the linear regression may be used, what would be the forecast for
month 16?