Decision Analysis

What is a Decision?
What is a Decision?
Choosing the alternative that gives me the best outcome
Famous Decisions

Continued to build huge inventory

and selling at lower prices

Dhirubhai Ambani
Tata Nano Plant at Singur
Outsourcing by IBM
Zara’s decision to source
locally
Google taking over
Motorola

Google sells handset division

to Lenovo
Yahoo refused to buy Google at $100million in 1998

Yahoo again refused to buy Google

at $3Bn in 2002

In 2008 Microsoft made bid of

$45Bn (Yahoo CEO asked for $4
more per share)

Verizon agrees to buy Yahoo at

$4.4Bn
Your decision to join IIMK
Rahul Gandhi’s Decision to
join Politics
Decisions?
Decisions in business can make or break a company

Taking decision is a challenge as decision precedes outcome

◦ At the time of taking decision we often do not know how the future is going to unfold

Not taking a decision is also a decision

A rational decision based on justification is better than taking a decision based on guts and
intuition.
Common Business Decisions?
Where to locate a facility Assortment selection

Capacity Decision Which market to enter

Partner Selection Pricing decision

Capital budgeting/Investment decision Technology selection

Inventory decision Manpower decision

Characteristics of a Decision
1. A list of alternatives.

2. A list of possible future states of nature.

3. Payoffs associated with each alternative/state of nature combination.

4. An assessment of the degree of certainty of possible future events.

5. A decision criterion.
Five Steps of Decision Making
Clearly define the problem at hand – we take decision to solve a problem

List all possible decision alternatives

Identify the possible future outcomes for each decision alternatives

Identify the payoff for each combination of alternatives and outcomes

Select one of the decision analysis techniques to make your decision (Decision Criteria)
Decision Steps – Thumpson Lumber Company
Problem Definition:

Whether to expand business by manufacturing and marketing a new product, backyard storage
sheds ?
Decision Steps – Thumpson Lumber Company
Problem Definition:

Whether to expand business by manufacturing and marketing a new product, backyard storage
sheds ?

Decision Alternatives:

(1) Build a large plant to manufacture the storage sheds

(2) Build a small plant to manufacture storage sheds
(3) Build no plant at all
Decision Steps – Thumpson Lumber Company
Identifying Outcomes – States of Nature:

State 1: Demand for storage sheds will be very high

State 2: Demand for storage sheds will be very moderate
State 3: Demand for storage sheds will be very low

Determine Payoffs: Demand States

High Moderate Low
Decision Alternatives

Build large plant $200,000 $100,000 -$120,000

Build small plant $90,000 $50,000 -$20,000

Build no plant $0 $0 $0
Payoff Table
Decision Making Environments
Decision Making Under certainty

◦ Knows the payoffs for sure

◦ There are only one outcome

Decision Making Under Uncertainty

◦ No information at all about outcomes

Decision Making Under Risk

◦ DM has some knowledge about the probability of occurrence of outcomes

◦ Decision is based on the estimation of expected payoff
Decision Models Under Uncertainty
Maximax

Maximin

Hurwicz (Realism)

Equally Likely (Laplace)

Minimax Regret
Hurwicz (Realism)
The approach offers the decision maker a compromise between
the maximax and the maximin criteria.

◦ Requires the decision maker to specify a degree of optimism, in the form

of a coefficient of optimism α, with possible values of α ranging from 0 to
1.00.
◦
◦ The closer the selected value of α is to 1.00, the more optimistic the
decision maker is, and the closer the value of α is to 0, the more
pessimistic the decision maker is.
Summary of Methods for Decision Making under
Complete Uncertainty
Decision Making under Risk
Decision making under partial uncertainty

◦ Distinguished by the present of probabilities for the occurrence of the various

states of nature under partial uncertainty.

◦ The term risk is often used in conjunction with partial uncertainty.

Sources of probabilities

◦ Subjective estimates
◦ Expert opinions
◦ Historical frequencies
Approaches to Incorporating Probabilities in
the Decision Making Process
Expected Monetary Value (EMV) approach

◦ Provides the decision maker with a value that represents an average payoff for each
alternative.

Expected Opportunity Loss (EOL)

◦ The opportunity losses for each alternative are weighted by the probabilities of their
respective states of nature to compute a long-run average opportunity loss, and the
alternative with the smallest expected loss is selected as the best choice.

Expected Value of Perfect Information (EVPI)

◦ A measure of the difference between the certain payoff that could be realized under a
condition of certainty and the expected payoff under a condition involving risk.
Expected Monetary Value

Expected Monetary Value = (Payoff of First Outcome) × Probability of First Outcome

+ (Payoff of Second Outcome) × Probability of Second Outcome
+ (Payoff of Third Outcome) × Probability of Third Outcome
+ … + (Payoff of Last Outcome) × Probability of Last Outcome
Expected Opoortunity Loss

Expected Monetary Value = (Regret of First Outcome) × Probability of First Outcome

+ (Regret of Second Outcome) × Probability of Second Outcome
+ (Regret of Third Outcome) × Probability of Third Outcome
+ … + (Regret of Last Outcome) × Probability of Last Outcome
Expected Opoortunity Loss

Expected Value with Perfect Information (EVwPI) = (Best Payoff of First Outcome) × Probability of First Outcome
+ (Best Payoff of Second Outcome) × Probability of Second Outcome
+ (Best Payoff of Third Outcome) × Probability of Third Outcome
+ … + (Best Payoff of Last Outcome) × Probability of Last Outcome

Expected Value of Perfect Information (EVPI) = EVwPI – Maximum EMV

Decision Tree Format

Decision trees are used by decision

makers to obtain a visual portrayal of
decision alternatives and their possible
consequences.
 Thompson Lumber Company
Probability Payoffs
Outcome Node High Demand (0.30)
$200,000
Moderate Demand (0.50)
$100,000

Low Demand (0.20)

-$120,000
Decision Node
High Demand (0.30)
$90,000

Moderate Demand (0.50)

$50,000

Low Demand (0.20)

-$20,000

All Demand (0.20)

$0
 Thompson Lumber Company
Probability Payoffs
Outcome Node High Demand (0.30)
$200,000
EMV 1 =$200,000×0.3 + $100,000×0.5+ (-$120,000)×0.2
Moderate Demand (0.50) =$86,000
1 $100,000
EMV 2 =$90,000×0.3 + $50,000×0.5+ (-$20,000)×0.2
Low Demand (0.20) =$86,000
-$120,000
Decision Node EMV 3 =$0
High Demand (0.30)
$90,000

2 Moderate Demand (0.50)

$50,000

Low Demand (0.20)

-$20,000

All Demand (0.20)

3 $0
Problem 10
Increase (0.50)
Increase (0.30) Unchanged (0.25)
Decrease (0.25)
Increase (0.25)
Unchanged (0.50) Unchanged (0.25)
1
Decrease (0.50)
Increase (0.25)
Accept the rate Decrease (0.20) Unchanged (0.25)
at settlement Decrease (0.50)

Increase (0.30)

Wait for One Month Unchanged (0.50)

2

Decrease (0.20)

Lock Now

All Demand (0.20)

3 $0+$1,000=$1,000
Problem 10
Increase (0.50)
$2,400+$2,400=$2,800
Increase (0.30) Unchanged (0.25)
$2,400+$0=$2,400
Decrease (0.25)
-$2,400+$2,400=-$0
Increase (0.25)
$0+$2,400=$2,400
Unchanged (0.50) Unchanged (0.25)
1 $0+$0=$0
Decrease (0.50) $0-$2,400=-$2,400
Increase (0.25)
-$2,400+$2,400=$0
Accept the rate Decrease (0.20) Unchanged (0.25) -$2,400+$0=-$2,400
at settlement Decrease (0.50) -$2,400-$2,400=-$2,800
Increase (0.30)
$2,400+$500=$2,900

Wait for One Month Unchanged (0.50)

2 $0+$ 500 =$500

Decrease (0.20)
-$2,400+$ 500 =-$1,900

Lock Now

All Demand (0.20)

3 $0+$1,000=$1,000
Problem 10
Increase (0.50)
$2,400+$2,400=$4,800
Increase (0.30) Unchanged (0.25)
$2,400+$0=$2,400
$4,800×0.50+ $2,400×0.25 Decrease (0.25)
+ $0×0.25 =$3,000 -$2,400+$2,400=$0
Increase (0.25)
$0+$2,400=$2,400
Unchanged (0.50) Unchanged (0.25)
1 $0+$0=$0
$2,400×0.25+ $0×0.25 Decrease (0.50)
$3,000×0.30+ $600×0.50 +- $2,400×0.50 =$600 $0-$2,400=-$2,400
Increase (0.25)
- $3,000×0.20 =$0 -$2,400+$2,400=$0
Accept the rate Decrease (0.20) Unchanged (0.25) -$2,400+$0=-$2,400
at settlement -$0×0.25- $2,400×0.25 Decrease (0.50)
-$4,800×0.5 =-$3,000 -$2,400-$2,400=-$4,800
Increase (0.30)
$2,400

Wait for One Month Unchanged (0.50)

2 $0
$2,400×0.30+ $0×0.5
- $2,400×0.20 +$500=$740
Decrease (0.20)
-$2,400

Lock Now

$1,000
All Demand (0.20)
3 $0+$1,000=$1,000