PCOA 009 – MANAGEMENT SCIENCE

Module 5: Decision Analysis

Introduction
• The module is organized as follows:
o Problem formulation
o Decision making without probabilities
o Decision making with probabilities
o Decision making with perfect information
o Assessment
• This module tackles about decision analysis and forecast with probabilities of occurrence.
• Topic requires basic knowledge of algebra and critical thinking and analysis
• Assessment is the and application of decision analysis.
Learning Outcomes
At the end of this module, the students can:
• Described and discussed the importance of decision theory analysis to decision-making
process.
• Employed decision theory using different approaches with or without probabilities in real
life day-to-day situations.

Decision Analysis
Decision analysis can be used to develop optimal strategy when a decision maker is faced with
several decision alternatives and an uncertain or risk-filled pattern of future events.
Even when a careful decision analysis has been conducted, the uncertain future events make the
final consequence uncertain. In some cases, the selected decision alternative may provide good or
excellent results. In other cases, a relatively unlikely future event may occur, causing the selected
decision alternative to provide only fair or even poor results. The risk associated with any decision
alternative is a direct result of the uncertainty associated with the final consequence. A good
decision analysis includes careful consideration of risk. Through risk analysis the decision maker
is provided with probability information about the favorable as well as the unfavorable
consequences that may occur.
We begin the study of decision analysis by considering problems that involve reasonably few
decision alternatives and reasonably few possible future events. Influence diagrams and payoff
tables are introduced to provide a structure for the decision problem and to illustrate fundamentals
of decision analysis. We then introduce decision trees to show the sequential nature of decision
problems. Decision trees are used to analyze more complex problems and to identify an optimal
sequence of decisions, referred to as the optimal decision strategy.

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 Problem Formulation
Pittsburgh Development Corporation (PDC) purchased land that will be the site of a new luxury
condominium complex. The location provides a spectacular view of downtown Pittsburgh and the
Golden Triangle, where the Allegheny and Monongahela Rivers meet to form the Ohio River. PDC
plans to price the individual condominium units between $300,000 and $1,400,000.
PDC commissioned preliminary architectural drawings for three different projects: one with 30
condominiums, one with 60 condominiums, and one with 90 condominiums. The financial success
of the project depends upon the size of the condominium complex and the chance event concerning
the demand for the condominiums. The statement of the PDC decision problem is to select the size
of the new luxury condominium project that will lead to the largest profit given the uncertainty
concerning the demand for the condominium.
Given the statement problem, it is clear that the decision is to select the best size for the
condominium complex. PDC has the following three decision alternatives:
𝑑1 = a small complex with 30 condominiums
𝑑2 = a medium complex with 60 condominiums
𝑑3 = a large complex with 90 condominiums
A factor in selecting the best decision alternative is the uncertainty associated with the chance
event concerning the demand for the condominiums. When asked about the possible demand for
the condominiums, PDC’s president acknowledge a wide range of outcomes: a strong demand and
a weak demand.
In decision analysis, the possible outcomes for a chance event are referred to as the states of
nature. The states of nature are defined so they are mutually exclusive and collectively exhaustive;
thus one and only one of the possible states of nature will occur. For the PDC problem, the chance
event concerning the demand for the condominiums has two states of nature:
𝑠1 = strong demand for the condominiums
𝑠2 = weak demand for the condominiums
Management must first select a decision alternative (complex size); then a state of nature follows
(demand for the condominium) and finally a consequence will occur. In this case, the consequence
is PDC’s profit.
Influence Diagrams
An influence diagram is a graphical device that shows the relationships among the decisions, the
chance events, and the consequences for a decision problem. The nodes in an influence diagram
represent the decisions, chance events, and consequences. Rectangles or squares depict decision
nodes, circles or ovals depict chance, and diamonds depict consequence nodes. The lines

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 connecting the nodes, referred to as arcs, shows the direction of influence that the nodes have on
one another. Figure 13.1 shows the influence diagram for the PDC problem.
Figure 13.1: Influence Diagram for the PDC

Payoff tables
Given the three decision alternatives and the two states of nature, which complex size should PDC
choose? To answer this question, PDC will need to know the consequence associated with each
decision alternative and each state of nature. In decision analysis, we refer to the consequence
resulting from a specific combination of a decision alternative and a state of nature as a payoff. A
table showing payoffs for all combinations of decision alternatives and states of nature is a payoff
table.
Because PDC wants to select the complex size that provides the largest profit, profit is used as the
consequence. The payoff table with profits expressed in millions of dollars. The payoff table with
profits expressed n millions of dollars is shown in Table 13.1. Note, for example, that if a medium
complex is built and demand turns out to be strong, a profit of $14million will be realized.
Table 13.1: Payoff table for the PDC condominium project (in millions)
State of Nature
Decision Alternative Strong Demand 𝒔𝟏 Weak Demand 𝒔𝟐
Small complex, 𝑑1 8 7
Medium complex, 𝑑2 14 5
Large complex, 𝑑3 20 –9
Decision Tree

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 A decision tree provides a graphical representation of the decision-making process. Figure 13.2
presents a decision tree for the PDC problem. Note that the decision tree shows the natural or
logical progression that will occur over time. First, PDC must make a decision regarding the size
of the condominium complex. Then, after the decision is implemented, either state of nature will
occur. The number of each end point of the tree indicates the payoff associated with a particular
sequence.
The decision in Figure 13.2 shows four nodes, numbered 1–4. Squares are used to depict decision
nodes and circle are used to depict chance nodes. Thus, node 1 is a decision node, and nodes 2, 3,
and 4 are chance nodes. The branches connect the nodes; those leaving the decision node
correspond to the decision alternatives. The branches leaving each chance node correspond to the
states of nature. The payoffs are shown at the end of the states-of-nature branches. We now turn
to the question: how can the decision maker use the information in the payoff table or the decision
tree to select the best decision alternative? Several approaches may be used.
Figure 13.2 : Decision Tree for the PDC condominium project

Decision Making without Probabilities

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 Optimistic Approach
The optimistic approach evaluates each decision alternative in terms of the best payoff that can
occur. The decision alternative that is recommended is the one that provides the best possible
payoff. For a problem in which maximum profit is desired, as in the PDC problem, the optimistic
approach would lead the decision maker to choose the alternative corresponding to the largest
profit. For problems involving minimization, this approach leads to choosing the alternative with
the smallest payoff.
Table 13.2: Maximum payoff for each decision alternative
Decision Alternative Maximum Profit
Small complex, 𝑑1 8
Medium complex, 𝑑2 14
Large complex, 𝑑3 20 Maximum of the payoff values

Because 20, as shown in table 13.2, corresponding to 𝑑3 , is the largest payoff, the decision to
construct the largest condominium complex is the recommended decision alternative using the
optimistic approach.
Conservative Approach
The Conservative approach evaluates each decision alternatives in terms of the worst payoff that
can occur. The decision alternative recommended is the one that provides the best of the worst
possible payoffs. For a problem in which the output measure is profit, as in the PDC problem, the
conservative approach would lead the decision maker to choose the alternative that maximizes the
minimum possible profit that could be obtained. For problems involving minimization, this
approach identifies the alternative that will minimize the maximum payoff.
Table 13.3: Minimum payoff for each PDC decision alternative
Decision Alternative Maximum Profit
Small complex, 𝑑1 8 Maximum of the minimum payoff
Medium complex, 𝑑2 14 values
Large complex, 𝑑3 20

Minimax Regret Approach

In decision analysis, regret is the difference between the payoff associated with a particular
decision alternative and the payoff associated with the decision that would yield the most desirable
payoff for a given state of nature. Thus, regret represents how much potential payoff would forgo
by selecting a particular decision alternative given that a specific state of nature will occur. This is
why regret is often referred to as opportunity loss.
As its name implies, under the minimax regret approach to decision making one would choose
the decision alternative that minimizes the maximum state of regret that could occur over all
possible states of nature. This approach is neither purely optimistic nor purely conservative.

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 Suppose that PDC constructs a small condominium complex (𝑑1 ) and demand turns out to be
strong (𝑠1 ). Table 13.1 showed that the resulting profit for PDC would be $8 million. However,
given that the strong demand state of nature (𝑠1 ) has occurred, we realize that the decision to
construct a large condominium complex (𝑑3 ), yielding a profit of $20 million, would have been
the best decision. The difference between the payoff for the best decision alternative ($20 million)
and the payoff for the decision to construct a small condominium ($8 million) is the regret or
opportunity loss associated with decision alternative (𝑑1 ) when state of nature 𝑠1 occurs; thus, for
this case, the opportunity loss or regret is $20 million – $8 million = $12 million. Similarly, if PDC
makes the decision to construct a medium condominium (𝑑2 ) and strong demand state of nature
(𝑠1 ) occurs, the opportunity loss, or regret, associated with (𝑑2 ) would be $20 million – $14 million
= $6 million.
Table 13.4: Opportunity loss, or regret, table for the PDC condominium project
State of Nature
Decision Alternative Strong Demand 𝒔𝟏 Weak Demand 𝒔𝟐
Small complex, 𝑑1 12 0
Medium complex, 𝑑2 6 2
Large complex, 𝑑3 0 16

The next step in applying the minimax regret approach is to list the maximum regret for each
decision alternative; Table 13.5 shows the results for the PDC problem. Selecting the decision
alternative with the minimum of the maximum regret values — hence, the name minimax regret
— yields the minimax regret decision. For the PDC problem, the alternative to construct the
medium condominium complex, with a corresponding maximum regret of $6 million, is the
recommended minimax regret decision.

Table 13.5: Maximum regret for each PDC decision alternative

Decision Alternative Maximum Profit
Small complex, 𝑑1 12
Medium complex, 𝑑2 6 Maximum of the maximum regret
Large complex, 𝑑3 16

Decision Making with Probabilities

In many decision-making situations, we can obtain probability assessments for the states of nature.
When such probabilities are available, we can use the expected value approach to identify the
best decision alternative. Let us first define the expected value of a decision and then apply it to
the PDC problem.
The expected value of a decision alternative is the sum of weighted payoffs for the decision
alternative. The weight for a payoff is the probability of the associated state of nature and therefore
the probability that the payoff will occur. Let us return to the PDC problem to see how the expect
value approach can be applied.

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 PDC is optimistic about the potential for the luxury high-rise condominium complex. Suppose that
this optimism leads to an initial subjective probability assessment of 0.8 that demand will be strong
(𝑠1 ) and a corresponding probability of 0.2 that demand will be weak (𝑠2 ). Thus, the expected
values for the three decision alternatives are computed as follows:
EV(𝑑1 ) = 0.8(8) + 0.2(7) = 7.8
EV(𝑑2 ) = 0.8(14) + 0.2(5) = 12.2
EV(𝑑3 ) = 0.8(20) + 0.2(–9) = 14.2
Using the expected value approach, we find that the large condominium complex, with an expected
value of $14.2 million, is the recommended decision. The calculations required to identify the
decision alternative with the best expected value can be conveniently carried out on a decision
tree. Figure 13.3 shows the decision tree for the PDC problem with state-of-nature branch
probabilities. We weight each possible payoff by its probability of occurrence. By doing so, we
obtain the expected values for nodes 2, 3, and 4, as shown in Figure 13.4
Figure 13.3: PDC Decision tree with state-of-nature branch probabilities

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 Figure 13.4: Applying the expected value approach

Expected value of perfect information

Suppose that PDC has the opportunity to conduct a market research study that would help evaluate
buyer interest in the condominium project and provide information that management could use to
improve the probability assessments for the states of nature. To determine the potential value of
this information, we begin by supposing that the study could provide perfect information regarding
the states of nature; that is, we assume for the mmoment that PDC could determine with certainty,
prior to making a decision, which state of nature is going to occur. To make use of this perfect
information, we will develop a decision strategy that PDC should follow once It knows which state
of nature will occur. A decision strategy is simply a decision rule that specifies the decision
alternative to be selected after new information becomes available.
If 𝑠1 , select 𝑑3 and receive a payoff of $20 million
If 𝑠2 , select 𝑑1 and receive a payoff of $7 million.
what is the expected value for this decision strategy? To compute the expected value with perfect
information, we return to the original probabilities for the states of nature: P(𝑠1 ) = 0.8 and P(𝑠2 )
= 0.2. Thus, there is a 0.8 probability that the perfect information will indicate state of nature 𝑠1 ,
and resulting decision alternative 𝑑3 will provide a $20 million profit. Similarly, with a 0.2
probability for state of nature 𝑠2 , the optimal decision alternative 𝑑1 will provide a $7 million
profit. Thus, the expected value of the decision strategy uses perfect information is 0.8(20) + 0.2(7)
= 17.4.

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 earlier in this section we showed that the recommended decision using the expected value approach
is decision alternative 𝑑3 , with an expected value of $14.2 million. Because this decision
recommendation and expected value computation were made without the benefit of perfect
information, $14.2 million is referred to as the expected value without perfect information
(EVwoPI).
The expected value with perfection is $17.4 million, and the expected value without perfect
information is $14.2; therefore, the expected value of the information (EVPI) is $17.4 – $14.2 =
$3.2 million represents the additional expected value that can be obtained if perfect information
were available about the state of nature.
Generally speaking, a market research study will not provide “perfect” information; however, if
the market research study is a good one, the information gathered might be worth a sizable portion
of the $3.2 million. Given the ECPI of $3.2 million, PDC might seriously consider a market survey
as a way to obtain more information about the states of nature.
In general, the expected value of perfect information (EVPI) is computed as follows:
EVPI = |EVwPI – EVwoPI|
Where:
EVPI = expected value of perfect information
EVwPI = expected value with perfect information about the states of nature
EVwoPI = expected value without perfect information about the states of nature
Note the role of the absolute value. For minimization problems, the expected value with perfect
information is always less than or equal to the expected without perfect information. In this case,
EVPI is the magnitude of the difference between EVwPI and EVwoPI, or the absolute value of the
difference.
We restate the opportunity loss or regret, table for the PDC problem (see Table 13.4) as follows:
State of Nature
Decision Alternative Strong Demand 𝒔𝟏 Weak Demand 𝒔𝟐
Small complex, 𝑑1 12 0
Medium complex, 𝑑2 6 2
Large complex, 𝑑3 0 16

Using P(𝑠1 ), P(𝑠2 ), and the opportunity loss values, we can compute the expected opportunity loss
(EOL) for each decision alternative. With P(𝑠1 ) = 0.8 and P(𝑠2 ) = 0.2, the expected opportunity
loss for each of the three decision alternatives is
EOL(𝑑1 ) = 0.8(12) + 0.2(0) = 9.6
EOL(𝑑2 ) = 0.8(6) + 0.2(2) = 5.2

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 EOL(𝑑3 ) = 0.8(0) + 0.2(16) = 3.2
Regardless of whether the decision analysis involves maximization or minimalization, the
minimum expected opportunity loss always provides the best decision alternative. Thus, with
EOL(𝑑3 ) = 3.2, 𝑑3 is the recommended decision. In addition, the minimum expected opportunity
loss always is equal to the expected value of perfect information. That is, EOL (best decision) =
EVPI; for the PDC problem, this value is $3.2 million.

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 Assessment
Problem 1
Lawson’s Department Store faces a buying decision for a seasonal product for which demand
can be high, medium, or low. The purchaser for Lawson’s can order one, two, or three lots of the
product before the season begins but cannot reorder later. Profit projections (in thousands of
dollars) are shown.
State of Nature
High demand Medium demand Low demand
Decision Alternative 𝒔𝟏 𝒔𝟐 𝒔𝟑
Order lot 1, 𝑑1 60 60 50
Order lot 2, 𝑑2 80 80 30
Order lot 3, 𝑑3 100 70 10

Required:
a. If the prior probabilities for the three states of nature are 0.3, 0.3, and 0.4, respectively,
what is the recommended order quantity?
b. At each preseason sales meeting, the vice president of sales provides a personal opinion
regarding potential demand for this product. Because the vice president enthusiasm and
optimistic nature, the predictions of market conditions have always been either
“excellent” (E) or “very good” (V). probabilities are as follows:
P(E) = 0.70 P(𝑠1 |E) = 0.34 P(𝑠1 |V) = 0.20
P(V) = 0.30 P(𝑠2 |E) = 0.32 P(𝑠2 |V) = 0.26
P(𝑠3 |E) = 0.34 P(𝑠3 |V) = 0.54
What is the optimal decision strategy?
Problem 2
Nit’z Company is planning to produce a new product, Duhat Soap. A marketing consultant
prepared the following payoff probability distribution describing the relative likelihood of
monthly sales volume levels and related contribution margin for Duhat Soap:
Monthly sales volume Probability Contribution
margin
15,000 units 40% P 75,000
18,000 30% 90,000
27,000 15% 135,000
36,000 10% 180,000
45,000 5% 225,000

Required:
a. If Nitz’ decides to market Duhat Soap, what is the expected value of the monthly sales
volume is?

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 b. If Nitz’ decides to market Duhat Soap, what is the expected value of monthly
contribution margin?
Problem 3
Leevoi Scan Company is developing its operating budget for 200B. it has developed the
following range of sales forecast and associated probabilities for the year:
Sales Estimates Probabilities
P48,000 10%
68,000 50%
80,000 40%
Leevoi Scan Company’s gross profit rate averages 20% of sales. What is the expected value of
Leevoi Scan Company’s budgeted cost of goods sold for 20B?

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 Reference:

Anderson, D., Sweeney, D., Williams, T., Camm, J., Cochran, J., Fry, M., & Ohlmann, J. (2016).

Decision Analysis. In An Introduction to Management Science: Quantitative Approaches

to Decision Making (14th ed., pp. 610–688). Cengage Learning.

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