Professional Documents
Culture Documents
Class 1: Introduction to OM
Best Box Builders
Process Analysis / Theory of Constraints
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Decision Analysis
Decision analysis is suitable for a wide range of operations
management decisions where uncertainty is present,
e.g.,
capacity planning,
product design,
equipment selection,
location planning.
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Decision Analysis
An analytic and systematic approach to decision making
In this chapter: under uncertain environment (i.e.,
decision maker doesn’t know which event will occur in
the future)
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Five Steps in Decision Making
1. Clearly define the problem
2. List all possible decision alternatives
3. Identify all possible outcomes for each decision
alternative
4. Identify the payoff for each alternative &
outcome combination
5. Use a decision modeling technique to choose
an alternative
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Thompson Lumber Company (TLC)
1. Decision: Whether or not to make and sell
backyard storage sheds
2. Alternatives:
• Build a large plant
• Build a small plant
• Do nothing (don’t forget this option)
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Thompson Lumber Company (TLC)
4. Payoffs:
Outcomes (Demand)
Alternatives High Moderate Low
Build large plant 200 000 100 000 -120 000
Build small plant 90 000 50 000 -20 000
No plant 0 0 0
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Decision-Making Environments
Type 1: Decision making under certainty
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Decision Making Under Certainty
The consequence (payoff) of every alternative is
known
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Decision Making Under Uncertainty
Possible alternatives and possible outcomes
(events) are known; however, probabilities of
the possible outcomes are not known
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Maximax Profit Criterion: TLC
The optimistic approach
Assume the best scenario will occur for each alternative
Maximize the maximum profits
Outcomes (Demand)
Alternatives High Moderate Low
Build large plant 200 000 100 000 -120 000
Build small plant 90 000 50 000 -20 000
No plant 0 0 0
Thus, choose large plant (best payoff)
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Maximin Profit Criterion: TLC
The pessimistic approach
Assume the worst scenario will occur for each alternative
Maximize the minimum profits
Outcomes (Demand)
Alternatives High Moderate Low
Build large plant 200 000 100 000 -120 000
Build small plant 90 000 50 000 -20 000
No plant 0 0 0
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Criterion of Realism /
Hurwicz Criterion
Uses the coefficient of realism (α) to estimate
the decision maker’s optimism (i.e., 0 ≤ α ≤ 1)
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Criterion of Realism /
Hurwicz Criterion: TLC
Suppose α = 0.45
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Equally Likely Criterion /
Laplace Criterion: TLC
Assumes all outcomes equally likely and uses
the average payoff
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Minimax Regret Criterion: TLC
Regret or opportunity loss measures how much better
we could have done
Regret = (best payoff) – (actual payoff)
Outcomes (Demand)
Alternatives High Moderate Low
Large plant 200,000 100,000 -120,000
Small plant 90,000 50,000 -20,000
No plant 0 0 0
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Using Excel for Solution: TLC
SCREENSHOT 9.1B: Excel Solution for Thompson Lumber
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Decision Making Under Risk
Where probabilities of outcomes (events or states of
nature) are available
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EMV Method: TLC
Outcomes (Demand)
High Moderate Low
Alternatives (PH=0.3) (PM=0.5) (PL=0.2) EMV
Large plant 200 000 100 000 -120 000 86 000
Small plant 90 000 50 000 -20 000 48 000
No plant 0 0 0 0
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Expected Opportunity Loss (EOL)
An alternative approach which minimizes EOL
How much regret do we expect based on the
probabilities?
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EOL Method: TLC
Outcomes (Demand)
High Moderate Low
Alternatives (PH=0.3) (PM=0.5) (PL=0.2) EOL
Large plant 0 0 120 000 24 000
Small plant 110 000 50 000 20 000 62 000
No plant 200 000 100 000 0 110 000
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Perfect Information (PI)
Perfect Information would tell us with certainty
which outcome (event) is going to occur
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Expected Value With PI (EVwPI)
Theexpected payoff when we have and use
perfect information before making a decision
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Expected Value of PI (EVPI)
The amount by which perfect information would
increase our expected payoff
The maximum amount the decision maker is
willing to pay for perfect information
Note: EVPI always equals the EOL for the best decision.
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Expected Value of PI (EVPI)
Outcomes (Demand)
High Moderate Low
Alternatives (PH=0.3) (PM=0.5) (PL=0.2)
Build large plant 200 000 100 000 -120 000
Build small plant 90 000 50 000 -20 000
No plant 0 0 0
* Payoffs in blue would be chosen based on
perfect information
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Decision Trees
A decision tree can be used instead of a table to
show alternatives, outcomes, and payoffs
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Thompson Lumber Company (TLC)
Payoff Table:
Outcomes (Demand)
Alternatives High Moderate Low
Build large plant 200 000 100 000 -120 000
Build small plant 90 000 50 000 -20 000
No plant 0 0 0
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Decision Tree: TLC
FIGURE 1:
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Folding Back a Decision Tree
A process of identifying the optimal decision in a
decision tree
The process begins after a complete decision
tree has been developed
Moving from right to left, calculate the expected
payoff at each outcome node
At each decision node, select the best decision
alternative (based on expected payoff)
– Largest payoff for the maximization problem
– Lowest cost for the minimization problem
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Decision Tree with EMVs: TLC
FIGURE 2: Completed Decision Tree
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Multistage Decision Problems
It
is possible for a decision alternative (or
outcome) to be immediately followed by another
decision alternative (or outcome)
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Expanded Decision Tree: TLC
FIGURE 3:
Note the
probabilities
for “high
demand”,
“moderate
demand”,
and “low
demand” in
the “conduct
survey”
subtree for
“positive
result” and
“negative
result”.
-> revised
probabilities 35
Decision Tree with EMVs: TLC
FIGURE 4:
Note: the
non-optimal
branches
are pruned.
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Decision Tree Analysis: TLC
Based on the decision tree with EMVs shown in Figure 4,
we have the following strategy:
Note: The actual payoff for TLC would be different from the
calculated EMVs.
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Expected Value of
Sample Information (EVSI)
The Thompson Lumber survey provides sample
information (which is not perfect information)
What is the value of this sample information (SI)?
In other words, what is the maximum amount of
money TLC willing to pay for the sample
information?
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EVSI: TLC
If sample information were available with no cost
EMV (with free SI) = $87 961 + $4 000 (because we
assumed the survey would cost $4 000)
= $91 961
EMV (no SI) = $86 000 (previously obtained)
Implication:
If the survey costs less than $5 961, then TLC should
purchase it; otherwise, do not purchase it.
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Efficiency of Sample Information
How close does the sample information come to
perfect information?
Efficiency of sample information is the proportion
(or percentage) of the expected value of sample
information to the expected value of perfect
information
EVSI
Efficiency of Sample Information =
EVPI
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Estimating Revised Probabilities
Given Known Prior Probabilities:
P(HD) = 0.30
P(MD) = 0.50
P(LD) = 0.20
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Estimating Revised Probabilities
It is necessary to understand the conditional probability
formula: P ( A and B )
P( A | B) =
P (B )
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Estimating Revised Probabilities
The marketing research firm provided the following
probabilities based on its track record of survey
accuracy:
P(PS|HD) = 0.967 P(NS|HD) = 0.033
P(PS|MD) = 0.533 P(NS|MD) = 0.467
P(PS|LD) = 0.067 P(NS|LD) = 0.933
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Estimating Revised Probabilities
Now we can calculate P(HD|PS):
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Tableau Approach: TLC
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Tableau Approach: TLC
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Readings
Ifyou want to have a better grasp the key concepts,
the following readings are recommended:
Chapter 3. Decision Analysis
– Originally Chapter 19 of Business Statistics: For
Contemporary Decision Making, Second Canadian Edition
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