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4/14/2010

Operations as a Competitive Weapon

Image photographed by Salvatore Vuono

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Operations Management
The systematic design, direction, and control of
processes that transform inputs into services and
products for internals, as well as external,
customers
Processes linked together to form a supply chain
 interrelated processes within/across an organisation
that produces a service/product to satisfy customer
needs

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Across the Organization


Finance
Acquires financial
resources and capital
for inputs

Material & Sales


Service Inputs Revenue

Support Functions
• Accounting
• Information Systems
Operations • Human Resources Marketing
• Engineering
Translates Generates sales of
materials and outputs
service into
outputs
Product &
Service Outputs

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A Process View
External environment

Internal and external


customers

Inputs Outputs
Processes and
• Workers operations • Goods
• Managers • Services
• Equipment 1 3
• Facilities
5
• Materials
• Land 2 4
• Energy

Information on
performance

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A Process View

More like a More like a


manufacturing service
process process

• Physical, durable output • Intangible, perishable output


• Output can be inventoried • Output cannot be inventoried
• Low customer contact • High customer contact
• Long response time • Short response time
• Capital intensive • Labor intensive
• Quality easily measured • Quality not easily measured

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The Supply Chain View


Support Processes

New
Customer
External customers

service/
External suppliers

product relationship
development management

Supplier Order
relationship fulfillment
process process

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The Supply Chain View

 Core processes are sets of activities that deliver


value to external customers
1. Supplier relationship process
2. New service/product development process
3. Order fulfillment process
4. Customer relationship process
 Support processes provide vital resources and
inputs to the core processes

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Support Processes
TABLE 1.1 | EXAMPLES OF SUPPORT PROCESSES
Capital acquisition The provision of financial resources for the
organization to do its work and to execute its
strategy
Budgeting The process of deciding how funds will be
allocated over a period of time
Recruitment and hiring The acquisition of people to do the work of
the organization
Evaluation and compensation The assessment and payment of people for
the work and value they provide to the
company
Human resource support and development The preparation of people for their current
jobs and future skills and knowledge needs
Regulatory compliance The processes that ensure that the company
is meeting all laws and legal obligations
Information systems The movement and processing of data and
information to expedite business operations
and decisions
Enterprise and functional management The systems and activities that provide
strategic direction and ensure effective
execution of the work of the business

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Operations Strategy

Specifies the means which operations


implements the corporate strategy’s that helps
build a customer-driven firm

Corporate strategy provides an overall direction


that serves as the framework for carrying out all
the organization's functions

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Operations Strategy
Corporate Strategy
• Environmental scanning Market Analysis
• Core competencies • Market segmentation
• Core processes • Needs assessment
• Global strategies
Competitive Priorities
• Cost
• Quality
• Time
• Flexibility

New Service/
Product Development
• Design
• Analysis No
• Development
• Full launch
Performance
Yes Gap?
Operations Strategy

Competitive Capabilities
Decisions
• Current
• Managing processes
• Needed
• Managing supply chains
• Planned

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Corporate Strategy
 Environmental scanning
 Developing core competencies
1. Workforce
2. Facilities
3. Market and financial know-how
4. Systems and technologies
 Developing core processes
 Global strategies

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Market Analysis

 Market segmentation
 Needs assessment
 Service or product needs
 Delivery system needs
 Volume needs
 Other needs

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Competitive Priorities
DEFINITIONS, PROCESS CONSIDERATIONS, AND EXAMPLES OF COMPETITIVE PRIORITIES

COST Definition Process Considerations Example


1. Low-cost Delivering a service or a Processes must be designed and Costco
operations product at the lowest operated to make them efficient
possible cost
QUALITY
2. Top quality Delivering an outstanding May require a high level of customer Ferrari
service or product contact and may require superior
product features
3. Consistent Producing services or Processes designed and monitored McDonald’s
quality products that meet design to reduce errors and prevent defects
specifications on a
consistent basis
TIME
4. Delivery speed Quickly filling a customer’s Design processes to reduce lead Dell
order time
5. On-time delivery Meeting delivery-time Planning processes to increase United Parcel
promises percent of customer orders shipped Service (UPS)
when promised
6. Development Quickly introducing a new Cross-functional integration and Li & Fung
speed science or a product involvement of critical external
suppliers

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Competitive Priorities

DEFINITIONS, PROCESS CONSIDERATIONS, AND EXAMPLES OF COMPETITIVE PRIORITIES

FLEXIBILITY Definition Process Considerations Example


7. Customization Satisfying the unique needs Low volume, close customer Ritz Carlton
of each customer by contact, and easily reconfigured
changing service or
products designs

8. Variety Handling a wide assortment Capable of larger volumes than Amazon.com


of services or products processes supporting customization
efficiently

9. Volume Accelerating or decelerating Processes must be designed for The United States
flexibility the rate of production of excess capacity Postal Service
service or products quickly (USPS)
to handle large fluctuations
in demand

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Order Winners and Qualifiers


Order Winner
Sales ($)

Order Qualifier
Sales ($)

Low High

Achievement of competitive priority

Low Threshold High

Achievement of competitive priority

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Using Competitive Priorities


At an airline
 Customer relationship
Top quality
Consistent quality
Delivery speed
Variety
 New service development
Development speed
Customization
Top quality

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Using Competitive Priorities


At an airline
Order fulfillment
Low-cost operations
Top quality
Consistent quality
On-time delivery
Variety

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Using Competitive Priorities


At an airline
Supplier relationship
Low-cost operations
Consistent quality
On-time delivery
Variety
Volume flexibility

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Operations Strategy
OPERATIONS STRATEGY ASSESSMENT OF THE BILLING AND PAYMENT PROCESS

Competitive Priority Measure Capability Gap Action


Low-cost operations  Cost per  $0.0813  Target is  Eliminate microfilming and
billing $0.06 storage of billing statements
statement
 Weekly  $17,000  Target is  Develop Web-base process for
postage $14,000 posting bills
Consistent quality  Percent  0.90%  Acceptable  No action
errors in
bill
information
 Percent  0.74%  Acceptable  No action
errors in
posting
payments
Delivery speed  Lead time  48 hours  Acceptable  No action
to process
merchant
payments
Volume flexibility  Utilization  98%  Too high to  Acquire temporary employees
support
rapid
 Improve work methods
increase in
volumes

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Trends in Operations Management


Productivity improvement
 Efficiency, Effectiveness
Global competition
 Increase market penetration by having foreign locations –
who’s slogan is this? “The World’s local bank”
 5 developments that stimulated the need for sound
global strategies- Transportation, loosed regulation, increased
demand, comparative cost advantage

Ethics, workforce & environmental issues

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Trends in Operations Management


Growing economics
 What role does China play in globalisation today?
 What about India?
 What other countries?
 Fifth BRIC?

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OM as a Set of Decisions
USING OPERATIONS TO COMPETE

 In practice, managers make


Competing with Operations
strategic and tactical decisions Project Management

1. Each part of the MANAGING PROCESSES


organization designs and
operates processes Process Strategy
Process Analysis
Quality and Performance
2. Each function is connected Capacity Planning
Lean Systems

through shared resources


MANAGING SUPLY CHAINS

Supply Chain Design


Supply Chain Integration
Location
Inventory Management
Forecasting
Operations Planning and Scheduling
Resource Planning

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Challenges in Operations Management

Part 1: Using operations to compete


Part 2: Managing processes
Part 3: Managing supply chains

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Decision Making

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Break-Even Analysis

Evaluating Services or Products


 Is the predicted sales volume of the service or product
sufficient to break even (neither earning a profit nor
sustaining a loss)?
 How low must the variable cost per unit be to break
even, based on current prices and sales forecasts?
 How low must the fixed cost be to break even?
 How do price levels affect the break-even quantity?

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Break-Even Analysis
 Break-even analysis is based on the assumption that all
costs can be divided into two categories:
 variable costs and fixed costs
 Variable cost, c, is the portion of the total cost that varies
directly with volume of output
 If Q = the number of customers served or units produced
per year, total variable cost = cQ
 Fixed cost, F, is the portion of the total cost that remains
constant regardless of changes in levels of output

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Break-Even Analysis
So
Total cost = F + cQ

Total revenue = pQ

By setting revenue equal to total cost


pQ = F + cQ
F
Q=
p-c
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4/14/2010

Finding the Break-Even Quantity


EXAMPLE A.1
A hospital is considering a new procedure to be offered at $200 per
patient. The fixed cost per year would be $100,000, with total variable
costs of $100 per patient. What is the break-even quantity for this
service? Use both algebraic and graphic approaches to get the answer.

SOLUTION
The formula for the break-even quantity yields

F 100,000
Q= = = 1,000 patients
p-c 200 – 100

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Finding the Break-Even Quantity


 To solve graphically we plot two lines: one for costs and one for
revenues
 Begin by calculating costs and revenues for two different output
levels
 The following table shows the results for Q = 0 and Q = 2,000
Quantity Total Annual Cost ($) Total Annual Revenue ($)
(patients) (Q) (100,000 + 100Q) (200Q)

0 100,000 0

2,000 300,000 400,000

 Draw the cost line through points (0, 100,000) and (2,000,
300,000)
 Draw the revenue line through (0, 0) and (2,000, 400,000)

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Finding the Break-Even Quantity

400 – (2000, 400)

Profits
300 –
Dollars (in thousands)

Total annual revenues

(2000, 300)
Total annual costs
200 –  The two lines intersect at
Break-even quantity
1,000 patients, the break-
even quantity
100 –
Loss Fixed costs

0– | | | |
500 1000 1500 2000
Patients (Q)
Graphic Approach to Break-Even Analysis

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Application 1
A Zoo must decide whether to move twin Siberian Tigers to a conservation
in eastern Russia or build a special exhibit for them and the zoo. The
expected increase in attendance is 200,000 patrons. The data are:
Revenues per Patron for Exhibit
Gate receipts $4
Concessions $5
Licensed apparel $15
 Is the predicted increase in
attendance sufficient to break even?
Estimated Fixed Costs
Exhibit construction $2,400,000
Salaries $220,000
Food $30,000

Estimated Variable Costs per Person


Concessions $2
Licensed apparel $9

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Application 1
Q TR = pQ TC = F + cQ Where
p = 4 + 5 + 15 = $24
0 $0 $2,650,000 F = 2,400,000 + 220,000 + 30,000
250,000 $6,000,000 $5,400,000 = $2,650,000
c = 2 + 9 = $11
7–

6–
(millions of dollars)

5–
Cost and revenue

4–

3–

2–

1–

0 |– | | | | |
50 100 150 200 250
Q (thousands of patrons)
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Application 1
Where
Q TR = pQ TC = F + cQ p = 4 + 5 + 15 = $24
0 $0 $2,650,000 F = 2,400,000 + 220,000 + 30,000
250,000 $6,000,000 $5,400,000 = $2,650,000
c = 2 + 9 = $11

Algebraic solution of the Zoo problem


pQ = F + cQ
24Q = 2,650,000 + 11Q
13Q = 2,650,000
Q = 203,846

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Sensitivity Analysis
EXAMPLE A.2
If the most pessimistic sales forecast for the proposed service in
example 1 (slide 40) were 1,500 patients, what would be the
procedure’s total contribution to profit and overhead per year?

SOLUTION
The graph shows that even the pessimistic forecast lies above the
break-even volume, which is encouraging. The product’s total
contribution, found by subtracting total costs from total revenues, is

pQ – (F + cQ) = 200(1,500) – [100,000 + 100(1,500)]


= $50,000

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Evaluating Processes
Choices must be made between two processes
 For example, between an internal process and buying
services or materials on the outside
We assume that the decision does not affect
revenues
The analyst finds the quantity for which the total
costs for two alternatives are equal

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Evaluating Processes
 Let Fb equal the fixed cost (per year) of the buy option, Fm
equal the fixed cost of the make option, cb equal the variable
cost (per unit) of the buy option, and cm equal the variable
cost of the make option
 The total cost to buy is Fb + cbQ and the total cost to make is
Fm + cmQ
 To find the break-even quantity, we set the two cost
functions equal and solve for Q:
Fb + cbQ = Fm + cmQ

Fm – Fb
Q= cb – cm
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Break-Even Analysis for Make-or-Buy Decisions


EXAMPLE 2

 A fast-food restaurant featuring hamburgers is adding salads to the


menu
 The price to the customer will be the same
 Fixed costs are estimated at $12,000 and variable costs totaling $1.50
per salad
 Preassembled salads could be purchased from a local supplier at
$2.00 per salad
 Preassembled salads would require additional refrigeration with an
annual fixed cost of $2,400
 Expected demand is 25,000 salads per year
 What is the break-even quantity?

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Break-Even Analysis for Make-or-Buy Decisions


SOLUTION
The formula for the break-even quantity yields the following:

Fm – Fb
Q= cb – cm

12,000 – 2,400
= = 19,200 salads
2.0 – 1.5

The break-even quantity is 19,200 salads. As the 25,000-salad sales forecast


exceeds this amount, the make option is preferred. Only if the restaurant
expected to sell fewer than 19,200 salads would the buy option be better.

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Application 1
At what volume should the Zoo be indifferent between buying
special merchandises from a supplier or have zoo employees make
them?

Buy Make

Fixed costs $0 $300,000

Variable costs $9 $7

Fm – Fb $300,000 – $0
Q= cb – c m = = 150,000
$9 – $7
Units

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Preference Matrix

 A Preference Matrix is a table that allows you to rate an


alternative according to several performance criteria
 The criteria can be scored on any scale as long as the same
scale is applied to all the alternatives being compared
 Each score is weighted according to its perceived
importance, with the total weights typically equaling 100
 The total score is the sum of the weighted scores (weight ×
score) for all the criteria and compared against scores for
alternatives

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Evaluating an Alternative
EXAMPLE 4
The following table shows the performance criteria, weights, and
scores (1 = worst, 10 = best) for a new thermal storage air conditioner.
If management wants to introduce just one new product and the
highest total score of any of the other product ideas is 800, should the
firm pursue making the air conditioner?

Performance Criterion Weight (A) Score (B) Weighted Score (A  B)


Market potential 30 8 240
Unit profit margin 20 10 200
Operations compatibility 20 6 120
Competitive advantage 15 10 150
Investment requirements 10 2 20
Project risk 5 4 20
Weighted score = 750

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Application A.3

Performance Criterion Weight Score Weighted Score


Market potential 10 5
Unit profit margin 30 8
Operations compatibility 20 10
Competitive advantage 25 7
Investment requirements 10 3
Project risk 5 4
Total weighted score =

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Application A.3

Performance Criterion Weight Score Weighted Score


Market potential 10 5 50
Unit profit margin 30 8 240
Operations compatibility 20 10 200
Competitive advantage 25 7 175
Investment requirements 10 3 30
Project risk 5 4 20
Total weighted score = 715

 Repeat this process for each alternative – pick the one with the
largest weighted score

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Preference matrix - criticisms

Requires the manager to state criterion weights


before examining alternatives, but they may not
know in advance what is important and what is not
Allows one very low score to be overridden by high
scores on other factors
May cause managers to ignore important signals

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Decision Theory
 Decision theory is a general approach to decision making
when the outcomes associated with alternatives are in
doubt
 A manager makes choices using the following process:

1. List a reasonable number of feasible alternatives


2. List the events (states of nature)
3. Calculate the payoff table showing the payoff for each alternative in
each event
4. Estimate the probability of occurrence for each event
5. Select the decision rule to evaluate the alternatives

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Decision Making Under Certainty

 The simplest solution is when the manager knows


which event will occur

 Here the decision rule is to pick the alternative


with the best payoff for the known event

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Decisions Under Certainty


EXAMPLE A.5
 A manager is deciding whether to build a small or a large facility
 Much depends on the future demand
 Demand may be small or large
 Payoffs for each alternative are known with certainty
 What is the best choice if future demand will be low?

Possible Future Demand


Alternative Low High
Small facility 200 270
Large facility 160 800
Do nothing 0 0

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Decisions Under Certainty


SOLUTION
 The best choice is the one with the highest payoff
 For low future demand, the company should build a small facility
and enjoy a payoff of $200,000
 Under these conditions, the larger facility has a payoff of only
$160,000

Possible Future Demand


Alternative Low High
Small facility 200 270
Large facility 160 800
Do nothing 0 0

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Decision Making Under Uncertainty


 Can list the possible events but cannot estimate
the probabilities
1. Maximin: The best of the worst, a pessimistic approach
2. Maximax: The best of the best, an optimistic approach
3. Laplace: The alternative with the best weighted payoff
assuming equal probabilities
4. Minimax Regret: Minimizing your regret (also
pessimistic)

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Decisions Under Uncertainty


EXAMPLE A.6
Reconsider the payoff matrix in Example A.5. What is the best
alternative for each decision rule?
SOLUTION
a. Maximin. An alternative’s worst payoff is the lowest number in its
row of the payoff matrix, because the payoffs are profits. The
worst payoffs ($000) are
Alternative Worst Payoff
Small facility 200
Large facility 160

The best of these worst numbers is $200,000, so the


pessimist would build a small facility

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Decisions Under Uncertainty


b. Maximax. An alternative’s best payoff ($000) is the highest
number in its row of the payoff matrix, or

Alternative Best Payoff


Small facility 270
Large facility 800

The best of these best numbers is $800,000, so the optimist would


build a large facility

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Decisions Under Uncertainty


c. Laplace. With two events, we assign each a probability of 0.5.
Thus, the weighted payoffs ($000) are

Alternative Weighted Payoff


Small facility 0.5(200) + 0.5(270) = 235
Large facility 0.5(160) + 0.5(800) = 480

The best of these weighted payoffs is $480,000, so the


realist would build a large facility

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Decisions Under Uncertainty


d. Minimax Regret. If demand turns out to be low, the best
alternative is a small facility and its regret is 0 (or 200 – 200). If a
large facility is built when demand turns out to be low, the regret
is 40 (or 200 – 160).

Regret
Alternative Low Demand High Demand Maximum Regret
Small facility 200 – 200 = 0 800 – 270 = 530 530
Large facility 200 – 160 = 40 800 – 800 = 0 40

The column on the right shows the worst regret for each alternative.
To minimize the maximum regret, pick a large facility.

The biggest regret is associated with having only a small facility and
high demand.

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Application A.4
Fletcher (a realist), Cooper (a pessimist), and Wainwright (an optimist) are
joint owners in a company. They must decide whether to make Arrows,
Barrels, or Wagons. The government is about to issue a policy and
recommendation on pioneer travel that depends on whether certain
treaties are obtained. The policy is expected to affect demand for the
products; however it is impossible at this time to assess the probability of
these policy “events.” The following data are available:

Payoffs (Profits)
Land Routes Land Routes Sea Routes
Alternative
No treaty Treaty Only
Arrows $840,000 $440,000 $190,000
Barrels $370,000 $220,000 $670,000
Wagons $25,000 $1,150,000 ($25,000)

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Application A.4
Fletcher (a realist), Cooper (a pessimist), and Wainwright (an optimist)
are joint owners in a company. They must decide whether to make
Arrows, Barrels, or Wagons. The government is about to issue a policy
and recommendation on pioneer travel that depends on whether
certain treaties are obtained. The policy is expected to affect demand
for the products; however it is impossible at this time to assess the
probability of these policy “events.” The following data are available:

Payoffs (Profits)
Land Routes Land Routes Sea Routes
Alternative
No treaty Treaty Only
Arrows $840,000 $440,000 $190,000
Barrels $370,000 $220,000 $670,000
Wagons $25,000 $1,150,000 ($25,000)

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Application A.4
 Which product would be favored by Fletcher (realist)?
 Which product would be favored by Cooper (pessimist)?
 Which product would be favored by Wainwright (optimist)?
 What is the minimax regret solution?
Payoffs (Profits)
Land Routes Land Routes Sea Routes
Alternative
No treaty Treaty Only
Arrows $840,000 $440,000 $190,000
 The short answers Barrels $370,000 $220,000 $670,000
are: Wagons $25,000 $1,150,000 ($25,000)

 Fletcher (realist – Laplace) would choose arrows


 Cooper (pessimist – Maximin) would choose barrels
 Wainwright (optimist – Maximax) would choose wagons
 The Minimax Regret solution is arrows
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Decisions Under Risk

 The manager can list the possible events and estimate their
probabilities

 The manager has less information than decision making under


certainty, but more information than with decision making under
uncertainty

 The expected value rule is widely used

 This rule is similar to the Laplace decision rule, except that the
events are no longer assumed to be equally likely

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Decisions Under Risk


EXAMPLE A.7
Reconsider the payoff matrix in Example A.5. For the expected value
decision rule, which is the best alternative if the probability of small
demand is estimated to be 0.4 and the probability of large demand is
estimated to be 0.6?
SOLUTION Possible Future Demand
Alternative Small Large
The expected value for each Small facility 200 270
alternative is as follows: Large facility 160 800

Alternative Expected Value

Small facility
0.4(200) + 0.6(270) = 242
Large facility
0.4(160) + 0.6(800) = 544

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Application A.5
For Fletcher, Cooper, and Wainwright, find the best decision using the
expected value rule. The probabilities for the events are given below.
What alternative has Payoffs (Profits)
the best expected Alternative
Land Routes Land Routes Sea Routes
No treaty Treaty Only
results?
Arrows $840,000 $440,000 $190,000
Barrels $370,000 $220,000 $670,000
Wagons $25,000 $1,150,000 ($25,000)

Land routes, No
Land Routes, Sea routes, Expected
Alternative Treaty
Treaty Only (0.30) Only (0.20) Value
(0.50)

Arrows (0.50)(840,000) + (0.30)(440,000) + (0.20)(190,000) = 590,000

Barrels (0.50)(370,000) + (0.30)(220,000) + (0.20)(670,000) = 385,000

Wagons (0.50)(25,000) + (0.30)(1,150,000) + (0.20)(-25,000) = 352,500

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Decision Trees
 Schematic models of available alternatives and
possible consequences
Useful with probabilistic events and sequential
decisions
Square nodes = decisions
Circular nodes = events
Events leaving a chance node are collectively
exhaustive

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Decision Trees
 Conditional payoffs for each possible alternative-
event combination shown at the end of each
combination

 Draw decision tree from left to right

 Calculate expected payoff to solve the decision tree


from right to left

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Decision Trees
E1 & Probability
Payoff 1
E2 & Probability
Payoff 2
E3 & Probability
Payoff 3

Alternative 3
Payoff 1
Alternative 4
1 2 Payoff 2
Alternative 5
1st Payoff 3
Possible
decision
2nd decision

E2 & Probability
Payoff 1
= Event node
E3 & Probability
Payoff 2
= Decision node

Ei = Event i
P(Ei) = Probability of event i A Decision Tree Model

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Decision Trees
 After drawing a decision tree, we solve it by
working from right to left, calculating the
expected payoff for each of its possible
paths
1. For an event node, we multiply the payoff of each event
branch by the event’s probability and add these products
to get the event node’s expected payoff
2. For a decision node, we pick the alternative that has the
best expected payoff

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Decision Trees

 Software for drawing and/or analyzing


decision trees, including
 PowerPoint - to draw decision trees, but does
not capable of analysis
 POM with Windows
 SmartDraw
 PrecisionTree decision analysis from Palisade
Corporation
 TreePlan

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Analyzing a Decision Tree


EXAMPLE A.8
 A retailer will build a small or a large facility at a new location
 Demand can be either small or large, with probabilities estimated to
be 0.4 and 0.6, respectively
 For a small facility and high demand, not expanding will have a payoff
of $223,000 and a payoff of $270,000 with expansion
 For a small facility and low demand the payoff is $200,000
 For a large facility and low demand, doing nothing has a payoff of
$40,000
 The response to advertising may be either modest or sizable, with
their probabilities estimated to be 0.3 and 0.7, respectively
 For a modest response the payoff is $20,000 and $220,000 if the
response is sizable
 For a large facility and high demand the payoff is $800,000

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Analyzing a Decision Tree


SOLUTION
The decision tree in Figure A.5 shows the event probability and the
payoff for each of the seven alternative-event combinations.
The first decision is whether to build a small or a large facility. Its
node is shown first, to the left, because it is the decision the retailer
must make now.
The second decision node is reached only if a small facility is built
and demand turns out to be high.
Finally, the third decision point is reached only if the retailer builds a
large facility and demand turns out to be low.

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Analyzing a Decision Tree


Low demand [0.4]
$200

Don’t expand
$223
2
Expand
$270
1 Do nothing
$40
Modest response [0.3]
3 $20
Advertise

Sizable response [0.7]


$220

High demand [0.6]


$800

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Analyzing a Decision Tree


Low demand [0.4]
$200

Don’t expand
$223
2
Expand
$270
1 Do nothing 0.3 x $20 = $6
$40
Modest response [0.3]
3 $20
Advertise

Sizable response [0.7]


$6 + $154 = $160 $220

0.7 x $220 = $154


High demand [0.6]
$800

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Analyzing a Decision Tree


Low demand [0.4]
$200

Don’t expand
$223
2
Expand
$270
1 Do nothing
$40
Modest response [0.3]
3 $20
Advertise
$160
Sizable response [0.7]
$160 $220

High demand [0.6]


$800

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Analyzing a Decision
$200 Tree
Low demand [0.4]

Don’t expand
$223
2
Expand
$270 $270
1 Do nothing
$40
Modest response [0.3]
3 $20
Advertise
$160
Sizable response [0.7]
$160 $220

High demand [0.6]


$800

shaping success
FIGURE A.5 – Decision
in business and finance
Tree for Retailer (in $000)

Analyzing a Decision Tree


Low demand [0.4]
$200 x 0.4 = $80
$80 + $162 = $242

Don’t expand
$223
2
Expand
$270 $270 x 0.6 = $162
1 Do nothing
$40
Modest response [0.3]
3 $20
Advertise
$160
Sizable response [0.7]
$160 $220

High demand [0.6]


$800

shaping success in business and finance

Analyzing a Decision Tree


Low demand [0.4]
$200
$242

Don’t expand
$223
2
Expand
$270 $270
1 Do nothing
$40
Modest response [0.3]
3 $20
Advertise
$160
Sizable response [0.7]
$160 $220
0.4 x $160 = $64

$544 High demand [0.6]


$800 x 0.6 = $480

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Analyzing a Decision Tree


Low demand [0.4]
$200
$242

Don’t expand
$223
2
Expand
$270 $270
1 Do nothing
$40
$544 Modest response [0.3]
3 $20
Advertise
$160
Sizable response [0.7]
$160 $220

$544 High demand [0.6]


$800

shaping success in business and finance

Analyzing a Decision Tree


Low demand [0.4]
$200
$242

Don’t expand
$223
2
Expand
$270 $270
1 Do nothing
$40
$544 Modest response [0.3]
3 $20
Advertise
$160
Sizable response [0.7]
$160 $220

$544 High demand [0.6]


$800

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Application A.6
a. Draw the decision tree for the Fletcher, Cooper, and Wainwright
Application A.5 problem
b. What is the expected payoff for the best alternative in the decision
tree below?

Land routes, Land Routes,


Sea routes,
Alternative No Treaty Treaty Only
Only (0.20)
(0.50) (0.30)

Arrows 840,000 440,000 190,000

Barrels 370,000 220,000 670,000

Wagons 25,000 1,150,000 -25,000

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Application A.6

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Solved Problem 1
 A small manufacturing business has patented a new device for
washing dishes and cleaning dirty kitchen sinks
 The owner wants reasonable assurance of success
 Variable costs are estimated at $7 per unit produced and sold
 Fixed costs are about $56,000 per year

a. If the selling price is set at $25, how many units must be produced and
sold to break even? Use both algebraic and graphic approaches.
b. Forecasted sales for the first year are 10,000 units if the price is
reduced to $15. With this pricing strategy, what would be the
product’s total contribution to profits in the first year?

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Solved Problem 1
SOLUTION
a. Beginning with the algebraic approach, we get

F 56,000
Q= =
p–c 25 – 7

= 3,111 units

Using the graphic approach, shown in Figure A.6, we first draw


two lines:
Total revenue = 25Q
Total cost = 56,000 + 7Q
The two lines intersect at Q = 3,111 units, the break-even quantity

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Solved Problem 1
b. Total profit contribution = Total revenue – Total cost
= pQ – (F + cQ)
= 15(10,000) – [56,000 + 7(10,000)]
= $24,000

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Solved Problem 1
250 –

200 –
Total revenues
Dollars (in thousands)

150 –

Break-even
100 – quantity
$77.7
Total costs
50 –
3.1

0– | | | | | | | |
1 2 3 4 5 6 7 8
Units (in thousands)

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Solved Problem 2
Binford Tool Company is screening three new product idea: A, B, and C.
Resource constraints allow only one of them to be commercialized. The
performance criteria and ratings, on a scale of 1 (worst) to 10 (best), are
shown in the following table. The Binford managers give equal weights
to the performance criteria. Which is the best alternative, as indicated
by the preference matrix method?

Rating
Performance Criteria Product A Product B Product C
1. Demand uncertainty and project risk 3 9 2
2. Similarity to present products 7 8 6
3. Expected return on investment (ROI) 10 4 8
4. Compatibility with current 4 7 6
manufacturing process
5. Competitive Strategy 4 6 5

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Solved Problem 2
Rating

SOLUTION Performance Criteria Product A Product B Product C


1. Uncertainty and risk 3 9 2
Each of the five criteria 2. Similarity 7 8 6
receives a weight of 1/5 or 3. ROI 10 4 8
0.20 4. Compatibility 4 7 6
5. Strategy 4 6 5

Product Calculation Total Score

A (0.20 × 3) + (0.20 × 7) + (0.20 × 10) + = 5.6


(0.20 × 4) + (0.20 × 4)
B (0.20 × 9) + (0.20 × 8) + (0.20 × 4) +
= 6.8
(0.20 × 7) + (0.20 × 6)
C (0.20 × 2) + (0.20 × 6) + (0.20 × 8) +
= 5.4
(0.20 × 6) + (0.20 × 5)
The best choice is product B as Products A and C are well behind in terms of total weighted score

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Solved Problem 3

Adele Weiss manages the campus flower shop. Flowers must be ordered
three days in advance from her supplier in Mexico. Although Valentine’s
Day is fast approaching, sales are almost entirely last-minute, impulse
purchases. Advance sales are so small that Weiss has no way to estimate
the probability of low (25 dozen), medium (60 dozen), or high (130 dozen)
demand for red roses on the big day. She buys roses for $15 per dozen and
sells them for $40 per dozen. Construct a payoff table. Which decision is
indicated by each of the following decision criteria?
a. Maximin
b. Maximax
c. Laplace
d. Minimax regret

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Solved Problem 3
SOLUTION
The payoff table for this problem is

Demand for Red Roses


Low Medium High
Alternative
(25 dozen) (60 dozen) (130 dozen)
Order 25 dozen $625 $625 $625
Order 60 dozen $100 $1,500 $1,500
Order 130 dozen ($950) $450 $3,250
Do nothing $0 $0 $0

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Solved Problem 3
a. Under the maximin criteria, Weiss should order 25 dozen, because if
demand is low, Weiss’s profits are $625, the best of the worst
payoffs.
b. Under the maximax criteria, Weiss should order 130 dozen. The
greatest possible payoff, $3,250, is associated with the largest order.
c. Under the Laplace criteria, Weiss should order 60 dozen. Equally
weighted payoffs for ordering 25, 60, and 130 dozen are about $625,
$1,033, and $917, respectively.
d. Under the minimax regret criteria, Weiss should order 130 dozen.
The maximum regret of ordering 25 dozen occurs if demand is high:
$3,250 – $625 = $2,625. The maximum regret of ordering 60 dozen
occurs if demand is high: $3,250 – $1,500 = $1,750. The maximum
regret of ordering 130 dozen occurs if demand is low: $625 – (–$950)
= $1,575.

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Solved Problem 4
White Valley Ski Resort is planning the ski lift operation for its new ski
resort and wants to determine if one or two lifts will be necessary
Each lift can accommodate 250 people per day and skiing occurs 7 days
per week in the 14-week season and lift tickets cost $20 per customer
per day
The table below shows all the costs and probabilities for each
alternative and condition
Should the resort purchase one lift or two?
Alternatives Conditions Utilization Installation Operation
One lift Bad times (0.3) 0.9 $50,000 $200,000
Normal times (0.5) 1.0 $50,000 $200,000
Good times (0.2) 1.0 $50,000 $200,000
Two lifts Bad times (0.3) 0.9 $90,000 $200,000
Normal times (0.5) 1.0 $90,000 $400,000
Good times (0.2) 1.0 $90,000 $400,000

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Solved Problem 4
SOLUTION
The decision tree is shown in Figure A.7. The payoff ($000) for each
alternative-event branch is shown in the following table. The total
revenues from one lift operating at 100 percent capacity are $490,000
(or 250 customers × 98 days × $20/customer-day).
Alternatives Economic Conditions Payoff Calculation (Revenue – Cost)

One lift Bad times


0.9(490) – (50 + 200) = 191
Normal times
1.0(490) – (50 + 200) = 240
Good times
1.0(490) – (50 + 200) = 240
Two lifts Bad times
0.9(490) – (90 + 200) = 151
Normal times
1.5(490) – (90 + 400) = 245
Good times
1.9(490) – (90 + 400) = 441

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Solved Problem 4
Bad times [0.3]
0.3(191) + 0.5(240) + $191
0.2(240) = 225.3
Normal times [0.5]
$240
One lift
$225.3
Good times [0.2]
$240
$256.0
Bad times [0.3]
$151

Two lifts Normal times [0.5]


$245

$256.0
Good times [0.2]
0.3(151) + 0.5(245) + $441
0.2(441) = 256.0

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