DECISION ENVIRONMENT

- Operation management decision environments are classified according to degree of certainty present:

3 BASIC CATEGORIES

1) CERTAINTY
- Environment in which relevant parameters have known values.
- Means that relevant parameters such as cost, capacity, and demand have known values
- The decision maker knows which state of nature will occur
- E.g. profit/unit is P50. You have an order for 200 units. How much profit will you make? (profits and total
demand are known)

2) RISK
- Environment in which certain future events have probable outcomes
- Means that certain parameters have probabilistic outcomes
- The decision maker does not know which state of nature will occur but can estimate the probability that
any one state will occur.
- E.g profit/ unit is P50. Based on previous experience there is a 50% chance of an order for 100 units and
a 50% chance of an order for 200 units. What is expected profit? (demand outcome are probabilistic)

3) UNCERTAINTY
- Environment in which it is impossible to assess the likelihood of various future events
- Means that it is impossible to assess the likelihood of various future events
- The decision maker lacks sufficient information even to estimate the probabilities of the possible states of
nature
- E.g. profit is to P50/unit. The probabilities of potential demand are unknown.

NOTE: These three decision environments require different analysis techniques. Some techniques are
better suited for one category than for others.

DECISION THEORY
- Suitable for a wide range of operations management decisions, e.g. capacity planning, product and
service design, equipment selection and location planning and inventory, because these are about an
uncertain future.
- General approach to decision making when the outcomes associated with alternatives are often in
doubt.
 ELEMENTS OF DECISION MAKING
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.
PROCESS OF DECISION MAKING
1. List the feasible alternatives
- One alternative that should always be considered as a basis for reference is to do nothing or to maintain
Status Quo.
Ex.: where to locate a new retail store in a certain part of the city

2. List the events (chance events or states of nature) that have an impact on the outcome of the choice but
aren’t under the managers’ control
 States of Nature- possible future conditions; these events must be mutually exclusive and exhaustive-
they don’t overlap and that they cover all eventualities.
Ex.:
a) Number of contracts awarded will be one, two or three
b) Competitors will or will not introduce a new product
c) Demand experienced by the new facility could be: low, medium or high
Location
Depending on Competition then group events into reasonable
General retail/ trends categories*
*e.g. average of sales per day could be from 1 to from 500 units. The manager can represent demand
with just 3 events: 100 units/day, 300 units/day or 500/day.

3. Calculate/determine/estimate the payoff for each alternative in each event.

- typically the payoff is in terms of total profit or total cost
- these payoffs can be entered into a payoff table
 Payoff table- shows the expected payoffs for each alternative under the various possible states of nature
- helpful in choosing among alternatives because they facilitate comparison of alternatives

POSSIBLE FUTURE DEMAND (in millions)

Alternatives Low Moderate High
Small Facility P10 P10 P10
Medium Facility 7 12 12
Large Facility -4 2 16

 Payoffs are in terms of present values which represent equivalent current peso
values of expected future income

4. Estimate the likelihood of each event using past data, executive opinion and other forecasting methods.
- express it as probability, making sure that the probabilities sum to 1.0; develop probability estimates from
past data if the past is considered a good indicator of the future.
5. Select a decision rule or criterion to evaluate the alternatives and select the best alternative
e.g. choosing the alternative with the lowest expected cost

A. DECISION MAKING UNDER CERTAINTY

- manager knows which event will definitely occur under each alternative
- decision rule is to pick the alternative with the best payoff for the known event
- the best alternative is the highest payoff if the payoffs are expressed as profit, if the payoffs are
expressed as costs, the best alternative is the one having the lowest payoff
- the decision is usually relatively straight forward: simply choose the alternative that has the best payoff
under state of nature
Examples:
1. A manager is deciding whether to build a small or a large facility. Much depends on the future demand
that the facility must serve and demand may be small or large. The manager knows which certainty the
payoffs that will result under each alternative. The payoffs, in thousands (P 000), are the present values
of future revenues minus costs for each alternative in each event.
Possible Future Demand
Alternative Low High
Small Facility 200 270
Medium Facility 160 800
Large Facility 0 0
Which is the best choice if the future demand will be low?
Answer: The best choice is the one with the highest payoffs. If the manager knows the future demand will
be low, the company should build a small facility and enjoy a payoff of P200 000.

B. Decision Making Under Uncertainty

-no information is available on how likely the various states of nature are.

4 Decision rules or criteria

A. Maximin - It maximizes the minimum payoffs given the various decisions that are possible.
-Its rule is a very conservative one that takes a pessimistic view on the various states of
nature.
B. Maximax - It maximizes the maximum payoffs for the different decisions starting with the identification
of the maximum payoffs of each alternative decision (optimistic view).
C. Laplace – determines the average payoff for each alternative and chooses the alternative with the best
average.
D. Minimax Regret – determine the worst regret for each alternative and choose the alternative with the
“best worst”
Example #1 (same problem given in certainty) Profit Payoffs
Required: Determine the best alternative for each decision rule

Solution:
a. Maximin
1. Select the column with minimum payoff.
2. Identify the worst payoff.
Alternative Payoffs Worst Payoffs
Small Facility 200
Large Facility 160

The best of these worst numbers is 200, so the pessimist would build a small facility.

b. Maximax
1. Highest number in its row
Alternative Payoffs Best Payoffs
Small Facility 270
Large Facility 800

The best of these numbers is 800, so the optimist would build a large facility.

c. Laplace
 1. With two events, we assign each a probability of 0.5.
Alternative Payoffs Weighted Payoffs
Small Facility 0.5(200) +0.5(270) = 235
Large Facility 0.5(160) + 0.5(800) = 480

The best of these payoffs is 480, so the realist would build a large facility.

d. Minimax Regret
1. Determine the largest element in both columns.
2. Subtract every element from the largest payoff in both columns.
3. Select the largest amount in each row.
4. Identify the maximum regrets.
Alternative Payoffs Low Demand High Demand Maximum Demand
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.

Example #2 (same problem given in certainty) Cost Payoffs

Required: Determine the best alternative for each decision rule

Solution:
a. Maximin
1. Select the row with highest payoff.
2. Identify the lowest payoff.
Alternative Payoffs Worst Payoffs
Small Facility 270
Large Facility 800

The best of these worst numbers is 270, so the pessimist would build a small facility.

b. Minimin
1. lowest number in its row
Alternative Payoffs Best Payoffs
Small Facility 200
Large Facility 160

The worst of these numbers is 160, so the optimist would build a large facility.

c. Laplace
1. With two events, we assign each a probability of 0.5.
Alternative Payoffs Weighted Payoffs
Small Facility 0.5(200) +0.5(270) = 235
Large Facility 0.5(160) + 0.5(800) = 480

The worst of these payoffs is 235, so the realist would build a small facility.

d. Minimax Regret
1. Determine the lowest element in both columns.
2. Subtract every element from the lowest payoff in both columns.
3. Select the largest amount in each row.
4. Identify the lowest payoff.
Alternative Payoffs Low Demand High Demand Maximum Demand
Small Facility 200-160=40 270-270=0 40
Large Facility 160-160=0 800-270=530 530
Build a small Facility with a minimax regret of 40.

Note: Payoff is:

Profit – choose the lowest in each row and then pick out the highest payoff in
the column.
Maximin
Cost – Choose the highest in each row and then select the lowest payoff.

Maximax Profit – Choose the highest in each row and select the highest in the
column.

Minimin Cost – Choose the lowest in each row and select the lowest payoff in the
column.
Profit – get the average in each row and select the highest payoff in the column.
Laplace
Cost – get the average in each row and select the lowest payoff in the column.

Profit – Subtract highest PO in each column to each PO in each row, select the
highest in each row then select the lowest.
Minimax Regret
Cost – subtract lowest PO to each PO in each row, select the highest in each
row, and select the lowest.

C. DECISION MAKING UNDER RISK

- The manager or decision maker has estimates of the probabilities of the various states of nature
or is willing to make them
- The manager can list the events and estimate their probabilities; the manager has less
information than with decision making under certainty but more information than with decision
making under uncertainty
- Widely used approach under this is the Expected Monetary Value Criterion.

Expected Monetary Value (EMV)

- The best expected value among the alternatives
- Sum of the payoffs for an alternative where each payoff is weighted by the probability for the
relevant state of nature or the expected value for an alternative is found by weighing each payoff
with its associated probability and then adding the weighted payoff scores- the alternative with the
best expected value (highest for profit and lowest for cost) is chosen.

EMV Criterion
- Determine the expected payoff of each alternative and choose the alternative that has the best
expected payoff
Note: This EMV approach is most appropriate when a decision maker is neither risk- averse nor
risk- seeking, but is risk- neutral.
The expected value is what the average payoff would be if the decision would be
repeated time after time.
The rule should not be used if the manager is inclined to avoid risk. This approach
provides an indication of the long run, average payoff that is, the expected value amount is not an
actual payoff but an expected or average amount that would be approximated if a large number of
identical decision, were to be made.
 Example 1
Possible Future Demand
Alternative Low High
Small Faculty 200 270
Large Faculty 160 800
Do Nothing 0 0
Which is the best alternative if the probability of small demand is estimated to be .40 and
the probability of large demand is estimated to be .6?

Solution: The expected value for each alternative is:

Alternative Expected Value
Small Facility .4(200) +.6(270) = 242
Large Facility .4(160) + .6(800) = 544
Choose a large facility because its expected value is the highest at P544.00

Example 2 Using the expected monetary value criterion, identify the best alternative for previous
payoff table for these probabilities: low= .30, moderate= .50 and high= .20
Solution:
EV small= .30(P10) + .50(P10) + .2(P10) = P10
EV medium=. 30(P7) + .50(P12) + .2(P12) = P10.5
EV large= .30(-4) + .50(P2) + .2(P16) = P3
Choose the medium facility because it has the highest expected value

Expected Value of Perfect Information

- Indicate the upper limit on the amount; the decision maker should be willing to spend, to obtain
perfect information. Thus, for the cost equals or exceed this amount. The decision maker would
be better off not spending additional money and simply go with the alternative that has the
highest expected payoff
- Difference between the expected payoff under certainty and the expected payoff under risk
- Amount by which the expected payoff will improve if the manager knows which event will occur.

Note: suppose that a manager has a way of improving the forecasts- through more expensive
market research or studying past trends. Assume that the manager, although unable to affect the
probabilities of the events, can predict the future without error.

Example:
Possible Future Demand
Alternative Low High
Small Faculty 200 270
Large Faculty 160 800
Do Nothing 0 0
The probability of small demand is estimated to be .40 and the probability of large demand is
estimated to be .6
Expected Value of the Perfect Information= .6(270) +.6(800) = 642
Expected Value of the Imperfect Information= .4(200) + .4(160) = 144
Value of the Perfect Information= 642-144