Mohd Shukri PM_F5 Notes (Risk and uncertainty)

Learning outcomes Example past exam questions Notes

Research technique to reduce uncertainty

Apply the technique of maximax, maximin Q16-18 Section B– Sept 2016

and minimax regret in decision making
problems including production of profit
table
Calculate the value of perfect and Q14 Section A – Dec 2016
imperfect information Q19 Section B – Sept 2016
Explain the use of simulation, expected
values and sensitivity
Apply EV and sensitivity to decision Q20 Section B – Sept 2016
making problems
Interpret a decision tree and use it to solve
a multi-stage decision problem

1. Risk & Uncertainty

Risk - Future outcome cannot be predicted

- Based on past experience
- Probabilities can be estimated
Uncertainty - Insufficient information to make reliable prediction
- No past experience
- There are no probability estimates
How to reduce - Market research
uncertainty - Estimate worst/most likely/best outcome (cover in 3.0)

2. Risk preference

- Risk Seeker = No matter how small the chance that they may occur + interested in the
best outcomes (optimist)

- Risk Neutral = Make a decision that balances risk and return (most likely outcome)

- Risk Averse = Will make any decision that minimise the risk + assume worst outcome
might occur (pessimist)

3. Worst/most likely/best outcome

- This will show full range of possibilities outcomes from a decision.

- A pay-off table is needed.

- Risk Neutral = Make a decision that balances risk and return.

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* sensitivity analysis - assess % changein variable b4 it would change
* simulation - using software assess the probability when there are several uncertain variables.
Mohd Shukri PM_F5 Notes (Risk and uncertainty)

Quick test 1:

• ABC Co have a capacity of 1,200 units.

• Monthly demand is 300 units, 500 units and 700 units.
• Contribution generated by ABC co is $5.
• They have the opportunity to enter one special agreement that will generate
contribution of only $3.
• However, they must enter a binding agreement now at level 900, 700 and 500
units.

Special contract (units)

Demand (units) 900 700 500
300 4200 3600 5000
500 4200 4600 4000
700 4200 4600 5000

Requirement:
Prepare all possible contributions in a data table?

Answer: 4200, 3600, 3000

4200, 4600, 4000
4200, 4600, 5000

4. Expected values

➢ EV = ∑px
p = probability of outcome
X = value of outcome (cost/profit)

➢ Highest EV should be chosen

➢ Support risk neutral attitude
➢ Valuable for outcomes that occur many times over

➢ Limitations:
1. EV is long term average, not suitable for one-off decisions
2. Result dependent on the accuracy of probability, may not be accurate
3. EV may not represent a single possible outcome

5. Other decision rules

Maximin = Maximise the minimum outcome (play it safe)

Maximax= Maximise the maximum outcome

Minimax regret = Opportunity loss basis decision making

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Mohd Shukri PM_F5 Notes (Risk and uncertainty)

Quick test 2:
• ABC Co have a capacity of 1,200 units.
• Monthly demand is 300 units, 500 units and 700 units with probability of 0.2, 0.6
and 0.2.
• Contribution generated by ABC co is $5.
• They have the opportunity to enter one special agreement that will generate
contribution of only $3.
• However, they must enter a binding agreement now at level 900, 700 and 500
units. 4000
EV 4200 4520
Special contract (units)
Demand (units) 900 700 500
300 0.2 4200 0 3600 600 3000 1200
500 4200 600 4800 0 4000 800
0.6 4600 400
700 4200 800 5000 0
0.2
800 600 1200
Requirement:
1. What is the optimal level of special contract to commit every month, using EV?
2. What is the optimal level of special contract to commit every month, if risk averse
attitude?
3. What is the optimal level of special contract to commit every month, if risk seeker
attitude?
4. Using minimax regret, what decision should be taken? minimise the max regret

2) maximin = 900 units

Answer:
3) maximax = 500 units 1. 700 units
4) minimax regret = 700 units 2. 900 units
3. 500 units
1) The highest EV is 700 units 4. 700 units
Solution:

Step 1: Find the main keyword at the requirement

Step 2: Calculate for ∑px (if needed)
Step 3: Double check the figure stated at the profit table above

In reality, value of perfect info does not happen.

6. Value of perfect information (VOPI)

- VOPI = EV profit with perfect information – EV of imperfect information

- Helps managers to make decision with complete confidence

- Perfect information? = 100% accuracy to predict the future

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Mohd Shukri PM_F5 Notes (Risk and uncertainty)

VOPI = EV profit with perfect info - EV profit without perfect info

Quick test 3:

• There are 2 mutually exclusive projects

• Expected profit are as follows:

Options Profit
Strong demand Moderate Weaker demand
demand
A $4,000 $1,200 $(1,000)
B $1,500 $1,000 $500
Probability 0.2 0.3 0.5
•
a) EV profit for A = $ 660 EV profit for B = $ 850
Therefore, the highest EV profit is B
Required:
a) If there is no information about demand, which decision should be chosen if
based on Expected values?
b) Calculate value of perfect information based on demand
b) EV with perfect info = (4000 x 0.2) +(1200 x 0.3) +(500 x 0.5) = $ 1410
EV without perfect info = $ 850
Answer:
Therefore VIPO = $1410 - $ 850
1. B, 850
= $560 2. 560
Solution:

Step 1: Calculate EV A, calculate EV B

Step 2: Choose the highest
Step 3: Compare with EV perfect information

7. Decision tree draw - from left to right

Calculate - from right to left
Step 1: Construct stage

- Decision

- Outcome

Step 2: Roll back analysis to calculate EV

- Calculate EV at outcome points

- Take the highest

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Mohd Shukri PM_F5 Notes (Risk and uncertainty)

Quick test 4: