QUANTITATIVE TECHNIQUES FOR DECISION MAKING

1. What is the purpose of decision tree analysis?

What are the advantages and disadvantages of decision tree analysis?
a. Decision tree analysis provides a systematic framework for analyzing a sequence of
interrelated decisions which may be made over time. Decision making is formulated in terms
of the consequence of acts, events and consequences because it is believed that present
decisions affect future profitability. The study and understanding of alternative scenarios is
encouraged with the use of decision tree analysis.
b. Advantages of Decision Tree Analysis
1. Clarifies the choices, risks, and monetary gains involved in an investment problem.
2. Presents the relevant information more clearly.
3. Combines action choices with different possible events or results of action which are
partially affected by chance or other uncontrollable circumstances.
4. Encourages the focus on the relationship between current and future decisions.
5. Utilizes such analytical techniques as present value and discounted cash flow.
6. Considers various alternatives with greater ease.
Weaknesses of Decision Tree Analysis
1. Not all events that can happen can be/are identified.
2. Not all the decisions that must be made on a subject under analysis are listed because
choices are usually not restricted to two or three.
3. If a large number of choices is involved, decision tree analysis by hand becomes
complicated.
4. Uncertain alternatives are generally treated as if they were discrete, well-defined
possibilities.

Sample Problem: Decision Tree Analysis with Probability Distribution

The AdidaNike Shoe Company is considering a new running shoe. A market study indicates a 60%
probability that demand will be good and a 40% chance that it will be poor. Initial cash outflow is P5
Million. Cash inflows are estimated at P3M per year for three years at full manufacturing capacity if
demand is good, but just P1.5M per year if it’s poor. The company’s cost of capital is 10%.

Develop a rough probability distribution for NPV using decision tree analysis.
Solution:
Now, on a different assumption, let’s look unto the following:
AdidaNike now feels there are two possibilities along the upper branch.
If first year demand is good, there’s a 30% chance it will be excellent in the second and third years, and a
P1 million factory expansion will generate cash inflows of P5 million in years 2 and 3. That means net
cash inflows will be P4 million in year 2 and P5 million in year 3.

Required:
Create a decision tree for the project with this additional possibility.
Solution:

2. Identify ways that Program Review and Evaluation Techniques (PERT) is superior to Gantt chart
techniques for complex projects.
PERT is superior to Gantt Charts in complex projects because:
a. PERT charts are flexible and can reflect slippage or changes in plans, but Gantt charts simply
plot a bar chart against a calendar scale.
b. PERT charts reflect interdependencies among activities; Gantt charts do not.
c. PERT charts reflect uncertainties or tolerances in the time estimates for various activities;
Gantt charts do not.
3. Discuss how PERT can be used in planning a complex project.
The use of PERT provides a structured foundation for planning complex projects in sufficient
detail to facilitate effective control.
A workable sequence of events that comprise the project are first identified. Each key event
should represent a task; then the interdependent relationships between the events are structured.
After the network of events is constructed, cost and time parameters are established for each
package. Staffing plans are reviewed and analyzed.
The “critical path” computation identifies sequence of key events with total time equal to the time
allotted for the project’s completion. Jobs which are not on the critical path can be slowed down
and the slack resources available on these activities reallocated to activities on the critical path.
Use of PERT permits sufficient scheduling of effort by functional areas and by geographic
location. It also allows for restructuring scheduling efforts and redeployment of workers as
necessary to compensate for delays or bottlenecks. The probability of completing this complex
project on time and within the allotted budget is increased.

4. Should management analyze time slippage on all activities?

Time slippage in noncritical activities may not warrant extensive managerial analysis because of
available slack, but activity cost usually increases with time and should be monitored.
5. Define the term critical path and explain why it is considered critical.
The critical path is the network path with the longest cumulative expected activity time. It is
critical because a slowdown along this path delays the entire project.
6. What is meant by crashing the network and what is differential crash cost of an activity?
Crashing the network means finding the minimum cost for completing the project in minimum
time in order to achieve an optimum tradeoff between cost and time. The differential crash cost
of an activity is the additional cost of that activity for each period of time saved.
7. What is slack and how can management utilize it?
Slack is the amount of time an event can be delayed without affecting the project’s completion date.
Slack can be utilized by management as a buffer against bottlenecks that may occur on the critical
path.
8. If we want to maximize profit, why do we use unit contribution margins in our analysis instead of
gross margin?
Unit gross margin are typically computed with an allocation of fixed costs. Total fixed costs
generally will not change with a change in volume within the relevant range. Unitizing the fixed
costs results in treating them as though they are variable costs when, in fact, they are not.
Moreover, when multiple products are manufactured, the relative contribution becomes the
criterion for selecting the optimal product mix. Fixed costs allocations can distort the relative
contributions and result in a suboptimal decision.
9. Management notes that the contribution margin from one product is greater than the contribution
margin from a second product. Hence, they conclude that the company should concentrate on
production of the first product. Under what, if any, conditions, will this approach result in
maximum profits?
This approach will maximize profits only if there are no constraints on production or sales, or if
both products use all scarce resources at an equal rate. Otherwise management would want to
maximize the contribution per unit of scarce resource.
10. What do we mean by the opportunity cost of a constraint?
The opportunity cost of a constraint is the cost of not having additional availability of the
constrained resources. This is also called a shadow price.
11. What is the feasible production region?
The feasible production region is the area which contains all possible combinations of production
outputs. It is bounded by the constraints imposed on production possibilities. The production
schedule which management chooses must come from the feasible production region.
12. What is the role of the accountant in the management decision process that uses linear
programming models (or other mathematical programming techniques)?
The accountant usually supplies the contribution margin data that is used in formulating a profit-
maximizing objective function. In addition, the accountant participates in the analysis of linear
programming outputs by assessing the costs of additional capacity or of changes in product mix.
13. For each of the following costs, indicate whether the cost would be an out-of-pocket carrying cost
(C), or a cost of placing the order (P). If the item does not quality for either of these
categories, note that it as none of the above (N). Assume that wages vary with the level of
work while salaries are fixed for a monthly or longer time period.
a. Hourly fee for inventory audit (C)
 b. Salary of purchasing supervisor (N)
c. Costs to audit purchase orders and invoices (P)
d. Taxes on inventory (C)
e. Stockout costs (P)
f. Storage costs charged per unit in inventory (C)
g. Fire insurance on inventory (C)
h. Fire insurance on warehouse (N)
i. Obsolescence costs on inventory (C)
j. Shipping costs per shipment (P)
14. Since the operations research specialists develop and maintain inventory models, why does the
accountant become concerned with inventory policy decisions?
Although the inventory models are developed by operations researchers, statisticians and
computer specialists, their areas of expertise do not extend to the evaluation of the differential
costs for the inventory models. Generally, discussions of inventory models take the costs as
given. It is the role of the accountant to determine which costs are appropriate for inclusion in an
inventory model.
15. Why is the cost of capital included as a carrying cost of inventory
Cost of capital represents the interest expense on funds if they were borrowed or opportunity cost
if funds were provided internally or by owners. It is included as carrying cost of inventory
because funds are tied up in inventory.
16. What does decision making under certainty and under uncertainty means?
Decision making under certainty means that for each decision action, there is only one event and
therefore only a single outcome for each action. When an event is certain, there is a 100% chance
of occurrence, hence the probability is 1.0.
Decision making under uncertainty, which is more common in reality, involves several events for
each action with its probability of occurrence. The decision maker may know the probability of
occurrence of each of the events because of mathematical proofs or the compilation of historical
evidence.
The probability of an event varies from 0 to 1.
(a) A probability of 0 means the event cannot occur, whereas a probability of 1 means the
event is certain to occur.
(b) A probability between 0 and 1 indicates the likelihood of the event’s occurrence, e.g., the
probability that a fair coin will yield heads is 0.5 on any single toss.
Rules in Combining Probabilities:
1. The joint probability for two events equals the probability (Pr) of the first event multiplied by
the conditional probability of the second event, given that the first has already occurred.
2. The probability that either one or both of two events will occur equals the sum of their
separate probabilities minus their joint probability.
3. The probabilities for all possible mutually exclusive outcomes of a single expermient must
add up to one.
17. A review of the inventories of a company indicates the following cost data for a given time:
Invoice price P102.25 per units
Processing invoices and other documents P 21.45 per order + P1,475.80 per month
 Permit fees for shipping P 201.65 per truckload
Excise tax 4% of invoice price
Inventory tax 2% of the invoice price
Insurance on shipments P 1.50 per unit
Insurance on inventory P 2.80 per unit
Warehouse rental P 985.00 per month
Stockout costs P 122.00 per order
Cost of capital 25%
Unloading – per order P 80.20 per order
Show the differential costs that would be included in an EOQ model.
Solution:
Costs that vary with the average number of units in inventory:
Inventory insurance P 2.80
Inventory tax 2.05 (P102.25 x 2%)
Total P 4.85
Costs that vary with the number of units purchased:
Purchase price P102.25
Insurance on shipment 1.50
Total P103.75
Total carrying cost = (25% x P103.75) cost of capital + P4.85 = P25.94 + P4.85 = P30.79
Order costs:
Shipping permit P201.65
Costs to arrange for the shipment 21.45
Unloading 80.20
Stockout costs 122.00
Total P425.30

Problem 1
Balagtas Construction Company developed the following network for building complex equipment. Your
assistance in using the program evaluation review technique is required.
Required:
a. Determine the critical path.
b. Determine the latest time for reaching Event 4.
c. Assume all other paths operate on schedule but path segement 4-7 has an unfavorable time
variance of 10. What is the effect on the critical path?
d. Compute the earliest time for reaching event 5 via path 0-1-2-5.

Requirement (a)
The critical path through each of the three alternative paths calculated as the longest is 0 - 1 - 6- 7- 8.
0-1-2-5-8 2 + 8 + 10 + 14 = 34
0-1-3-4-7-8 2 + 8 + 7 + 5 + 3 = 25
0-1-6-7-8 2 + 26 + 9 + 3 = 40*
________
* critical

Requirement (b)
40 - 3 - 5 = 32

Requirement (c)
If path 4 - 7 has an unfavorable time variance of 10, this means it takes a total time of 15 to finish this
activity rather than 5. This gives the path 0 - 1 - 3 - 4 - 7 - 8 a total time of 35, but since this is less
than the critical path of 40, it has no effect.

Requirement (d)
The earliest time for reaching event 5 via 0 - 1 - 2 - 5 is 20, the sum of the expected times.

Problem 2
Bethel Company produces two products that use the same material input. Product A uses 2 pounds of the
Material for every unit produced. , and Product B uses 5 pounds. Currently, Bethel has 6,000 pounds of
the materials in inventory and will not be able to obtain more for the coming year. The maximum
demand (sales) for A is estimated at 1,000 units, and for B it is estimated at 2,000 units. The detail of
each product’s unit contribution margin follows:
Product A Product B
Selling price P81 P139
Less variable expenses:
Direct materials (20) (50)
Direct labor (21) (14)
Variable overhead (10) (15)
Contribution margin P30 P60

Assume that Product A uses 3 direct labor hours for every unit produced and that Product B uses 2 hours.
A total of 6,000 direct labor hours is available for the coming year.
Required:
1. Formulate the linear programming problem faced by Bethel Company. To do so, you must derive
mathematical expressions for the objective function and for the material and labor constraints.
2. Solve the linear programming problem using the graphical approach.
 3. Compute the total contribution margin produced by the optimal mix developed in Requirement 2.

Solution:
Requirement 1

Let X = number of Product A produced

Let Y = number of Product B produced

Maximize Z = 30X + 60Y (objective function)

2X + 5Y ≤ 6,000 (direct material constraint)
3X + 2Y ≤ 6,000 (direct labor constraint)
X ≤ 1,000
Y ≤ 2,000
X≥0
Y≥0

Requirement 2

Solution: the corner points are the origin, the points where X = 0, Y =0, and where two linear constraints
intersect. The point of intersection of the two linear constraints is obtained by solving the two equations
simultaneously.

Corner Point X-Value Y-Value Z = P30X + P60Y

A 0 0 P 0
B 1,000 0 P30,000
C 1,000 800 P78,000*
D 0 1,200 P72,000

* The values for X and Y are found by solving the simultaneous equations:

X = 1,000
2X + 5Y = 6,000
2(1,000) + 5Y = 6,000
Y = 800

Z = P30 (1,000) + P60 (800) = P78,000

Optimal solution: X = 1,000 units and Y = 800 units.

Requirement 3: The optimal level, the contribution margin is P78,000.

Problem 3
Paper Products, Inc. produces table napkins and facial tissues. The manufacturing process is highly
mechanized; both products are produced by the same machinery by using different settings. For the
coming period, 200,000 machine hours are available. Management is trying to decide on the
quantities of each product to produce. The following data are available (for napkins, one unit is one
package of napkins; for facial tissue, one unit is one box of tissue):
Napkins Tissue
Machine hours per unit 1.00 0.50
Unit selling price P2.50 P3.00
Unit variable cost P1.50 P2.25

Required:
1. Determine the units of each product that should be produced in order to maximize profits.
2. Because of market conditions, the company can sell no more than 150,000 packages of napkins
and 300,000 boxes of paper tissue. Do the following:
a. Formulate the problem as a linear programming problem.
b. Determine the optimal mix using a graph.
c. Compute the maximum profit given the optimal mix.

Solution:

Requirement 1

Napkins: CM / machine hour = (P2.50 – P1.50) / 1 = P1.00

Tissue: CM / machine hour = (P3.00 – P2.25) / 0.5 = P1.50

Tissues provide the greatest contribution per machine hour, so the company should produce 400,000 packages
of tissues (200,000 mach. Hrs times 2 packages per hr) and zero napkins.

Requirement 2

Let X = boxes of napkins; T = boxes of tissue

(a) Z = P1.00X + P0.75Y (objective function)
X + 0.5Y ≤ 200,000 (machine constraint)
X ≤ 150,000 (demand constraint)
Y ≤ 300,000 (demand constraint)
X ≥ 0; Y ≥ 0

Corner Point X – Value Y – Value Z = X + .75Y

A 0 0 0
B 150,000 0 150,000
C* 150,000 100,000 225,000
D* 50,000 300,000 275,000*
E 0 300,000 225,000

* Point C: Point D:
X = 150,000 Y = 300,000
X + 0.5Y = 200,000 X + 0.5Y = 200,000
150,000 + 0.5Y = 200,000 X + 0.5 (300,000) = 200,000
Y = 100,000 X = 50,000

The optimal mix is D, 50,000 packages of napkins and 300,000 boxes of tissue. The maximum profit is
P275,000.