Week 7

Video Transcripts

Video 1: Introduction to Prescriptive Analytics

Welcome to our module on prescriptive analytics. Where we looked at descriptive analytics,
we show how descriptive analytics help us understand what happened in the past. In
contrast, predictive analytics look forward they look into the future and they allow us to
make forecasts to estimate probabilities about what will happen in the future. In this
module we focus on prescriptive analytics that essentially answer the question. What
should we do in response to those information if we have the inputs from descriptive and
predictive analytics how it should affect our action how this should affect our
decisions? Consider the following example of a hotel chain. Descriptive analytics would
answer questions such as what is the revenue by hotel type, by customer category
business versus leisure, by seasons and different type of variables. What is the
composition of revenue from existing vs new customers? Why did the new customer come
to my hotel? What made an old customer leave? Predictive analytics will allow us to
estimate probabilities about future events. For example, what might be the occupancy rates
at various price points how likely is that I might end up with having empty rooms. How many
new customers should I expect for the next holiday season for the next festival? Now when
we turn to prescriptive analytics, we try to understand how these inputs affect future
decisions including investments promotions and so on. For example should we expand the
capacity of our hotel if we're expecting a lot of yes in the coming years which
promotions should we ran for the next holiday seasons how much budget should we
allocate to marketing and how do we target specific customers do we use a different
promotion for the business kind of customers and if you're coming from a specific
geographical location all those are issues that prescriptive analytics allow us to address

Video 2: Linking Predictive Analytics to Business Objectives

So, let's look at a more concrete example on how we can connect predictive analytics to a
business objective. In predictive analytics we talked about classifier, for example predicting
whether a given customer would respond to a marketing campaign or not. Different
classifiers would give a different output meaning a different prediction. While there
are different metrics to compare those models. The performance of the model should be
based on its performance on the business objective. Assume we have prepared a marketing
campaign and we're hoping that the customers will reach to the campaign actually buy our
product. A predictive model can help us better target our campaign by telling us who is
our customers more likely to respond positively to buy the product No model is perfect of
course. And sometimes a customer that was classified as a good target might end up not

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buying the product a false positive type of error. On the other hand, a customer that was
classified as a no target might have bought the product had she received the campaign a
false negative type of error. So, let's look at the following prediction model. Let's say we
target a 100 customers with our marketing campaign. 27 out of these 100 people
received the campaign and they actually buy the product. So that will be a true positive
because the prediction was actually good. At the same time, we have 14 people that
they received the campaign but did not buy the product. What we call the false
positives which occur at a rate of 20%.
We also have the true negative. Those are customers of the model correctly predicted that
they wouldn't buy the product. So, we didn't send them a marketing campaign. Lastly, we
have the False Negative. Three people that should how received our marketing campaign
because they would have bought the product but did not. We also know from our historical
data that about 30%. So, 30 out of a 100 customers buy our product and 70%. So, 70
customers do not buy our product. All this information we can get it from a predictive
analytic models a classifier either using logistic regression or machine learning as
you discussed with David let's add some cost and benefit numbers in this example. For
example, let's assume that we can sell our product for a $100 a unit. And our production
cost is $50 per unit. Let's also assume that the cost of the marketing campaign to reach a
customer is just a dollar per person. What would be our expected profit if we actually ran
this campaign and sell products. You can see that each true positive kind of customer will
result in a benefit of $49. A $100 from revenues minus $50 from our production cost minus
the $1 altogether $49. At the same time, we have loss because of the false positive those
customers that we put the effort to approach them and target them with our marketing
campaign, but they didn't respond.
This has a negative value of $1 the cost of our marketing campaign. Altogether. For those a
100 customers we can calculate the expected profit as follows. We can say that there's a
30% chance that you will be in essentially in the left-hand side. And in which case there is a
90% chance that you will actually pay the $49 or net value. Or you might be on the right-
hand side with a probability of 70%. And in this case, there is an additional probability
of 20% that we might end up losing a dollar. We will come back on how exactly we
derive this expected value calculation when we discuss about decision trees. But altogether
this example shows that from those 100 customers, we expect to make a net profit of
$13.1. And this is the value associated with this specific model. We can try out different
models. For example, different classifiers might reduce one type of error the false positive,
but they might create another one, the false negative. And we can find the optimal
balance of what is it exactly we are trying to optimize and whether we are happy to take the
risks of approaching more customers, but they may not respond to our campaign. Those are
the kinds of topics we will be discussing in the remaining of this module

Video 3: Deep Dive into a Business Model

To maximize the value, we get from analytics we need to have a solid understanding of our
business model. As we discussed in predictive analytics, we can use different models
to make predictions about the future. But if we are aiming to maximize our KPIs or key
performance indicator or profits or anything else I think is important for our business. We
need to have a good understanding of our business model the relationships the
interdependency and any potential constraints. This will allow us to make the best decisions
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for our specific business model. Consider the following example. A company plans to
develop a new e-commerce service for is it will charge about $60 per transaction. There is
no marginal cost for providing the service. So, we can think of this as the operating profit for
each additional customer. However, a services facility must be constructed which will
require $20 of upfront investment for each unit of capacity. Demand for the service is
uncertain, we don't know how many customers would be interested in our
service. According to our predictive model the best estimate for the demand would be a
bell-shaped curve a normal distribution. As we discussed in our descriptive analytics
sessions with an average of 2 thousand transactions and the standard deviation of 500
transactions. How can we get that estimate? Well the most common method is to look at
historical data with comparable service and our predictive model can help us identify which
services might be. a good comparable for our model. And then we can directly fit a
distribution such as the normal or we could even use the raw data from what we believed to
be a representative sample. All this can give us a nice summary that describe our
distribution as a normal distribution with an average of 2000 reduction. Let's try to get
some estimates about the profits now. The company's best guess that is the most likely
estimate for the demand is 2000 transaction. That would be the peak of the normal
distribution. Therefore, planning for this best guess case. The company decides to set up a
facility with a capacity of 2000 transaction. This will require an investment of $40000. Since
the capacity cost per unit is $20. And given that the revenue is $60 per this will make a nice
profit of $80000. Would you feel confident with this estimation?

Video 4: Deep Dive into a Business Model – Simulation

So, let's deep dive into our business model with a method called the value driver
tree. Essentially this approach allows us to understand what drives value in our
organization into our business model. What are the determinants of revenue and our cost,
how do we make money how do we spend our money? In this case the drivers of revenue
are obviously the units sold the number of customers that show up in our service times the
price that we receive per customer. You can see here that we can unpack even further the
number of units sold and break it down to two building blocks. The one is the demand which
corresponds to how many customers actually want to sign up for our service and the other
is the capacity is how many customers can we actually accommodate. You can see here why
it's important to break it down into those components. The first one, the demand is actually
our uncertain input. It's a number that we're using the predictive model to predict. Maybe
we have historical data. But of course, we don't know what the demand might be
tomorrow.
On the other hand, the capacity is entirely our decision. And what we're trying to do is
use the prescriptive analytics model to find the best decision for this business model. Now
let's look at our cost structure. Again, we can break it down to fixed cost which in this case
would be the level of capacity times the cost per unit of capacity plus any variable cost
which in this case will be the production cost per unit times the number of units
produced. And recall that in this example we decided to overlook the variable cost just to
keep the example simple. Now we have a good understanding of our business model and
we can put everything together and produce the entire value driver tree. For our simple
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capacity example. When you do this for your own business try to identify the blocks that
they are assumptions. For example, estimates about the future data that come from your
predictive model and the decisions that you can make. The next step is of course
to calculate our expected profits. This is where simulation becomes very powerful
because the best approximation, we can get about our future is if we play out all the
different scenarios. So rather than just focusing on our best estimate which would have
been a demand of 2000 units. We can use our entire historical data set and try to account
for all the possible scenarios that might occur for example on a good day we might have a
demand of 3000 units or in a very bad day. Maybe we'll only have 500 customers showing
up. Simulation is the powerful tool that allows us to essentially calculate our profit using the
entire range of data and not just a single data point. The output of a simulation will be a
distribution will be a histogram that will describe our expected profits. And you can see here
why it's so important to use simulations.
If you know that your business model has some kind of uncertainty and information that
you have about this uncertainty is described by distribution. Essentially meaning that there
is no way to have a perfect forecast about the demand. Then how would it have been
possible to have a perfect estimate what we often called the point estimate about your
profits. Instead what a good analysis should give you is the range of outcomes that you
expect. If you have uncertainties in your inputs, then you should have uncertainties in your
outputs. And that's exactly what we will get once we run our simulation. So here is the
outcome of our simulations. You can use different software’s to produce such a graph. The
first thing to notice here is the interesting shape. Even though we use the
normal distribution as an input what we see on our screen is definitely not a normal
distribution. Take a moment to reflect what could possibly explain this odd shape. You can
see that for low values of demand. On the left-hand side there is a fairly linear increase in
our profits. So, it's likely that we will be making something around 80000 a little less
likely that we will make 60000. So on. Recall based on our earlier analysis that 80000 was
our most likely estimate our best guess. Well according to this graph this
becomes extremely likely that we'll be making 80000. Another graph that help us get a
better intuition about what is happening is the often-called accumulated distribution. In this
one we don't see the likelihood of an event happening. But on the y-axis, we see the
probability that our profits we'll be below a specific number. So, for example if we look at
the point of $60000, we can see that there's about a 25% chance that we might make
$60000 or less. If we look at the $80000, we can see that this probability approaches one
meaning that we are a 100% sure that we will make $80000 or less. In other words, we will
never exceed the $80000. On average we expect to make about $68000. Now here's
another question for you. Based on our best estimate about the demand we had calculated
an expected profit of $80000. According to the simulation discussed on the previous slide
our average profit should be closer to $68000. That's quite a big gap. One would explain this
difference. Try to explain this difference based on the graphs we discussed earlier. Another
powerful tool that sheds light to this kind of questions is sensitivity and scenario
analysis. With sensitivity analysis we try to see how sensitive are our profits or any kind of
KPI to our different assumptions. So, in this graph on the x-axis we see our key
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uncertainty how many people will show up on the y-axis we see our profit for each level of
demand. So, we know that if 2 thousand people show up, we will make 80 thousand
profits. If fewer people show up the profit will go down. What happens if more people
show up you can see here that the profit curve becomes flat because of the capacity
constrain.
And that can help give us an intuition about what was happening with our expected
profits. On a bad day we lose money because not enough customer shows up. But on a good
day we don't make up for this loss even if a billion customers we're about to show up in our
service if we had set our capacity decision to 2000 units, we wouldn't be able to
accommodate and provide service. This is a key insight from our simulation. And you can
see that sensitivity analysis is another way to approach this. The downside of course of
sensitivity analyses is that it wouldn't be able to give us the correct number which is the
$68000. For that we would need to require and run a simulation of all the possible
outcomes. Our example of the new service investment provided intuition about a powerful
flaw of averages. What we learn from this example that the average value of a project
cannot be reliably predicted using forecast. Specifically, the average value of uncertain
inputs. Consider the following. An example of a little dark trying to cross the straight up and
down our best estimate about the inputs. Meaning the position of the duck would be
somewhere in the middle of the road which would imply that the duck would be
perfectly fine in a few hours. In reality we all know that. Unfortunately, that's not going to
be the case. The average output. In this case the survival of the duck would be very different
from the prediction we would get if we were to use the average input
Video 5: Making a Business Decision
Let's look at another example which would be relevant for any kind of retail store. London
Time are small boutique watch store operates several stores in London. They're launching a
new model called a inspire 20-20. They know that the selling season for fashion watches
is short and styles change significantly from year to year. As a result, London Time
receive only one delivery of watches before the selling season. We know the following
about the benefit and cost of their business model. We know that they purchase it for £75
and they sell them for £115. At the end of the season London Time will need to offer deep
discounts to sell the remaining inventory. They estimate that they will only be able to
fetch £25 per leftover items. According to their predictive model the demand for inspire
watches can be approximated by distribution with a mean of 250 and a standard deviation
of 125. How many watches do you think that London Times should order should it be 250
which again will be the guest estimate about the future demand? At this point it might be
useful to think of the different trade-offs involved for this kind of decision. Obviously, you
don't want order close to 0. Because you know there will be a lot of loss sales a lot of people
that you could have. sold the item to, but you can’t, at the same time it's unlikely that you
will order 1000 watches because that seems like a very high number. And you will be left a
lot of unsold items that you would have to mark down. Here is a another graphical
representation of this trade-off. We know that on average our best estimate is about 250
customers.

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 So, let's assume that we set our capacity the supply of the watches to a number slightly
above 250. Then we see that whenever the demand is above our capacity, we will have lost
sales customer show up to buy a product but unfortunately, we don't have enough to
provide them with. If, however decide to set our capacity at K, let's say 260. But the demand
turned out to be much lower something like just only 50 customers show up. We'll end up
with a lot of unsold items. So, as we increase our supply, we increase the cost due to the
unsold items. And at the same time, we decrease the cost of lost sales because it's much
less likely that we're gonna have lost sales. At the same time every time we reduce our k our
capacity, we decrease the cost due to the unsold items, but we increase the cost of lost
sales. How should we balance those things before we run a simulation that will account for
all the possible scenarios? We need to take a moment and again deep dive into our business
model. We need to understand what kind of constraints we have and how it's building block
of our business model interacts with the rest. So, for example what would determine the
number of actual sales? Again, as in the previous example it will depend both on the
demand the number of people showing up and our capacity. If we have demand that's
higher than our capacity, then the number of sales will be determined by our capacity. If on
the other hand the demand is lower than our capacity, then the number of actual sales will
be determined by our demand. We can model this using an if statement either in Excel or
any kind of other software or by using a command such as the minimum function in Excel. In
this model we have one more complication which is the number of items that they are
leftovers. Note here that we only have leftovers if our capacity exceeds our
demand. Otherwise this number is just 0 and there are no leftovers. This is another if
statement that we need to include in our business model try to set up a simple business
model using Excel or any other spreadsheet software and run a sensitivity analysis try to
see how your profit changes.
As your assumptions about the demand go up and down. Fix your capacity to 250 or 260
and play out with different demands. What do you observe? Once we have specified our
model the next step will be to simulate our profits for the entire range of values rather than
just doing it for one per one as you were doing before your sensitivity analysis. We can try
out different capacities. Each one corresponds to a different decision. For example. We
could decide to invest in a capacity of 240 we could decide to order 260 and so on. In the
following graph I have plotted the distributions five different level of capacity. You can see
here that again the output of a graph looks similar to the graph before precisely because in
this example. Just like in New Service example we have a capacity constraint. In this case
however it's our decision. How to move this capacity constraint and that's why for example
we see that the yellow line corresponds to a much higher order unit. We decide to have a
much higher capacity. And this has the upside of allowing us perhaps higher profit. At the
same time, it might bring more risk. We might end up with unsold items. If we try out
different values, we will figure out that the optimal order quantity in this example would be
close to 233. You can also ask the software to calculate this for you. This is the number
that maximizes your expected profit. This may or may not be the correct answer for your
type of problem. As we will discuss in our next session. The decision will critically lie only on
the level of risk. You're willing to take. For example, what would you do if you had to face
the same problem but with a much higher standard deviation? Do you think that you would
order more or less? In this case. Extreme demand outcomes affect you both ways right you
might end up with once more unsold items. or you might end up with lost sales. However,
having leftovers is relatively more expensive. And therefore, what we would expect to
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see. And that's something for you to try out. Is that as the uncertainty about our data
increases, we tend reduce fewer and fewer items because we're trying to avoid the specific
type of error which corresponds to having a lot of leftovers

Video 6a: Decision Trees 1 - ePhone Part A

We will now look at another powerful tool in prescriptive analytics that allows us to
break down our decision problem in a sequence of actions decisions and potential
contingencies things that may or may not go the way we have predicted. Read part a of the
ePhone case that you can find in your folder and try to estimate your expected profit. If you
launch the product Would you go ahead and launch the iPhone?

Video 6b: Decision Trees 1: ePhone Part A – Debrief

As you saw in the case what's interesting about this example is that there are three different
potential outcomes. We know that there is a 33% chance that the product might be
success. There is also a 50% chance that it might be just okay. A scenario that we referred to
as survival. And lastly there is 17% chance that it might be a failure. We also have the
corresponding numbers the revenue for each type of scenario, 5 million for the first K, 2
million units for the second one and just 800 thousand units for the last one. We also have
information about the cost of capacity. If we were to invest 5 million units which would be
$60 million. Given that we also know our margins per unit $20. We can also estimate our
operating profit, for each possible scenario we can get this by simply multiplying the
number of units sold for each scenario times the unit margins. We could probably do this on
the back of an envelope and calculate the expected profit from three scenarios. In this case
will be 33% chance times $100 million plus 50% chance of $40 million plus a 70% chance of
16 million. Yielding $55.72 million. Now recall that this cost of capacity would be $60
million. So altogether this product launch would result in negative net present value of
approximately $4 million. So, we will not launch this product. Here is the decision tree
representation of this problem and you can also do this by hand, or you can even use the
software on the website to produce this graph. You can see here that with a decision tree
representation we typically use a square to represent a decision. In this case whether we
launch or not we typically use a circle to indicate a contingency an uncertain outcome. It's
very important to separate the two because the square would indicate that something
within our control as opposed to a circle that indicate that's beyond our control. And it's
entirely a matter of probabilities. In this case we have to put down the probabilities for
each event 33% for success 50% for survival and 70% for failure. And also, the
outcomes associated with all three scenarios. And you can see here we've put down the 100
million for the first one, 40 million for the second one, and just 16 million for the third one.

Those are the inputs will provide to the software and together with that investment cause
the $60 million which we have to put down the moment we decide to launch. So, one step
before, it completes the inputs we provide to the software. The rest of the numbers are
calculations that that can be done for us. So, for example under the yellow circle you can
see that we can automatically see that the expected value would be 55.72. And because this
is less that the cost of investment the $60 million. The decision tree will recommend to us to

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not invest in this product. That's why you can see in the decision node. The "No" branch
is highlighted in bold which recommends the optimal action

Video 7a: Decision Trees 1: ePhone Part B

Now read part b of the ePhone case and try to write down the timeline of the events that
take place. How to break down this problem decision and contingencies. the chance nodes
that we described earlier. Try to describe the problem in the following format Write down a
square for your decision, put down a circle if you are faced with an uncertainty and
maybe then another decision all the weight you can work out your final payoff, the N nodes

Video 7b: Decision Trees 1: ePhone Part B - Debrief

When we do this for part b, we realize that there is a major contingency. Another chance
node introduced into our trees which essentially describes the outcome of a test. This time
before we make that big decision of launching the product, we can run some kind of market
research in a test market. And even though the test is not perfect it can provide valuable
information about how likely it is that our product will be a success. For example, the test
might say that our product will be successful. And in this case our predictive model says that
there's a 60% chance that the product will be actually successful. So that will be our sort of
true positive number. There is also 30% chance that given that the test indicated success
that the actual launch would be more of a survival. And lastly there is the 10% chance that
despite the very optimistic outcome of a test our product turned out to be a
failure. Similarly, we can fill out the tree for the remaining events. For example, there is a
scenario where the test has predicted survival but actually the product turns out to be a
massive success. You can see here that the so-called contingent probabilities change for the
different nodes of the tree. If we put everything together, we get this tree which
describes all possible scenarios. All the possible combinations between what the test has
said and what we observe in practice the probabilities associated with those scenarios. And
lastly the net payoff for us under all the possible scenarios. Most importantly you can
see here that we have introduced three new decision nodes. Essentially once we observe
the outcome of the test, we can either decide to go ahead with our investment or we can
call it off and avoid investing the massive $60 million investment which is the cost of
capacity. Let's work out the numbers to see how introducing a predictive analytics model in
this case the test the market research test has affected our valuation for this project. So,
what we see in this example is that a predictive model even though it's imperfect combined
with a Prescriptive Decision Trees has significantly increase our valuation for the project.
From evaluation of 0 to close to $5.5 million. Note that in this assumption we assume
that the cost of the test is 0. But even so if we were to include a cost, we would still derive a
lot of additional value. So, for example if we assume the cost of the test will be a million-
dollar then we would still be able to benefit $4.5 million from performing this test

Video 8: Decision Trees 2

So, let's do another example using decision trees. This time we will be looking at a company
called smart service which is an IT service provider. They typically develop complex IT
solutions for their corporate clients. They had been recently invited to bid. That means to
provide a contract value for a new IT project. This is a sealed-bid auction where the lowest
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bid wins the contract, but no one knows what everybody else has bid. The cost to prepare
the bid is $5000. The cost to design and delivers the IT system is approximately to $95000. If
all goes well, and Smart Service wins the contract. The revenue would be the contract
value the bid they have placed. Or they might lose the contractor competitor.
From historical data they know that there's usually a 30% chance that there will be no
competition for this specific kind of projects. If there is competition the likelihood of
winning the contract will depend on the price. They put forward the bid. They know that
there's about a 20% chance that someone else might bid less than $115000. In which case
they're going to lose a contract if they bid for $115000. They also know that it's hardly ever
the case that someone might bid for over $125000. There's only 10% chance that the lowest
bid will exceed this number. They also know that there's a 40% chance that the lowest bid
that their competitors might be between $115 and $120. Lastly there's a 30% chance that
the lowest bid will be between $120 & $125 All these again based on historical data and
data assessment for the current project. What decision and contingencies are relevant for
smart service? Try to summarize them on a timeline. Just as we did in our previous
example. We can think of the timeline as follows Smart Service first decided on whether to
bid or not. And if so, how much to bid again this is a decision entirely under the control of
smart service. So, we should indicate this with a square node whether or not they will win
the contract. For a given specific bid, it will be denoted by a chance node because we
have probabilities for those events. And in the end, we want to have an end note that give
us our final payoff. Now tried to put the decision tree representation that accounts for all
the possible scenarios. Assuming that you only bid for three levels you can bid for one
hundred and fifteen thousand one hundred and twenty. And one hundred and twenty-
five. Or you may decide to not bid at all. This should also be a perfectly legitimate option on
your decision tree. Put everything together and for the time being ignore probabilities. And
profits. Just try to work out the structure of the tree. So, your tree should look something
along the following lines. First of all, you should start your tree with a decision node. Do you
bid or not? If you don't bid, then that's the end of the game. If you decide to bid then you
need to decide that the level of your bid could be 115, could be 120 or 125.Then we need to
account for probabilities. There is a chance that you'll be the only one bidding. A 30%
chance or most likely with a 70% chance there will be competitors in the auction. Lastly for
each level of bidding you need to calculate the probabilities of winning the contract and
probabilities of losing the contract, plus your payoff for each one of those scenarios. Clearly
the trade-off here is the following. As you increase your bid and you request more and more
money from your client. You become less likely to win the contract. But of course, assuming
you win the contract you can collect more revenues. Let's try to see how we can calculate
those probabilities for each level of our bid. Assume we bid for $115000. We know from our
historical data. That in this case there is only a 20% chance that one of our
competitors might offer a lower price. And that's the only event. We lose this
contract. Therefore, there's an 80% chance that if we bid $115000 then we're going to win
the contract. How do these probabilities change if we increase the price to 120? How do
they change if we increase the price to 125? Fill out the rest of the tree by calculating those

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probabilities and also the associated payoffs with those scenarios. This will give you a much
better understanding about what should be your optimal bidding strategy.

Video 9: Debrief & Contract Optimisation

So here is how the complete decision tree looks like. You can see here that if we decided to
bid for 115 then there is an 80% chance that we're going to win the contract. In which case
our net payoff is $15000. Remember that we have to pay $5000 to prepare for the auction
to prepare our bid we have to pay $95000 to design and develop the service. So that's why
the remaining out of the 115 is a net of $15000. You can see clearly on this decision
tree that if we increase our price to 120 the likelihood of winning the contract goes down to
40%. And if we increase it even further it goes down to 10%. Of course, the benefit of doing
so is that now we can get to keep $25000 If we bid at a price of 125 on this tree, we can also
see the recommended action which is based on the action that will maximize our expected
payoff. As we've seen the highlighted numbers if we bid 115 our expected payoff is 12.2. If
we bid 120 are expected payoff is 9.5. And if we bid 125 our expected payoff is
6.1. Therefore, the software recommends that we bid 115 with an expected payoff of
12.2. This payoff is also higher compared to the decision of doing nothing which would yield
a payoff of 0. And therefore, if we put everything together the optimal course of action is to
bid at a level of 115. At this point when you present this to decision-makers, it might be
useful to also in addition to the expected value produce what we call the risk profile. This
graph gives you the possible scenarios and the corresponding probabilities of those
scenarios happening. So, if we decided to go ahead with our plan which is to bid 115. There
are only two outcomes that could happen. One is to lose the contract. In this case we end
up with a loss of $5000 or we might win the contract and make a nice $15000 net
payoff. And this is precisely what we see in this graph in the red graphs. On the blue bar we
see the action of doing nothing which simply gives us a payoff of 0 with certainty and
probability of a 100% and more complex version of the previous example Was used by a
major IT service provider to improve its bidding process for a corporate client. The process
for assigning these multi-million-dollar contracts typically has multiple phases. And it can be
quite lengthy during this bidding process. A lot of pressure is placed on solution designers
who must design cost and price solutions fully customized to the requirements of a specific
client. As discussed in the previous example higher bids corresponds to higher profit
margin. The same time the higher the bid laced by the service provider. The lower the
likelihood that the provider will win the contract. To better understand the relationship
between bidding price and likelihood of winning the contract. The service provided we
worked with used the predictive analytics model.
In fact, they tried multiple different models including logistic regression and machine
learning algorithms to pick the best one. While of course we are not able to disclose exact
figures. They calculate the falling probabilities when they only use historical data to
estimate probabilities. So, data based on what they've done in the past with similar
contracts they estimated that probability of winning the next contract would be
approximately 75%. When they included the latest market information about what our
competitors are doing. This probability went up to 87.5%. Lastly, when they just used
assumptions without properly using data this probability when significant down to 65%. An
interesting findings of this analysis was that price turned out to be the fourth most

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important factor. Determining the likelihood of winning the contract. What they found out
with a predictive model was that the type of client for example is if a client was just aiming
for an initiative that would reduce the cost versus a growth initiative was the single most
important factor. The second most important factor was the executive involved with the
specific contract. From their service provider's perspective there were certain people in the
company for which the clients were happy to pay much higher price. Lastly, as you can
imagine the prior relation with the client turn out to be one of the most important
factors. Again, ranking much higher than the price. With this tool the company could
estimate the exact probability of success for a given proposal taking into account not just
the price but also who would be the executives in these contracts. What type of client that
we're talking about and it could build a much more complex sophisticated and precise
decision tree? The next step was to optimize the price. What will be the price the bid price
that will maximize profits? Overall, contracts that were priced based on the software, so
double-digit increase in their win rates. The corresponding net profit lift from winning those
additional context was estimated in the range of tens of millions of dollars. Interestingly the
company was not willing to run a randomized controlled experiment to measure the value
of the software.
As they were too worried about losing the contracts that they wouldn't be using the
software. There are numerous other applications of decision tree. The more mathematical
term of this class of problem is referred to as dynamic programming. And it's called
dynamic for a reason. It basically takes into account all the future action that you might take
into the future that affect the value of an asset today. This is typical in the airline industry
for example if I sell an item today if I sell a specific seat for a flight than this item would not
be available tomorrow. And on the other hand, if I deserve it I might be able to get a
business customer who is willing to pay five times the price for this specific seat. Similarly,
dynamic pricing and revenue management techniques are being used in the hospitality
entertainment, retail industry, and so on. A specific prominent example that illustrates the
concepts we cover in this module comes from Zara. As we know Zara is one of the world's
most successful fashion retail brand. A lot of research has attributed a success of Zara. The
fact that they can dynamically use the latest information and adjust the inventory
decisions. accordingly. Zara keeps a close watch on how fashion is changing and evolving
every day across the world. Based on the latest styles and trends it creates, a new design
and puts them into stores in a week or two and start comparison. Most other fashion brands
would take close to six months to get all new designs and collection into the market. And
you can see here what allows Zara to do this is their flexibility in benefiting from the
information and adjusting their course of action, for example, their order quantity or
capacity decision to what customers really want. Rather than trying to predict. and second
guess what those demands would be.

Video 10: Debrief & Contract Optimisation

In this module, we discussed the numerous opportunities that prescriptive analytics
provides us to make the best decision for our companies. I hope that we've come to realize
that those tools can be very flexible and adaptable to your own specific needs. What's
important to remember from this module is that making the connection between our data
and the business objective requires a sound understanding of our business model. The
constraints and how do we connect our assumptions and known facts to our key
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performance indicators. We also learned how to use historical data to train and test our
predictive models. Simulation allows us to exploit the full range of our input data
and explore all possible outcomes rather than constrain ourselves to one specific scenario.
Which as we learned in the bias sessions can be quite dangerous. Decision trees allows us to
optimise our current decisions taking into account our ability to respond to future
events. Just like Zara is able to respond to the latest customer trends. These are all
tools that can help your companies optimize their investments, their pricing strategies, and
a number of other things

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