Hum 4817: Planning and Decision Making

Humor without Malice

Two idiots were eating together. One of them took a salted egg and said in
surprise, "I have often eaten eggs, but have always found them tasteless. Why is
this one salty?"
His companion answered, "You're fortunate that you have asked a wise person.
That salty egg was laid by a salted duck."

Wisdom/Hikmah
Prophet Muhammad (peace be upon him) said: By his/her good character,
a believer will attain the degree of one who prays during the night and fasts
during the day. – Reported by Abu Dawood

Meet the people in such a manner that if you die, they should weep for
you, and if you live, they should long for you. – ‘Ali ibn Abi Talib

Quotable quote
Life is like riding a bicycle. To keep your balance, you must keep moving. – Albert
Einstein.

Moderation that beautifies human life

Is Moderation (wasatiyyah) the governing principle of Islam? The Qur’anic
affirmation. Muslim (who submitted to the principles of Islam) community as a
community of the middle path (ummatan wasatan) (Al-Baqarah, 2:143). Justice is
the closest synonym for wasatiyyah, and a great virtue in its own right; it is a
major theme of the Quran and a principal assignment/commitment of government
in Islam. Wasatiyyah without justice would be an empty concept. Mutual
recognition (ta’aruf Q 49:13): spirit of ta’aruf that nurtures friendship and
peaceful co-existence.

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 • Recognition of reasonable disagreement (ikhtilaf) in matters of
interpretation and opinion. Ikhtilaf is an aspect of Islamic life and thought
and acts as a significant moderator from within. Islam advocates
consultation (shura) in matters of community affairs, governance and
leadership (Q 3:109 & 42:38). Shura is a great moderator manifested in its
support for dialogue (hiwar) and cooperation (ta’awun) among people in
pursuit of beneficial objectives (Q 5:2: “cooperate in good and righteous
works, and cooperate not in [pursuit of] hostility and sin”). Dialogue in the
“best and most courteous manner” (16:125). Moderation in the practices.
Opt for easier ways in the practice of Islam, Allaah’s purpose is “to lighten
your burdens”; and “make things easy for you”. (Q 4:28; 4:185), the
cardinal purposes (maqasid) of Syariah. Hence the ruler, judge and mufti
must opt for easier solutions and fatwas as a matter of priority and
preference.
• The middle path is further manifested in Islam’s recognition of people’s
customary practice (‘urf). “Take to forgiveness, follow the ‘urf and turn
away from the ignorant.” (7:199). People and communities who nurture
these values are likely to be practising wasatiyyah. God praises those “who
swallow their anger and forgive others (Q 3:134)”; and those who choose to
forgive in preference to retaliation and revenge (2:178).
• The middle path in financial transactions and business relations. This is
manifested, in the affirmative sense, in the Syariah laws of commerce and
contract which enjoin fair exchange and equivalence in counter values. Fair
exchange is also pursued in the prohibitive injunctions of Syariah on usury
(riba), excessive risk-taking and uncertainty in contracts (gharar) and
avoidance of unethical business transactions.
• Moderation in the personal lifestyle and character that Islam seeks to
nurture among the believers. To this effect, the Quran praises those who are
peaceful, walk the earth with humility, and are the agents and propagators of
peace (25:63). The Prophet added his voice as to say: “Every religion has its
ethos and the ethos of Islam is modesty — al-haya’”.
• The Quran frequently mentions justice side by side with ihsan (affection,
another beauty), nurturing of inner beauty through self-discipline and
devotion.

Planning is a Management Function: Planning (a thinking/decision

process for future). Features:
a. Determination of company/organizational objectives

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 b. Formulating of policies, programs, and procedures designed for
attainment of objectives
c. Designing of performance and cost standards and their incorporation
in a budget (short-range plan of operations)
d. Long-range planning on products, services and processes.

Determination of what to do (Mission, goals and objectives) and how

(actions) to do it. So, planning is a matter of making decisions from among
all possible (several/many) alternatives (opportunities).

Planning horizon: Typically, long-range planning (2-5 years), medium-

range planning (1-2 years) and short-range planning (< 1 year).

Types of planning
Strategic planning: determining long-term goals for an entire
organization.
Tactical planning: specific effort to establish means by which to achieve
the desired goals.
Operational planning: short-term planning that implements the tactical
objectives.

Planning is a team work: Rational planning vs participatory planning.

Types: another way

• Strategic planning
• Business planning
• Project planning
• Program planning
• Municipal planning

Planning as a profession
• Professional “planners”
• Planning functions in other professions

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General Planning Process

Define the problem/issues

and set objectives

Identify alternatives to achieve

the objectives

Evaluate the alternatives

(quantitative and qualitatively)

No
Does anyone going to
fulfill objectives?

Yes

Choice of the “best” alternative

Make a tactical implementation

plan
Make detailed plan for
implementation

Monitor and follow up

Strategic Planning – What is this?
The “big picture” of what your agency is doing and where it is going.
Helps determine where your organization is going over the next year or
more
Why is this important or Benefit?
• Used by community groups, government departments, organizations,
and businesses to develop blueprint for action and change
• The process should be community based, inclusive and participatory
to allow for maximum stakeholder involvement and input
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 • Defines mission, vision and values
• Establishes realistic goals, objectives and strategies
• Ensures effective use of resources
• Provides base to measure progress
• Develops consensus on future direction
• Builds strong teams
• Solves major problems

Takes you outside the day-to-day activities of your organization or

project and helps give you clarity about what you actually want to
achieve and how to go about achieving it rather than a plan of action for
day-to-day operations.

Why strategic planning

• Change
• Renewal
• Funding requirement
• Financial forecasting
• Mandate
• Build consensus
• Improve staff and board relations
• Develop ownership
• Build community support
• Other (discussion)

Planning to plan requires:

• Organizational readiness
• Recognition of need to plan
• Commitment to plan
• Organizational commitment
• Board and volunteer commitment
• Staff commitment

Organizational Capacity
• Human resources
• Staff
• Volunteers
• Board committees
• Special/Standing committees
• Financial resources
• Identify budget
• Determine resources
• Time
• Allocate organizational time
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 • Determine realistic time lines

Organization Strategic Planning

Vision, Mission and KRAs

External Analysis Internal Analysis

Political, Economic, Value chain, 7Ss
Social and Technical (Style, Staff, Skills, Shared
(PEST) Values, Strategy, Structure
and Systems

OT SW
Opportunities and Threats Strengths and weaknesses

Assumptions
PLANNING GAP

Strategic fit and Strategic choice plan

Objectives

Strategy and program formulation

Implementation and monitoring

Feedback and control

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Environmental Scanning Methodologies
▪ SWOT (Strengths, Weaknesses, Opportunitites, Threats)
▪ PEST analysis (Political, Economic, Social, and Technological)
▪ STEER analysis (Socio-cultural, Technological, Economic,
Ecological, and Regulatory factors)
▪ EPISTEL (Environment, Political, Informatic, Social, Technological,
Economic and Legal)

Strategic Issues
The issues that create a gap between the ideal and reality
Strategic planning issues: Planning to Plan
• Strategic Planning Team
• Board, staff, community volunteers
• Strategic Planning Budget
• Establish budget, identify funding sources
• Strategic Planning Facilitator(s)
• Identify a facilitator to lead the process
• Strategic Planning Partners
• Internal board and staff
• External community groups/government departments/others
Operational Plans – How are you going to achieve your vision?

Steps in developing an Organization Strategy

1. Establish organization Mission and Goals/KRAs
2. Analyze – Internally and Externally
• Market features
• Competition
• Competitive strengths and weaknesses
3. Identify and select
• Products
• Geographic market
• Order-winning dimensions (price, quality, delivery, flexibility)
4. Specify policy and constraints and guidelines

Quantitative Planning Tools

• Decision analysis
• Sampling theory – random sample that represents
process/population.
• Game theory – strategy of action against competitors

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 • Search theory – searching out unknown objectives/s with allocation
and utilization of limited means.
• Linear and non-linear programming – mathematical formulation and
solution.
• Queuing theory
• Simulation, etc.

Strategic Analysis
• Environmental Scan
• Gathering of information that concerns the organization’s
environments
• Analysis and interpretation of this information
• Application of this analyzed information in decision making

Strategic Analysis: SWOT Analysis

Strengths
• What are some internal positive things about your organization?
• What does the community see as your strengths?
Weaknesses
• What are some weaknesses in organization?
• What does the community see as your weaknesses?
Opportunities
• What are some opportunities in your community or region?
• What are some emerging trends?
Threats
• What are some provincial or national issues facing the organization?
• What are some technology issues that face the organization?

Developing the Plan

Goals
• Identify long-term outcomes to provide focus for the planning process
Strategies
• Outline how you will achieve your goals
Objectives
• Identify specific, measurable results produced while implementing
strategies
Developing the Plan
Implementation
• Tasks – assigned to various board and staff responsible for specific
items
• Timelines - established for implementation of the plan for
implementation
Funding the plan
• What is required to fund the goals in the plan
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Communicating the plan

STRATEGY RELATIONSHI ORGANIZATIONA CO-

and P BUILDING L SKILLS and OPERATIVE
PLANNING MANAGEMENT DEVELOPMEN
T
Strategic Community Organizational Strategic
Planning Development Governance Planning
Proposal Public Board Orientation Proposal Writing
Writing Participation
Project Alternative Meeting Project
Managemen Dispute Management Management
t Resolution
Opportunity Group Leadership and Opportunity
Identification Dynamics Motivation Identification
Opportunity Interpersonal Opportunity
Managemen Communications Management
t
Communications
Planning
Legal Issues

How will you communicate the plan to stakeholders?

• Monitoring and evaluation
• Critical to plan’s success and credibility
• Must be built into the plan
• Critical for continuous improvement
• Continuous improvement
• Focuses on improving customer satisfaction through continuous and
incremental improvements to processes.

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 DECISION ANALYSIS or DECISION THEORIES

Decision analysis is a set of alternative techniques that

evaluates alternative actions by explicitly considering the
probabilities and consequences of different future outcomes.

Decision making is a broad term. Wide range of problems –

manufacturing, R&D, marketing, new product introduction, human
resources, financial and land development. It includes a wide
range of topics. Need a lot of Qualitative and quantitative
techniques.

Operations research is a scientific method of providing with a

quantitative basis for decisions regarding manufacturing, service
and government operations.

Consequences of a decision environment cannot be generally

predicted with complete certainty. The future is uncertain but
we have to make a decision NOW! But needs to estimate with
enough accuracy to justify using mathematical and qualitative
models with sensitivity analysis.

Availability of PERFECT information for LPP (certainty) for a long

or medium term is not possible. Natural imperfect or partial
information can be defined by risk and uncertainty.
1. Decision making under risk (stochastic) is defined by
probability density function (pdf)
2. Decision making under uncertainty where probability density
function (pdf) cannot be secured
3. Decision making under conflict (competitors) – apply game
theory

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 Decreasing information availability

Certainty Risk Uncertainty

(Objective (Probabilistic (Subjective
decisions) decisions) decisions)
By Decision analysis, we mean applications of a set of
quantitative (and generic) techniques to evaluate alternative
actions by explicitly considering probabilities and effects of
different future outcomes.

Risk or Decision making with probabilities

Ex. Product-mix
Cj = profit/unit is not a fixed value, but a random variable whose
exact numerical value is unknown and can be represented by a
pdf, f(Cj)

So, Cj xj = profit contribution of jth product is also a random

variable and its exact value is unknown
Therefore, maximization (or minimization) of profit (or cost) is
sometimes acceptable but cannot be applied to every situation.
Need to depend on expected value or judgment.

However, steps that should be followed:

1. list all possible alternatives (exhaustive alternative)
2. list all possible future events – also called states of nature
(that are not fully under the control of decision maker)
3. construct a payoff table (outcomes, profits, losses,
revenue, costs, utilities, etc.)

Decision under Risk

• expected value of profit or loss
• combined expected value and variance
• known aspiration level
• most likely occurrence of a future state

Expected Value Criterion

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Determining expected monetary value (EMV)
Assumption: decision maker is risk neutral.
There could risk averse (risk avoider) and risk taker.

EMV(alternative i) = (payoff of 1st state of nature x probability of

1st state of nature) + (payoff of 2nd state of nature x probability of
2nd state of nature) + … + (payoff of last state of nature x
probability of last state of nature)

A Payoff is the outcome of a decision. Table showing the

outcomes of all alternatives under all defined states of nature is
called payoff table.

A Decision Payoff Matrix

Alternative States of nature (with probabilities)

actions or s1(p1) s2(p2) sn(pn)
strategies
A1 Q11(p1) Q12(p2) … Q1n(pn)
A2 Q21(p1) Q22(p2) … Q2n(pn)
. . . … .
. . . … .
. . . … .
Am Qm1(p1) Qm2(p2) … Qmn(pn)

So, EMV or expected value for alternative i =

EMVi = EVi =  Qij ( p j )

i = an alternative; j = states of nature (conditions) = 1, 2, …, n, Qij

= outcome (payoff, or loss)

Ex. A company must purchase one of the three machines. Each

machine produces the same basic product but different
production rates/quantities. Probability of production is dependent
on market demand. Demand situations are ranked as high (40%),
medium (25%) and low (35%).

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 Machine Payoff for possible market
(future) demand (000’s Tk)
High Medium Low
A 300 150 (50)
B 200 200 -10
C 400 100 -20
Probabilit 0.95 0.25 0.35
y

Which machine should be purchased?

If we know future demand with certainty, say medium, we would

select machine B, because it has the highest payoff of the three
machines. But if we do not know what the future demand will be.
Should we choose the machine that has the highest possible
payoff? Should we choose the one with the highest guaranteed
payoff? What if the probability of future demand being high is
0.95? Does this affect our choice?
The key issue is the criterion to select any machine. In other
words, how do we measure the goodness of an alternative?
There are a few criteria.
Another Ex.

Alternatives State of nature EMV

Favorable market Unfavorable
market
• Create large facility 200,000 -180,000
• Small facility 100,000 -20,000
• Do nothing 0 0 00
Probability 0.65 0.35

Opportunity cost

Expected Value of Perfect Information (EVPI)

An attempt of changing the decision making under risk to one under
certainty. By doing that one may avoid/prevent from making a very costly
mistake.
But the decision maker(s) must consider the cost of decision making. Does
the worth will be larger than or equal to cost?
No doubt, perfect information can be very useful. It places upper bound of
achievement.
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Now, expected value with perfect information = (best outcome/payoff or
consequence for 1st state of nature x probability of 1st state of nature) +
(best payoff of 2nd state of nature x probability of 2nd state of nature) + …
+ (best payoff of last state of nature x probability of last state of nature)

EVPI = expected value with perfect information – maximum EMV

Ex. Use data of the previous exercise and find EVPI

Alternatives State of nature EMV
Favorable market Unfavorable
market
Create large facility 200,000 -180,000 67,000
Small facility 100,000 -20,000 58,000
Do nothing 0 0 00
Probability 0.65 0.35
expected value with perfect information = best outcome/payoff or
consequence for 1st state of nature x probability of 1st state of nature +
best payoff of 2nd state of nature x probability of 2nd state of nature + … +
best payoff of last state of nature x probability of last state of nature =
130,000
EVPI = expected value with perfect information – maximum EMV =
130,000 – 67,000 = 63,000
If your cost collection of extra info < 63,000, = 63,000
➢ 63,000 (still you may go more info)

Opportunity Loss – Regret

Difference between the optimal profit or payoff and the actual payoff
received
Objective: minimize expected opportunity loss (EOL).
EOL - cost of not picking the “best” solution.

Ex. Use the data of the previous ex.

Prepare an opportunity loss table.

Alternatives State of nature

Favorable market Unfavorable EOL (EMV)
market
Create large facility 0 63,000
Small facility 100,000 72,000
Do nothing 200,000 130,000
Probability 0.65 0.35

Is there any relationship between minimum EOL and EVPI?

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 Sensitivity Analysis
As payoff and probabilities are estimated values, then question of
how sensitive the choice of alternative is to changes in one or
more of these values. It is not possible to consider all possible
combinations. Sensitivity analysis is to locate the range of
probability for which an alternative has the best expected payoff.

Alternatives State of nature

#1 #2
A 4 12
B 16 2
C 12 8
Probability 0.50 0.50

Find the probability P(2) for which each alternative is optimal under the expected value
approach.
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B
A
C
Payoff

B is best C is best A is best

0
P(2)
To find the point of intersection use y = mx + c line

Alternatives State of nature

#1 #2 Slope Equation
A 4 12 12 – 4 8P(2) + 4
B 16 2 2 – 16 -14P(2) + 16
C 12 8 8 - 12 -4P(2) + 12
Probability 0.50 0.50

For low values of P(2) B is better. For P(2) = 0, B is the best choice. At point of
intersection between B & C …..
Now B is the best between …….
Find the other values of P(2) and also corresponding values of P(1)

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 HOW MUCH CO2 DO YOU PRODUCE EVERYDAY!
One gram of co2 is produced when we just switch on hand phone.

Decision making under Uncertainty

Under the circumstances of lack of data and lack of experiences.

Decision environment (data, time horizon, etc.)

Is/can probability of
occurrence of a state of nature
Yes known/predicted?

Risk
No
Use
EMV/EOL Decision making under uncertainty.
Criteria:
1. Maximax 2. Maximin 3. Equally likely
4. Realism 5. Minimax
Maximax Decision Criterion
• Finds the alternative that maximizes the maximum outcome or consequence for
every alternative.
• Since it locates the alternative with the highest possible gain, it is also termed as
optimistic approach.
Ex.
Alternatives State of nature Maximum in
row
Favorable Unfavorable
market market
• Create large facility 200,000 -180,000 200,000
• Small facility 100,000 -20,000 100,000
• Do nothing 0 0 00

Decision: CREATE LARGE FACILITY.

Maximin Decision Criterion

• Finds the alternative that maximizes the minimum outcome or consequence for
every alternative.
• Since it locates the alternative that has the least possible loss, it is also termed
as pessimistic approach.

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Ex.
Alternatives State of nature Minimum in row
Favorable Unfavorable
market market
• Create large facility 200,000 -180,000 -180,000
• Small facility 100,000 -20,000 -20,000
• Do nothing 0 0 00

Decision: do nothing

Equally Likely or La Place Decision Criterion

• Finds the alternative with the highest average outcome or consequence.
• Average outcome = sum of individual outcome/number of outcomes
• Choose the alternative with the highest average value/number
• Probability of occurrence of every outcome for the states of nature is equal

Alternatives State of nature Row average

Favorable Unfavorable
market market
• Create large facility 200,000 -180,000 10,000
• Small facility 100,000 -20,000 40,000
• Do nothing 0 0 00
Probability 0.50 0.50

Decision: small facility

Realism or Hurwicz Decision Criterion

• A weighted average method
• A compromise between optimistic and pessimistic criteria
• A coefficient of realism α (0-1) is used. If α = 1, decision maker is optimistic
about the future, and α = 0, decision maker is pessimistic about the future.
• Realsim value = α (maximum in row) + (1 – α)(minimum in row)

Alternatives State of nature Realism value (α = 0.8)

Favorable Unfavorable
market market
• Create large facility 200,000 -180,000 124,000
• Small facility 100,000 -20,000 76,000
• Do nothing 0 0 00

Decision: create large facility

Minimax Decision Criterion: it is based on opportunity loss

• Chooses the alternative with “worst” regret.
• Finds the alternative that minimizes the maximum opportunity loss (regret).
• Finds the maximum opportunity loss within each alternative.
• Then pick the alternative with the minimum value.

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 Alternatives State of nature
Favorable Unfavorable Opportunity loss
market market
• Create large facility 00
• Small facility
• Do nothing

Decision:

Sequential Decision Making: Decision Trees

In real world, people make decisions sequentially over the time.
Make a series of decisions – process manner. Then come up with
an optimal decision.
Decision trees decompose large complex decision problems into
several smaller problems

Symbols:
Decision fork or nodes (use square or rectangle), event forks (use
circle)
Nodes are points in time where:
• One or another decision must be made, or
• Face one or another state of nature, or
• Terminate the process.

Then out of a node

• Branch for each possible decision
• Branch for each possible state of nature.
An Event fork is drawn when outside forces determine which of
several random events will occur. Each branch of an event fork
represents a possible outcome, and the number on each branch
represents the probability that the event will occur.
Probability of respective event is written under each branch.

Usually solution starts from the terminal nodes (backward

direction for folding back the tree). A branch of a decision tree is
a terminal branch if no forks emanate from the branch.
Calculate the expected gains at the intermediate nodes. Decision
is made by max expected gain criterion.

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You can apply a priori criterion or posteriori criterion
The former is based on max expected gain.
Ex. Probability for a product to be profitable is estimated to be 0.6. Determine the
recommended decision under a priori criterion for the decision tree given below:
S1, 0.4 60

Alt A S2, 0.6

660
S1, 0.4 -100

Alt B S2, 0.6

2000

Ex. Analyze the decision tree in adjoining figure. What is the expected payoff for the
best alternative? Be sure to infer the missing probabilities. Alt. = alternative.

[0.5] $15

$30

2 $20
Alt 1 [30%] $18

1 [0.3] $24
Alt 2
[0.2] $25
3
$20

[40%] $30

[0.5] $26

$20
Ex. Under what circumstance is expected monetary value (EMV) appropriate as a
decision criterion? From the following tree diagram, determine the alternative that has
the higher/highest EMV. Show the calculation on the diagram.

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 1/3
0
1/3
.30 600
1/3
900

.50 40
Alt A 440
.20
600
1/3
(45)
1/3
Alt B .30 4560
0
990
.50 400
500
300
.20 1/2
40
1/2
50
Assignment I

1. A company wants to open a new manufacturing facility to serve the world market.
The possible location could be in four countries. Malaysia, Thailand, Indonesia and
Japan. The annual profit that would result from building the plant at each location
depends on the relative exchange rates of currencies in these countries. The
company has identified three possible exchange rate scenarios and they have
estimated the profits that would result (in RM) for each scenario and each plant site.

Plant location Exchange rate

scenario
(Annual profits in
million RM)
I II III
Japan 22 13 7
Malaysia 18 16 15
Indonesia 12 19 13
Thailand 5 12 25

i. Determine the optimal plant location using the following decision criteria: (a)
maximax, (b) maximin, (c) Laplace, and (d) minimax regret.
ii. If the company estimated the probabilities of the scenarios occurring to be 0.3,
0.5, 0.2, respectively, determine the locations that maximizes expected profit.

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2. ABC company is considering an expansion of its factory. There are two options. The
first accommodate 25% increase of its production and second 50% increase. The
return to the company depends on how much sales volume increases. Four
scenarios are considered possible: (1) volume will decrease, (2) volume remains
stable, (3) volume increases moderately, and (4) volume increases substantially.
The expected payoffs for each option under each scenario are as follows:

Expansion Sales volume scenario (net

option payoffs in million RM)
(1) (2) (3) (4)
No expansion -0.4 0 0.5 0.5
25% -1.3 -0/9 2.0 2.5
expansion
50 expansion -1.9 -1.5 1.3 3.0

i. Determine the best decision using the estimated values given in the table.
ii. Determine the best alternative using the following decision criteria: (a)
maximax, (b) maximin, (c) Laplace, (d) minimax regret, and Hurwicz
where coefficient of optimism is 0.3.
iii. If the company estimated the probabilities of the scenarios occurring to be
0.3, 0.1, 0.3, 0.3 respectively, determine the locations that maximizes the
expected payoff.

3. XYZ company is going to introduce one of the three new products: widget, hand-
phone set or a mini-computer. The possible market conditions are: favorable, stable,
or unfavorable will determine the profit or loss the company realizes, as shown in
the following payoff table.

Product Market conditions

Favorable Stable Unfavorable
0.2 0.7 0.1
Widget RM360,000 210,000 -90,000
Hand-phone 180,000 120,000 60,000
set 105,000 90,000 90,000
Mini-computer

i. Compute the expected value for each decision and select the best one.
ii. Determine how much the firm would be willing to pay to a market research firm
to gain better information about future market conditions.
iii. Assume that probabilities cannot be assigned to future market conditions, and
determine the best decision using the maximax, maximin, minimax regret, and
equal likelihood criteria.

4. The Southern Textile Company is considering two alternatives: to expand its

existing production operation to manufacture a new line of lightweight material; or to
purchase land to construct a new facility on in the future. Each of those decision has
outcomes based on product market growth in the future that result in another set of
decisions (during a ten-year planning horizon), as shown in the following figure of a
sequential decision tree. In this figure the square nodes represent decisions and the
circle nodes reflect different states of nature and their probabilities.

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The first decision facing the company is whether to expand or buy land. If the company
expands, two states of nature are possible. Either the market will grow (with a
probability of 0.60) or it will not grow (with a probability of 0.40). Either state of nature
will result in a payoff. On the other hand, if the company chooses to purchase land,
three years in the future another decision will have to be made regarding the
development of the land.

At decision node 1, the decision choices are to expand or to purchase land. Notices
that the costs of the ventures ($800,000 and $200,000, respectively) are shown in
parentheses. If the plant is expanded, two states of nature are possible at probability
node 2: the market will grow, with a probability of 0.60, or it will not grow or will decline,
with a probability of 0.40. if the market will grow, the company will achieve a payoff of
$2,000,000 over a ten-year period. However, if no growth occurs, a payoff of only
$225,000 will result.
If the decision is to purchase land, two states of nature are possible at probability node
3. These two states of nature and their probabilities are identical to those at node 2;
however, the payoffs are different. If the market growth occurs for a three-year period,
no payoff will occur, but the company will make another decision at node 4 regarding
development of the land. At the point, either the plant will be expanded at a cost of
$8000,000 or the land will be sold, with a payoff $450,000. The decision situation at
node 4 can occur only if market growth occurs first. If no market growth occurs at node
3, there is no payoff, and another decision situation becomes necessary at node 5: A
warehouse can be constructed at a cost of $600,000 or the land can be sold for
$210,000. (Notice that the sale of the land results in less profit if there is no market
growth than if there is growth.)
If the decision node 4 is to expand, two states of nature are possible; the market will
grow, with a probability of 0.80 or it will not grow, with a probability of 0.20. The
probability of market growth is higher (and the probability of no growth is lower) than
before because there has already been growth for the first three years, as shown by the
branch from node 3 to node 4. The payoffs for those two states of nature at the end of
the ten-year period are $3,000,000 and $700,000.

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If the company decides to build a warehouse at node 5, then two states of nature can
occur. Market growth can be occurred, with a probability of 0.30 and an eventual payoff,
of $2,300,000, or no growth can occur, with a probability of 0.70 and a payoff of
$1,000,000. The probability of market growth is low (i.e., 0.30) because there has
already been no market growth, as shown by the branch from node 3 to node 5.

5. An Oil Company is considering making a bid for a shale oil development contract to
be awarded by the federal government. The company has decided to bid RM330
million. The company estimates that it has a 60-percent chance of winning the
contract with this bid. If the firm wins the contract, it can choose one of three
methods for getting the oil from the shale. It can develop a new method for oil
extraction, use an existing (inefficient) process, or subcontract the processing out to
a number of smaller companies once the shale has been excavated. The results
from these alternatives are given as follows.

Develop New Process

Outcomes Probability Profit (millions)
Great Success 0.30 RM1,800
Moderate Success 0.60 900
Failure 0.10 -300
Use Present Process
Outcomes Probability Profit (millions)
Great Success 0.50 RM900
Moderate Success 0.30 600
Failure 0.20 -120
Subcontract
Outcomes Probability Profit (millions)
Moderate Success 1.00 RM750

The cost of the preparing the contract proposal is RM6,000,000. If the company does
not make a bid, it will invest in an alternative venture with a guaranteed profit RM90
million. Construct a sequential decision tree for this decision solution and determine
whether the company should make a bid.

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