BDDN4103 Introductory Business Decision Making - Vapr20

BDDN4103
Introductory Business Decision Making
Copyright © Open University Malaysia (OUM)

BDDN4103
INTRODUCTORY
BUSINESS DECISION
MAKING
Prof Dr Mohd Ghazali Mohayidin
Dr Lim Yet Mee

Project Directors: Prof Dr Widad Othman
Prof Dr Shamsul Nahar Abdullah
Open University Malaysia
Module Writers: Prof Dr Mohd Ghazali Mohayidin

Universiti Putra Malaysia
Dr Lim Yet Mee

Universiti Tunku Abdul Rahman
Moderator: Prof Dr Salleh Yahya

Kolej Universiti Teknikal Kebangsaan Malaysia
Enhancer: Prof Dr Mohd Ghazali Mohayidin

Universiti Putra Malaysia
Developed by: Centre for Instructional Design and Technology

Open University Malaysia
First Edition, January 2005

Second Edition, April 2020 (MREP)
Copyright © Open University Malaysia (OUM), April 2020, BDDN4103
All rights reserved. No part of this work may be reproduced in any form or by any means without
the written permission of the President, Open University Malaysia (OUM).

Table of Contents
Course Guide ix–xiv
Topic 1 Introduction to Decision Making 1

1.1 Economic Problem 2
1.1.1 Wants 2
1.1.2 Resources 3
1.1.3 The Economic Problem 4
1.1.4 Opportunity Cost and Decision Making 4
1.2 Why is It Difficult to Make Decisions? 5
1.3 Why Study Decision Making/Analysis? 8
1.4 Decision Making and Subjective Judgement 9
1.5 Decision-making Process 9
Summary 12
Key Terms 13
References 13
Topic 2 Models and Scientific Method 14

2.1 The Role of Models in the Decision Process 15
2.1.1 Model of Adaptive Behaviour 15
2.1.2 Classifications of Models 16
2.1.3 Major Modelling Concerns 17
2.2 The Decision Maker, the Model and the Model Builder 18
2.2.1 Using Decision Models 19
2.2.2 Considerations in using Decision Models 19
2.2.3 What Constitutes Successful Modelling? 20
2.3 The Scientific Method 20
2.4 Elements of Model Construction 21
2.4.1 Identification of Model Components 22
2.4.2 Example of the Break-even Model 23
Summary 26
Key Terms 26
References 27

iv  TABLE OF CONTENTS
Topic 3 Common Decision Models and Sensitivity Analysis 28

3.1 Econometric Models 29
3.1.1 Simple Linear Regression Model 30
3.1.2 Test of Significance and Goodness-of-fit 33
3.1.3 Multiple Linear Regression Model 33
3.1.4 Example: Cholesterol Level Estimation 34
3.2 Programming Models 37
3.2.1 Profit Maximisation 38
3.2.2 Cost Minimisation 41
3.3 Sensitivity Analysis 44
3.4 Simulation Models 47
Summary 50
Key Terms 50
References 50
Topic 4 Elements of Decision Problems 51

4.1 Identifying and Defining a Problem 52
4.2 Elements of Decision Problems 53
4.2.1 Values and Objectives 54
4.2.2 Decisions to Make 55
4.2.3 Uncertain Events 56
4.2.4 Risk and Uncertainty 57
4.2.5 Sources of Business Risk and Uncertainty 57
4.2.6 Consequences 59
4.2.7 Time Value of Money 60
Summary 63
Key Terms 63
References 64

TABLE OF CONTENTS  v
Topic 5 Structuring Decisions 65

5.1 Identifying and Structuring Objectives 66
5.1.1 Techniques for Identifying Objectives 66
5.1.2 Fundamental and Means Objectives 69
5.2 Structuring Decisions Using Influence Diagrams 70
5.2.1 Decisions and Alternatives 70
5.2.2 Uncertain Events 71
5.2.3 Consequences 72
5.2.4 Using Arcs to Show Relationships 72
5.2.5 Basic Influence Diagram 73
5.3 Structuring Decisions Using Decision Trees 75
5.3.1 Elements and Symbols 75
5.3.2 Cash Flows and Probabilities 78
5.4 Measuring Fundamental Objectives 80
Summary 84
Key Terms 85
References 85
Topic 6 Making a Choice 86

6.1 Decision-theory Approach 87
6.2 Decision Making Under Risk and Uncertainty 89
6.3 Making Choices Using a Decision Tree 93
6.3.1 Decision Tree and Expected Monetary Value (EMV) 93
6.3.2 Solving Decision Tree with Computer Software 95
Summary 98
Key Terms 98
References 98
Topic 7 Decision Making in Practice: Getting the Problems and 100

Objectives Right
7.1 Getting the Objectives Right 101
7.1.1 Practical Prescriptions: Specifying the Objectives 101
7.1.2 Practical Prescriptions: Checklist 102
7.2 Understanding the Problem 104
7.2.1 Practical Prescriptions: Data Collection 105
7.2.2 Practical Prescriptions: Data Processing 108
Summary 117
Key Terms 118
References 118

vi  TABLE OF CONTENTS
Topic 8 Decision Making in Practice: Generating Options and 119

Making the Choice
8.1 Generating the Options 120
8.1.1 Critical and Creative Thinking in Decision Making 120
8.1.2 The Creative Individual 123
8.1.3 The Creative Organisation 125
8.1.4 Techniques for Aiding Creative Thinking 126
8.2 Evaluating the Options 128
8.3 Making a Choice 131
Summary 133
Key Terms 134
References 134
Topic 9 Approaches to Decision Making 135

9.1 Types of Decisions 136
9.1.1 How Routine are the Decisions? 137
Programmed versus Non-programmed Decisions
9.1.2 How Risky are the Decisions? 139
Certain versus Uncertain Decisions
9.1.3 Who Makes the Decision? 141
Top-down versus Empowered Decisions
9.2 Decision Environment 142
9.3 Decision-making Process 144
9.4 Decision-making Approaches in Organisations 146
9.4.1 Rational or Analytical Approach 147
9.4.2 Bounded Rationality Approach 149
9.4.3 Garbage Can Model 150
Summary 153
Key Terms 153
References 154
Topic 10 Factors Influencing Organisational Decision Making 155

10.1 Factors Influencing Decision Making 156
10.2 Individual versus Group Decision Making 160
10.2.1 Advantages and Disadvantages of 160
Group Decision Making
10.2.2 How Groups Make Decisions 163
10.3 Technology and Decision Making 164
10.4 Ethics in Decision Making 166
Summary 167
Key Terms 168
References 169

COURSE GUIDE  ix
COURSE GUIDE DESCRIPTION

You must read this Course Guide carefully from the beginning to the end. It tells
you briefly what the course is about and how you can work your way through the
course material. It also suggests the amount of time you are likely to spend in order
to complete the course successfully. Please refer to the Course Guide from time to
time as you go through the course material as it will help you to clarify important
study components or points that you might miss or overlook.
INTRODUCTION
BDDN4103 Introductory Business Decision Making is one of the courses offered
at Open University Malaysia (OUM). This course is worth 3 credit hours and
should be covered over 8 to 15 weeks.
COURSE AUDIENCE
This is an elective course for all learners taking the Diploma of Management
programme specialising in General Management.
As an open and distance learner, you should be acquainted with learning

independently and being able to optimise the learning modes and environment
available to you. Before you begin this course, please ensure that you have the
right course material and understand the course requirements as well as how the
course is conducted.
STUDY SCHEDULE
It is a standard OUM practice that learners accumulate 40 study hours for every
credit hour. As such, for a three-credit hour course, you are expected to spend 120
study hours. Table 1 gives an estimation of how the 120 study hours could be
accumulated.

x  COURSE GUIDE
Table 1: Estimation of Time Accumulation of Study Hours
Study
Study Activities
Hours
Briefly go through the course content and participate in the initial discussion 3
Study the module 60
Attend 3 tutorial sessions 6
Online participation 16
Revision 15
Assignment(s), Test(s) and Examination(s) 20
TOTAL STUDY HOURS ACCUMULATED 120
COURSE LEARNING OUTCOMES

By the end of this course, you should be able to:
1. Discuss the importance of making good decisions in business;
2. Demonstrate the ability to differentiate the different types of business

decisions;
3. Apply various types of decision-making tools and techniques; and
4. Perform the practical steps in making sound business decisions.
COURSE SYNOPSIS
This course is divided into 10 topics. The synopsis for each topic is as follows:
Topic 1 defines the economic problem, explains the concept of opportunity cost
and discusses the decision-making process.
Topic 2 discusses the roles of scientific method and models in decision making.
Topic 3 discusses selected models that are commonly used by decision makers.
Sensitivity analysis and simulation method are also covered in this topic.

COURSE GUIDE  xi
Topic 4 discusses the need and the process of establishing an accurate problem
statement before proceeding to outline the process of mapping the underlying
structure of a decision problem.
Topic 5 examines the process of decision making by defining and mapping the
underlying structure of a decision problem.
Topic 6 completes the process of making decisions using simple tools and
techniques.
Topic 7 revisits the decision-making process by focusing on the practical guide in

making decisions in the business world especially in terms of getting the right
problems and objectives.
Topic 8 continues with the discussion on the practical guide in making decision
with a focus on generating options and making the choice.
Topic 9 discusses the different approaches to decision making within

organisations. This topic also explains the typical decision-making process and
various models used to explain how decisions are made in organisations.
Topic 10 discusses the various factors that influence organisational decision

making, the role of technology and ethical issues in decision making.
TEXT ARRANGEMENT GUIDE

Before you go through this module, it is important that you note the text
arrangement. Understanding the text arrangement will help you to organise your
study of this course in a more objective and effective way. Generally, the text
arrangement for each topic is as follows:
Learning Outcomes: This section refers to what you should achieve after you have
completely covered a topic. As you go through each topic, you should frequently
refer to these learning outcomes. By doing this, you can continuously gauge your
understanding of the topic.
Self-Check: This component of the module is inserted at strategic locations

throughout the module. It may be inserted after one subtopic or a few subtopics.
It usually comes in the form of a question. When you come across this component,
try to reflect on what you have already learnt thus far. By attempting to answer
the question, you should be able to gauge how well you have understood the
subtopic(s). Most of the time, the answers to the questions can be found directly
from the module itself.

xii  COURSE GUIDE
Activity: Like Self-Check, the Activity component is also placed at various locations
or junctures throughout the module. This component may require you to solve
questions, explore short case studies, or conduct an observation or research. It may
even require you to evaluate a given scenario. When you come across an Activity,
you should try to reflect on what you have gathered from the module and apply it
to real situations. You should, at the same time, engage yourself in higher order
thinking where you might be required to analyse, synthesise and evaluate instead
of only having to recall and define.
Summary: You will find this component at the end of each topic. This component
helps you to recap the whole topic. By going through the summary, you should be
able to gauge your knowledge retention level. Should you find points in the
summary that you do not fully understand, it would be a good idea for you to
revisit the details in the module.
Key Terms: This component can be found at the end of each topic. You should go
through this component to remind yourself of important terms or jargon used
throughout the module. Should you find terms here that you are not able to
explain, you should look for the terms in the module.
References: The References section is where a list of relevant and useful textbooks,
journals, articles, electronic contents or sources can be found. The list can appear
in a few locations such as in the Course Guide (at the References section), at the
end of every topic or at the back of the module. You are encouraged to read or
refer to the suggested sources to obtain the additional information needed and to
enhance your overall understanding of the course.
PRIOR KNOWLEDGE
Learners of this course are required to pass the BDPP1103 Introductory
Management course.
ASSESSMENT METHOD
Please refer to myINSPIRE.

COURSE GUIDE  xiii
REFERENCES
Ashe-Edmunds, S. (2019). Factors influencing decision making in a business
environment. Retrieved from https://smallbusiness.chron.com/factors-
influencing-decision-making-business-environment-65082.html
Australian Curriculum (2018). Primary matters – Critical and creative thinking,

Issue 16. Retrieved from https://www.australiancurriculum.edu.au/f-10-
curriculum/general-capabilities/critical-and-creative-thinking/#
Baker, A. J. (2018). Business decision making. New York: Taylor and Francis.
Clemen, R. T., & Reilly, T. (2001). Making hard decisions with decision tools.
Pacific Grove, CA: Duxbury/Thomson Learning.
Clemen, R. T., & Reilly, T. (2014). Making hard decisions with decision tools
(3rd ed.). Mason, OH: South Western, Cengage Learning.
Ekings, J. D. (1986). A nine-step quality improvement programme to increase

customer satisfaction. European Organisation for Quality Control 30th
Conference, Stockholm.
Exodus Escape Room. (2016). Critical thinking in the decision-making process.

Retrieved from https://exodusescaperoom.com/critical-thinking-in-the-
decision-making-process
Haughey, D. (2015). Pareto analysis step-by-step. Retrieved from

https://www.projectsmart.co.uk/pareto-analysis-step-by-step.php
Keeney, R. L. (2002). Common mistakes in making value trade-offs. Operations

Research 50(6):935–945; doi:10.1287/opre.50.6.935.357
Sherman, F. (2019). Garbage can theory. Retrieved from https://bizfluent.

com/facts-7741400-garbage-can-model-approach.html
Teale, M., Dispenza, V., Flynn, J., & Currie, D. (2003). Management decision
making: Towards an integrative approach. Edinburgh, United Kingdom:
Prentice-Hall.
Vahid, L., & Pegels, C. C. (1996). Decision support systems for operations
management & management science (3rd ed.). Chicago, IL: Irwin McGraw
Hill.
Williams, S. W. (2016). Making better business decisions. SAGE Publications.

xiv  COURSE GUIDE
TAN SRI DR ABDULLAH SANUSI (TSDAS) DIGITAL

LIBRARY
The TSDAS Digital Library has a wide range of print and online resources for the
use of its learners. This comprehensive digital library, which is accessible through
the OUM portal, provides access to more than 30 online databases comprising e-
journals, e-theses, e-books and more. Examples of databases available are
EBSCOhost, ProQuest, SpringerLink, Books24×7, InfoSci Books, Emerald
Management Plus and Ebrary Electronic Books. As an OUM learner, you are
encouraged to make full use of the resources available through this library.

Topic  Introduction
1 to Decision
Making
LEARNING OUTCOMES
By the end of this topic, you should be able to:

1. Explain how an economic problem arises;
2. Describe the role of opportunity costs in making decisions;
3. Explain why many decisions are difficult to make; and
4. Describe the decision-making process.
 INTRODUCTION
Making decisions and bearing the responsibility for them is one of the cornerstones
of the managerÊs job. Quite simply, if managers are not able to make decisions,
they should not be appointed managers in the first place! This fundamental
importance of decision making is reflected in the attention given by all academic
disciplines – philosophy, economics, mathematics and social sciences. They have
all contributed towards helping us understand how decisions are made or could
be better made (Williams 2016).
Between these disciplines, two academic areas stand out as offering particularly
helpful contributions to the practical business of making better decisions. These
areas are the behavioural sciences, which help us to understand how we behave
when faced with a decision, and the applied mathematics of operational research,
which provides potentially powerful tools for the modelling and analysis of
complex decisions.

2  TOPIC 1 INTRODUCTION TO DECISION MAKING
However, the full contributions of these two academic areas are only realised when
they are focused through the reality of practical management experience. After all,
decision making must be followed by the commitment to do something (Baker,
2018).
To understand decision-making management and to make better decisions, you

must be able to recognise different types of decisions. Besides that, you have to
understand the contribution of the behavioural and quantitative sciences, and
have knowledge and skills of the practical steps to be taken when making
decisions. This topic provides an introduction to decision making and discusses
all these issues.
1.1 ECONOMIC PROBLEM

Have you ever thought about the growing number of economic problems around
you? Have you ever looked in depth at your problems, those that you are now
facing and the ones that you might be facing in the future? Perhaps, most of us
think that the major root cause of most of our economic problems is money! „It's
all about the money⁄‰ as the lyrics go. Maybe so but have you ever considered
how an economic problem arises?
Basically, an economic problem arises because of scarcity; in other words,

resources are limited to meet our unlimited wants. Since resources have alternative
uses, it gives rise to choices. As a manager, you have to make decisions as to how
these resources are to be allocated to optimise their use in achieving your
objectives.
1.1.1 Wants
A want, in the context of economics, is simply something that people like to have,
which they may or may not be able to obtain. Human beings have many different
types of wants and they are often unlimited. These wants can only be satisfied by
consuming (using) either:
(a) Goods (physical items such as food and clothing); or
(b) Services (non-physical items such as food preparation and recreation).

TOPIC 1 INTRODUCTION TO DECISION MAKING  3
See Figure 1.1 for example.
Figure 1.1: Example of goods and services
There are four reasons why wants are virtually unlimited:
(a) Goods eventually wear out and need to be replaced;
(b) New or improved products become available;
(c) Over time, people tend to get fed up with what they have already owned; and
(d) PeopleÊs wants are often insatiable – what he already has, he would want to
have more of it.
1.1.2 Resources
Commodities (goods and services) are produced using resources. The resources as
shown in Table 1.1 are sometimes called inputs or factors of production.
Table 1.1: Different Types of Resources
Type Description Reward

Land Natural resources Rent
Labour Physical and mental work of people Wages
Capital Man-made tools and machines Interest
Enterprise Managers and entrepreneurs Profit

There are two major characteristics of resources which have a direct bearing on
decision making, namely:
(a) They are limited (in terms of quantity, quality and capacity); and
(b) They have alternative uses (the same piece of land, for instance, can be used
for agriculture, industry or housing).
In economics, every resource must be rewarded for use in the production of goods
and services, including your own resource.
1.1.3 The Economic Problem

The economic problem arises due to the scarcity of resources. At any level of the
economy (national, regional, business entity and individual), there is always not
enough (limited) resources available to produce the unlimited amount of goods
and services that we desire.
Society at large has to decide which commodities to produce, how much to

produce, how they are to be produced and for whom they are produced. As an
example, at any given time, do we make weapons or build hospitals? Based on
current technology, we have to decide how to make these commodities. Do we
employ robots or human workers? Who is going to use the goods that are
eventually made? Are they for local consumption or for exports?
1.1.4 Opportunity Cost and Decision Making

Opportunity cost can assist you to make a better decision simply because it puts
your decision in a better context. When applying opportunity cost, all costs and
benefits are framed in terms of what is most important to you at the time the
decision is made. When we make a decision especially those involving mutually
exclusive alternatives, we will always be subject to what economists called
opportunity cost.
Opportunity cost is the cost you pay for choosing one alternative over the others.
It is not the cost as what we usually understand it to be. It is actually the benefit of
the next-best alternative forgone or that you would give up. As a rule of thumb in
making your decision, you must ensure that the opportunity cost must be lower
than the return that you would derive from your choice. If not, you are making the
wrong decision.

The opportunity cost principle is a principle stating the cost of one type of goods
in terms of the next best alternative. For example, a vegetable farmer decides to
grow cabbages on his land. The opportunity cost of his cabbage harvest is the
alternative crop that might have been grown instead (for example, watermelon).
Further examples are given in Table 1.2.
Table 1.2: Examples of Opportunity Cost Decisions
Group Decision
Individual Should I buy a DVD or a book on decision making?
School Should we build a classroom block or squash courts?
Country Should we increase teachersÊ pay or allowances?
SELF-CHECK 1.1
1. What is an economic problem? How does it come about?
2. Define opportunity cost and give an example.
1.2 WHY IS IT DIFFICULT TO MAKE

DECISIONS?
We all make decisions. Decisions are made at the personal, business or government
domains. At the personal level, you may be facing questions such as „Which
university should I choose?‰ or „Which career should I pursue?‰ Businesses may
be asking questions such as „Which market should we focus on?‰ or „Should we
buy or make a technology that we need?‰ At the government level, the questions
may include „Should we continue giving subsidies?‰ or „Should we increase
taxes?‰
A good decision is actually the end result of a careful and thorough effort in
selecting a preferred course of action among a number of alternative courses of
action. The emphasis is on the process of the decision rather than the decision itself.

Have you ever made a difficult decision? Did you end up making the decision
based on a hunch or a gut feeling? Take a look at the following case.
The choices we make today may determine how well we live tomorrow.
Why are many decisions difficult to make? Making decisions can be difficult due
to various reasons including the presence of risks and uncertainties, different
perspectives and competing concerns among those involved in or affected by the
decisions, and the complexities of the decision context itself. There are four major
reasons why many decisions are difficult to make and they are illustrated in
Figure 1.2.

Figure 1.2: Major reasons why decisions are difficult to make
The four major reasons are briefly explained in Table 1.3 (Clemen & Reilly, 2014).

Table 1.3: Major Reasons Why Decisions are Difficult to Make
Reason Explanation
Complexity Too many issues to consider such as the values of different
players, the different courses of action that can be taken and
the outcomes of each course of action.
Uncertainties in the There are inherent uncertainties that have to be dealt with
situation such as the effectiveness of the pesticide used, the
acceptance of the local population and environmentalists,
and the effects on the environment.
Multiple objectives There are many objectives to satisfy and some of these
objectives work in opposite directions. For instance, the
farmersÊ objective is to obtain returns from their crops while
the objective of the local population is to make sure that the
environment they live in is not polluted with chemicals.
Different perspectives This usually happens when more than one person or groups
lead to different are involved in making the decision.
conclusions
SELF-CHECK 1.2
Why is it often difficult for us to make decisions? Discuss.
1.3 WHY STUDY DECISION

MAKING/ANALYSIS?
The reason we are studying decision making/analysis is not to replace decision
makersÊ (DM) intuition but to complement, augment and work alongside the DM
in exemplifying the nature of the problem.
In many instances, proper application of decision making/analysis can lead to

better decisions. Better decisions often lead to better outcomes. A good decision is
one that gives the best outcome. However, they are also situations where decisions
are not made properly but the outcomes happen to be desirable. These are lucky
outcomes. Decision making/analysis provides the structure and guidance for
systematic thinking during difficult situations. It is an information source that
helps the decision maker makes good decisions.

SELF-CHECK 1.3
How can studying decision making/analysis help business decision?
1.4 DECISION MAKING AND SUBJECTIVE

JUDGEMENT
An objective judgement or point of view is one that is independent of the decision
maker and is measurable or verifiable by some standards that do not vary from
one decision maker to another. On the other hand, subjective judgement is
dependent on something innate and unique to the decision maker, and usually not
verifiable by any external standard.
Personal judgements about uncertainties and values are important inputs for
decision making/analysis. Decision making allows the inclusion of subjective
judgements. However, we must be cautious because human beings are imperfect
and they may provide imperfect information.
SELF-CHECK 1.4
How would subjective judgement affect business decision?
1.5 DECISION-MAKING PROCESS

An important criterion for a good decision is the way the decision is made. Hence,
in this module, we will examine the process with sufficient detail.
The decision-making process flowchart adopted from Clemen and Reilly (2005) is
shown in Figure 1.3. The process starts with the identification of the situation and
understanding the objectives. In coming up with the optimal decision, all decision-
making processes will have their own tool kits (models and analytical tools). The
decision-making process should end up with the implementation of the chosen
alternatives.

Figure 1.3: The decision analysis process flowchart

Source: Clemen & Reilly (2005, 2014)
Now let us look at the six steps in the process as follows:
Step 1: Identify the decision situation and define the problem;
Step 2: Identify the objectives and determine the alternative courses of action
(options);
Step 3: Analyse the options by decomposing and modelling the problem based
on the problem structure, the uncertainties involved and preferences of
the decision maker;

Step 4: Choose the best alternative;
Step 5: Conduct a sensitivity analysis; and
Step 6: Implement the best alternative.
After conducting the sensitivity analysis, if no further analysis is needed,

implement the chosen alternative. If further analysis is needed, go back to Step 1,
Step 2 or Step 3.
SELF-CHECK 1.5
TRUE (T) or FALSE (F) Statements
No. Statement True False

1. The opportunity cost principle states the cost of
one goods in terms of the next-best alternative.
2. Complexity usually happens when more than one
person or group are involved in making the
decision.
3. Uncertainties in the situation happen when there
are many objectives to satisfy and these objectives
work in opposite directions.
4. The economic problem refers to the scarcity
of commodities.
5. Decision making/analysis provides the structure
and guidance for systematic thinking during
difficult situations.
6. There are eight steps to follow in the decision-
making process.
7. Step 3 of the decision-making process is choosing
the best alternative.
8. Step 6 of the decision-making process is sensitivity
analysis.
9. Step 1 of the decision-making process is to identify
alternatives.
10. Decision making allows the inclusion of subjective
judgments.

ACTIVITY 1.1
1. The opportunity cost principle states the cost of one good in terms
of the next best alternative. Relate this principle to the economic
problem, i.e. scarcity and choice.
2. Give an example in which a decision was complicated because of

difficult preference trade-offs. Give one that was complicated by
uncertainty.
• The purpose of decision making/analysis is to help a decision maker think

systematically about complex problems and to improve the quality of the
resulting decisions.
• A good decision is one that is made on the basis of a thorough understanding

of the problem and careful thought regarding important issues. Outcomes, on
the other hand, may be good or poor, regardless of the decision quality. Quality
decision may reduce the chances of getting poor outcomes, but we cannot be
100 per cent sure that we will always get good outcomes.
• In general, decision making/analysis consists of a framework and a tool kit for

dealing with difficult decisions.
• The incorporation of subjective judgement is an important aspect of decision

making/analysis. To a great extent, mature judgements develop as the
decision maker reflects on the decision at hand and develops a working model
of the problem.
• The overall strategy is to decompose a complicated problem into chunks that

can be more readily analysed and understood.

Commodities Opportunity cost

Decision-making process Resources
Decisions Wants
Baker, A. J. (2018). Business decision making. New York, NY: Taylor and Francis.
Williams, S. W. (2016). Making better business decisions. Thousand Oak, CA: Sage.

Topic  Models and
2 Scientific
Method
LEARNING OUTCOMES

1. Explain the role of models in the decision-making process;
2. Identify the types of models used in decision making and the
elements of model construction;
4. Discuss the major concerns in model construction; and
5. Use the scientific method in making decisions.
 INTRODUCTION
A model is basically a simplified representation of the important elements of
reality and how these elements interact with each other. It is an explicit statement
of our image of the real world. In the current context, it represents the relevant
aspects of the very decision with which we are concerned with. It represents the
decision context by structuring and formalising the information we possess about
the decision and, in doing so, presents reality in a simplified, organised and
manageable form.
A model, therefore, provides us with the means of presenting a more complex

reality so that its components and elements can be described, explained, controlled
and predicted. It also shows how the various components and elements interrelate
with one another. Therefore, when the term „model‰ is used in this context, it
becomes apparent that the decision makers are communicating to their audience
by means of models all the time and applying them in the decision process.

TOPIC 2 MODELS AND SCIENTIFIC METHOD  15
2.1 THE ROLE OF MODELS IN THE DECISION

PROCESS
Models can take any form that is illuminating to the decision maker that could help
him make a decision. A model need not be abstract, that is, quantitative or
physical; it can be conceptual and qualitative as well. Intangibles such as customer
satisfaction and job satisfaction may all be parts of a model. Hence, models can
cover a broad spectrum of things. Besides physical replications and mathematical
representations, the term also covers the more commonly used organisational
charts, flow diagrams, checklists and other visual aids (Vahid & Pegels, 1996).
2.1.1 Model of Adaptive Behaviour

Let us begin our discussion by familiarising ourselves with the model of adaptive
behaviour. Adaptive behaviour refers to behaviour that enables a person to get
along in his decision environment with the greatest success and least conflict with
others. The general idea of modelling adaptive behaviour is to establish a close
relationship between an individualÊs reflection and action. This often requires the
analysis of the model of the decision process itself. The decision makerÊs goals,
perceptions and the environment in which that decision is made must be taken
into consideration.
Goal formation is the nucleus of any decision making, without which there is no
way that performance can be measured accurately (Uskali, 2012). Goals, objectives
and targets also provide a very good guide in the implementation of any decision.
These goals, however, should be assessed and evaluated from time to time to
determine whether they are still relevant, especially with the ever-changing
business, political and social environments.
Perceptions, learning and acting are also important parts of the model of adaptive
behaviour. Perceptions depend upon a personÊs past experience and tend to shape
the behaviour and action of a person. Learning, on the other hand, is a process that
modifies oneÊs perceptions.
In essence, decisions are made by individuals who, through their actions, attempt
to modify their situations vis-à-vis their environment.

16  TOPIC 2 MODELS AND SCIENTIFIC METHOD
2.1.2 Classifications of Models

There are a variety of abstract models that can be applied to problem solving in
the personal, business and government domains. In general, abstract models can
be classified in many different ways, among them, by their usage and by the
structure of their input data.
(a) Positive and Normative Models

Figure 2.1 shows one way of classifying models while Table 2.1 provides a
brief explanation of each of the models.
Figure 2.1: Classification of models
Table 2.1: Positive and Normative Models
Model Explanation
Positive Models which are viewed as representing how a person actually
behaves.
Normative Models indicating what a person should do.
Conditional If this is what a person wants, this is what he should do.
Normative
(b) Optimising and Satisficing Models

Optimising models attempt to find „the single best‰ solution to the decision.
These models can be optimised if they have objective functions. These
objective functions have either maximum or minimum values.
Satisficing models, on the other hand, accept that the theoretical optimums
may be either too time consuming to search for or not recognisable even if
found. These models aim for a good sub-optimal solution which may not be
the single best but is likely to be better than any solution reached without the
aid of the models.

(c) Deterministic and Probabilistic Models

Deterministic models use single estimates to represent the value of each
variable in the decision, whereas probabilistic models use probability
distributions, histogram or any other description of the range of values
which the variables may take. Probabilistic models describe decisions in
terms of the uncertainties inherent in them.
(d) Simulation Models

The deterministic and probabilistic models place certain restrictions on the
structure of the problem typically to ensure that some widely-acceptable and
widely-available procedures can be used to determine the best alternative
solution. Simulation models can easily incorporate more complex
interactions among components and elements of the decision environment.
It can also include probabilities. However, simulation models are generally
more complicated and more involved.
(e) Discipline Specific Models

Different disciplines have developed their own specific types of decision-
making models. Economists, for instance, have often relied on the demand
and supply model, among others.
2.1.3 Major Modelling Concerns

In any decision-making exercise, especially when it involved modelling, there are
three major areas of concerns. These concerns must be addressed to ensure you
have the right information to make good decisions. The three major areas of
concerns are as described in Table 2.2.
Table 2.2: Major Modelling Concerns
Model Explanation
Model What level of approximation is accepted? One must decide what
specification variables to be included in the model and how these variables are
measured.
Model Is the model logically consistent? One must compare the model with
validation reality and determine whether it is consistent with observation as
well as with experience.
Test of Does the model lead to the right action?
workability

SELF-CHECK 2.1
1. What is the role of models in decision making?
2. Discuss briefly the main classifications of models.
3. What are the main concerns of modelling?
2.2 THE DECISION MAKER, THE MODEL AND

THE MODEL BUILDER
The place of models in the decision-making process is to reach better coherence
between goals and action. One important question, though, is what would be the
ideal relationship between the model builder and the decision maker, if they are
not the same person.
There is no easy answer to this question. Some suggest that the model builder
should work closely with the decision maker, however, the model builder (the
social scientist) must maintain his neutrality as a scientist so that he can remain as
objective as possible in stating his stand regarding the problem analysis and the
decision to be made.
ACTIVITY 2.1
Imagine yourself as the managing director of one of the top five

construction companies in Kuala Lumpur. As a manager, one of your
obvious responsibilities is, of course, making big decisions that would
affect the entire organisation. Think for a minute or two. What would
you base your decisions on? Do you seek collective ideas from your
employees, do you seek advice from the president of your company, or
do you have a specific guide, say, decision models to base your decisions
on?

2.2.1 Using Decision Models

What, then, should be the role of decision models? When faced with such a
question, managersÊ reactions tend to be polarised. A minority would reject
modelling as having no useful role to play. After all, a good managerÊs judgement
and intuition are worth any number of mathematical models. They would argue
that many models either state the obvious about trivial problems or fail to grasp
everything but the bare quantifiable skeleton of more important decisions. How is
it possible, they would argue, to devise a model that can compete with years of
accumulated background knowledge and experience in making similar important
decisions?
On the other hand, those who firmly believe in mathematical models or have a
vested interest in their use, know that the hard discipline and rigorous logic of the
modelling process can cut through some of the half-truths and unjustified
assumptions of much management debate (Clopper, 2014).
There is no greater danger than applying the seductive simplicity of plain old
common sense. A well-developed model can spring surprises by showing a
solution that would not have been thought of otherwise. Furthermore, the models
are available, or can be developed, so why not use them?
2.2.2 Considerations in Using Decision Models

Before deciding whether it is worth using a decision model to help with the
decision process, four questions should be addressed as illustrated in Figure 2.2.
Figure 2.2: Questions to ask before using the decision model

2.2.3 What Constitutes Successful Modelling?

Successful modelling is highly dependent on the right organisational setting, the
right modelling process and the application of the right model. Refer to Table 2.3
for more details.
Table 2.3: What Constitutes Successful Modelling?
Factor Explanation
The right Includes:
organisational • The extent of top management support.
setting
• Meaningful involvement of the decision makers.
• The organisational position of the modelling function.
• The reputation of the modellers.
The right modelling Focuses on:

process • The competence and experience of modellers and
managers.
• The extent of mutual understanding between the modeller
and decision maker.
• The closeness of the manager during modelling.
The right model Must have several characteristics:

• The model should be simple.
• The model must be robust.
• The model should be easy to control.
• The model must be adaptive.
• The model should be complete.
• The model should be easy to communicate with.
2.3 THE SCIENTIFIC METHOD

The objective of the scientific approach to decision making is to make good choices
from existing alternatives by utilising systematic means to generate information
concerning the decision environment and to evaluate the range of decision
alternatives in a logical and precise manner. Steps in the scientific method are
explained in Table 2.4.

Table 2.4: Steps in the Scientific Method
Step Explanation
Step 1 Continuing study of the systems (business and organisation)
Observation in an attempt to identify problems.
Step 2 • Define the problem as precisely as possible.
Definition of the • Define goals and objectives.
problem
Step 3 • Formulate the model (hypothesis):
Model construction – Describe the relationship between the components.
– Specify the measurement criteria.
Step 4 • Collect the relevant data.

Model estimation • Estimate the model.
Step 5 • Check if the model correctly reflects the operation of the
Model validation – system it represents.
problem solution • Check whether the problem reflected by the model is
solved.
Step 6 The true value of the process is in the impact that
Implementation implementation has on the performance of the system under
study.
2.4 ELEMENTS OF MODEL CONSTRUCTION

Models contain several elements that are combined in the construction of the
models, namely variables and parameters:
(a) A variable within a decision refers to some elements in the decision which
takes on different values; and
(b) A parameter, on the other hand, refers to some elements which assume a
constant value over the period of time under study or the range of options
considered.
In practice, many factors in the decision which in reality are variables are treated
as constants. This is part of the process of simplification which characterises the
modelling process. Variables can be classified as either input or output variables.

Input variables (sometimes called exogenous variables) are the independent

inputs to the model which may be taken as acting upon the decision. They can
either be controllable or uncontrollable.
Controllable input variables are inputs to the decision over which the decision
maker has influence. The values which the controllable input variables take are
directly determined by the decision options. Uncontrollable input variables are
those which affect the decision but are generated by the uncontrollable factors in
the decision environment.
Output variables (sometimes called endogenous variables) are generated from

the interactions of the modelÊs input factors and the structure of the decision
itself. The output variables indicate the consequences of the decision.
2.4.1 Identification of Model Components

Identification of various components of the model is a very crucial step in the
analysis. The purpose of the identification is to extract from the system of interest
the essential elements to the problem analysis. The output variables, the input
variables and the parameters must be identified and defined, and appropriate
measures must be assigned to each variable and parameter.
Symbols are used to facilitate model construction and manipulation. In break-

even analysis, for example, the components would include total revenue, fixed
costs, variable costs and volume.
Each variable should also be identified whether it is a solution variable or a

criterion variable. A solution or decision variable represents what one is making
a decision about, for example, the break-even volume.
A criterion variable is a variable to be measured in order to evaluate various

solutions, for example: Profit = Total revenue – Total cost.

2.4.2 Example of The Break-even Model

To illustrate what has been discussed, an example of the break-even model is
illustrated in the following:
(a) Example: The Break-even Model

To determine a companyÊs break-even point algebraically, one must set the
total revenue and total (operating) cost functions equal to each other and
solve the resulting equation for the break-even volume. Suppose profit Z is
a function of Q, the quantity of output.
Z = f (Q)
Profit = Total revenue (TR) – Total cost (TC).
Z = TR – TC
P is the price per unit of output, FC is fixed cost and VC is variable cost.
TR = P * Q, and
TC = FC + VC * Q
Therefore,
Z = P * Q – FC – VC * Q

(b) Solution to the Model

In break-even analysis, the objective is to find the value of Q for which the
profit (Z) equals zero.
Thus,
P * Q – FC –VC * Q = 0
P * Q –VC * Q = FC
Q (P –VC) = FC
Therefore, the break-even quantity

QBE = FC
P –VC
Break-even analysis can also be performed in terms of dollar sales rather than
units of output.

SELF-CHECK 2.2

1. The general idea of modelling adaptive behaviour is
to establish a close relationship between an
individualÊs reflection and action.
2. Learning depends upon a personÊs past experience
and it tends to shape the behaviour and action of a
person.
3. Perception is a process that will modify oneÊs
perceptions.
4. Models can be classified in many different ways,
among them, by their usage and by the structure of
their input data.
5. Optimising models attempt to find „the single best‰
solution to the decision.
6. Satisficing models accept that the theoretical
optimums may be either too time consuming to
search for or not recognisable even if found.
7. There are four steps in the scientific model.
8. Exogenous variables are generated from the
interactions of the modelÊs input factors and the
structure of the decision itself.
9. Endogenous variables are the independent inputs to
the model which may be taken as acting upon the
decision. They can either be controllable or
uncontrollable.
10. Profit is equivalent to total cost minus total revenue.
11. Symbols are used to facilitate model construction and
manipulation. In a break-even analysis, for example,
the components would include total revenue, fixed
costs, variable costs and volume.

SELF-CHECK 2.3
1. Explain how modelling is used in decision making.
2. What constitutes successful modelling?
• There is a strong and understandable desire by managers to look for help in

their decision-making process through the use of a framework or more
precisely, decision model; and indeed, there are many of them.
• With the availability and application of mathematical methods, numerous

methods, techniques or models have been developed.
• Managers should not rely on decision models alone to make the final decision.
Nevertheless, these models can provide an extremely valuable support to the
managers in the decision-making process.
• To get the most out of decision models, managers must be aware of both the
principles, which underlie their development, and the variety of available
decision models.
• A proper scientific method will at least ensure that a reliable model will be
developed for application.
Conditional normative model Normative model

Deterministic model Optimising model
Discipline specific model Positive model
Endogenous (output) variable Probabilistic model
Exogenous (input) variables Satisficing model
Model specification Simulation model
Model validation Test of workability

Clopper, A. (2014). The craft of economic modelling. College Park, MD: University
of Maryland.
Uskali, M. (2002). Fact and fiction in economics: Models, realism and social
construction. Cambridge, United Kingdom: Cambridge University Press.
Hill.

Topic  Common
3 Decision
Models and
Sensitivity
Analysis
LEARNING OUTCOMES

1. Use a simple econometric model;
2. Apply linear programming model;
3. Conduct sensitivity analysis; and
4. Describe the concept of simulation.
 INTRODUCTION
In Topic 2, we introduced modelling. A model is an explicit statement of our image
of reality. It is a representation of the relevant aspects of the decision with which
we are concerned about. It represents the decision environment by structuring and
formalising the information we possess about the decision. By doing so, we are
able to present reality in a simplified and organised form. A model, therefore,
provides us with an abstraction of a more complex reality.

TOPIC 3 COMMON DECISION MODELS AND SENSITIVITY ANALYSIS  29
Psychological differences in perception are likely to cause the reality of the

decision situation to be viewed in different ways by different individuals (Clopper,
2014). Each individualÊs „mental model‰ of the decision is therefore likely to be
different. Clearly, we wish to develop as good a model as possible. We wish to
develop a model which reflects accurately our perceptions of the decision area and
can be used to aid the decision-making process.
In this topic, we will look very briefly at a few models commonly used in aiding
the decision-making process.
3.1 ECONOMETRIC MODELS
Econometrics is the combination of theory, statistical analysis and

mathematical model building to explain economic relationships. Econometric
models may vary in their level of sophistication from simple to extremely
complex models.
The most significant advantage of econometric models is that they identify

independent variables that the decision maker may be able to manipulate (Basu,
2009). The models can predict not only the direction of change of the dependent
variable but also the magnitude of change. The simplest form of an econometric
model is the single-equation model.
Regression analysis is used to develop a functional relationship between the

dependent variable and a set of independent (or explanatory) variables.
Once a functional relationship (that is, the regression equation) is developed, the
equation can be used to make forecasts or predictions concerning the value of the
dependent variable.
The least squares technique is used to estimate the regression coefficients.

Least squares minimise the sum of squares of the differences between the
observed and estimated values of the dependent variable over the sample.

30  TOPIC 3 COMMON DECISION MODELS AND SENSITIVITY ANALYSIS
3.1.1 Simple Linear Regression Model

The analysis in this subtopic is limited to the simple case of one independent and
one dependent variable, where the form of the relationship between the two
variables is linear.
Y =α + βX +ε
The simple linear regression model that is used in this problem involves several
basic underlying assumptions.
A standard convention in regression analysis, which will be followed here, is to

use X to represent the independent variable and Y to represent the dependent
variable.
(a) Assumption 1
The value of the dependent variable Y is postulated to be a random variable,
which is dependent on fixed (non-random) values of the independent
variable X.
(b) Assumption 2
A theoretical straight-line relationship exists between X and the expected
value of Y for each of the possible values of X, E (Y | X ). This theoretical
regression line has a slope of β and an intercept of α. The regression
coefficients α and β constitute population parameters whose values are
unknown and we need to estimate them.
E (Y |X ) = α + β X
(c) Assumption 3
Associated with each value of X is a probability distribution, p(y|x), of the
possible values of the random variable Y. When X is set equal to some value
x, the value of Y that is observed will be drawn from the p(y|xi) probability
distribution and will not necessarily lie on the theoretical regression line. If
ei is defined as the deviation of the observed yi value from the theoretical
value yi, then

y i = y i′ + e i
y i = α + β xi + ei
or in general, the linear regression relation becomes
Y =α + βX +ε
where e is a zero mean stochastic disturbance (or error) term.
(d) Assumption 4
The disturbance term (ei ) is assumed to be an independent random variable
[that is, E (ε i , ε j ) = 0, for i not equal j ] with an expected value equal to zero
[that is, E (ε i2 = 0) = 0 ] and with a constant variance equal to σ 2 [that is, E (ε 2 )
= σ for all i ]. Furthermore, to perform the statistical tests of significance
2
(i.e., t-tests and F-tests), we also must assume that the disturbance term (ε 1 )
follows the normal probability distribution.
Together, Assumptions 1 and 4 imply that the disturbance term is expected

to be not correlated with the independent variables in the regression model.
Once the regression model is specified, the unknown values of the

population regression coefficients α and β are estimated by using the n pairs
of sample observations ( x i , y i ) , ( x 2 , y 2 ) ,..... ( x n , y n ) This process involves
finding a sample regression line that best fits the sample of observations the
analyst has gathered.
The sample estimates of α and β can be designated by a and b, respectively.

The estimated or predicted value of Y, i, for a given value of X is:
ýi = a + bx i ,
Letting e be the deviation of the observed y value from the estimated value,
then:
y i = ýi + e i
= a + bx i + e i

or, in general, the sample regression equation becomes
Y = a + bX + e
Although there are several methods for determining the values of a and b
(that is, finding the regression equation that provides the best fit to the series
of observations), the best known and most widely used is the method of least
squares.
The objective of the least squares analysis is to find the values of a and b that
minimise the sum of the squares of the e, deviations. (By squaring the errors,
positive and negative errors cumulate and do not cancel each other.) From
the above, the value of ei, is given by:
e i = y i − a − bx i
Squaring this term and summing over all n pairs of sample observations, one
obtains
"e i2 = " ( y i − a − bx i )
2
Using calculus, the values of a and b that minimise this sum of squared deviations
expression are given by
b = ( n  x i y i −  x i  y i )/ n  x 2 i − (  x i )2
a = y − bx
where x and y are the arithmetic means of X and Y respectively (that is, x = x/n
and y = y/n) and where the summations range over all the observations (i = 1,
2,. . ., n).

3.1.2 Test of Significance and Goodness-of-fit

There are several tests, which we can carry out to test how good the estimated
regression equation is. Three important statistics are the t-statistics, the F-statistics
and the coefficient of determination.
(a) The t-test is used to test the hypothesis that a specific independent variable
is useful in explaining variation in the dependent variable.
(b) The F-test is used to test the hypothesis that all the independent variables
(X1, X2,., Xm) in the regression equation explain a significant proportion of
the variation in the dependent variable.
(c) The coefficient of determination (r 2 ) measures the proportion of the

variation in the dependent variable that is explained by the regression
equation (that is, the entire set of independent variables).
3.1.3 Multiple Linear Regression Model
A linear relationship containing two or more independent variables is known

as a multiple linear regression model.
In the (completely) general multiple linear regression model, the dependent

variable Y is hypothesised to be a function of m independent variables X1, X2,. ..,
Xm, and to be of the form
Y = β + β 1 X 1 + β 2 X 2 + β 3 X 3 + .. . + β m X m + ε
In addition to satisfying a set of four assumptions similar to those for the simple
linear regression model, the application of the least squares estimation procedure
to the multiple linear regression model requires two further assumptions.
(a) Assumption 1
The number of observations (n) must exceed the number of parameters to be
estimated (m + 1).

(b) Assumption 2
No exact linear relationships can exist between any of the independent
variables. A definitional relationship or identity, for example, cash in the
register is equal to initial cash plus receipts cannot be estimated if there are
some sources of randomness in the data. For example, the clerk on duty may
commit occasional errors when making a change.
3.1.4 Example: Cholesterol Level Estimation

Given a situation where the cholesterol levels are available for 12 individuals
together with their respective ages, heights and weights. Our interest in this case
centres on finding the possible relationship between the cholesterol level, the
dependent variable and the independent variables, namely age, height and weight.
Cholesterol Level Age Height Weight

Individual
(Units) (Years) (Inches) (Pounds)
1 50 20 67 85
2 100 25 67 110
3 150 20 65 121
4 157 33 60 150
5 600 60 65 317
6 300 26 67 230
7 175 35 78 130
8 476 36 61 268
9 243 41 70 147
10 250 44 71 160
11 198 27 78 132
12 200 33 60 150
If there is a significant relationship, we can use multiple regressions to predict the

cholesterol level of other individuals whose age, height and weight are known.
The data for this example, consisting of 12 observations on 12 individuals, are
presented in the following.

Results of the regression estimation for this problem using computer software are
shown in Table 3.1.
Table 3.1: Regression Function Coefficients
Coefficient Value Standard Deviation T-ratio

Intercept –283.844 120.878 –2.348
Age 2.335 1.190 1.962
Height 1.738 1.692 1.028
Weight 1.982 0.206 9.632
Table 3.2: Analysis of Variance Table
Sources DF SS MS F-value
Regress 3 259476.076 86492.025 88.974
Residual 8 7776.841 972.105
Total 11 267252.917
Coefficient of determination r-squared = 0.971

Residual standard deviation = 31.179
The first section of the results consists of the regression function equation. The
output provides the estimated value of the intercept and the coefficients of the
three independent variables, namely age, height and weight. Hence, the regression
function equation is:
Cholesterol = –283.844 + 2.335 (Age) + 1.1738 (Height) + 1.982 (Weight)
The second part of the results consists of the analysis of variance table, together
with the coefficient of determination and residual standard deviation. The
coefficient of determination is 0.971, which implies that about 97.1% of the
variation in the model (cholesterol level) can be explained by the three
independent variables.
The F-value is the ratio of mean-squared regression over mean-squared residual.

For the model to be statistically significant, the F-value should be greater than the
tabulated value of F with 3 and 8 degrees of freedom. The tabulated F-value at
0.05 level of significance is 4.07, which implies that this model is highly significant.

The t-ratios which are reported in the first section of the results indicate the
statistical strength of each independent variable separately. For instance, weight
with a t-ratio of 9.632 appears to be the strongest predictor and height with t-ratio
of 1.028 is the weakest predictor in a statistical sense. For the coefficient to be
statistically significant, the t-ratio should be larger than the absolute value of
tn-p-1 which is the tabulated value of the t distribution with n-p-1 degrees of
freedom.
Here, n is the number of observations and p is the number of independent

variables. As a rule of thumb, t-ratios larger than 1.95 indicates a strong predictor
variable.
SELF-CHECK 3.1
Multiple-choice Question
1. Econometrics may best be defined as:
A. Combination of theory, statistical analysis and mathematical

model building to explain economic relationships.
B. Application used in estimating the regression coefficients.

Least squares minimise the sum of squares of the differences
between the observed and estimated values of the dependent
variable over the sample of observations.
2. Regression analysis may best be defined as:
A. A model that may vary in their level of sophistication from

the simple to the extremely complex.
B. An application used to develop a functional relationship

between the dependent and independent (or explanatory)
variables.

3. The objective of least squares analysis is to find values of a and b

that minimise the sum of the squares of the e deviations.
A. True
B. False
4. A linear relationship containing two or more independent

variables is known as a multiple linear regression model.
A. True
B. False
3.2 PROGRAMMING MODELS

This group of models treats the class of decision resources to be allocated to one or
more activities. Generally, these rules govern the feasibility of allocation. These
rules either limit the level of resources which can be committed to the activities or
affect the way in which the resources can be combined. The rules are called
constraints.
The combination of resources is then linked to a formal measure of the objectives

called the objective function and it can be maximised (if it is expressed, for
example, in profit terms) or minimised (if expressed in cost terms) by
computational procedures. When both the constraints and objective function are
linear functions, a linear programming model can be formulated.
Linear programming (LP) is probably one of the most widely utilised quantitative
techniques for modelling and solving decision analysis problems (Eiselt &
Sandblom, 2007; Baker, 2018). Practical applications of LP are quite widespread
and include production scheduling, staff scheduling, resource allocation, portfolio
selection and many more. LP problems are usually either profit maximisation or
cost minimisation problems. The decision variables are usually for measuring the
level of the activities.

In a profit maximisation problem, the profit generated by the aggregate of all

activities represented by the decision variables are to be maximised subject to
availability of the constrained resources that are required to supply and
support the activities.
In a cost minimisation problem, the cost incurred by the aggregate of all

activities represented by the decision variables are then minimised, subject to
the requirements of the demands of the system for which the activities are
performed.
3.2.1 Profit Maximisation

The examples illustrated in this subtopic are obtained from Lofti and Pegels (1996).
The first problem is about a profit maximisation linear programming model. A
mail order personal computer supplier is considering the production and sales of
ZZ-PCs, a famous brand name personal computer. The manager is considering
three desktop models. The three desktop models are briefly explained in Table 3.3.
Table 3.3: Three Desktop Models
Model Explanation
Model M420-4 Model M420-4 includes a 420 megabytes hard drive with
4 megabytes of random-access memory (RAM).
Model M750 Model M750 includes a 750 megabytes hard drive with 8 megabytes
of RAM.
Model C950-8 Model C950-8 includes a 950 megabytes hard drive, a CD-ROM and
8 megabytes of RAM.
The relevant data for the three models have been compiled as follows:
Table 3.4: Compilation of Relevant Data for Three Computer Models
Computer Assembly Burn Test Packaging Production Wholesale

Model Time (hrs) Time (hrs) Time (min) Cost ($) Price ($)
M420-4 9 2 10 $400 $500
M750-8 7 7 15 500 850
C950-8 7 8 20 600 1,000

The total available manpower on a per week basis includes 300 hours of assembly,
340 hours of testing and 10 hours of packaging. Because of a contractual agreement
with ZZ-PC, the company must sell at least 10 units of the M420-4 model per week.
The objective is to determine the optimal number of each model to produce so that
the total profit will be maximised.
We begin the formulation process by first defining our three decision variables as
follows:
X1: number of M420-4 models to be produced

X2: number of M750-8 models to be produced
X3: number of C950-8 models to be produced.
Next, we develop a profit function. The contribution to profit by each model is

determined by subtracting its variable cost from the sale price. For example:
The unit profit for M420-4 model is $500 – $400 = $100.

The unit profit for M750-8 is $850 – $500 = $350.
The unit profit for C950-8 is $1,000 – $600 = $400.
Therefore, the profit function to be maximised (also called the objective function):
Maximise profit = 100X1 + 350X2 + 400X3
Because production is subject to the availability of limited resources, there are

several constraints. The first three constraints relate to the limited available
assembly, testing and packaging times as follows:
Assembly: 9X1 + 7X2 + 7X3 ≤ 300 hours
Testing: 2X1 + 7X2 + 8X3 ≤ 340 hours
Packaging: 10X1 + 15X2 + 20X3 ≤ 600 minutes
The constraints state that each unit of the M420-4 model requires 9 hours of
assembly time, 2 hours of testing time and 10 minutes of packaging time. Time
requirements for the other two models can be deduced from the constraints.
The next constraint represents the contractual agreement for the M420-4 model,
which specifies that at least 10 units of the M420-4 model must be produced.
Contract: X1 ≥ 10
The three decision variables represent the number of units of the three products to
be produced and, therefore, cannot accept negative values. That is:
X1 ≥ 0, X2 ≥ 0, and X3 ≥ 0
Table 3.5: Complete Linear Programming Model
Maximise profit = 100X1 + 350X2 + 400X3

Subject to:
Assembly 9X1 + 7X2 + 7X3 ≤ 300 hours
Testing 2X1 + 7X2 + 8X3 ≤ 340 hours
Packaging 10X1 + 15X2 + 20X3 ≤ 600 minutes
Contract X1 ≥ 10
X1 ≥ 0, X2 ≥ 0 and X3 ≥ 0
You can ignore the last set of constraints, representing the non-negativity of the
decision variables because most linear programming solution methods assume
that the decision variables are larger than or equal to zero.
The solution to the above problem is not immediately obvious. One possible
approach is to produce only model M420-4. In this case, the largest possible
quantity to produce is 33.3 units, because of the limited available assembly time.
The total profit will be $100 × 33.3 = $3,333.33. Another possibility is to produce as
many of the most profitable model C950-8 while satisfying the minimum
requirement for M420-4.
That is, produce 10 units of M420-4 and determine the remaining resources to be
used for C950-8. This will result in producing as many as 25 units of C950-8 before
depleting the packaging time. The profitability of this solution is $11,000.

As the number of possible combinations of production quantities is extremely

large, manual evaluation of these combinations is not practical. The problem can
be solved by using many types of linear programming software available in the
market. The optimal solution for the Computer Store example is shown in
Table 3.6.
Table 3.6: Optimal Solution for Computer Store
Optimal Solution
No. of Iterations = 3 Objective: +12000.00
Decision Variables Section
Variables Status Value Reduced Cost
M420-4 Basic 10.00 0.00
M750-8 Basic 20.00 0.00
C950-8 Basic 10.00 0.00
As shown in Table 3.6, the optimal solution consists of producing 10 units of model
M420-4, 20 units of model M750-8 and 10 units of model C950-8. The total profit is
$12,000.
3.2.2 Cost Minimisation

The second example is to illustrate a cost minimisation problem. A typical cost
minimisation problem is the feed mix problem. Two kinds of corn and two kinds
of grain are mixed to produce cattle feed. The feed must contain amounts of
nutrients, necessary for healthy animal growth. Three different nutrients, labelled
A, B and C, are to be present in the feed mix. The different grades of corn and
grains contain different amounts of these nutrients and are shown in Table 3.7.
Table 3.7: Nutrient Contents of Different Grades of Corns and Grains
Nutrient Contents
A B C Cost
($/1b)
Ingredient (gr/1b) (gr/1b) (gr/1b)
CORN-1 25 15 16 1.20
CORN-2 10 20 20 1.75
GRAIN-1 17 35 20 2.25
GRAIN-2 10 70 25 2.70

The minimum nutrient requirements per 10-pound bag include 150 grams of A,
250 grams of B and 200 grams of C. Furthermore, the mix should not include more
than 3 pounds of GRAIN-1 per 10-pound bag. Determine an optimal mix of the
four ingredients to minimise the total cost of a 10-pound bag.
The decision variables represent the quantities of the four ingredients to be

included in a 10-pound bag. That is, let:
X1: quantity of CORN-1 to be included in the mix

X2: quantity of CORN-2 to be included in the mix
X3: quantity of GRAIN-1 to be included in the mix
X4: quantity of GRAIN-2 to be included in the mix
The linear programming formulation is:
Minimise cost = 1.20X1 + 1.75X2 + 2.25X3 + 2.70X4
Subject to:
Nutrient A 25X1 + 10X2 + 17X3 + 10X4 ≥ 150 grams
Nutrient B 15X1 + 20X2 + 35X3 + 70X4 ≥ 250 grams
Nutrient C 16X1 + 20X2 + 20X3 + 25X4 ≥ 200 grams
Max GRAIN-1 X3 ≤ 10 pounds

Size 7 X1 + X2 + X3 + X4 = 10 pounds
X ≥ 0, X2 ≥ 0, X3 ≥ 0, and X4 ≥0

As with the maximisation problem, the solution to the above problem is not
obvious. One possible approach is to mix equal quantities of the four ingredients
to make a 10-pound bag. In this case, 2.5 pounds of each ingredient is added. The
amounts of nutrients in the mix are:
Nutrient A: 25(2.5) + 10(2.5) + 17(2.5) + 10(2.5) = 155.0 grams

Nutrient B: 15(2.5) + 20(2.5) + 35(2.5) + 70(2:5) = 350.0 grams
Nutrient C: 16(2.5) + 20(2.5) + 20(2.5) + 25(2.5) = 202.5 grams
The above solution satisfies the nutrient requirements of the mix and cost:
Cost = 1.20(2.5) + 1.75(2.5) + 2.25(2.5) + 2.70(2.5) = $19.75 per 10-pound bag.
Is the proposed mix the minimum cost solution? There are many possible
combinations of acceptable mixes to consider manually. The problem can be easily
solved by using linear programming software.
The optimal solution to this problem is shown in the following table.
No. of Iterations = 6 Cost = 18.20

Decision Variables Section
Variables Status Value Reduced Cost
CORN-1 Basic 3.333 0.000
CORN-2 Basic 4.000 0.000
GRAIN-1 Non-Basic 0.000 0.402
GRAIN-2 Basic 2.667 0.000
The optimal mix consists of 3.33 pounds of CORN-1, 4 pounds of CORN-2 and 2.67
pounds of GRAIN-1. The cost of the mix is $18.20.

SELF-CHECK 3.2

1. Linear programming (LP) is probably one of
the most widely utilised quantitative
techniques for modelling and solving decision
analysis problems.
2. In a cost minimisation problem, the profit
generated by the aggregate of all activities
represented by the decision variables are to be
maximised subject to availability of the
constrained resources that are required to
supply and support the activities.
3. In a profit maximisation problem, the cost
incurred by the aggregate of all activities
represented by the decision variables are then
minimised, subject to the requirements of the
demands of the system for which the activities
are performed.
4. A typical cost minimisation problem is the feed
mix problem.
5. The linear programming formulation is:

Minimise cost = 1.20X1 + 1.75X2 + 2.25X3 +
2.70X4
3.3 SENSITIVITY ANALYSIS

It is frequently desirable to evaluate to what extent the objective function
coefficients and the values on the right-hand side of the constraint equations can
be varied. For example, in the feed mix problem presented earlier, we may wish to
know the range of CORN-1 and CORN-2 price for which the optimal mix remains
the same. Similarly, in the mail order computer store problem, we may wish to
know the range of assembly time capacity for which the optimal solution remains
the same.

For the coefficients of the objective function and for the right-hand side of the
constraint equations, the maximum increase and maximum decrease are shown.
This information is useful for evaluating changes in the linear programming
formulation.
Results of the sensitivity analysis for the computer store example are shown in
Table 3.8 and Table 3.9.
Table 3.8: Objective Function Coefficients Ranges
Objective Function Coefficient Ranges
Original Maximum Maximum

Variable
Coefficient Increase Decrease
M420-4 100.000 257.143 Infinity
M750-8 350.000 50.000 50.000
C950-8 400.000 66.667 50.000
Table 3.9: Right-hand Side Range
Right-hand Side Range

Row
RHS Increase Decrease
Assembly 300.000 23.333 35.000
Testing 340.000 Infinity 100.000
Packing 600.000 100.00 50.000
Contract 10.000 6.364 5.385
The first part of the sensitivity analysis involves objective function coefficients. As
seen from the report, the maximum increase and maximum decrease for each
variable are reported.
For example, the maximum increase in the profit coefficient of M420-4 is 257.143
and the maximum decrease is infinity. This implies that the current optimal
production combination remains valid for as long as the profitability of M420-4
model remains m the range of -∞ to $100 + $257.14 = $357.14. Outside this range,
the current optimal solution is no longer the maximum profit (optimal) solution.
The ranges for the M750-8 and C950-8 models are much tighter and are equal to
$300 to $400 for M750-8 and $350 to $466.67 for C950-8 model. This indicates that
the optimal production is quite sensitive to the profitability of these two models.

The second part of the output is called right-hand side ranges. It contains the
maximum increase and maximum decrease values for the right-hand sides. For
example, the maximum increase for the Assembly constraint is 23.33 and the
maximum decrease is 35. This implies that the current solution remains optimal
for as long as the total available. Assembly time remains in the range of 265 to
323.33 hours. Outside this range, the optimal solution will change and the current
production plan is no longer the best one.
Results of the sensitivity analysis for the feed mix example are given Table 3.10
and Table 3.11:
Table 3.10: Objective Function Coefficients Ranges
Objective Function Coefficient Ranges

Variable
Coefficient Increase Decrease
CORN-1 1.200 0.861 0.210
CORN-2 1.750 0.117 Infinity
GRAIN-1 2.250 Infinity 0.402
GRAIN-2 2.700 1.077 0.263
Table 3.11: Right-hand Side Ranges
Right-hand Side Ranges

Row
RHS Increase Decrease
NUTR-A 150.000 33.333 28.571
NUTR-B 250.000 66.667 Infinity
NUTR-C 200.00 20.000 6.667
MAX-GRAIN 3.000 Infinity 3.000
WEIGHT 10.000 0.328 0.645
The objective function coefficient ranges and right-hand side ranges in the
sensitivity analysis show the maximum increase and decrease of those values
without changing the status of the decision variables (from basic to non-basic or
vice versa).

For example, the original objective function coefficient (the cost per pound) of
CORN-1 which is $1.20 may be increased by $0.861 to 2.06 without changing the
optimal mix. The cost may also be decreased by $0.21 without changing the
optimal mix. The cost of CORN-2 could be decreased to zero without changing the
optimal mix.
The right-hand side ranges indicate that the required Nutrient A could be varied
from 150 – 28.571 = 121.43 grams to 153 + 33.33 = 183.33 grams without changing
the optimal mix. Similarly, the required Nutrient B can be increased to 250 + 66.67
= 316.67 grams without changing the mix. Decreasing the requirement for this
nutrient has no effect on the optimal mix.
3.4 SIMULATION MODELS

The essence of simulation models is that it relies on a statement of procedures
which underlies the logical relationships between variables. A simulation model
usually takes the form of a logical flow chart which describes the interrelationship
between these variables.
The model is then used to execute the procedures described in the flow chart, and
thus the behaviour of whatever system is being modelled is simulated. Simulation
models are especially useful for predicting the dynamic behaviour of systems and
also for modelling systems where some of the uncontrollable input variables are
described in probabilistic terms.
In short, simulation explores the consequences of decision making rather than

directly advising the decision itself; it is a predictive rather than an optimising
technique.
Simulation models will not be covered in this course.

ACTIVITY 3.1
1. Cascade Pharmaceuticals developed the following regression

model using time series data from the past 33 quarters for one of its
non-prescriptive cold remedies:
Y = −1.04 + 0.24X1 − 0.27X 2
Where Y = Quarterly sales (in thousands of cases) of the cold

remedy
X1 = CascadeÊs quarterly advertising (in $1,000) for the

cold remedy
X2 = CompetitorsÊ advertising for similar products (in

$10,000)
Additional information concerning the regression model is as

follows:
Sb1 = 0.032
Sb = 0.070
R2 = 0.64
Se = 1.63
F-statistic = 31.402
(a) Which of the independent variables (if any) appear to be

statistically significant (at .05 level) in explaining sales of the
cold remedy?
(b) What proportion of the total variation in sales is explained by

the regression equation?
(c) Perform an F-test (at .05 level) of the overall explanatory

power of the model.

2. For each of the following two problems:
(a) Solve the problem.
(b) Identify the objective function value at optimum.
(c) Identify the values of the decision at optimum.
(i) Maximise P = X 1 + 5X 2
Subject to:
5X1 + 6X2 ≤ 30
3X1 + 2X2 ≤ 12
0X1 + 1X2 ≤ 3
X1 ≥ 0, X2 ≥ 0
(ii) Minimise P = X 1 + 5X 2
Subject to:
X1 + X2 X3 ≥ 6
2X1 + 4X2 3X3 ≥ 21
4X1 + 1X2 2X3 ≥ 18
X1 ≥ 0, X2 0, X3 ≥ 0
ACTIVITY 3.2
There are a number of online software which you can use to solve linear
programming problems. One of them can be accessed at:
https://comnuan.com/cmnn03/cmnn03004/
Use the examples in Subtopic 3.2.1 and 3.2.2 and find out if you can get
the same answers. Then, solve the problem using the tool or any other
tools available to you.

• Decision making has often used models which formalise the relationships
between the elements in the decision.
• Not only the model is the most important part of understanding the problem
but it is capable of being translated into more formal language such as the
language of mathematical symbols.
• Words, although conveying the flavour of the decision, can be ambiguous and
may not focus on the important features within the decision as effectively as a
diagrammatic or a mathematical formulation.
• Econometrics and linear programming are two major types of models, which
are commonly used by business decision makers.
Econometrics Multiple linear regression model

Least squares technique Regression analysis
Linear programming model Simulation models
Clopper, A. (2014). The craft of economic modeling. College Park, MD: University
of Maryland.
Dipak Basu. (2009). Economic model: Methods, theory and applications.

Singapore: World Scientific.
Eiselt, H. A., & Sandblom, C. L. (2007). Linear programming and its applications.
New York, NY: Springer.

Topic  Elements of
Decision
4 Problems
LEARNING OUTCOMES

1. Identify problem concisely;
2. Distinguish individual elements of a decision problem, namely
values and objectives, decisions to make, uncertain events and
consequences; and
3. Recognise the importance of risks and uncertainties in decision
making.
 INTRODUCTION
The term „decision problem‰ refers to the combination of a problem to be resolved
and a decision to be made regarding its resolution. The first step to solving a
decision problem is defining the problem clearly.
This topic examines the process of establishing an adequate problem statement,

followed by the process of mapping the underlying structure of a decision
problem, which indicates the various elements of the problem and their
interrelationships. Once a clear picture of the overall structure has been developed,
the analyst can focus on specific details, one at a time.

52  TOPIC 4 ELEMENTS OF DECISION PROBLEMS
4.1 IDENTIFYING AND DEFINING A PROBLEM

A problem is operationally defined as the difference between a current and a
preferred situation. Based on this definition, a well-formed problem statement
should clearly indicate at least three components (Figure 4.1).
Figure 4.1: Components of a well-formed problem statement

Source: Clemen & Reilly (2005 and 2014)
There can be more than one basis for the preference but there must be at least one.
It is important to start by identifying the problem and the aspect of the current
situation that needs improvement. Looking at the problem carefully, the analyst
can identify the alternatives that could help resolve the situation. These
alternatives might represent a wide range of possibilities that have little in
common except that they are all possible solutions to the problem.
A problem statement should start by identifying the problem, not a possible

solution. Here are some examples:
(a) AhmadÊs car might break down at any time;
(b) The production costs at the ABC plastic factory are higher than at other
factories;
(c) Wak SemanÊs paddy yield is well below the anticipated level; and
(d) Unrepentant drug addicts are being released into society and committing
further offences.
These statements clearly imply the problem with the current situation and what
situation would be preferred. An important part of the problem definition step is
describing the details of the problem.

TOPIC 4 ELEMENTS OF DECISION PROBLEMS  53
A detailed understanding of the problem can be of great help in the subsequent

steps of the decision analysis.
4.2 ELEMENTS OF DECISION PROBLEMS

When deciding on a particular matter, for example, when you are deciding to buy
a car, do you just buy the car or do you have a checklist of the important things
that should be taken into consideration prior to purchasing?
How do we design a house, a computer or a car? Each of these products contains

a number of elements. The basic approach involves careful thought along with
certain directions. The design of a car, for instance, requires careful thought in
terms of the appearance of the final product, the details of each element
(performance, overall capacity, durability, safety, fuel efficiency, cost and so forth)
and the relationships between the elements.
Similarly, decision problems contain numerous interconnected elements.

Identifying the structure of a decision problem involves moving and shuffling
between thinking about the overall structure, details of individual elements and
their interactions.

Decision problems include four types of elements. They are as listed in Figure 4.2.
Figure 4.2: Elements of decision problems

Source: Clemen & Reilly (2005 and 2014)
Let us now look at the explanation of each of the elements of the decision problems.
4.2.1 Values and Objectives

Values and objectives are two related terms, which form an integral part of
decision making. Table 4.1 explains briefly the difference between values and
objectives.
Table 4.1: Difference between Values and Objectives
Values Values refer to things that matter to oneself.

• Students of a diploma in business management programme, for
instance, want to improve themselves academically so that they can
attain a higher status in their future business career, which will
eventually lead to a higher status in society.
• Venture capitalists hope to make more money by taking on higher-
risk projects.
Objectives Objectives are specific things that an individual want to achieve.
• A diploma student would want to earn a higher income when he
graduates.
• A venture capitalist wants to maximise the rate of return on his capital
investment.
An individualÊs objectives, taken together, will make up his values. These values
determine what is important to the individual in making his decisions.

One interesting question to ask at this juncture is whether making money is a

plausible objective. Some consider making money as a special objective. It is not a
basic objective but a proxy objective because it is not an end in itself but a means
to achieve other objectives like buying a car and going on a vacation. What do you
think?
Each situation where a decision is required, calls for specific objectives. The setting
in which the decision occurs is called a decision context.
4.2.2 Decisions to Make

A decision is a choice between two or more alternatives. If there were no
alternatives, then there would be no need to make a decision. Take a look at the
following simple example.
In many decision-making situations, there is a central decision to be made. Often,

there are several possible alternatives which the decision maker can consider. One
alternative is whether to do or not to do anything about the problem at hand.
In the example given, the farmer has the alternative whether to take or not to take
the protective action. And if the farmer decides to take protective action, he usually
has several alternatives such as to adopt the use of chemicals or to adopt a
biological method, or some other integrated approaches.
In many cases, we may not be facing a single, one-time decision.
One decision often leads to another decision in a sequence. This is called

sequential decisions.

In the case of the farmer mentioned earlier, the first decision perhaps is to decide
whether or not to protect the crops. If the farmer decides to protect his crops, he
will then have to decide on the type of protective action.
When a decision situation involves sequential decisions, the decision maker must
consider all the decisions available when making the immediate one. This is
because a future decision is dependent on the one before that. It is a dynamic
decision situation.
4.2.3 Uncertain Events

Most decisions are made without knowing what is going to happen in the future.
In other words, decisions are made today without knowing the ultimate or
possible things that will happen in the future. The possible things that can happen
in the resolution of an uncertain event are called outcomes.
Let us take a look at a simple example regarding an individualÊs decision to invest

in the stock market.
In the case of the farmer, the uncertainty is whether the pest infestation will take
place. Here, the outcome will either be crop damage or no crop damage.
In a given decision situation, we might consider more than one uncertain event.
Our farmer may face uncertainty whether his crop will be accepted by the
consumers. A decision situation which has more than one uncertain event will be
more complicated and more difficult.
In a sequential decision situation, the uncertain events must be dove-tailed with

the time sequence of the decision. It is important to know at each decision point
exactly what information is known and what is not.

4.2.4 Risk and Uncertainty
Frank Knight (1921) defined risk as a situation where a decision maker (DM)
has enough information to establish a probability distribution of possible
outcomes, while uncertainty is a situation where a DM cannot establish any
probability distribution of possible outcomes.
In modern decision theory, the definition may not be valid because modern
decision theory suggests that the DM can always attach subjective probabilities to
any events with more than one outcome (Dillon & Scandizzo,1978). However,
Barry (1984) introduced another theory.
Barry (1984) introduced the following:
• Events are uncertain when their outcomes are not known with certainty:
and
• Events are risky when the outcomes alter the DMÊs well-being.
Risk, therefore, is a subset of uncertainty.
SELF-CHECK 4.1
Discuss the four elements of decision problem.
4.2.5 Sources of Business Risk and Uncertainty

In identifying sources of risk and uncertainty, it is important for business operators
to also understand and determine the effects of these risks and uncertainties on
their businesses so that they can respond more appropriately. Table 4.2 briefly
explains sources of business risk and uncertainty.

Table 4.2: Sources of Business of Risk and Uncertainty
Business Risk
Sources
and Uncertainty
Production or • Random variability is inherent in a business
technical risk production process.
• Sources: weather, pest infestation, diseases, fire,
wind, theft, etc.
• Causes yield or production fluctuations.
Market or price risk • Can occur for purchased inputs and saleable
commodities.
• Short-run fluctuations in price can cause income losses
and cash shortfalls.
• Unavailability of inputs is also a market risk.
• In the long run, price variability, interest rates and
relative price movements can affect the firmÊs decision
in investment.
• Variability of commodity prices is a major source of
concern.
Technological risk • Current decisions may be offset by future technical
improvements.
• Technological changes in other areas such as
transportation and processing may affect the firmÊs
incomes.
Legal and social • May increase as the firm grows larger and more
risks dependent on external sources of capital.
• Government policies, especially those associated with
unexpected changes in these policies.
• Middle-man activities, landlords and etc.
Human resource- • Associated with labour and management functions
related risk like health problems, accidents and etc.
Global risk • An occurrence that causes a significant negative
impact for several countries and industries over time.
• Examples include:
– Environmental risks such as natural disasters
(earthquakes) and man-made disasters (haze).
– Geopolitical risks covering areas like diplomacy,
conflict and terrorism.

4.2.6 Consequences
After the final decision has been made and the last uncertain event has been
considered, the decision makerÊs fate is finally determined. To the stock market
investor, it may be an increase in the value of his portfolio. To the farmer, it may
be a matter of making profit or loss. The consequences occur at the end of the
planning horizon.
What is the appropriate planning horizon? It must be consistent with the decision
context and the relevant objectives. For the farmer, the planning horizon will start
when the decision is to be made (now) and ends when the crops are harvested and
profit or loss is obtained.
To the stock market investor, it may start now and end when he decides to
consolidate and evaluate his position, maybe at the end of the year. In some cases,
the final consequence may be a net value, after accounting for cash inflows and
outflows.
A food manufacturing firm, for instance, will incur some costs (cash outflows) for
the production of food. When the food products are sold, the firm will receive
income (cash inflows). The final consequence will be the difference between the
two figures.
Once the final consequences have been determined and the planning horizon
established, the next step is to find how the consequences are valued. The simplest
method is to measure the consequences in terms of monetary value. In many cases,
it is possible to work out in terms of monetary values. Consequences such as profit,
cost and wealth are measured in monetary values. It is also possible to price out
non-monetary objectives such as the value of providing healthcare services in rural
areas, the value of goodwill and so forth.
One common consequence in business decisions is the stream of cash flows. A

person may invest in a project where an initial capital outflow takes place in order
to obtain revenue in the form of a stream of cash inflows in the future. Time value
of money is a special kind of trade-off between current and future „Ringgit‰.

4.2.7 Time Value of Money
Investment is all about spending money today to obtain money tomorrow.

Investing means trading off between current and future dollars (and between
future dollars at different points in time).
If one Ringgit today is worth the same as one Ringgit next year, there would be no
problem. However, this is not the case. One Ringgit invested now would be worth
one Ringgit plus the interest paid in the future. Fortunately, there is a way to solve
this problem. Let us look at the example in the following:

A straightforward way is to collapse a stream of cash flows into a single amount

(called the present value) or to value the stream of cash flows in present dollars.
Net present value (NPV) of the cash flows is the present value of the cash flows
minus the cost of the deal. The formula for a stream of cash flows X, ⁄X over n
periods at interest rate r is
X0 X1 Xn
NPV = + +
(1 + r ) (1 + r ) (1 + r )n
0 1
NPV reveals the value of the stream of cash flows. A negative NPV for a project
indicates that the money would be better invested to earn interest rate r.

SELF-CHECK 4.2
1. A problem statement should start by identifying the

problem, not a possible solution.
2. Values and objectives are one of the four elements of

decision problems.
3. Values are specific things that an individual wants to

achieve.
4. Objectives refer to things that matter to oneself.
5. A decision is a choice between two or more

alternatives. If there are no alternatives, then there is
no need to make a decision.
6. In many cases, we may not be facing a single, one-

time decision. One decision often leads to another
decision in a sequence. This is called the decision
context.
7. In a sequential decision situation, the uncertain

events must be dove-tailed with the time sequence of
the decision.
8. Risk investing is a situation where a decision maker

(DM) has enough information to establish a
probability distribution of possible outcomes.
9. Investing means trading off between current and

future dollars (and between future dollars at different
points in time).
10. Technological risk is not one of the sources of

business risk and uncertainty.

ACTIVITY 4.1
1. Imagine the difficulty of an employer whose decision context is to

choose a new employee from a set of candidates whom he will
interview. What do you think the employerÊs objectives should be?
Identify the specific decisions that the employer must make and the
uncertainties faced, and describe the relevant uncertain events.
2. Calculate the new present value of a business deal that costs $2,500
today and will return $1,500 at the end of this year and $1,700 at the
end of the following year. Use an interest rate of 13%.
• Many decisions arise from problems faced by the decision maker. Identifying
and defining the problem is useful in helping the process of decision making.
Decisions have many different aspects.
• The basic elements of a decision include values and objectives, decisions to

make, uncertain events and consequences.
• It is important to consider time in the valuation of consequences where a

stream of cash flows is involved.
Decision context Sources of risk and uncertainty

Investment Uncertain events
Sequential decision

Barry, P. J. (1984). Risk management in agriculture. Ames, IA: Iowa State

University Press.
Dillon, J. L., & Scandizzo, P. (1978). Risk Attitudes of Subsistence Farmers in

Northeast Brazil: A Sampling Approach, American Journal of Agricultural
Economics, vol 60(3), pg 425–435.
Knight, F. H. (2006). Risk, uncertainty and profit. New York, NY: Dover
Publications.

Topic  Structuring
Decisions
5
LEARNING OUTCOMES

1. Discuss the relevant objectives of a decision problem;
2. Apply the influence diagram and decision tree method of structuring
a decision problem; and
3. Construct management scales for measuring fundamental objective.
 INTRODUCTION
The previous topic discussed the first step to solving a decision problem by
defining the problem clearly. It then examined the process of establishing an
adequate problem statement and identifying various elements of the problem and
their interrelationships.
This topic continues the process of decision making by mapping the underlying
structure of a decision problem. It discusses two types of diagrams in representing
the structure of the decision problem, namely the influence diagram and decision
trees. However, for this course, the focus is on decision trees.

66  TOPIC 5 STRUCTURING DECISIONS
5.1 IDENTIFYING AND STRUCTURING

OBJECTIVES
The first step in structuring a decision situation is to structure the values by
identifying the relevant objective or objectives. An objective is a criterion for
evaluating the desirability of a decision situation. In many cases, a single objective
may be the driving factor of a decision, for instance, a farm manager may want to
maximise profit or an investor may want to maximise his wealth or to minimise
risk.
If a decision involves only one objective, oftentimes, that single objective is easily
identified. However, to ensure that we can arrive at a good decision, the objective
must be defined clearly.
Even though we may be satisfied with a single objective, in other instances, we

may be facing multiple objectives. The farm manager may want to maximise profit
but at the same time, he may want to minimise risk. A business firm may want to
maximise profit as well as increase market share. Mind you, specifying objectives
is not always easy. Let us now discuss some ways on how we can identify and
state objectives clearly.
5.1.1 Techniques for Identifying Objectives

Decisions can be very difficult especially if you are an entrepreneur or if you are
in a leadership or managerial position in a big company. Since you are required to
make the best possible decision for your business or for your employer, you must
use a line of objective reasoning and eliminate any emotional or biased influences
that might affect or compromise that decision.
Of course, that is easier said than done. A detailed understanding of the problem
can be of great help in the subsequent steps of the decision analysis. Keeney and
Raiffa (1994) suggested the following eight considerations to help identify
objectives for a given decision situation.

TOPIC 5 STRUCTURING DECISIONS  67
Figure 5.1: Considerations to help identify objectives
Table 5.1 shows the questions to be raised for each of the consideration suggested
by Keeney and Raiffa (1994).

Table 5.1: Questions for Each Consideration to Help Identify Objectives
Consideration Questions to be Raised

Develop a wish list • What do you want?
• What do you value?
• What should you want?
Identify alternatives • What is a perfect alternative, a terrible alternative, a
reasonable alternative?
• What is good or bad about the alternatives?
Consider problems and • What is wrong or right with your organisation?
shortcomings • What needs fixing?
Predict consequences • What has occurred that was good or bad?
• What might occur that you care about?
Identify goals, constraints • What are your aspirations?
and guidelines • What limitations are placed on you?
Consider different • What would your competitor or your constituency be
perspectives concerned about?
• At some point in the future, what would you be
concerned about?
Determine strategic • What are your ultimate objectives?
objectives • What values are absolutely fundamental for you?
Determine generic • What objectives do you have for your customers, your
objectives employees, your stockholders, yourself?
• What environmental, social, economic or health and
safety objectives are important?
Source: Keeney & Raiffa (1994)
SELF-CHECK 5.1
What considerations are helpful in identifying and defining the

objectives of a decision problem?

5.1.2 Fundamental and Means Objectives

Once we have a list of objectives, what would we do next? We start by separating
the list into items pertaining to different types of objectives. We will end up with
several objectives that are relevant to the decision context. It is important at this
juncture for us to separate the list of objectives into fundamental objectives, which
reflect the ends we are trying to achieve and means objectives, which are important
ways of achieving them.
Table 5.2: Difference between Fundamental Objectives and Means Objectives
Fundamental Objectives Means Objectives

Fundamental objectives may be defined as Means objectives help to achieve other
objectives of what we actually want to objectives.
accomplish.
One way to identify whether a particular objective is a means objective or a

fundamental objective is to ask ourselves, „Why is that important?‰ If that objective
is to accomplish something else (for instance, A), then it is a means objective.
Then we continue asking why A is important. We continue until we get the answer
„That objective, say D, is important simply because it is important to us.‰ Hence,
D is the fundamental objective. The rest are means objectives. Let us look at an
example.
Fiza Pharmacy Sdn Bhd wants to make as much money as possible. The
companyÊs research arm has recently developed a new traditional slimming gel
and it is planning to market the new product. When it comes to introducing
new product lines, other strategic concerns need to be taken into account. They
include obtaining market share for the emerging product line and developing
a good reputation for providing effective and premium products. Hence, the
fundamental objectives may include:
(a) To maximise revenue; and
(b) To expand market share.
Developing good reputation may be a means objective since it helps in the

achievement of maximising revenue and expanding market share.
The Board of Directors of the company believes that the above objectives are
very important for the future of the company since it aims to grow and become
a leading pharmaceutical company.

5.2 STRUCTURING DECISIONS USING

INFLUENCE DIAGRAMS
After specifying the fundamental objectives, we are ready to go on with the
structuring process by focusing on the various elements of a decision situation,
namely decisions and alternatives, uncertain events and outcomes, and
consequences.
Influence diagrams provide simple graphical representations of decision

situations. Symbols are used to represent various elements of decision situations
and their interrelationships. Refer to Table 5.3.
Table 5.3: Elements of Decision Situations and Interrelationships in Influence Diagrams
Element Symbol
Rectangle Decision node
Oval Chance node
Rounded rectangle Consequence or calculation node
Graph When nodes are put together
Arc with arrow To connect various nodes
Predecessor The node at the beginning of an arc
Successor The node at the end of an arc
5.2.1 Decisions and Alternatives

A decision is a choice between two or more alternatives. By convention, a decision
is represented by a rectangle.
Assume Fiza Pharmacy is considering to introduce a slimming gel as a new

product line. And assume that it has one fundamental objective, that is, to make as
much money as possible. The decision is whether to introduce the product or not.

If the company decides to introduce the product into the market, the next decision
is to set the appropriate price for the newly introduced product. Thus, this becomes
a sequential decision situation.
5.2.2 Uncertain Events

As discussed in the previous topic, an uncertain event is a situation outside the
control of the decision maker that could result in either two or more possible
outcomes. By convention, an uncertain event is represented by an oval, as
illustrated in the following:
In introducing a new product line, one major uncertainty faced by Fiza Pharmacy
is whether the new product will be accepted by the consumers. This will be
reflected by the number of sales recorded by the company. In its simplest form, the
outcomes of the decision may be accepted by consumers or not accepted by
consumers. Acceptance level can also be categorised as low, medium or high.
Choosing the number of outcomes associated with an uncertain event is

judgemental. The larger the number of outcomes, the more realistic it is. However,
this will make the model more complex and more difficult to solve. Getting
relevant information may also be costly and time consuming.

5.2.3 Consequences
As discussed in the previous subtopic, after the last decision has been made and
the last uncertain event resolved, the fate of the decision maker is finally
determined. This is the consequence of the decision. The consequence reflects the
result of the decision. The criterion used to evaluate the desirability of the decision
is the objective. By convention, an objective is represented by a rectangle with
rounded corners as shown:
Continuing with our discussion using the Fiza Pharmacy example, if the company
has a single objective, that is, to maximise revenue, the consequence node is as
follows:
However, since the company has identified an additional fundamental objective,

this will be represented by an additional consequence node, that is:
5.2.4 Using Arcs to Show Relationships

In general, arcs are used to represent relationships between decision, chance
(uncertain event) and consequence nodes. An arc can represent either relevance or
sequence. The direction of the arrow and the types of nodes from where it comes
from and to where it leads indicates the meaning; that is, whether it is relevance or
sequence. This can be gleaned from Table 5.4.

Table 5.4: Explanation on Relevance and Sequence
Arc Explanation
Relevance • An arrow directed at a chance node indicates the predecessor is
relevant for assessing the chance associated with the uncertain
event.
• An arrow directed at a consequence node indicates the
consequence depends on the outcome of the predecessor node.
Sequence An arrow directed at a decision node indicates a decision is made
after knowing the outcome of the predecessor node.
5.2.5 Basic Influence Diagram

The most elementary decision under uncertainty that a person can face consists of
one decision to make and one uncertain event. Many decision situations can be
reduced to a basic risky decision. The influence diagram representing the basic
risky decision is shown in Figure 5.2.
Figure 5.2: Basic influence diagram representing risky decision
In the case of Fiza Pharmacy, the simplest basic influence diagram is illustrated in
Figure 5.3.

Figure 5.3: Basic influence diagram in the case of Fiza Pharmacy
In our example shown in Figure 5.3, at the decision point, the decision maker has
more than one alternative. Suppose the company has allocated RM2,500 to initiate
the process of introducing the new product line. The decision maker has a choice
of spending the money and initiating the process or to keep the money in a savings
account.
Table 5.5 shows the alternatives at the decision node and the possible outcomes at
the uncertain node.
Table 5.5: Alternatives at Decision Node and Possible Outcomes at Uncertain Node
Node Explanation
Decision Node The alternatives are:
1. Introduce the product (spend the money)
2. Do not introduce the product (keep the money)
Uncertain Event The possible outcomes are consumers may either:
Node 1. A ccept the new product
2. D o not accept the new product
Since there is no arrow emanating from the decision node going into the uncertain
node, it means that the decision maker has no control over the acceptance of the
consumers.

The consequence node after taking both the decision and the uncertain event into
consideration is shown in Table 5.6.
Table 5.6: The Consequence Node
Choice Acceptance Final Cash Position

Introduce Accepted RM10,000
Not Accepted RM0
Do not introduce Accepted RM2,500
Not Accepted RM2,500
ACTIVITY 5.1
When faced with a particular problem, we normally solve it as soon as

possible. However, there are times when we may just leave the problem
unsolved, hoping that „time will eventually solve the problem.‰ Do we
normally analyse the decisions we make? What do we usually base our
analysis on? Share your answer with your coursemates on myINSPIRE
online forum.
5.3 STRUCTURING DECISIONS USING

DECISION TREES
A decision tree is a graphical approach to analyse a decision problem. It allows the
decision maker to see exactly what is happening at each stage of the decision-
making process by showing its natural or logical progression.
Eventually, it makes the computation of expected monetary value (EMV) easier

because it can be made directly on the decision tree. EMV is a technique used to
solve a decision problem. It will be discussed in the following subtopics.
5.3.1 Elements and Symbols

In structuring a decision problem using a decision tree, a square denotes a decision
node in which one of several alternatives may be chosen while a circle denotes the
state of nature or chance node in which one state of nature will occur.

The terminating points are used to show payoffs associated with various decision
alternatives-state of nature combinations. The decision tree is completed (the
problem is solved) by computing the EMV associated with the initial decision
node.
The elements and symbols used to display a decision framework in a decision tree
are shown in Table 5.7.
Table 5.7: Elements and Symbols in a Decision Tree
Element Symbol
Square Decision node
Circle Chance node
End of branch Consequence
Branches emanating from square Choices available
Branches emanating from circle Possible outcomes of a chance
Again, let us consider the case of Fiza Pharmacy. The decision tree for the problem
is shown in Figure 5.4.
Figure 5.4: A decision tree in the case of Fiza Pharmacy

The decision tree flows from left to right. The immediate decision is the square on
the left side of the figure. The two branches represent the two alternatives – to
introduce or not to introduce the product into the market. If the company decides
to introduce the product, the next issue is whether the product will be accepted by
the consumers. If the product is accepted, the company will make a high return.
However, if the consumers reject the product, the company will lose all the money
it invested. On the other hand, if the company decides not to introduce the new
product, the company may use the money somewhere else and perhaps earn some
returns in a less risky project. These outcomes are shown at the end of the branches
on the right.
The interpretation of decision trees requires explanation. Firstly, the options

represented by branches from a decision node must be such that the decision
maker can choose only one option. For example, in the Fiza Pharmacy case, the
decision maker can either introduce or not introduce the product into the market,
but not both.
Secondly, each chance node must have branches that correspond to a set of
mutually exclusive and collectively exhaustive outcomes.
Mutually exclusive means that only one of the outcomes can happen. In our
example, the project to introduce the new product can either succeed or fail,
but not both. Consumers either accept or reject the new product.
Collectively exhaustive means that no other possible outcomes exist. One of

the specified outcomes has to occur.
When these two specifications are taken together, it means that when the
uncertainty is resolved, one and only one of the outcomes will occur.
Thirdly, a decision tree represents all the possible paths that the decision maker
might follow throughout, including all possible decision alternatives and
outcomes of chance events. Four such paths exist for Fiza Pharmacy,
corresponding to the four branches at the right-hand side of the tree.
However, notice that there are actually three paths. If the company does not
introduce the new product, there is only one branch as shown in Figure 5.5. In a
complicated decision situation with many sequential decisions or sources of
uncertainty, the number of potential paths may be very large.

Figure 5.5: Decision tree in the case of Fiza Pharmacy
Finally, it is sometimes useful to think of the nodes as occurring in a time sequence.

Beginning on the left side of the tree, the first thing to happen is typically a
decision, followed by other decisions or chance events in chronological order. In
the Fiza Pharmacy problem, the company decides first whether to introduce the
new product. The second step is whether the product will be accepted by the
consumers (success) or rejected by the consumers (failure).
5.3.2 Cash Flows and Probabilities

Many business decision situations involve some chance event, one or more
decisions to make and a fundamental objective that can be measured. In these
situations, once the decisions and chance events are defined, the last step is to
specify the specific chances associated with the uncertain events and the cash flows
that may occur.
Specifying the chances for the different outcomes at a chance event requires us to
use probabilities. In order to specify probabilities, we need to know a few basic
rules as stated in the following:
(a) Probabilities must fall between 0 and 1 (or equivalent between 0 and 100 per
cent);
(b) The outcomes associated with a chance event must be such that they are
mutually exclusive and collectively exhaustive; and
(c) The probability assigned to any given chance outcome (branch) must be
between 0 and 1, and for any given chance node, the probabilities for its
outcomes must add up to 1.

For each decision alternative or chance outcome, indicate the associated cash flow
on the appropriate branch in the decision tree. For example, in the new product
decision, different cash inflows are associated with different quantities sold, and
different outflows are associated with different costs. All of these cash flows must
be combined (possibly using net present value if the timing of the cash flows is
substantially different) at the end of each branch in order to show exactly what the
overall consequence is for a specific path through the decision model.
Suppose Fiza Pharmacy has conducted a research project and it has succeeded
in developing a slimming gel. However, before it can be sold to the public,
further development is required. Fiza has to decide whether to continue with
the development which will cost an additional $0.3 million. Once completed,
Fiza intends to apply for a patent. It believes that there is a 75 per cent chance
that the patent will be awarded. If it is awarded, Fiza can sell the license to
another company to produce and sell the product, from which it expects to
receive $2.4 million.
Alternatively, Fiza can undertake the production and market the product on
its own. This will cost an additional $1.2 million. If this is the case, it will face
three possible market scenarios, namely good (gross sales $5.8 million),
medium (gross sales $4.5 million) and poor (gross sale $1.8 million) market
conditions with the probabilities of occurrence of 0.25, 0.55 and 0.20
respectively. The net revenues for each of the three situations are shown in
Figure 5.6.

Figure 5.6: Net revenue for each of the three situations
5.4 MEASURING FUNDAMENTAL OBJECTIVES

We often have multiple objectives and some of those objectives are not easily
measured on a single, natural numerical scale. What sort of measure should we
use when we have fundamental objectives such as maximising our level of
physical fitness, enhancing a companyÊs image or improving the quality of a
television programme? We use a scale to measure the objectiveÊs attributes.
In this context, attributes are the measurement scales for fundamental objectives.
Identifying the right attributes not only allows the measurement of our
achievement but it also forces us to have a clear definition of each objective. This
will serve our purpose well since decision analysis should provide us with a
transparent comparison of various alternatives and these attributes can provide
the quantitative measure of the consequences of each alternative. The capacity to
make informed trade-offs is severely compromised if the attributes are not clearly
described (Keeney, 2002). Because the fundamental objectives are the focus of
decision analysis, measurable attributes should be developed for fundamental
objectives.

There are basically three types of measurable attributes, namely natural, proxy and
constructed. For objectives with natural attribute scales such as to maximise profit
and to minimise cost, we use monetary values. For others such as to maximise
market share or to maximise the rate of return, we can use percentages. Table 5.8
lists down some objectives with the possible measures of their attributes.
Table 5.8: Objectives with the Possible Measures of Their Attributes
Objective Measurement of Attribute

Maximise profit Monetary (for example, dollars)
Maximise revenue
Maximise savings
Minimise cost
Maximise market share Percentage
Maximise rate of return
Maximise proximity Miles, minutes
Maximise fuel efficiency Miles per kilometres
Maximise time with friends, family Days, hours
Minimise hypertension Inches of mercury or Hg (blood pressures)
For objectives without natural attribute scales such as a studentÊs achievement, we

can use proxy measures such as cumulative grade point average (CGPA). For other
objectives such as job satisfaction and companyÊs image, we need to construct an
attribute scale. The attributes can be measured on a two-point scale, three-point
scale, four-point scale, five-point scale and so forth.
However, it is very important that each of the scales must be clearly defined. An
example of the attribute scale is shown in Table 5.9.

Table 5.9: Examples of Attribute Scale
Attribute Scale Explanation

BEST State-of-the-art survey. No apparent substantive issues left
unaddressed. Have characteristics of the best survey projects
presented at professional conferences.
BETTER Excellent survey but not perfect. Methodological techniques were
appropriate for the project and similar to previous projects but in
some cases more up-to-date techniques are available. One
substantive issue could have been handled better. Similar to most
of the survey projects presented professional conferences.
SATISFACTORY Satisfactory survey. Methodological techniques were appropriate
but superior methods exist and should have been used. Two or
three unresolved substantive issues. The project could be
presented at the professional conference but has characteristics
that would make it less appealing than most presentations.
WORSE Although the survey results will be useful temporarily, a follow-
up study must be done to refine the methodology and address
substantive issues that were ignored. Occasionally similar projects
are presented at conferences but they are poorly received.
WORST The survey must be repeated to obtain useful results. Members of
the staff are aware of advances in survey design that could have
been incorporated but were not. Many substantive issues left
unanswered. Not a presentable project.
Source: Clemen & Reilly (2001)

SELF-CHECK 5.2

1. According to Keeney (1994), in a given situation,
there are six considerations to be taken into account
to help decision makers identify objectives.
2. Developing a wish list and predicting consequences
are two of the considerations to be taken into account
when one is identifying the objectives.
3. Means objectives may be defined as objectives of
what we actually want to accomplish.
4. Fundamental objective helps achieve other
objectives.
5. By convention, a decision is represented by a
rectangle.
6. Mutually exclusive means that no other possible
outcomes exist. One of the specified outcomes has to
occur.
7. Surveys which are scaled as „Worse‰ must be
repeated to obtain useful results.
8. Methodological techniques were appropriate but
superior methods exist and should have been used.
Two or three unresolved substantive issues. This is
the explanation for a scale attributed as „Better‰.

ACTIVITY 5.2
1. Along and Associates sell a computer program that supports the

accounting function for small law partnerships. To make their
product more attractive, they are considering to offer a helpline to
provide perpetual free customer support. Introducing this feature
should greatly improve sales. Determine the means and
fundamental objectives for Along and Associates.
2. Shaukat is considering opening a lemonade stand at the beach

during the school holiday season. When swimming and relaxing in
the sun, most people enjoy a cool refreshing drink. If it is a
particularly hot day, Shaukat could earn a lot of money. However,
if it rains, sales will suffer. Draw an influence diagram and a
decision tree for this case. Try to come up with hypothetical figures
(probabilities and consequences) to complete the two models.
Post your answer on myINSPIRE online forum.
• A problem can be operationally defined as the difference between a current

and a preferred situation.
• In a well-formed problem statement, at least three components should be

distinguishable – the nature of the current situation, the nature of the preferred
situation and a central objective that distinguishes the two.
• The current and preferred situations may differ according to more than one
objective.
• A decision problem includes various elements that can be identified as values

and objectives, decisions, uncertain events and consequences.

• The interrelationship among decisions, uncertain events and consequences can

be illustrated in an influence diagram, which presents influence arrows
indicating which elements affect others.
• A decision problem can also be represented using a decision tree, which

consists of a series of branches indicating the potential alternatives that can be
chosen and outcomes that may occur in order of time precedence from left to
right.
Collectively exclusive Mutually exclusive

Expected monetary value (EMV) Relevance
Fundamental objective Sequence
Means objective Uncertain events
Keeney, R. L., & Raiffa, H. (1994). Decisions with multiple objectives–preferences

and value tradeoffs. New York, NY: Cambridge University Press.
Keeney, R. L. 2002. Common mistakes in making value trade-offs. Operations

Research, 50(6):935–945; doi:10.1287/opre.50.6.935.357

Topic  Making a
Choice
6
LEARNING OUTCOMES

1. Discuss the decision theory approach;
2. Apply the decision rules in making business decision; and
3. Use the relevant decision criteria when making a choice.
 INTRODUCTION
The previous topic discussed the decision-making process by mapping the
underlying structure of a decision problem. It discussed two types of diagrams in
representing the structure of the decision problem, namely influence diagram and
decision tree.
In this topic, before we continue with finding the solution to the decision tree, we
will discuss three decision rules which can assist managers in making business
decisions. The decision rules include:
(a) The optimistic decision rule;
(b) The pessimistic decision rule; and
(c) The expected value decision rule.
Finally, we will make a choice using the expected value decision rule in
conjunction with the decision tree.

TOPIC 6 MAKING A CHOICE  87
6.1 DECISION-THEORY APPROACH

Decision theory is typically followed by economists, statisticians, psychologists,
political and social scientists, and philosophers. It provides a formal structure for
making rational choices in a situation of risk and uncertainty. Decision theory is
derived from economics discipline by using the utility function of payoffs (Clemen
& Railly, 2005, 2014; Keeney and Raiffa, 1994; Keeney, 2002). It suggests that
decisions be made by considering utility and probability values, and a range of
options. It also lays down the strategies for making a good decision.
Decision theory can be used to determine the best choice when a decision maker
is faced with several decision alternatives and uncertain future events (Baker,
2018). The basic steps are as follows:
(a) Determine the decision alternatives or the possible courses of action available
to the decision maker;
(b) Develop a list of all future events (states of nature). The states of nature are
mutually exclusive and collectively exhaustive; and
(c) Specify the outcomes associated with each decision alternative and the state-
of-nature combination (the payoff for the given combination).
Take a look at the following example.

88  TOPIC 6 MAKING A CHOICE
Before using the decision rules to assist us to make a choice, we will first go
through the steps as shown in Table 6.1.
Table 6.1: Steps in the Decision Rules
Step Explanation
Step 1 • Decision 1 (D1): Expand present manufacturing facility
List all alternatives
• Decision 2 (D2): Build a new manufacturing facility
• Decision 3 (D3): License another manufacturer to
produce the product
Step 2 • State of nature 1 (θ1): High product demand
List all possible
• State of nature 2 (θ2): Moderate product demand
future events
(outcomes) • State of nature 3 (θ3): Low product demand
Step 3 Specification of consequences resulting from the interactions

Construct a payoff of decision alternative and state of nature.
table
The payoff table for the TKJ EnterpriseÊs chilli sauce proposal is shown in
Table 6.2.
Table 6.2: Payoff Table – TKJ Enterprise for Chilli Sauce
State of Nature
Decision
Alternative Moderate Demand
High Demand (θ1 ) Low Demand (θ3 )
(θ2 )
Expand present 1,000,000 500,000 –100,000

facility (D1)
Build new 2,500,000 1,200,000 –500,000

facility (D2)
License to other 1,500,000 800,000 –50,000

manufacturer (D3)
SELF-CHECK 6.1
Briefly explain the decision-theory approach.

6.2 DECISION MAKING UNDER RISK AND

UNCERTAINTY
In making decisions under risk and uncertainty, the following decision rules can
be applied. The rules are illustrated in Figure 6.1.
Figure 6.1: Decision making under risk and uncertainty
Now let us look at each explanation in detail.
(a) Maximax Decision Procedure
(i) This is an aggressive and optimistic approach.
(ii) Select the decision alternative that has the maximum payoff from the
maximum of each of the various states of nature.

State of Nature
Decision Maximum
Alternative High Demand Moderate Low Demand Payoff
(θ1) Demand (θ2) (θ3)
Expand present 1,000,000 500,000 –100,000 1,000,000
facility (D1)
Build new facility 2,500,000 1,200,000 –500,000 2,500,000
(D2)
License to other 1,500,000 800,000 –50,000 1,500,000
manufacturer (D3)
From the earlier table, create another column. For each decision alternative,
select the highest payoff from the various states of nature and place it in the
corresponding cell under the Maximum Payoff column. Then, select the
highest payoff from amongst the maximum payoffs.
Using the maximax decision procedure, TKJ Enterprise would select

alternative D2, that is, to build a new facility.
(b) Maximin Strategy (Wald Criterion)
(i) This is a conservative and pessimistic approach to making decision.
(ii) Array the minimum payoffs and select the decision alternative that is
the maximum of these minimums.
State of Nature
Decision Minimum
Alternative High Moderate Low Payoff
Demand (θ1) Demand (θ2) Demand (θ3)
Expand present 1,000,000 500,000 –100,000 –100,000

facility (D1)
Build new facility 2,500,000 1,200,000 –500,000 –500,000

(D2)
License to other 1,500,000 800,000 –50,000 –50,000

manufacturer (D3)
Using the maximin strategy decision procedure, TKJ Enterprise would select
alternative D3, that is, to license to another manufacturer to produce the
product.

(c) Criterion of Realism (Harwics Criterion)
(i) This decision criterion is a compromise between the optimistic and

pessimistic decision criteria.
(ii) The decision maker first selects a coefficient of optimism, α, which

measures his degree of optimism (α is between 0 and 1).
(iii) For each alternative the maximum payoff is multiplied by α, the

minimum payoff is multiplied by (1 – α) and these values added to
produce a weighted average payoff.
(iv) Select the decision alternative that has the highest weighted average
payoff.
Let us say that α = 0.6. The weighted average payoffs for the various decision
alternatives are as follows:
D1: (1,000,000 × 0.6) + (–100,000 × 0.4) = 560,000
D2: (2,500,000 × 0.6) + (–500,000 × 0.4) = 1,300,000
D3: (1,500,000 × 0.6) + (– 50,000 × 0.4) = 880,000
Using the criterion of realism decision procedure, TKJ Enterprise would

select alternative D2, that is, to build a new facility.
(d) Equally Likely Criterion (Leplace Criterion)
(i) Since the probabilities of future states are unknown, each state is
assumed to be equally likely to occur.
(ii) Select the decision alternative with the highest average outcome (row
average). The computations for the equally likely criterion are as
follows:
D1: (1,000,000 × 1/3) + (500,000 × 1/3) + (–100,000 × 1/3) = 466,667
D2: (2,500,000 × 1/3) + (1,200,000 × 1/3) + (–500,000 × 1/3) = 1,066,667
D3: (1,500,000 × 1/3) + (800,000 × 1/3) + (–50,000 × 1/3) = 750,000

Using the equally likely criterion decision procedure, TKJ Enterprise would
(e) Expected Value of Returns (Expected Monetary Value, EMV)
(i) The use of the expected value of returns decision procedure requires
probability estimates for the likelihood of all states of nature.
(ii) EMV for a particular alternative is the sum of possible payoffs of that
alternative, with each payoff weighted by the probability of that payoff
occurring.
(iii) Select the alternative with the highest EMV.
Given the probabilities of θ1, θ2, θ3 are 0.4, 0.4 and 0.2 respectively, the
expected monetary values for the decision alternatives are computed as
follows:
EMV (D1) = (1,000,000 × 0.4) + (500,000 × 0.4) + (–100,000 × 0.2) = 580,000
EMV (D2) = (2,500,000 × 0.4) + (1,200,000 × 0.4) + (–500,000 × 0.2) = 1,380,000
EMV (D3) = (1,500,000 × 0.4) + (800,000 × 0.4) + (–50,000 × 0.2) = 910,000
The results are as shown in the following table.
State of Nature Expected

Decision
High Moderate Low Monetary
Alternative
Demand (θ1) Demand (θ2) Demand (θ3) Value
Expand present 1,000,000 500,000 –100,000 580,000

facility (D1)
Build new facility 2,500,000 1,200,000 –500,000 1,380,000

(D2)
License to other 1,500,000 800,000 –50,000 910,000

manufacturer (D3)
Probability of θ 0.4 0.4 0.2
Using the expected value of returns decision procedure, TKJ Enterprise would

6.3 MAKING CHOICES USING A DECISION

TREE
In the previous topic, we have discussed and structured decision problems using
decision trees. A decision tree allows the decision maker to see exactly what is
happening at each stage of the decision-making process by showing its natural or
logical progression (Magee, 1964). Many business decisions are in reality a series
of related sequential decisions, where choices made at one point in time can change
the probability of their decision happening or altering their consequences.
The decision tree format enables sequential decisions to be represented and the
consequences of future decisions to be traced back to assess their influence on the
present decision. In this subtopic, we will use the expected monetary value (EMV)
to make the best decision that is structured using the decision tree.
6.3.1 Decision Tree and Expected Monetary Value

(EMV)
If our objective is to maximise monetary value such as profit, the way to choose
among risky alternatives is to pick the alternative with the highest expected
monetary value (EMV). Finding EMVs when using decision trees is called „folding
back the tree‰ or „rolling back.‰ We start at the terminating points, that is, the
endpoints of the branches on the far right-hand side and move towards the left.
We will do the following:
(a) Calculate expected monetary values when we encounter a chance node; or
(b) Choose the branch with the highest value or expected value when we
encounter a decision node.
It is much easier to understand the procedure through an example. We will show

how to use the procedure with a simple example – Fiza PharmacyÊs plan to
introduce its new product.
Suppose the probability that consumers will accept the new product is 0.6.
Figure 6.2 shows the complete decision tree where a choice can be made using the
EMV criterion.

Figure 6.2: Complete decision tree using the EMV criterion
To solve the decision tree using EMV, begin by calculating the expected value of
introducing the new product. This expected value is simply the weighted average
of the possible outcomes of the decision, the weights being the chances with which
the outcomes occur. The calculation is as follows:
EMV (Introduce) = 0.6(10,000) + 0.4(0) = 6,000
Now we can replace the chance node in the decision tree with the expected value
as shown in the decision tree.
Finally, choose between „to introduce‰ and „do not introduce‰ the new product
amounts to choosing the branch with the highest expected value.
The double slash through the „do not introduce‰ branch indicates that this branch
would not be chosen. Hence, the decision would be to introduce the product
because it yields a higher EMV.

Just like any other models, the decision tree has its limitations:
(a) Only one decision criterion can be considered;
(b) The decision tree is an abstraction and simplification of the real problem.
Only important decisions and events are included;
(c) We cannot use decision trees if the chance event outcomes are continuous;
and
(d) The significant result of the analysis of a decision tree is to choose the best
alternative. After this stage, changes may occur, thus, a new optimal strategy
is required.
6.3.2 Solving Decision Tree with Computer Software

We have learned that decision theory is a set of concepts, principles, tools and
techniques that help the decision maker in dealing with complex decision
problems under risk and uncertainty. In essence, decision theory helps us deal
with methods for determining the optimal course of action when a number of
options or alternatives are available and their consequences cannot be forecasted
with certainty. Based on our earlier discussion, we know that discrete decision
theory problems can be represented pictorially using decision trees, which
chronically portrays the sequence of actions and events as they unfold.

Since the decision tree is universal, researchers and practitioners have made the
structure of the decision process more accurate and facilitate communication
among solvers of the decision problem. This has facilitated the development of
computer software to solve a decision problem based on decision tree formulation.
Analysis of decision tree by means of computer has also quickly established the
impact of changes in the input parameters of the tree regarding the best policy
choice.
To see the available software to build your own decision tree, check out some of
the following resources:
(a) SmartDraw:
https://www.smartdraw.com/decision-tree/decision-tree-maker.htm
(b) SilverDecisions:
https://github.com/SilverDecisions/SilverDecisions/wiki/1.-Decision-
tree-model
(c) Lucidchart:
https://www.lucidchart.com/pages/planning/decision-tree-examples
(d) Edraw Decision Tree Software:

https://www.edrawsoft.com/linuxdiagram/decision-tree-software-
linux.php
(e) Zingtree Interactive Decision Tree Template:

https://zingtree.com/

SELF-CHECK 6.2
1. Given the situation as depicted by the decision tree below, solve the
problem using:
(a) Maximax decision procedure
(b) Minimax strategy
(c) Criterion of realism (a = .6)
(d) Equally likely criterion
2. Construct a decision tree for the TKJ chilli sauce problem as

discussed in this topic and solve using the expected monetary
value.
3. Solve the Fiza Pharmacy research and development project (in

Topic 5) using the decision tree and expected monetary value.

• There are a variety of ways to use quantitative tools to make choices in

uncertain situations. Decision theory can be used to determine the best choice
when a decision maker is faced with several decision alternatives and
uncertain future events.
• Several decision rules which can be applied including maximax decision

procedure, minimax strategy, criterion of realism, equally likely criterion and
expected value of returns.
• The solution process for a decision tree using expected monetary value is the
simplest way to make a choice.
Criterion of realism Expected value of returns

Decision theory Maximax strategy
Equally likely criterion Maximin decision procedure
Expected monetary value (EMV)


Keeney, R. L. (2002). Common mistakes in making value trade-offs. Operations

Research 50(6):935–945; doi:10.1287/opre.50.6.935.357
Magee, J. F. (1964). Decision trees for decision making. Harvard Business Review,
July, 1964.

Topic  Decision
Making in
7 Practice:
Getting the
Problems and
Objectives
Right
LEARNING OUTCOMES

1. Set the right objectives; and
2. Find out the actual cause of a problem using appropriate tools.

TOPIC 7 DECISION MAKING IN PRACTICE: GETTING THE PROBLEMS  101
AND OBJECTIVES RIGHT
 INTRODUCTION
In the previous topics, we have presented decision making as seen from the
perspective of the behavioural scientists and mathematical modellers. The rest of
the module will continue to draw knowledge and information from these materials
and discuss them in the context of practical management decisions. As mentioned
before, making decisions and bearing the responsibility for them are among the
cornerstones of a managerÊs job. The importance of decision making is reflected in
the attention and treatment given by academicians and practitioners in many
disciplines including sciences and mathematics, business management and
economics, and other social sciences as well as those in the industrial and services
sectors.
Among them, two areas that stand out are the behavioural sciences and
operational research. The behavioural sciences help us understand how we and
others behave when faced with a decision while operational research provides the
tools and techniques for us to make the easier decisions. However, their
contributions can only be realised if they are focused through the reality of
practical management experience.
7.1 GETTING THE OBJECTIVES RIGHT

This subtopic deals with the fundamentals of effective decision making, that is, the
objective(s) or outcome(s) in which the decision is supposed to achieve or to
contribute. The important aspects of the decision objectives are explained and
some characteristics of relevant objectives are described next.
7.1.1 Practical Prescriptions: Specifying the Objectives

Unless the objectives are well specified and understood, we will not be able to
determine how far the preferred action will be able to achieve what we have set
out as our objectives (Baker, 2018; Clemen & Reilly, 2014; Keeney & Raiffa, 1994;
Teale et al., 2003; Williams, 2016). In practice, we must always set objectives for
any decision and throughout the decision process, we must relate each of the items
shown in Figure 7.1 back to its original statements of objectives.

102  TOPIC 7 DECISION MAKING IN PRACTICE: GETTING THE PROBLEMS
Figure 7.1: Relating decision making aspects to the original statements of objectives
Organisational objectives can be categorised into three hierarchical levels, namely

primary objectives, strategic objectives and operational objectives. Primary
objectives may appear in the vision and mission statements of the organisation.
They do not change. Strategic objectives may change and they usually guide the
organisation in achieving the primary objectives towards long-term perspective.
Operational objectives, on the other hand, interpret the organisational strategic
objectives into smaller manageable terms and are usually shorter term in nature.
7.1.2 Practical Prescriptions: Checklist

For every decision, we should define how its objectives contribute to the overall
fundamental or strategic objectives of the organisation. We should also define how
the objectives of the decision contribute to the business competitiveness of the
organisation. To ensure that we get the objectives right and in the proper
hierarchical order, we can use the checklist shown in Figure 7.2 and a brief
explanation of the decision objective criteria in Table 7.1.

Figure 7.2: Decision objective criteria
Table 7.1: Decision Objective Criteria
Criteria Explanation
Appropriate They contribute to higher-level objectives in the hierarchy and

finally the primary or fundamental objectives.
Coherent The objectives of each part of the organisation must point
towards the same direction. They do not conflict with each
otherÊs decisions.
Consistent over time No organisation benefits from overly rigid strategies but they
should not always be changing.
Clear The objectives must be clear and understandable to all.
Agreed There must be agreement on who is responsible to articulate
certain objectives.

Related Since no decision objectives can exist in isolation, they must be

connected to one another. Means-end chain is a useful way to
sort out how objectives connect.
Balanced Long-term and short-term objectives must be balanced. Over-
emphasising short-term objectives may jeopardise the long-term
growth of the organisation.
Inclusive Most objectives are extrinsic because they are seen to be effective
in reaching the next objective. Intrinsic objectives may enhance
the performance of the organisation.
Comprehensive Decision objectives need not cover every aspect but they should
be comprehensive enough to cover important issues.
SELF-CHECK 7.1
List and briefly explain the criteria for good decision objectives.
7.2 UNDERSTANDING THE PROBLEM

„If I were given one hour to save the planet, I would spend 59 minutes defining
the problem and one minute resolving it,‰ Albert Einstein said.
Even though the quotation may sound extreme, it does point out the importance
of identifying problems. A problem is the perceived gap between the existing state
and the desired state or a deviation from the norm, standard or status quo. In most
cases, we start our scientific inquiry with problem identification and followed by
problem definition. Once we have done this, we can proceed to state the objectives.
Before going further with the decision-making process, we will follow the notion
of expanding the problem from the objective phase. Understanding the problem
context of a decision usually involves two broad activities (see Table 7.2). Firstly,
it is critical that we have adequate data and information about the problem.
Therefore, data collection needs to be carried out. Secondly, the data needs to
processed, analysed and interpreted.

Table 7.2: Developing an Understanding of the Problem Text
Activity Description
Data collection It is necessary to collect relevant data. Some may be „hard facts‰
while others may be in the form of opinions.
Analysis and The data needs to be analysed and interpreted so as to find the
interpretation underlying meaning of the problem. The analysis can be simple or
complex. This process should improve our understanding of the
problem significantly.
Next, we will look into the broader context and examine a number of approaches
and techniques that can help to develop good thinking habits for data collection,
processing, analysis and interpretation.
7.2.1 Practical Prescriptions: Data Collection

The context of the decision is always worth considering. When the decision area is
unclear, it is vital that time and efforts are invested in identifying and defining the
problems. Even when the decision seems clear cut, it is worth thinking it through
to make sure that you are really solving the right problem. This step is important
because if we do not identify the actual problem, we will be wasting a lot of time
and effort. It could be very costly.
Developing critical thinking habits would help us look deeper into the problem.
Some of the tips are listed as follows:
(a) Do not be afraid to question the status quo even when the assumptions and
procedures are entrenched in the organisation. Ask the „why‰ question or
any other relevant questions;
(b) Develop the ability to visualise the bigger picture rather than just focusing
on the one which immediately presents itself; and
(c) Develop the ability and the willingness to imagine what the future might
hold. It is important to spot problems before they become worse.
Techniques which are useful in data collection are illustrated in Figure 7.3.

Figure 7.3: Useful techniques in data collection
(a) Input-output Analysis

All business activities, whether at the organisational level or at the
departmental level, involve the conversion of some inputs such as materials,
labour, money and information into outputs in the form of goods and
services. Thus, looking at a business entity as an input-process-output
system is logical and very common. A prerequisite for understanding the
problem area which requires decisions is to understand the context of the
input-process-output operation. Formulating the input-output model
involves basically three tasks. They are as follows:
(i) Identifying all the inputs and outputs from the process. Examples of
input include raw materials, labour, plant and equipment, and
information. Examples of output would include physical or tangible
outputs and various types of services.
(ii) Identifying the sources of input and the destinations of the output.
These would include suppliers and customers of the business entity.
(iii) Determining the requirements of internal customers who are served by

the outputs from the process and determining what requirements the
process has for internal suppliers who provide inputs to the process.
(b) Flow Chart

The input-output model provides a useful overview of the overall process
and it could help us understand the problem from the context of the process.
The flow chart provides a more detailed understanding of the various parts
of the process by providing a flow. It records all information at the various
stages such as the passage of information, products, labour, customers or
anything else which flows through the operation.

When using the flow chart, decision makers are required to identify each
stage in the flow process as either:
(i) An action of some sort, which is recorded in a rectangular box; or
(ii) A question/decision, which is recorded in a diamond-shaped box.
The purpose of this is to ensure that all different stages in the flow are
included in the problem-solving process and that these stages are in a logical
sequence. This process can clarify and, to some extent, amplify the problem
and shed further light on the internal mechanics or workings of a particular
operation.
Finally and probably most importantly in understanding the problem, the

flow chart highlights bottlenecks or problem areas where no operating
procedure has been put in place to cope with the particular circumstances.
(c) Systematic Fact Finding

In many instances, the decision-making process is affected by omitting
certain aspects which initially appear to be trivial. The purpose of the
systematic fact-finding procedure is to generate and ensure that all
significant facts surrounding the problem area are accounted for. Important
and relevant factual information is gathered by systematically asking
questions which relate to the general problem area. The questions asked are:
(i) What activities are carried out and why?
(ii) How are things done and why?
(iii) Where are things done and why?
(iv) Who carries out the activities and why?
(v) How many times do things happen and why?
This list of questions serves as a guide and can be expanded, shortened or

adapted accordingly. The important point though is that it provides
discipline and a consistent way for systematic questioning. The follow-up
question „why?‰ is used to gather the reasons explaining why things are
done the way they are. Of course, the reasons may be challenged later,
however, at this stage, it is important just to collect the answers.

7.2.2 Practical Prescriptions: Data Processing

There are numerous analytical models, tools and techniques which we can employ
to assist us to make good decisions. Some of the more advanced techniques have
been discussed in the earlier topics. This subtopic discusses several tools which
can be readily used without sophisticated software. Some of the tools are shown
in Figure 7.4.
Figure 7.4: Analytical tools used in assisting decision makers
(a) Scatter Diagram

A scatter diagram is a quick and simple method of identifying whether there
appears to be a relationship between two sets of data, for example, the
amount of quantity sold and the price of each unit sold. Plotting each sales
activity on a graph which has quantity sold on one axis and price per unit on
the other could give an indication of whether quantity sold and price per unit
are related, and if yes, how are they related. Figure 7.5 indicates that quantity
sold and price per unit are negatively correlated. Figure 7.6, on the other
hand, shows that the quantity sold and income of customers are positively
related.

Figure 7.5: Scatter diagram for quantity sold against price
Figure 7.6: Scatter diagram for quantity sold against income

Plotting scatter diagrams can be treated in a far more sophisticated manner

by quantifying how strong the relationship between the sets of data are. But
no matter how sophisticated the approach is, we can only identify a
relationship, not the cause and effect of the relationship.
(b) Cause and Effect Diagram

The cause and effect diagram is an easy yet effective and powerful tool
commonly used to visually search and describe potential root causes of
specific problems. The tool enables us to readily organise the causes of the
problem into useful categories. We do this by asking the what, when, where,
how and why questions as before. However, in this case, we add some
possible answers in an explicit way. This diagram can also be used to identify
areas where further data is needed.
Cause and effect diagrams (also known as fishbone or Ishikawa diagrams)

have been used extensively in various organisationsÊ quality improvement
programmes. Many organisations have found them to be an effective part of
their quality-related problem-solving initiatives. The steps for drawing a
cause and effect diagram is explained in Table 7.3.
Table 7.3: Steps for Drawing a Cause and Effect Diagram
Step Explanation
Step 1 State the problem to be solved in the „effect‰ box (Refer to Figure 7.7).
This is probably the most important task in building a cause and effect
diagram.
Step 2 Identify the main categories for possible key causes of the problem.
Although many types of categories can be used for the main branches
of the diagram, there are several categories which are commonly used:
machinery, manpower, materials, methods and procedures, money.
Step 3 Use systematic fact finding and group discussions to generate possible
causes under the categories. Anything which may result in the effect
which is being considered should be recorded as a potential cause.
Step 4 Consider all potential causes on the diagram under each category and
discuss each item in order to combine and clarify causes. (At the end of
Step 3, we should have a good idea of the possible causes of the
problem.) Identify and focus more specifically on the most likely causes.

Figure 7.7: Cause and effect diagram
Many quality-conscious organisations use the cause and effect diagram to

identify the causes of the problems that they face. An example is shown in
Figure 7.8.
Figure 7.8: An example of cause and effect diagram

Source: Ekings (1986)
How do we get the most out of the cause and effect diagram? One of the key
pitfalls when completing a cause and effect diagram is getting into the habit
of providing never-ending possible causes to the problem. This pitfall can be
avoided by knowing when to stop the cause and effect discussion. To do that
we can focus on the groupÊs span of control and sphere of influence. The span
of control refers to work areas where the team has complete control of its
environment while the sphere of influence refers to the work areas where the
team is able to exert some influence but not full control. To come up with
some meaningful solutions, we should consider both these work areas.

To ensure the effectiveness and fruitfulness of the cause and effect diagram,
it would be good if we are able to get an experienced person as a facilitator.
An experienced facilitator should be able to help the group unearth the real
reasons behind the problem. It would also be very beneficial to look for data
and information to back-up opinions expressed in order to confirm the true
nature of the causes.
(c) Pareto Analysis

For many who are in charge of operations, there are usually a number of
decisions to be made. The question is which one should be handled first. At
this stage of the problem-understanding process, it is wise to start
distinguishing between what are important and what are less important. We
can rely on the Pareto analysis to answer this question.
A Pareto analysis helps prioritise decisions so that decision makers

know which ones will have the greatest influence on their overall
objectives and which ones will have the least amount of impact.
The purpose of a Pareto analysis is to distinguish between the „vital

few‰ issues and the „trivial many‰ issues. It is a relatively simple and
straightforward technique which involves arranging information on the
types or causes of problems based on their order of importance.
This can then be used to highlight areas where further decision making will
be useful. Pareto analysis is based on the frequently occurring phenomenon
of relatively few causes explaining the majority of effects. For example, most
of the companyÊs revenues are likely to come from relatively few of the
companyÊs customers.
The Pareto analysis, sometimes also known as the 80/20 rule, is based on the
idea that 80 per cent of a projectÊs benefits come from 20 per cent of the efforts
put into the project. In the context of decision making, we can assume that
80 per cent of the problems can be traced to 20 per cent of the causes.

Haughey (2015) listed eight steps to identify the principal causes of a decision
problem using Pareto analysis:
(i) Create a vertical bar chart with causes on the x-axis and count (the
number of occurrences) on the y-axis.
(ii) Arrange the bar chart in descending order of cause importance, that is,
the cause with the highest count first.
(iii) Calculate the cumulative count for each cause in descending order.
(iv) Calculate the cumulative count percentage for each cause in

descending order. Percentage calculation: {Individual Cause Count} /
{Total Causes Count} *100.
(v) Create a second y-axis with percentages descending in increments of 10

from 100 to 0 per cent.
(vi) Plot the cumulative count percentage of each cause on the x-axis.
(vii) Join the points to form a curve.
(viii) Draw a line at 80 per cent on the y-axis running parallel to the x-axis.
Then drop the line at the point of intersection with the curve on the
x-axis. This point on the x-axis separates the important causes on the
left (vital few) from the less important causes on the right (trivial
many).
A simple example of a Pareto diagram showing the relative frequency of

causes for errors on websites is shown in Figure 7.9. The diagram enables us
to view the 20 per cent cases which are causing 80 per cent of the problem. It
also tells us where we should focus our efforts in order to achieve the greatest
improvement. From Figure 7.9, we should focus on broken links, spelling
errors and missing title tags.

Figure 7.9: Example of a Pareto analysis diagram

Source: Haughey (2015)
The value of the Pareto analysis for decision makers is that it reminds us to
focus on the 20 per cent of things that matter. However, as a word of caution,
we should not ignore the remaining 80 per cent of the causes entirely.
(d) Why-why Analysis

A why-why analysis is a way of reaching the root cause(s) of a problem of
any stature. The name of the method comes from the main question asked
during the analysis, that is, „Why?‰ By asking that question many times, it is
possible to find the real, often hidden causes of the problem. Some people
suggest asking as many as five times. The idea of five whys comes from
Genichi Taguchi (1987), who once said that, „to find the real causes you, need
to ask why five times.‰ Dealing with the real cause prevents the problem
from happening again.

Why-why analysis is an expansion technique, which starts by stating the

problem and asking why that problem occurred.
The method is an evolution of the fishbone diagram which was created by

Kaoru Ishikawa (1968). The why-why analysis is used mainly in Six Sigma;
however, it can be used in any organisation.
Once the major reasons for the problem occurring have been identified,
each of the major reasons is taken in turn and again the question is asked as
to why those reasons have occurred and so on. This procedure is continued
until either a cause seems sufficiently self-contained to be addressed by itself
or no more answers to the question „Why?‰ can be generated.
To better explain this concept and how it can work in practical application,
let us walk through two examples.
Example 1:
Problem Statement: You are on your way home from work and your car
stops in the middle of the road.
(i) Why did your car stop?

– Because it ran out of fuel.
(ii) Why did it run out of fuel?

– Because I did not buy any fuel on my way to work.
(iii) Why didnÊt you buy any fuel this morning?

– Because I did not have any money.
(iv) Why didnÊt you have any money?

– Because I forgot to bring my wallet.
Example 2:
Assume that the problem at hand is that one specific product within a large
product line is not selling well. Well, we can just take the product out off the
marketplace and cut losses. But do we know what are the real causes of the
problem? Let us use the why-why analysis.

Problem Statement: One specific product within a large product line is not
selling well.
(i) Why is this specific product not selling well?

– Because this product is sold at a higher price point than the other
similar products in the line.
(ii) Why is this product being sold at a higher price?

– Because the product is made from more expensive raw materials,
resulting in the need for a higher price.
(iii) Why is the product made using more expensive materials?

– Because the purchasing contract for the materials is an old one and
should have been renegotiated.
Once the real cause or information is uncovered, the business can work on a
new deal for the materials, subsequently lowering the cost of the unit and
lowering the price of the product, and resulting in selling more products in
the end. In this example, we only went through three levels of „whys‰ and
we are able to get down to the heart of the matter.
As you can see, in both examples, the final why leads us to a statement (root
cause) that we can take action on. It is much quicker to come up with a system
than keep trying to directly solve the stated problem without further
investigation.
SELF-CHECK 7.2
1. State and explain the techniques that are useful in data collection.
2. What are the data analytical tools that can help you understand the
problem better?

SELF-CHECK 7.3
Fill in the blanks with the correct answers.
1. It is necessary to collect relevant data. Some may be hard facts

while others may be in the form of opinions, which is known as
_____________.
2. _____________ provides a detailed understanding of parts of the

process where a flow occurs.
3. The purpose of the_____________ procedure is to generate all

significant facts surrounding the general problem area. Purely
factual information is gathered by systematically asking questions
which relate to the problem area.
4. The purpose of a _____________ analysis is to distinguish between

the „vital few‰ issues and the „trivial many‰ issues.
5. _____________ diagram is an effective method for helping to search

for the root causes of problems.
• It is important to identify the right objective(s) and understanding the actual

problem before looking to solving the problem.
• Organisational objectives can be categorised into three hierarchical levels,

namely primary objectives, strategic objectives and operational objectives.
• Various techniques for collecting data can be used to gather the relevant data
and information. They include input-output analysis, flow chart and
systematic fact finding.
• The collected data must be analysed to assist in understanding the problems.

Various methods can be used for this purpose, namely scatter diagram, cause
and effect diagram, Pareto analysis and why-why analysis.

Cause and effect diagram Pareto analysis

Data collection Scatter diagram
Decision objectives Systematic fact finding
Flow chart Why-why analysis
Input-output analysis
Ekings, J. D. (1986). „A nine-step quality improvement programme to increase

customer satisfaction.‰ European Organisation for Quality Control 30th
Conference, Stockholm.
Haughey, D. (2015). Pareto analysis step by step. Retrieved from https://www.

projectsmart.co.uk/white-papers.php; search: https://www.projectsmart.
co.uk/pareto-analysis-step-by-step.php.
Ishikawa, K. (1968). Guide to quality control. Tokyo, Japan: JUSE.

Taguchi, G. (1987). System of experimental design: UNIPUB. New York: Kraus

International Publications.
Prentice-Hall.
Williams, S. W. (2016). Making better business decisions. Thousand Oaks, CA:

Sage.

Topic  Decision
Making in
8 Practice:
Generating
Options and
Making the
Choice
LEARNING OUTCOMES

1. Generate enough options for making decisions;
2 Evaluate the various options; and
3. Select ways to make better decisions.

120  TOPIC 8 DECISION MAKING IN PRACTICE: GENERATING OPTIONS AND
MAKING THE CHOICE
 INTRODUCTION
As mentioned earlier, making decisions and bearing the responsibility for all the
consequences of the decision are among the cornerstones of the managerÊs job. In
recent years, the behavioural sciences and operational research areas have done
substantial work on this topic. The behavioural sciences help us understand how
people behave when faced with a decision, while operational research provides
the tools and techniques to make the decision easier.
8.1 GENERATING THE OPTIONS

The process of optimisation in the decision-making process depends to some
extent on the ability to consider all possible alternatives. While it may seem
difficult to generate all possible alternatives due to the constraints of time and
other resources, coming up with enough options will likely improve the prospect
of making high-quality decisions.
In generating the options, we focus on the development of critical and creative

thinking and behaviour, especially in the area of creating alternative possibilities.
We look at how the essential quality of imaginative decision making can be
integrated with the more obvious analytical skills. This subtopic explains the
factors which encourage or block creativity and presents a range of operational
techniques which have been used to enhance the creative process.
8.1.1 Critical and Creative Thinking in Decision

Making
Critical thinking is the practice of systematically and methodically gathering,
analysing, and evaluating data and information. It is one of the most essential
components of the problem-solving and decision-making process. It is the act of
thinking seriously through various options which will eventually lead to the final
choice. It determines whether the choice is practically sound.
There are four key structures that all critical thinking is based on:
(a) Logic
Logic is the ability to see direct and indirect relationships between causes and
effects. This is one of the most important decision-making skills as logic
provides accurate predictions about what kinds of effects a potential solution
will have on individuals and systems.

TOPIC 8 DECISION MAKING IN PRACTICE: GENERATING OPTIONS AND  121
MAKING THE CHOICE
(b) Truth
Truth is the unbiased data and information of an event. Good critical
thinking removes biases and focuses on documented data that will support
the final choice.
(c) Context
Context refers to a list of extenuating pressures and factors affecting the final
solution. All of these elements must be considered in the decision-making
process.
(d) Alternatives
In effective critical thinking, we should be able to consider new or alternative
ways of approaching problems based on accurate and unbiased data. In other
words, we need to be critical as well as creative.
Creative thinking and critical thinking are two expressions that complement one
another. The difference between them can be seen in terms of their inner meanings.
Creative thinking goes beyond limitations and usually brings forth original and
fresh ideas. Critical thinking, on the other hand, is more evaluative in nature and
analyses a particular subject. Hence, we can say that while creative thinking is
generative in purpose, critical thinking is more analytical in purpose.
The ultimate goal of decision making is to arrive at an actionable conclusion that

matters while critical and creative thinking is the process that proves whether the
conclusion is sound. In addition, the critical thinking process also depends on
asking the right critical thinking questions. Here are some key points to consider
when formulating a critical question:
(a) A good question is designed to solicit specific information. It must be stated

concisely and with a direct meaning;
(b) Frame the question properly. A question with a clearly stated purpose must
be framed correctly to be sure that the person to whom the question is
directed understands the specific answer the question is seeking;
(c) Use open-ended instead of closed-end questions. An open-ended question

cannot be answered by a yes or a no; it requires elaboration; and
(d) Consider follow-up questions. The answer to your question may indicate
that more questions are required to obtain the information you need.
The Australian Curriculum (2018), emphasises the importance of critical thinking

and creative thinking. The challenges resulting from the complex environmental,
social and economic pressures require people to be innovative and enterprising.

MAKING THE CHOICE
This requires them to be able to use critical and creative thinking purposefully.
Although these two types of thinking (critical thinking and creative thinking) are
not interchangeable, they are strongly linked and they bring complementary
dimensions to thinking and learning.
The key ideas for critical and creative thinking are organised into four interrelated
elements in the learning continuum, as shown in Figure 8.1.
Figure 8.1: General capabilities of critical and creative thinking

Source: Australian Curriculum (2018)
Critical thinking is at the core of most intellectual activities which involve learning
to recognise or develop an argument, use evidence in support of that argument,
draw reasoned conclusions and use the information to solve problems. Examples
of critical thinking skills are interpreting, analysing, evaluating, explaining,
sequencing, reasoning, comparing, questioning, inferring, hypothesising,
appraising, testing and generalising.

MAKING THE CHOICE
Creative thinking involves learning to generate and apply new ideas in specific
contexts, view existing situations in a new way, identify alternative explanations,
and make new links that generate a positive outcome. This includes combining
parts to form something original, sifting and refining ideas to discover
possibilities, constructing theories and objects, and acting on intuition.
8.1.2 The Creative Individual

Different writers describing individuals who are creative appears to have a
different list of characteristics for the creatively-gifted individual. The variations
in perspectives are mostly about the combination and order of the traits rather than
the listing of the traits. The difference can also be found in the way the writers
describe each of the traits. For example, one writer may describe a highly creative
individual as rebellious while another may indicate that this person tends to be an
independent thinker. Still another writer may label the individual as having
unique viewpoints. Whatever the difference may be, all these descriptions simply
indicate that highly creative individuals tend to think for themselves and they are
not easily influenced or swayed by others.
Creative thinking plays a valuable role in management decision making.

Recognising and formulating problems, and in particular generating a range of
alternative solutions require a creative approach which must be brought together
with the more analytical processes of objective setting and evaluation.
How do we stimulate creative thinking? Figure 8.2 shows us how.

MAKING THE CHOICE
Figure 8.2: Ways to stimulate creativity
It is only fair to acknowledge that some people are visibly more creative than
others. Only a small proportion of employees consistently produce original and
worthwhile products and ideas (at least while they are at work!). By looking at the
qualities and characteristics of those individuals who are judged to be highly
creative, we can get an idea of what might be enhanced or encouraged in order to
stimulate creative behaviour throughout a wider population. They are as follows:
(a) Highly creative individuals tend to show considerable dissatisfaction with

the current state of affairs.
(b) Relatively high levels of general intelligence would seem to be associated

with creativity.
(c) Creative individuals are continuously experiencing conflict in being

attracted towards what would normally be thought of as conflicting states:
between order and disorder, between rationality and intuition, between
conformity and non-conformity.
(d) Creative individuals seem to emphasise the extent to which they have an
awareness of themselves, their acceptance of both good and bad personnel
characteristics, and, in a sense, the way in which they seem able to turn what
to other people would seem weaknesses into strengths.

MAKING THE CHOICE
8.1.3 The Creative Organisation

Creative organisations seem to build on the variety and richness of their members,
allowing and even encouraging differences, rather than insisting on prescribed
and singular approaches.
In this context, there is the need for a structure which is able to capture and to
capitalise on this richness, together with a climate that places a high value on
creativity and perceives it as the norm rather than the exception. In a sense, the
characteristics of the creative individual are replicated in the organisation, many
features of individual creativity having their parallel in the operating mode of the
creative organisation.
Organisations which allow their members to display their creative talents are
themselves behaving in a creative manner. Managers can encourage the
development of creative behaviour by adopting a supportive personal style and
by developing reward and control systems which:
(a) Link rewards to task accomplishment;
(b) Set high performance standards;
(c) Reward cooperative activities; and
(d) Encourage adaptation and change.
Idea generation techniques generally rely on the following two basic principles:
(a) Separating judgement and evaluation from the actual process of idea
generation; and
(b) Giving equal consideration to all ideas that are generated.

MAKING THE CHOICE
8.1.4 Techniques for Aiding Creative Thinking

Use techniques positively and selectively in order to help solve problems. At the
same time encourage a general move towards more creative behaviour among
decision makers. Some techniques are designed to help problem solvers in the
process of thinking through and exploring new linkages. The following ideas can
facilitate creative thinking:
(a) Analogy
In order to understand and explore situations and gain new insights, it is
often helpful to consider analogous circumstances or situations. Four types
of analogies are possible and they are explained in Table 8.1.
Table 8.1: Four Types of Analogies
Analogy Explanation
Personal analogy The personal analogy is where the decision maker tries to identify
personally with elements of the situation, expressing and exploring
characteristics through drawing personal parallels.
Direct analogy Drawing comparisons with parallel situations where perhaps more
can be discovered about the direct parallel that can be seen in the
immediate problem.
Symbolic analogy Giving the problem the characteristics of some object such as a tree
or an animal.
Fantasy analogy Literally fantasising about solutions to problems and then
developing, in a sense, a „working model‰ of that fantasy solution.
(b) Brainstorming
Brainstorming would appear to be generally applicable across a wide range
of problems but is perhaps particularly useful in tackling how-to-do-it
problems or those that require broad directions. Familiar rules apply in the
brainstorming session as shown in Figure 8.3.

MAKING THE CHOICE
Figure 8.3: Rules in brainstorming sessions
The last rule is particularly important in brainstorming situations because it

is very easy to indicate disapproval of other peopleÊs ideas by either verbal
or non-verbal means.
(c) Nominal Group Technique

Nominal group technique was developed in an attempt to overcome some of
the biases that arise from the social processes within brainstorming groups.
It differs from other group techniques in that the evaluation stage is built into
the process in a more prescribed way. The nominal group technique has the
following major stages as shown in Figure 8.4.
Figure 8.4: Stages in nominal group technique

MAKING THE CHOICE
SELF-CHECK 8.1
1. Briefly discuss the key ideas for critical and creative thinking which
are organised into four interrelated elements in the learning
continuum.
2. Explain the techniques used for aiding creative thinking.
SELF-CHECK 8.2
Fill in the blanks with the correct answers.
1. Drawing comparisons with parallel situations where more can be

discovered about the direct parallel than can be seen in the
immediate problem. This is _____________ analogy.
2. Literally fantasising about solutions to problems and then

developing, in a sense, a „working model‰ of that fantasy solution.
This is known as _____________ analogy.
3. _____________ technique was developed in an attempt to

overcome some of the biases that arise from the social processes
within brainstorming groups.
8.2 EVALUATING THE OPTIONS

Evaluating is the process of determining the value of things. Here we are
determining the worth of the various decision options by specifying the attributes
of each option which need to be explored prior to the final choice. The evaluation
of alternatives or options essentially involves exploring, understanding and
describing the consequences of each option.
Before we can evaluate an option, we must already have set the objectives as well
as whatever workable decision criteria established from it. The decision context
and specific problems which require decisions should be well understood. Before
the evaluation stage, the alternative options from which the choice will be made
should have been identified and well specified. At this evaluation stage, we will
spell out what it would mean to adopt each option by considering several criteria
including feasibility, acceptability and vulnerability. Table 8.2 briefly explains the
three decision criteria.

MAKING THE CHOICE
Table 8.2: Three Decision Criteria in the Evaluation Stage
Criteria Explanation
Feasibility The feasibility of each option refers to the degree of difficulty in
adopting the option and should assess the investment of time,
effort and money which it will need.
Acceptability The acceptability of each option refers to the extent the option
fulfils the decision objectives (the return we get for choosing that
option).
Vulnerability The vulnerability of each option refers to the extent in which things
could go wrong if the option is chosen (the risk we run into by
choosing the option).
Evaluating the feasibility of each option can be done by considering the following:
(a) The skills required to implement it – technical and human skills;
(b) The effect it would have on the capacity of the operation – operational
requirements necessary to cope with an increased level of activity;
(c) The financial requirements of the option over time – fund or cash
requirements to carry out the option;
(d) The proportional change in the resources of the operation implied by the
option; and
(e) The „degree of fit‰ of the option with existing activities – the extent in which
any activity implied as a consequence of an option is compatible with the
way in which resources are currently organised.
Evaluating the acceptability of each option can be done by considering its

operational impact on the following:
(a) Technical Specifications of Services and Products

Does the option increase the likelihood that the service or product which the
operation produces will be closer to what customers want? For example,
better out-patient treatment in a hospital, enhanced product of a
manufacturer and better meals in the restaurant chain.
(b) Quality of Services and Products

Does the option reduce the chance of errors occurring in the creation of
services or products? For example, fewer errors in bank account statements,
less chance of paint scratches on automobiles and fewer errors in dental
records.

MAKING THE CHOICE
(c) Responsiveness of the Operation

Does the option shorten the time customers have to wait for their services or
products? For example, shorter queues at the supermarket, faster response
from consultants and shorter delivery lead time from manufacturers.
(d) Dependability of the Operation

Does the option increase the chance of things happening when they are
supposed to happen? For example, the train arriving on time and the
building is completed on time.
(e) Flexibility of the Operation

Does the option increase the flexibility of the operation, either in terms of the
range of things that can be done or the speed of changing what can be done?
For example, can the customer service department handle more varieties of
customer enquiries without referring to the specialist?
Spell out the competitive benefits of changes in operational performance by

comparing performance with competitors. Financial evaluation should take into
account the total life cycle costs of the option and the time value of expenditures
and benefits.
This includes the use of financial tools such as net present value (NPV), internal
rate of return (IRR) and payback period.
Evaluating the vulnerability of each option to risk can be done by:
(a) Assessing its Downside Risk

The simplest but the most powerful method of evaluating risk is to assess the
worst possible outcome from the option. Then we can ask the question,
„Would we be prepared to accept such a consequence?‰
(b) Considering Risk and Return Together

The most useful measure of the risk of an option is the dispersion or spread
of its possible outcomes and the most convenient measure of dispersion is
the standard deviation. But this alone is inadequate for evaluation. The most
satisfactory method of expressing the spread of consequences for evaluation
purpose is to view it as a proportion of the expected payoff. The most
common form of such a measure is the coefficient of variation (CoV) of a
distribution.

MAKING THE CHOICE
SELF-CHECK 8.3
Identify and explain the three criteria used to evaluate any decision
option.
8.3 MAKING A CHOICE

This last subtopic brings us to the decision itself, where we look at each of the
options and express a preference among them. Several techniques have been
discussed in Topic 6. The various standards against which each option may be
compared against are mentioned and the distinction between each optionÊs
feasibility and its acceptability is discussed.
The particular process of choice is presented as being a function of the extent of

agreement in the decision body, with the key issues being the extent of consensus
over objectives and over outcomes and consequences.
The distinction between the two phases of evaluation and choice is difficult to
define. Indeed the way in which evaluation is carried out sometimes means that
the choice is made at the same time. On the other hand, actually „making‰ a choice
can sometimes appear to be impossibly difficult. Remember that:
(a) The moment of choice is really just the start of the implementation phase, not
the end of solving the problem;
(b) Very few choices are absolutely right; and
(c) Once you have made a choice, you should keep in mind that there are other
options available that can also be made to work.
It is important to establish appropriate reference standards against which to judge

our evaluated options (see Figure 8.5). These standards can be historical, external
or absolute. The do-nothing standard is an important one in relating all options to
the status quo.

MAKING THE CHOICE
Figure 8.5: Setting reference standards
The mechanism of choice depends on two factors:
(a) The degree of confidence we have in our understanding of the consequences

of the options (how clear we are about what will happen); and
(b) The degree of consensus about what our objectives should be (what we
actually want to happen).
Take note that:
(a) Where there is consensus over consequences and objectives, make the choice
by computation.
(b) Where there is consensus over objectives but not over consequences, make
the choice by judgement.
(c) Where there is consensus over consequences but not over objectives, make
the choice by negotiation.
(d) Where there is no consensus about anything, find an inspired leader or

change the problem!

MAKING THE CHOICE
ACTIVITY 8.1
Downtime and maintenance costs for the TKJ EnterpriseÊs chilli packing
operation have risen steadily over the last year. However, production has
declined during the corresponding period. Sales figures have also fallen.
Absenteeism is increasing and operator morale is low. In addition to the
competitors already in the market, new firms have emerged in the
market.
Go through the various stages of the decision-making process and make

a decision.
• This topic put together the discussion of the previous topics into some
prescriptive and practical approach to making decisions in a business context.
• After getting the objective right and understanding the problem, the next steps
are generating and evaluating options or alternative decisions, and finally
making the choice.
• Creative thinking and critical thinking are two expressions that complement
one another. Creative thinking goes beyond limitations and usually brings
forth original and fresh ideas. Critical thinking is more evaluative in nature
and analyses a particular subject. Hence, creative thinking is generative in
purpose while critical thinking is more analytical in purpose.
• Various standards can be used to compare each of the options. The decision
criteria to analyse each option are feasibility, acceptability and vulnerability.
• The particular process of choice is presented as being a function of the extent

of agreement in the decision body, with the key issues being the extent of
consensus over objectives and over outcomes and consequences.

MAKING THE CHOICE
Acceptability Feasibility
Creative thinking Vulnerability
Critical thinking

Australian Curriculum. (2018). Primary matters – Critical and creative thinking,

Issue 16. https://www.australiancurriculum.edu.au/f-10-curriculum/
general-capabilities/critical-and-creative-thinking/#
Exodus Escape Room (2016). Critical thinking in the decision-making process.

https://exodusescaperoom.com/critical-thinking-in-the-decision-making-
process
Prentice-Hall.
management & management science (3rd ed.). Chicago: Irwin McGraw Hill.

Sage.

Topic  Approaches to
9 Decision
Making
LEARNING OUTCOMES

1. Differentiate the different types of decisions;
2. Identify three different conditions or environments in which
decisions are made;
3. Describe the steps in the decision-making process; and
4. Discuss three decision-making models, namely rational model,
bounded rationality model and garbage can model.
 INTRODUCTION
We make decisions every day in our lives. We decide what time to get up in the
morning, what clothes to wear, what to eat for breakfast and what to do for the
day. Occasionally, we have to make more challenging yet important decisions in
our lifetime. We have to decide what school to go to, what major of study to
pursue, whether to seek employment or to start a new business and how to
manage our finances. Each time we do something, a decision is involved.
Making decisions is important in organisations as well (Baker, 2018; Clemens

& Reilly; Teale et al., 2003; Vahid & Pegels, 1996; Williams, 2016). People in
organisations make decisions all the time. Top managers make decisions regarding
the organisation as a whole. They determine the strategic direction of the company,
the companyÊs mission and vision, what core business to be in, where to locate a
new manufacturing plant, and whether to diversify to other new businesses.
Functional managers make strategy and operational decisions in their department.
136  TOPIC 9 APPROACHES TO DECISION MAKING
Operations managers decide how best to produce the final goods, what production
schedules to follow and where to source for materials. Marketing managers decide
on the pricing strategy, how to promote and market the products, how to get them
to the customers and what new products or services to be offered. Finance
managers decide how to allocate financial resources among different functional
departments and how to finance operations and investments within the
organisation. Human resource managers make decisions regarding where to
source for employees, how job performance is to be evaluated, what reward
system to be used and what training programmes are needed.
Non-managerial employees also make decisions in relation to their own work –

how to carry out their assignments, what materials and equipment are needed and
the type of support to request from the organisation in order to complete their
tasks.
The results or consequences of a decision are often directly related to the

approaches used in the decision process. A systematic approach to decision-
making analysis helps ensure that the right criteria are identified and defined, and
that all appropriate options are considered. When we adopt a decision-making
approach that includes ways to define criteria, identify alternatives and make the
decision analysis as objective as possible, we are much more likely to exploit and
explore all the options and possibilities pertinent to the particular decision
problem.
The focus of this topic is on the different approaches to decision making within
organisations. Firstly, this topic examines the types of managerial decisions and
decision environments. Subsequently, the typical decision-making process and the
various models used are explained and how decisions are made in organisations.
9.1 TYPES OF DECISIONS

It is safe to say that decision making is one of the most important managerial
activities within the organisation. It is one of the most common and most crucial
roles of managers. It is also important to note that not only managers make
decisions, non-managerial employees make decisions as well. In fact, employees
at all levels are involved in decision making in some way. Making good decision
is a crucial skill at every level of the organisation.

TOPIC 9 APPROACHES TO DECISION MAKING  137
Decision making is about making choices from among several options or

alternatives. It is a process in which organisational members choose a specific
course of action to respond to a problem or an opportunity. Decision making in
response to a problem occurs when an individual, group or organisational goal
attainment or performance is in jeopardy. For example, an organisationÊs goal of
making profits or its financial performance is being threatened when sales
revenues have been declining consecutively for the past few years.
On the other hand, decision making in response to an opportunity occurs when

organisational members make choices or act in ways that result in gains or benefits.
Such decisions range from those made by top managers attempting to decide
whether to take over another company to individual employee deciding whether
to attend a training programme to enhance his skills and promotion opportunity.
Through the decision-making process, members of the organisation choose how to
respond to various types of problems and opportunities.
Getting the right approach to decision making is important for organisations and
since there are many types of decisions involved, we need to distinguish them
based on the following questions:
(a) How routine they are?
(b) How much risk is involved in making the decision?
(c) Who makes the decision?
9.1.1 How Routine are the Decisions?

Programmed versus Non-programmed Decisions
Think of a decision that is made repeatedly in a situation that occurs frequently and
according to a pre-established procedure. For example, a customer service employee
knows exactly what to do when a customer has a complaint about an order or the
operations manager knows when to place a purchase order to replenish the stock.
Decisions such as these are called programmed decisions because a standard
procedure has been worked out to guide the decision. Decisions are programmed to
the extent that they are repetitive and routine, they follow standard operating
procedures and they are typically made by lower-level personnel.
Programmed decisions are made in response to recurring problems or

opportunities. Usually, well-defined procedures are put in place for making
these decisions.

On the other hand, non-programmed decisions are non-routine and unstructured.

The decision is made during a novel situation in which there is no predetermined
course of action. There is no specified procedure for handling the problem because
the decision maker faces a unique situation or a complicated problem which has
never happened before. Non-programmed decisions are specifically tailored to a
particular situation. They probably take more time to make and may involve more
people. Non-programmed decision making involves searching for more
information which is needed to make the „best‰ choice. Usually, senior managers
will spend a large amount of their decision-making time on non-routine problems.
For example, the top manager needs to decide where to locate a new plant in
response to the companyÊs growth strategy. Although past experience may help,
the immediate decision is made based on the unique characteristics of the present
situation.
Non-programmed decisions are made in response to new problems or

opportunities. Clear-cut decision criteria often do not exist.
SELF-CHECK 9.1
Give some examples of programmed and non-programmed decisions.
Programmed decisions can be distinguished from non-programmed decisions

based on the following aspects:
(a) The nature of the task;
(b) The degree of reliance on organisational policies;
(c) The time involved;
(d) Who typically makes the decision; and
(e) The number of people involved.
Table 9.1 describes the differences between programmed and non-programmed

decisions. Examples of each type of decisions in different organisational settings
are also given in the table.

Table 9.1: Programmed versus Non-programmed Decisions
Type of Decision Programmed Decision Non-programmed Decision

Nature of task Simple and routine Complex and novel
Reliance on Considerable guidance from No guidance from past
organisational past decisions, pre-established decisions, pre-established
policies procedures or policies procedures or policies
Time involved Shorter time span Longer time span
Typical decision Lower-level employees Upper-level employees or
maker managers
Number of people Decisions usually made alone Decisions usually made in
involved groups
Examples Business firm: Periodic Business firm: New business
reordering of inventory venture
Bank: Approval of loan Bank: Introduction of new
applications banking products and services
University: Graduating University: Construction of
students research facilities
Hospital: Admission of Hospital: Purchase of
patients experimental medical
equipment
Government: Merit systems Government: Introduction of
for the promotion of civil new policies
servants
9.1.2 How Risky are the Decisions?

Certain versus Uncertain Decisions
Just think of how easy it would be to make decisions if we knew exactly what
would happen in the future. Of course, we will never know for sure what is going
to happen in the future; however, we can be more certain at some times under
some situations than others. The decision is certain when we have sufficient
information about the factors in which the decision is made. On the other hand,
the decision is uncertain when we do not have sufficient information in making
the decision and we have difficulty predicting the outcome of the decision.

The degree of certainty and uncertainty is expressed in terms of risk. Uncertainty

increases the risk of failure, that is, the chance of making the wrong decision is
higher. Hence, uncertain decisions are risky decisions. In fact, all decisions involve
a certain degree of risk, ranging from complete certainty (no risk) to complete
uncertainty (high risk). What makes a decision risky or otherwise is the probability
of obtaining the desired outcome. Decision makers attempt to calculate the
probabilities, or odds, of certain events occurring given that other events have
occurred. They make decisions based on objective probabilities which are
calculated from past records and verifiable data. Knowing such odds help people
make better decisions. For example, a restaurant manager decides how many
chickens to cook or how many employees to schedule on a daily basis. Such
decisions are made based on objective probabilities computed from previous sales
records over a period of time. This makes it possible to enhance the quality of
routine decisions, thus improving customer service and reducing waste as a result.
In addition to making decisions based on objective probabilities, very often people

also make decisions based on subjective probabilities – personal beliefs or gut
feelings about what will happen. For example, a gambler buys a lottery number
just because he dreamed about it the night before. Generally, decisions made based
on subjective probabilities (hunches) are riskier than those made based on
objective probabilities.
Uncertain decisions are risky decisions – the probability of obtaining the

desirable outcome is not known or not very high.
To make the best possible decisions in business, people try to manage the risks
they face in making a decision. They try to minimise the riskiness of their decision
by obtaining enough information relevant to the decision and incorporating the
information into the decision-making process (Williams, 2016). Certainty about the
factors in which decisions are made is highly desirable in decision making at all
levels – individual, group and organisational.
SELF-CHECK 9.2
Give some examples of certain and uncertain decisions.

9.1.3 Who Makes the Decision?

Top-down versus Empowered Decisions
Very often, decision making is a top-down practice where the responsibility of
making decision lies in the hands of managers rather than lower-level employees.
Subordinates collect information and pass it on to their superiors, who then use it
to make decisions. These are top-down decisions. This approach of top-down
decision-making leaves little or no opportunities for lower-level employees to
make decisions. This has been the way most organisations operate even up to
today.
However, in the quest for creating a competitive advantage in this era of

globalisation, many organisations have become more customer-driven. They focus
on customer relationships and emphasise on speed – fast and more responsive to
the changing demands of customers. Customer-focused organisations require a
new approach to decision making, that is, empowered decision making. The idea
of empowered decision making is to allow lower-level employees to make job-
related decisions. They are empowered (given the authority) to decide what they
need to do to perform their job successfully. These are empowered decisions. The
rationale for this decision making approach is that front-line employees who
perform the jobs know what is best, therefore having someone else make the
decision may not be appropriate.
Note that managers who empower their subordinates to make their own decisions
are not giving up their responsibility and accountability. Rather, they are
delegating some power they have to their lower-level employees who are capable
of making decisions. Managers usually provide guidance to their employees about
how to make decisions; they do not set up specific rules to be followed in each
problem case. This gives employees discretion about what to do. For example,
customer service employees may be empowered to spend up to $1,000 of the
companyÊs money per case to resolve any customer problem they encounter.
Another example would be for a car rental employee to decide whether to offer
discounts or upgrades without additional charges as an appeasement to customers
who have reasonable complaints.
Empowered decision making has several advantages:
(a) When employees are empowered to make decisions, they are more
committed to the courses of action based on their own decisions;
(b) Employees are also more likely to accept the consequences of their own
decisions;

(c) Empowerment not only motivates employees but also serves as a source of
job satisfaction;
(d) Empowering lower-level employees frees up managersÊ time; and
(e) Empowerment enables managers to focus on making higher-level decisions.
ACTIVITY 9.1
What specific types of organisations should take the approach to

empower decision making? Or, should all types of organisations use
empowered decision making?
9.2 DECISION ENVIRONMENT

When making routine or non-routine decisions, managers do so under three
different conditions or environments, namely certain, risky and uncertain.
(a) Certain Environment

This environment exists when decision makers have sufficient information
regarding the expected outcome of each alternative in advance of
implementation. For example, when a person invests money in fixed
deposits, he is absolutely certain about the interests that will be earned for a
fixed period of time. Certainty is an ideal condition for managerial decision
making. The only challenge is to generate alternatives and locate the one that
offers the best solution. Unfortunately, organisations operate in risky and
uncertain environments and certainty is the exception rather than the rule in
decision environments.
(b) Risky Environment

This environment exists when decision makers do not have complete
certainty regarding the outcomes of respective options. They are aware of the
outcomes but not the probabilities associated with the occurrences. A
probability is the degree of likelihood of an eventÊs occurrence, which can be
assigned through the objective statistical procedure (objective probability) or
through personal intuition and hunch (subjective probability). For example,
marketing managers can make statistical estimates of future demand for their
new products or they can make similar estimates based on past experience.
Risk is a common decision environment for todayÊs business organisations.

When making decisions in a risky environment, it is important to conduct a

risk analysis to identify the presence of different types of risks and their
magnitudes. Risks can be classified as follows:
(i) Strategic risks – threats to the overall success of the business. For
example, risks involved in relation to acquisitions and mergers;
(ii) Operational risks – threats inherent to the technologies used to reach

business success. For example, risks involved in introducing online
banking systems; and
(iii) Reputation risks – threats to a brand or to the firmÊs reputation. For

example, risks in relation to public campaigns and ethics.
Risk analysis enables firms to determine which aspects of their environment

and operations are risky. Managers are able to identify who and what might
be affected by the decision. In addition, the analysis prioritises risks in terms
of importance. Areas of high risks can be identified and monitored. Action
plans can be developed to minimise or to moderate the risk.
(c) Uncertain Environment

This environment exists when decision makers have so little information on
hand that they are unable to predict the expected outcomes of the decision.
They cannot even assign probabilities to various courses of action and their
associated outcomes. This is the most difficult of the three types of decision
environments. Making a decision in an uncertain environment usually
requires unique and novel solutions. It relies heavily on individual and
group creativity to come up with innovative alternatives.
Some people work in an environment that is full of uncertainties, for

example, scientists and those involved in research and development.
Furthermore, a dynamic, turbulent business environment gives rise to
uncertainties. Organisations facing rapidly changing environmental factors
also operate in uncertain decision environments.

9.3 DECISION-MAKING PROCESS

Decision making is defined as the process of developing a commitment to a
specific course of action among several options. Three elements are noteworthy
about this definition. Firstly, decision making is about making a choice among
several alternatives. The CEO of a company, for instance, has to make a choice as
to the type of business to diversify into. Secondly, decision making is a process, in
other words, we want to know how the decision is being made. How does the CEO
decide whether to diversify and how does he choose what type of new business to
venture into? Lastly, decision making involves commitment of resources such as
capital, labour and time. If the CEO decides to expand through diversification, a
large amount of financial resources would be used up for the diversification
decision.
Decision making is about choosing between alternatives. The three elements

involved in decision making are choices, process (how the choice is made) and
commitment of resources.
Being a process, decision making involves a series of steps (see Figure 9.1).

Figure 9.1: Steps in the decision-making process
Now let us look at each step of the decision-making process mentioned in

Figure 9.1.
(a) Recognising the Presence of a Problem or an Opportunity

Identify the problem or opportunity and determine whether a decision needs
to be made.
(b) Determining the Objective of the Decision

Find out what is to be accomplished by the decision.

(c) Gathering Information Relevant to the Problem or Opportunity

Collect data and conduct a thorough diagnosis of the situation.
(d) Generating and Evaluating Alternative Courses of Action

Conduct a what-if analysis to determine the various factors that could
influence the outcome. Develop a wide range of options and possible
solutions. Each generated alternative should be evaluated based on its pros
and cons through a cost and benefit analysis.
(e) Selecting the best Alternative

Decide on the alternative that best meets the objectives of the decision
identified in Step (b).
(f) Implementing the Decision

Execute the course of action decided upon in Step (e).
(g) Gathering Feedback

The situation must be monitored to ensure that the objective of the decision
is achieved. Careful monitoring and periodic feedback are essential parts of
the follow-up process.
(h) Following Up
By monitoring the outcome, the decision maker may find that the chosen
alternative did not work. Hence, a new solution may be needed. This step
involves identifying appropriate corrective actions.
9.4 DECISION-MAKING APPROACHES IN

ORGANISATIONS
There are a number of ways to characterise approaches in making decisions but
for our purposes, we will only consider three main categories. In most cases, we
all tend to make decisions by using all of the approaches at one time or another.
What is important is that we must think about which approach would best
characterise how we make most of our decisions or would prefer to make our
decisions.

To understand how decisions are being made in organisations, this subtopic

describes the three categories of decision-making models:
(a) The rational or analytical approach;
(b) The bounded rationality model or intuitive decision-making approach; and
(c) The random, chance or luck approach or the garbage can model.
9.4.1 Rational or Analytical Approach

This classical decision theory views decision makers as acting in a world of perfect
information with complete certainty. It describes an ideal way to make decisions.
The decision maker faces a clearly defined problem, is aware of all possible action
alternatives and their outcomes, and selects the best possible alternative or the
optimum solution to the problem. This is a rational approach to decision making.
Rationality refers to a logical, step-by-step approach with a complete analysis of
all possible alternative courses of action and their consequences. Rational model is
a normative (prescriptive) model; it describes how decisions „should‰ or „ought‰
to be made.
The rational model has the following assumptions:
(a) The decision maker has access to all the information he needs to make a
decision;
(b) The decision maker is able to identify all the relevant options;
(c) The decision maker chooses the best possible solution to a problem or
response to an opportunity;
(d) The decision maker has a consistent system of preferences, which is used to
select the best option;
(e) The decision maker is able to calculate the likelihood of success for each
possible alternative; and
(f) The outcome of the decision will be completely rational.

According to this classical decision-making model, a decision maker will respond

to a problem or opportunity in the following manner:
Step 1: List down all possible alternatives from which a choice will be made.
Step 2: List out the consequences of each alternative and associated probabilities.
Step 3: Rank all the alternatives from most-preferred to least-preferred

alternative.
Step 4: Select the alternative that will result in the most preferred set of
consequences.
Unfortunately, this optimising style of decision making is unrealistic. The

assumption that people have all the information needed to make optimal decision
bears little resemblance to real-world situations. There is a limit to human
knowledge. Even if people did have all the necessary information, most likely they
would not be able to use it all. This is because the information-processing
capability of human is limited. Often people cannot take into account a large
amount of information available to them. Furthermore, there is the time constraint
and peopleÊs preferences and needs will change over time.
In summary, the problems inherent in the rational model are as follows:
(a) It is impossible for decision makers to make the best possible decision; and
(b) The time, cost and effort needed to make the best decision might not be
worthwhile.
The rational model captures the way a decision should be made but it does not
reflect the accurate description of how most decisions are made in organisations.
SELF-CHECK 9.3
Discuss the strengths and weaknesses of the rational model.

9.4.2 Bounded Rationality Approach

Due to the limited cognitive capability of human beings, it is impossible to
assimilate and understand all the information in order to optimise the decision.
The human mind cannot conceptualise and solve complex problems with complete
rationality. As such, we operate within the confines of bounded rationality, a
theory suggesting that there are limits to how rational people can actually be.
While we are reasoned beings and logical, we have our limits. When decision
makers are constrained by bounded rationality, they satisfice, meaning they seek
solutions to problems that are satisfactory and sufficient.
Bounded rationality – the ability to reason that is constrained by the limited

cognitive capability of the human mind.
The bounded rationality model has four assumptions:
(a) The decision makers recognise that their conception of the world is simple;
(b) They are comfortable making decisions without considering all the
alternatives;
(c) Decision makers select the alternative that is good enough. This is because
the costs of optimising are too great; and
(d) Decision makers make decisions according rules of thumb or heuristics.

Heuristics are shortcuts in decision making that save mental efforts. They are
rules of thumb or simplified strategies that help decision makers cope with
information overload in search of solutions to problems.
How does bounded rationality work? After we have identified the problem, we
develop a list of alternatives as possible solutions. But the list is far from
exhaustive. We usually identify a limited list of the most conspicuous choices that
are obvious and easy to find. Next, we begin to review the list of alternatives but
our review will not be comprehensive. Instead, we focus on the alternatives that
are not so much different from the previous choices. We review alternatives until
we have identified one that is satisfactory and good enough, that meets an
acceptable level of performance in terms of achieving the objectives of the decision.
That ends our search. Therefore, the selected alternative represents a satisficing
choice – the acceptable choice – rather than the optimal one.

Satisficing is choosing an acceptable alternative rather than the optimal one.

The alternative is „good enough‰ because the costs in time and effort are too
great to optimise.
Bounded rationality model is a descriptive model, which attempts to explain how

people actually make decisions in organisations. Does the bounded rationality
model more accurately portray the decision-making process in business
organisations? The answer is yes. Very often managers make decisions under risky
and uncertain environments. They make decisions under time pressure without
full access to relevant information, and the probability of success is difficult to
calculate.
SELF-CHECK 9.4
Give an example of situation where satisficing is most likely to be

engaged when making choices.
9.4.3 Garbage Can Model

The bounded rationality model may still not be able to fully explain the dynamics
of decision making in business organisations. The decision-making contexts in
todayÊs businesses are so complex that it becomes difficult to specify the steps used
in the decision process. Rather, the decision-making process in organisations
appears to happen in an unpredictable manner. Problems, solutions, decision
makers and decision makersÊ choice opportunities are floating around randomly
and they co-exist in a turbulent state of flux. These are a collection of streams of
events happening at the same time and when they are connected by chance, a
decision is made. This being the case, decisions would not be made in an orderly,
step-by-step manner.

In the garbage can model, decisions are random and unsystematic (Sherman,
2019). Problems, solutions, participants and choice opportunities (the opportunity
to make a decision) are all independent streams of events that are flowing into the
organisational decision environment. When the four factors become connected by
chance, they interact and a decision is made. These four independent factors
interact in a random manner and hence, they are all mixed together in the
organisationÊs decision environment (garbage can). Decisions are only made when
the appropriate elements of each factor connect with each other. Since things occur
randomly, luck or timing may influence whether a decision is taken. The quality
of the decision depends on the timing. The right participant must find the right
solution to the right problem at the right time.
Research provides some evidence that the garbage can model is a fairly accurate
but complex picture of how decisions are being made in business organisations.
In todayÊs highly competitive environment, managers need to make critical
decisions fast with incomplete information. They must also involve employees in
the decision-making process. Under conditions of high uncertainty, the decision
process may be chaotic. Furthermore, some decisions appear to happen out of
sheer luck. Figure 9.2 illustrates the garbage can model process.

Figure 9.2: Garbage can model of decision making

Source: http://www.unc.edu/~nielsen/soci410/nm11/nm11.htm
There is a final aspect of the garbage can model – many problems go unsolved.
Hence, all organisations have chronic, persistent deficiencies that never seem to be
resolved. Under the garbage can model, the key challenge for managers is to make
the appropriate linkages among problems and solutions.

• Decision making is important at all levels of the organisation. At times,

managers may be able to optimise, that is, to select the best option.
• But more often they are forced to satisfice, that is, to select the option that is
good enough.
• Organisational decisions are often made in an uncertain environment, where

situations are ambiguous and complete information is lacking.
• In understanding the decision-making process, managers should address the

following questions:
– The structure of decision – what types of decisions are made?
– The decision body – who makes decisions?
– The decision context – where or when are decisions made?
– The purpose of decision – why are decisions made?
– The methodology of decision making – how are decisions made?
• Three decision-making models used are rational model, bounded rationality

model and garbage can model.
Bounded rationality approach Rational or analytical approach

Certain decision Risky environment
Certain environment Satisfice
Empowered decision Top-down decision
Garbage can model Uncertain decision
Non-programmed decision Uncertain environment
Programmed decision

Sherman, F. (2019). Garbage can theory. Retrieved from https://bizfluent.com/

facts-7741400-garbage-can-model-approach.html
Prentice-Hall.
Hill.

Sage.

Topic  Factors
10 Influencing
Organisational
Decision
Making
LEARNING OUTCOMES

1. Determine individual, group and organisational factors that
influence decision making;
2. Evaluate the advantages and disadvantages of both individual and
group decision making; and
3. Discuss the current issues in relation to decision making in todayÊs
workplace.
 INTRODUCTION
Each decision that we make in our business organisations might address a specific
problem or need in a particular department. However, all decisions, taken
together, can affect the performance and eventually the major goal of the
organisation. And if we as managers make decisions in a vacuum or on our own,
it can lead to interdepartmental complications. Knowing the major factors
influencing the decision-making process and taking these into considerations, we
should be able to make better plans and react appropriately to individual
situations.
156  TOPIC 10 FACTORS INFLUENCING ORGANISATIONAL DECISION MAKING
Given the critical impact of decision making in organisations, it is not surprising

that it is being influenced by many factors. In fact, how people make decisions are
affected by individual differences, group influences, organisational constraints
and contextual characteristics. The first half of this topic describes the various
factors influencing organisational decision making.
The second half of the topic discusses the role of technology and ethical issues in
decision making. The problems facing decision makers in todayÊs environments
seem to be much more difficult and complex. Very often, managers turn to
technological tools to increase their effectiveness in decision making. In addition,
the ethical implications of the decision must be evaluated carefully. In fact, ethical
considerations should be an important criterion in organisational decision making.
Businesses today are under scrutiny to behave in an ethical and socially
responsible way. A large number of scandals (such as the well-known case of
Enron) have led to a public outcry demanding that the business community place
more emphasis on the morality of leaders and ethics in decision making.
10.1 FACTORS INFLUENCING DECISION

MAKING
Decision making in organisations is influenced by a wide variety of factors (Ashe-
Edmunds, 2019; Teale et al., 2003; Williams, 2016). Four major groups of influential
factors are as follows:
(a) Individual Factors

Individual differences can have a profound influence on how people make
decisions. Differences in terms of perception, personality, decision style,
ethics, values, gender, experience and risk acceptance will affect the way
individuals view the problem, how long it takes to make a decision and what
decision to take.
Individuals who are more experienced in making decisions are able to make
decisions faster and better. Highly experienced experts are able to make
better decisions because they draw on a wealth of accumulated experiences
collected over the years. They are able to assess the situations they face and
compare them to experiences they have had before. They know what to look
for and what pitfalls to avoid. On the other hand, novices tend to be very
deliberate in their decision-making process. They would consider one option
at a time. In addition, they may not be able to make good decisions under
pressure.

TOPIC 10 FACTORS INFLUENCING ORGANISATIONAL DECISION MAKING  157
(b) Group Factors

Many decisions in organisations are made by groups. Who is in the group
and how group members interact will have an impact on how decisions are
made. The two major categories of group influential factors are:
(i) Group Composition

This category includes variables in relation to the characteristics of the
members in the decision-making group. Group composition includes
such variables as the size of the group; knowledge, skills and abilities
of individual members within the group; membersÊ personality
characteristics; and group diversity in terms of age, race, gender,
religion, educational background, experience and cultural differences.
(ii) Group Processes

This category includes variables in relation to the processes within the
decision-making groups – how group members interact. Group
processes include communication pattern, conflict level, group efficacy,
group cohesion and group norms.
(c) Organisational Factors

These are forces stemming from within the organisation which shape the
decision-making process. Managers make decisions within the constraints
imposed by the organisation. These constraints range from formal
regulations to past precedents. The details are as follows:
(i) Formal Regulations

Every organisation has developed company policies, rules and
regulations which must be complied with when making decisions. For
example, a restaurant manager needs to comply with his companyÊs
rules and regulations in all decisions he makes – from how to prepare
a meal to how to handle a customerÊs complaint.
(ii) Performance Evaluation Criteria

Managers are strongly influenced in their decision making according
to the criteria in which their performance is evaluated. If the
performance of a coffee chain manager is reflected by the number of
outlets he has, we should not be surprised that he has quantity in mind
when deciding on the expansion strategy.

(iii) Reward System

The organisationÊs reward system will indicate to employees what
behaviours are desirable and this will influence what choices are
preferable in terms of personal payoff. If the organisation rewards
creativity and innovation, managers are more likely to make innovative
decisions.
(iv) Imposed Time Constraints

Many decisions in organisations come with explicit deadlines. This is
how things get done within the necessary time frame. For instance,
with a new product just introduced into the market, the marketing
manager needs to launch an appropriate promotion campaign to
achieve its sales target. He has to decide how the new product is going
to be promoted and the promotion campaign must be executed during
a specific time frame. The rapid pace with which businesses operate
nowadays results in time pressure, whereby decisions have to be made
almost immediately in many cases.
(v) Historical Precedents

Decisions made in the past would have an influence on the decisions
made today. For instance, the size of the budget allocated to a
department in any given year is largely determined by the budget of
the previous year. Decisions made today are, therefore, primarily a
result of choices and commitments made over the past years.
(vi) Organisational Culture

The culture and climate of an organisation have a profound impact on
how decisions are being made by the organisational members.
Organisational founding philosophy, mission, vision, values, beliefs,
principles, rituals and ceremonies largely determine „the way we do
things around here.‰
(vii) Organisational Politics

The pervasiveness of organisational politics can shape the nature of
decision making. Managers who play politics will manoeuvre the
decision situation towards the pursuit of their own personal goals.
They will make choices that are directed towards the goal of furthering
their own self-interests without regard to the well-being of other
members. In a high political context, decision making can become a
matter of game playing.

(d) The Decision Context

The nature of the decision, the degree of uncertainty and urgency of the
decision are some contextual factors that influence decision making (Baker,
2018; Clemen & Reilly, 2014).
(i) Nature of the Decision

The types of decisions – programmed or non-programmed, certain or
uncertain, top-down or empowered – discussed in the previous topic
will determine how fast and how many people are involved in making
the decision. Furthermore, the importance of the decision and the costs
involved would also determine how careful the decision is made. A
more detailed and complete evaluation would be made if the
consequences of making the wrong decision are detrimental.
(ii) Degree of Uncertainty

The degree of uncertainty surrounding the outcome of a decision can
shape how the decision is made. In most cases, the risk is reflected by
the likelihood that a particular decision option will succeed in solving
the problem. However, uncertainty is a characteristic of the problem
itself. There is uncertainty when the problem itself is not clear, when
information needed to solve the problem is lacking and when the
availability of alternative options cannot be determined. It usually
takes more time and mental effort when uncertainties and risks are
involved in decision making.
(iii) Urgency
Making decisions during emergencies require fast thinking as there is
a need to make good decisions quickly. Unexpected and rapid changes
in the business environment as well as in crises often result in severe
pressures in making decisions almost immediately. Among firefighters,
emergency room doctors and fighter pilots, it is clear that time is of
essence and decisions need to be made in split seconds. The practice of
collecting information, carefully analysing it and thoroughly reviewing
the alternative options is not feasible in critical and urgent situations.
SELF-CHECK 10.1
Discuss four major factors that affect the organisational decision-making

process.

10.2 INDIVIDUAL VERSUS GROUP DECISION

MAKING
Should a manager make the decision alone, should he invite employee
participation in making the decision or should he resort to group decision-making
approach? Managers refer to groups to make decisions for various reasons. One is
the ability of the group to generate more ideas through synergy, a positive force
that occurs when group members stimulate new solutions to problems by mutual
influence and encouragement within the group. Another reason is that groups
bring more knowledge and experience to the problem-solving situation due to
their diverse backgrounds. Groups also enhance the evaluation of alternative
solutions and the commitment to the decision (see Figure 10.1).
Figure 10.1: Decision making in a group

Source: http://www.resourcesunlimited.com/Decision_Making.asp
10.2.1 Advantages and Disadvantages of Group

Decision Making
Although groups generally produce better decisions, there are advantages and
disadvantages associated with group decision making. The pros and cons of group
decision making are given in Table 10.1.

Table 10.1: Advantages and Disadvantages of Group Decision Making
Advantages Disadvantages
• Groups can accumulate more • Groups take more time to reach a
knowledge and information through decision than individuals.
the pooling of group membersÊ
resources.
• Groups are able to generate more and • Group social interaction may lead to
better decisions. premature compromise and failure to
consider all alternative solutions fully.
• Group involvement in the various • There is a pressure within the group to

stages of the decision process leads to conform and fit in.
a greater understanding of both the
problem and the decision.
• Participation in group decision • Groups are often dominated by one or
making leads to increased acceptance two forceful members, which may
and commitment to the decision and reduce the acceptance, satisfaction, and
satisfaction. quality of the decision.
• Groups often exhibit superior • There is always the potential for conflict
judgement when evaluating in decision-making groups. The
alternative solutions, especially for diversity of group members in skills,
complex problems. knowledge, expertise and experiences
causes them to view problems and
solutions in different ways.
• Group decision making provides • Groups may develop groupthink, a

personal growth for the group dysfunctional process whereby there is
members. Members have the a deterioration of mental efficiency
opportunity to learn decision-making and moral judgement resulting from
skills. pressures within the group. Groupthink
usually leads to poor decisions.
ACTIVITY 10.1
Think of a group discussion that you were involved lately. Discuss the
advantages and disadvantages of the groupÊs decision-making process.
Post your answer on the myINSPIRE online forum.

Given these advantages and disadvantages, should an individual or a group make

the decision? In judging the overall value of group decision making as opposed to
individual decision making, consider such factors as the time needed to reach the
decision, the quality of the decision, the costs of making it, the nature of the
problem, the satisfaction and commitment of employees affected by the decision,
and the opportunities for personal growth.
(a) Time
Some decisions must be made immediately such as during an emergency. In
other situations, several weeks may be available for decision making. When
time is an important consideration, the manager may make the decision
alone. Groups typically take more time to reach a decision than individuals.
(b) Quality
Under proper conditions, group decision making should increase the
number of ideas generated and improve the evaluation of alternatives. As a
result, groups are able to make better decisions.
(c) Costs
When it takes more people and more time to make a decision, group decision
making will inevitably cost more than individual decision making.
(d) Nature of the Problem

Complex and difficult problems tend to be solved more effectively by groups
than by individuals. Deciding what new product to be developed, for
example, may require expertise from the department of research and
development, production, engineering and design, and marketing. Hence, a
group should be better at making this type of decision.
(e) Satisfaction and Commitment

Employees who share in an important activity such as decision making
usually feel more „ownership‰ of the decision than when they are excluded
from it. They will be more satisfied with and committed to the decision
because it is their decision, not someone elseÊs.
(f) Personal Growth

In many cases, advancement in career depends on the ability to learn new
skills. Participation in group decision making provides an opportunity for
group members to acquire social skills, communication skills, team-building
skills and, most important of all, decision-making skills. If learning such
skills is an objective, group decision making is preferable to individual
decision making.

ACTIVITY 10.2
1. Can you think of any other situations where group decision

making is more effective than individual decision making?
2. Do you prefer to make decisions alone or in group? If you prefer

to make decisions alone, why? Similarly, if you prefer to make
decision in groups, why? Share your answer in the myINSPIRE
online forum.
10.2.2 How Groups Make Decisions

Groups may make decisions through any of the five methods presented in
Table 10.2.
Table 10.2: Methods Used by Groups to Make Decisions
Method Explanation
Decision by unanimity Every group member agrees to the same course of
action.
Decision by consensus Not every group member wants to pursue the same
course of action but everyone agrees to try it.
Decision by majority rule A vote is taken to choose among alternative courses of
action and the alternative chosen by the majority is
selected.
Decision by minority rule A small subgroup dominates and determines the
course of action.
Decision by authority rule One person dominates and determines the course of
action.
ACTIVITY 10.3
Can you describe any other methods that groups use to make decisions?
Post your answer on the myINSPIRE online forum.

10.3 TECHNOLOGY AND DECISION MAKING

Given the widespread use of computers at the workplace, it is not surprising that
todayÊs business organisations are becoming more sophisticated in applying
computer technologies to facilitate decision making. There is advanced
development in the field of artificial intelligence, the study of how computers can
be programmed to think like human brains. Managers can have access to decision-
making support from expert systems that reason like a human being. Uses of such
computer-aided decision-making systems or tools can be found in different types
of organisations, for example:
(a) Banks
To help screen loan applications;
(b) Hospitals
To check laboratory results and drug interactions;
(c) Factories
To operate the production schedules for machines and people; and
(d) Financial Institutions

To help calculate the risks of an investment.
Computer technologies also facilitate group decision making. The developments

of the Internet and intranet enable people working in geographically dispersed
locations to define problems and make decisions together, and simultaneously.
Face-to-face meetings are no longer necessary. In addition, the availability of
group decision software such as electronic brainstorming is especially useful for
generating a large number of ideas and for improving the time efficiency of
decision making.
Various computer-based approaches have been used to improve the quality of

both individual and group decisions. Table 10.3 presents a few of such
technological aids in decision making.

Table 10.3: Computer-based Techniques for Promoting Effective Decisions
Technique Explanation
Expert systems A programmed decision tool developed from artificial
intelligence. The system uses decision rules to make logical
reasoning. Its effectiveness is highly dependent on its design.
Decision support These are computer and communication systems that process
systems incoming data and synthesise relevant information for managers
to make complex decisions. An example is the Fire Management
Information System that helps fire officials in their decision-
making tasks during forest fires.
Group decision GDSS uses computer-based and communication facilities to
support systems support group decision-making processes in either face-to-face
(GDSS) meetings or dispersed meetings. Users of these systems pose their
ideas and discuss their ideas with others in chat rooms. A record
of the discussion is kept for future reference. An example is a
forum implemented by Shell Oil. Shell developed a
communication system based on the familiar model of web
discussion groups. Within the specific discussion community,
engineers can pose questions or topics of discussion to experts in
other segments of the business. More importantly, Shell indexes
and archives these discussions to create a living, growing
knowledge base to support future decision-making tasks.
Electronic meeting These systems allow individuals from different locations to
systems participate in group conferences by means of telephone or
satellite transmissions. Messages are sent either via characters on
a computer monitor or images viewed during the teleconference.
Computer-aided The dissemination and sharing of information such as text
communication messages and data relevant to the decision over computer
networks. The underlying idea of this communication system is
that on-screen messages provide an effective means of sending
some form of information that can assist groups to make better
decisions.
ACTIVITY 10.4
Do you know any specific computer software tool that can be used to
help managers make decision? If yes, describe how it works. Share your
answer with your coursemates in the myINSPIRE online forum.

10.4 ETHICS IN DECISION MAKING

It is no doubt that ethics play an important role in the decision-making process. In
many situations, the decision maker faces an ethical dilemma. It occurs when a
person must decide whether or not to do something; although it may be beneficial
to the organisation, however, it may be considered morally wrong or perhaps
illegal. Furthermore, there have been numerous highly publicised scandals
involving unethical business practices. The most widely reported scandal is the
Enron case, where several Enron executives were indicted on various charges
including conspiracy, fraud and money laundering. A large number of scandals
has led to a public outcry demanding that business leaders place more emphasis
on ethical behaviour and decision making.
Hence, decisions made by individuals or groups should be evaluated to see

whether they are ethical. How can managers rationally think through ethical
decisions so that they make the „right‰ choices? Table 10.4 presents three criteria
to frame decisions ethically.
Table 10.4: Three Ethical Decision Criteria
Criterion Explanation
Utilitarian The goal of this criterion is to provide the greatest good for the
greatest number. This view tends to dominate decision making in
businesses. By maximising profits, for example, a manager can
argue that he is securing the greatest good for the greatest number
even as he lays off 10 per cent of his employees.
Moral rights This criterion calls on individuals to make decisions consistent
with the fundamental liberties and privileges of human beings.
An emphasis on rights in decision making means respecting and
protecting the basic rights of individuals such as the rights to
privacy, free speech and due process.
Justice This criterion requires decision makers to impose and enforce
rules impartially so that benefits and harms can be allocated in a
fair, equitable manner. Trade unions typically favour this view.
For instance, it justifies using seniority as the primary
determinant in making layoff decisions.

In summary, all decisions, especially those made by the managers, must be

assessed for their ethical implications. Organisations should reinforce ethical
decision making among employees by encouraging and rewarding them. A proper
code of conduct should be developed to guide employee behaviour and decision
making. Employees can also be trained to behave and to make decisions ethically.
Finally, groups may use the devilÊs advocate (a person who expresses a
contentious opinion in order to provoke debate or test the strength of the opposing
arguments) and/or dialectical methods (a form of dialogue between individuals,
based on asking and answering questions to stimulate critical thinking and to draw
out ideas and underlying presuppositions) to reduce the potential for groupthink
and unethical decisions that may result.
ACTIVITY 10.5
Provide some examples of outcomes when managers are not being

ethical in decision making. What are the impacts of unethical decisions
on the part of the employees and on the organisation? Share your
answers in the myINSPIRE online forum.
• There are four major groups that influence decision making, namely
individual, group, organisational and the decision context.
• Individual differences in terms of perception, personality, ethics, gender and

risk acceptance will affect the way people view the problem, how long it takes
to make a decision and what decision to make.
• There are two major categories of group factors influencing a group, namely
group composition and group process. Members in the group and how group
members interact will influence how decisions are being made.
• Organisational factors influence managers in making decisions within the

constraints imposed by the organisation. These constraints range from formal
regulations to past precedents.

• The nature of the decision, the degree of uncertainty and the urgency of the
decision are some contextual factors that will influence decision making.
• The advantages of group decision making include having more information

from members, generating better decision, having a greater understanding of
both the problem and the decision as well as providing personal growth for
group members.
• The disadvantages of group decision making are such that it will take more
time to reach a decision, group social interaction may lead to premature
compromise, may involve pressure within the group to conform and fit in,
conflict may potentially exist and the group may develop groupthink, which
usually leads to a poor decision.
• Some decisions are best made by individuals while some by groups. The task
of the manager is to diagnose the decision situation and determine the
appropriate level of participation. To do this effectively, managers should
know the advantages and disadvantages of individual and group decision
making.
• All decisions, whether made by individuals or by groups, must be carefully

evaluated for their ethical implications. Ethical decision making among
employees should be promoted and rewarded.
Computer-aided communication Groupthink

Decision support systems Justice
Electronic meeting systems Moral rights
Expert systems Utilitarian
Group decision support systems (GDSS)


https://www.google.com/search?q=group+decision+making&client=firefox-b-
d&sxsrf=ALeKk02ad-VqEk6CwhPxBZjnMHxpCW5lJQ:1585056319811&
source=lnms&tbm=isch&sa=X&ved=2ahUKEwifqpD3mrPoAhUb6XMBHZ
aIBnIQ_AUoAXoECBMQAw&biw=1141&bih=720
Prentice-Hall.
Williams, S. W. (2016). Making better business decisions. SAGE Publications.

MODULE FEEDBACK
MAKLUM BALAS MODUL
If you have any comment or feedback, you are welcome to:
1. E-mail your comment or feedback to modulefeedback@oum.edu.my
OR
2. Fill in the Print Module online evaluation form available on myINSPIRE.
Thank you.
Centre for Instructional Design and Technology

(Pusat Reka Bentuk Pengajaran dan Teknologi )
Tel No.: 03-78012140
Fax No.: 03-78875911 / 03-78875966


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BDDN4103

Introductory Business Decision Making

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

Module Writers: Prof Dr Mohd Ghazali Mohayidin

Dr Lim Yet Mee

Moderator: Prof Dr Salleh Yahya

Enhancer: Prof Dr Mohd Ghazali Mohayidin

Developed by: Centre for Instructional Design and Technology

First Edition, January 2005

Copyright © Open University Malaysia (OUM)

Topic 1 Introduction to Decision Making 1

Topic 2 Models and Scientific Method 14

Copyright © Open University Malaysia (OUM)

Topic 3 Common Decision Models and Sensitivity Analysis 28

Topic 4 Elements of Decision Problems 51

Copyright © Open University Malaysia (OUM)

Topic 5 Structuring Decisions 65

Topic 6 Making a Choice 86

Topic 7 Decision Making in Practice: Getting the Problems and 100

Copyright © Open University Malaysia (OUM)

Topic 8 Decision Making in Practice: Generating Options and 119

Topic 9 Approaches to Decision Making 135

Topic 10 Factors Influencing Organisational Decision Making 155

Copyright © Open University Malaysia (OUM)

COURSE GUIDE DESCRIPTION

As an open and distance learner, you should be acquainted with learning

Copyright © Open University Malaysia (OUM)

Table 1: Estimation of Time Accumulation of Study Hours

COURSE LEARNING OUTCOMES

1. Discuss the importance of making good decisions in business;

2. Demonstrate the ability to differentiate the different types of business

3. Apply various types of decision-making tools and techniques; and

4. Perform the practical steps in making sound business decisions.

Copyright © Open University Malaysia (OUM)

Topic 7 revisits the decision-making process by focusing on the practical guide in

Topic 9 discusses the different approaches to decision making within

Topic 10 discusses the various factors that influence organisational decision

TEXT ARRANGEMENT GUIDE

Self-Check: This component of the module is inserted at strategic locations

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

Australian Curriculum (2018). Primary matters – Critical and creative thinking,

Ekings, J. D. (1986). A nine-step quality improvement programme to increase

Exodus Escape Room. (2016). Critical thinking in the decision-making process.

Haughey, D. (2015). Pareto analysis step-by-step. Retrieved from

Keeney, R. L. (2002). Common mistakes in making value trade-offs. Operations

Sherman, F. (2019). Garbage can theory. Retrieved from https://bizfluent.

Williams, S. W. (2016). Making better business decisions. SAGE Publications.

Copyright © Open University Malaysia (OUM)

TAN SRI DR ABDULLAH SANUSI (TSDAS) DIGITAL

Copyright © Open University Malaysia (OUM)

By the end of this topic, you should be able to:

Copyright © Open University Malaysia (OUM)

To understand decision-making management and to make better decisions, you

1.1 ECONOMIC PROBLEM

Basically, an economic problem arises because of scarcity; in other words,

(a) Goods (physical items such as food and clothing); or

(b) Services (non-physical items such as food preparation and recreation).

Copyright © Open University Malaysia (OUM)

See Figure 1.1 for example.

Figure 1.1: Example of goods and services

There are four reasons why wants are virtually unlimited: