UNIT

4 DECISION ANALYSIS

LESSONS COVERED

4.1. Steps in Decision Making

4.2. Methods of Listing
4.3. Types of Decision Modelling Environments
4.3.1. Decision Modelling Environments Under Uncertainty
4.3.2. Decision Modelling Environments Under Risk
4.3.3. Decision Modelling Environments Under Certainty
4.4. Decision Making Under Uncertainty
4.4.1. Sensitivity Analysis
4.5. Decision Making Under Certainty
4.5.1. Evaluation of Mutually Exclusive Alternatives
4.5.2. Evaluation of Independent Projects
4.5.3. Depreciation
4.5.4. Replacement Studies
4.5.5. Break-Win analysis

DURATION

12 hours

INTRODUCTION

The process of decision making where the selection of an alternative among

two or more possible alternatives will be discussed in this unit. The seven-step
procedure in engineering economic analysis was discussed in Unit 1 and in this unit,
Step 5 (analysis and comparison of the feasible alternatives) and Step 6 (selection of
the preferred alternative) of this procedure will be addressed. When correctly
applied, these methods result in the correct selection of a preferred alternative from
a set of mutually exclusive and independent alternatives.
In Step 4, two methods of listing will be shown.
In Step 5, the types of decision modelling techniques under three conditions
such as certainty, risk and uncertainty will be differentiated.
In step 6, the output of these modelling techniques will be used in analysing
and comparing in selection of the best alternative.

OBJECTIVES / COMPETENCIES

At the end of the lesson, the students should be able to:

1. List possible actions or events using pay-off table and decision tree.
2. Differentiate the different modelling techniques used under the conditions of
certainty, risk and uncertainty.
3. Identify mutually exclusive and independent projects; define revenue and cost
alternatives.

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 4. Select the best of equal-life or different-life alternatives using present
worth and future worth analysis.
5. Calculate the decrease in the value of property using straight line, sinking
fund, sum of the year’s digit, and declining balance method.
6. Determine whether an existing asset has the need to be replaced or still
remain at a point of time.
7. Determine the breakeven amount to be able to accept or reject a project.

PRETEST

Multiple Choices. Encircle the letter of your answer.

1. What is a method of determining when the value of one alternative becomes equal
to the value of another?
A. Specific identification method
B. Average cost method
C. Break-even analysis
D. Incremental value method

2. What is defined as the length of time usually in years, for cumulative net annual
profit to equal the initial investment?
A. Return of investment period
B. Turnover period
C. Break-even period
D. Payback period

3. A method of depreciation whereby the amount to recover is spread uniformly over

the estimated life of the asset in terms of the periods or units of output.
A. Straight line method
B. Sinking fund method
C. Declining balance method
D. SYD method

4. A method of depreciation where a fixed sum of money is regularly deposited at

compound interest in a real or imaginary fund in order to accumulate an amount
equal to the total depreciation of an asset at the end of the asset’s estimated life.
A. Straight line method
B. Sinking fund method
C. Declining balance method
D. SYD method

5. What is defined as the reduction or fall of the value of an asset due to constant
use and passage of time?
A. Depletion
B. Inflation
C. Depreciation
D. Deflation

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 Management and Decision Making
 The essence of management is decision making
 Decision making is the process of selecting an alternative among two or more
possible alternatives
 The right selection depends on the successful expectation of the outcomes of
each alternative and matching these outcomes with the desired goal

 Terminologies used in Decision Making

 Course of action:
The decision taken by the decision maker is called a course of action.
 State of nature:
Future events that are beyond the control of the decision maker are called
state of nature.
 Pay-off:
A pay-off is an outcome, expressed in numerical values, that results from
each possible combination of alternatives and states of nature.

LESSON 4.1. STEPS IN DECISION MAKING

1. Clearly define the problem

2. List all possible alternatives
3. Identify all possible outcomes for each alternative
4. Identify the payoff for each alternative & outcome combination
5. Use a decision modeling technique to choose an alternative

 Example Problems (Steps 1,2 and 3)

LESSON 4.2. METHODS OF LISTING

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a. Alternative (A) — a course of action or strategy that may be chosen by the
decision maker
b. State of nature (E) — an occurrence or a situation over which the decision maker
has little or no control

Symbols used in a decision tree:

a.  — decision node from which one of several alternatives may be selected
b.  — a state-of-nature node out of which one state of nature will occur

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Decision Tree in Ethical Decision Making

LESSON 4.3. TYPES OF DECISION MODELING ENVIRONMENTS

The decision-making process takes place under one of three conditions:

Under Certainty

Under Risk

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Under Uncertainty

LESSON 4.3.1 DECISION MODELLING ENVIRONMENTS UNDER

UNCERTAINTY

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LESSON 4.3.2 DECISION MODELLING ENVIRONMENTS UNDER RISK

 It is assumed that the decision maker has sufficient information about the
states of nature.
 He can easily list the various states of nature and can also assign probabilities
to their occurrence.
 The decision maker may use the past experience or may use subjective
judgment in assigning probabilities.
 The most commonly used criterion is the criterion of expected value or the
Baye’s criterion.

 Expected Monetary Value Of Alternatives

 uses the probabilities to calculate the average payoff for each alternative
 expected pay-off for each alternative is calculated as the sum of the weighted
pay-offs for the alternatives
 The weights are the probability values which the decision-maker assigns to
the different states of nature.

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 Expected Opportunity Loss (EOL)
 How much regret do we expect based on the probabilities?
 The decision maker calculates the opportunity loss for each state of nature
and then calculates the expected value of each alternative by the sum of the
product of opportunity loss and probability.
 The alternative with the minimum expected value is selected as the best
alternative.

Example Problem
A retailer purchases a particular product at the rate of P200 per kg daily and sells it
at the rate of P250 per kg. The unsold product at the end of the day can be disposed
off the next day at the salvage value of P170 per kg. Past sales have ranged from 25
to 28 kg per day. The table shows the sales record for the past 100 days.
Determine the quantity of the product in kg which the retailer should purchase to
optimize the profit.

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If the retailer can correctly estimate the daily demand of the product then he or she
can remove all uncertainty and would have no losses.
But for this the retailer has to obtain perfect information regarding occurrence of
various states of nature.

LESSON 4.3.3 DECISION MODELLING ENVIRONMENTS UNDER CERTAINTY

 Perfect Information would tell us with certainty which outcome is going to occur
 Having perfect information before making a decision would allow choosing the
best payoff for the outcome

 Expected Value of Perfect Information (EVPI)

 The amount by which perfect information would increase our expected payoff
 Provides an upper bound on what to pay for additional information
 EVPI is the difference between the payoff under certainty and the payoff
under risk

 Expected Value With Perfect Information (EVwPI)

 The expected payoff of having perfect information before making a
decision

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SELF-STUDY

Unit 4: Decision Analysis 90

It may be noted that the decision maker may not necessarily assign the same
probability to different states of nature for all the alternatives. The decision maker
may feel that the probability of occurrence of different states of nature may vary
with the alternative and, therefore, he or she may assign different probabilities to
different states of nature for different alternatives.

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POST-TEST 1

The management of a manufacturing firm is required to choose between

product X and product Y for manufacturing.

The probability matrix for the two products is as follows:

The expected profit by selling these products is given below:

Evaluate the alternatives using

1. Maximax rule
2. Maximin rule
3. Minimax Regret rule
4. Equally Likely rule
5. EMV
6. EOL

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ANSWER KEY

UNIT 4
Post Test (Part 1)

1. Maximax: Choose Product Y

2. Maximin: Choose Product X
3. Minimax: Choose Product Y
4. Equally Likely: Choose Product Y
5. EMV: Choose Product Y
6. EOL: Choose Product Y

REFERENCES

Blank, L., & Tarquin, A., (2018). Engineering Economy (8th edition). New York, NY:
McGraw-Hill Education

Khan, Z., Siddiquee, A., Kumar, B., & Abidi, M., (2018). Principles of Engineering
Economics with Applications (2nd edition). New York, NY: Cambridge
University Press

Park, C. S. (2016). Contemporary Engineering Economics (6th edition). London, UK:

Pearson Education Limited

Sullivan, W., Wicks, E. & Koelling, C. (2015). Engineering Economy (16th edition).
Upper Saddle River, NJ: Pearson Higher Education, Inc.

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