Discussion Question – Module 06: Reliability and Decision Theory

Module 06: Reliability and Decision Theory
Discussion Question
Question Requirements:
Capacity Planning
1. Discuss the importance of capacity planning in deciding the number of police officers on duty
at any given time.
2. How does capacity decisions influence productivity? Give an example.
Directions:
• Discuss the concepts, principles, and theories from your textbook. Cite your textbooks and
cite any other sources.
• Write a discussion that includes an introduction paragraph, the body, and a conclusion
paragraph to address the assignment’s guide questions.
• Your initial post should address all components of the question with a 600-word limit.
Learning Outcomes
• Evaluate the impact of product reliability on the decision-making process of
operations management.
• Differentiate the environments under which operations decisions are made.
• Analyze the techniques that apply to decision making under uncertainty.
Readings
Required:
• Chapters 5 & 5S Decision Theory in Operations Management
Recommended:
• Liao, S., & Liu, Z., (2022). Enterprise financial influencing factors and early warning
based on decision model tree. Scientific Programming,2022, 1-8.
• Kascelan, L., Pejic Bach, M., Rondovic, B., & Durickovic, T. (2020). The interaction
between social media, knowledge management and service quality: A decision tree
analysis. PLoS ONE, 15(8), 1-30.
• Dai, D., Wu, X., Si, F., Feng, Z., & Chu, W. (2023). The impact of tariff policies on
vaccine supply chains: short-term and evolutionary game behaviors based on
uncertain utility. Applied Mathematical Modelling, 115, 754–
777.
Strategic Capacity
Planning for
Products and
Services
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior
written consent of McGraw-Hill Education.
5-1
You should be able to:
LO 5.1
LO 5.2
LO 5.3
LO 5.4
LO 5.5
Name the three key questions in capacity planning
Explain the importance of capacity planning
Describe ways of defining and measuring capacity
Name several determinants of effective capacity
Discuss factors to consider when deciding whether
to perform in-house or outsource
LO 5.6 Discuss the major considerations related to
developing capacity alternatives
LO 5.7 Describe the steps used to resolve constraint issues
LO 5.8 Briefly describe approaches that are useful for
evaluating capacity alternatives
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-2
 Capacity
 The upper limit or ceiling on the load that an operating
unit can handle
 Capacity needs include
 Equipment
 Space
 Employee skills
LO 5.1
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-3
 Goal
 To achieve a match between the long-term supply
capabilities of an organization and the predicted level of
long-term demand
 Overcapacity → operating costs that are too high
 Undercapacity → strained resources and possible loss of
customers
LO 5.1
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-4
 Key questions:
 What kind of capacity is needed?
 How much is needed to match demand?
 When is it needed?
 Related questions:
 How much will it cost?
 What are the potential benefits and risks?
 Are there sustainability issues?
 Should capacity be changed all at once, or through several smaller
changes?
 Can the supply chain handle the necessary changes?
LO 5.1
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-5
 Capacity decisions
1.
Impact the ability of the organization to meet future demands
2. Affect operating costs
3. Are a major determinant of initial cost
4. Often involve long-term commitment of resources
5. Can affect competitiveness
6. Affect the ease of management
7. Have become more important and complex due to globalization
8. Need to be planned for in advance due to their consumption of
financial and other resources
LO 5.2
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-6
 Measure capacity in units that do not require
updating
 Why is measuring capacity in dollars problematic?
 Two useful definitions of capacity
 Design capacity
 The maximum output rate or service capacity an operation,
process, or facility is designed for
 Effective capacity
 Design capacity minus allowances such as personal time and
maintenance
LO 5.3
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-7
Business
Inputs
Outputs
Auto
manufacturing
Labor hours,
machine hours
Number of cars per shift
Steel mill
Furnace size
Tons of steel per day
Oil refinery
Refinery size
Number of acres,
number of cows
Gallons of fuel per day
Bushels of grain per acre per
year, gallons of milk per day
Restaurant
Number of tables,
seating capacity
Theater
Number of seats
Number of meals served per
day
Number of tickets sold per
performance
Retail sales
Square feet of floor
space
Farming
Revenue generated per day
TABLE 5.1 Measures of capacity
LO 5.3
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-8
 Actual output
 The rate of output actually achieved
 It cannot exceed effective capacity
 Efficiency
actual output
Efficiency =
effective capacity
 Utilization
actual output
Utilizatio n =
design capacity
Measured as percentages
LO 5.3
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-9
 Design Capacity = 50 trucks per day
 Effective Capacity = 40 trucks per day
 Actual Output = 36 trucks per day
actual output
36
Efficiency =
=
= 90%
effective capacity 40
actual output
36
Utilizatio n =
=
= 72%
design capacity 50
LO 5.3
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-10
 Facilities
 Product and service factors
 Process factors
 Human factors
 Policy factors
 Operational factors
 Supply chain factors
 External factors
LO 5.4
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-11
TABLE 5.2 Factors that determine effective capacity
LO 5.4
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-12
 Strategies are typically based on assumptions and
predictions about:
 Long-term demand patterns
 Technological change
 Competitor behavior
LO 5.4
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-13
 Leading
 Build capacity in anticipation of future demand increases
 Following
 Build capacity when demand exceeds current capacity
 Tracking
 Similar to the following strategy, but adds capacity in relatively
small increments to keep pace with increasing demand
LO 5.4
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-14
 Capacity cushion
 Extra capacity used to offset demand uncertainty
 Capacity cushion = 100% − utilization
 Capacity cushion strategy
 Organizations that have greater demand uncertainty typically
have greater capacity cushions
 Organizations that have standard products and services
generally have smaller capacity cushions
LO 5.4
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-15
1.
Estimate future capacity requirements
2.
Evaluate existing capacity and facilities; identify gaps
3.
Identify alternatives for meeting requirements
4.
Conduct financial analyses
5.
Assess key qualitative issues
6.
Select the best alternative for the long term
7.
Implement alternative chosen
8.
Monitor results
LO 5.4
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-16
 Long-term considerations relate to overall level of
capacity requirements
 Require forecasting demand over a time horizon and
converting those needs into capacity requirements
 Short-term considerations relate to probable
variations in capacity requirements
 Less concerned with cycles and trends than with
seasonal variations and other variations from average
LO 5.4
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-17
 Calculating processing requirements requires
reasonably accurate demand forecasts, standard
processing times, and available work time
k
pD
N R = i =1
i
i
T
where
N R = number of required machines
pi = standard processing time for product i
Di = demand for product i during the planning horizon
T = processing time available during the planning horizon
LO 5.4
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-18
 Service capacity planning can present a number of
challenges related to:
 The need to be near customers
 Convenience
 The inability to store services
 Cannot store services for consumption later
 The degree of demand volatility
 Volume and timing of demand
 Time required to service individual customers
LO 5.4
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-19
 Strategies used to offset capacity limitations and that
are intended to achieve a closer match between supply
and demand
 Pricing
 Promotions
 Discounts
 Other tactics to shift demand from peak periods into
slow periods
LO 5.4
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-20
 Once capacity requirements are determined, the organization
must decide whether to produce a good or service itself or
outsource
 Factors to consider:
 Available capacity
 Expertise
 Quality considerations
 The nature of demand
 Cost
 Risks
LO 5.5
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-21
 Things that can be done to enhance capacity management:
 Design flexibility into systems
 Take stage of life cycle into account
 Take a “big-picture” approach to capacity changes
 Prepare to deal with capacity “chunks”
 Attempt to smooth capacity requirements
 Identify the optimal operating level
 Choose a strategy if expansion is involved
LO 5.6
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-22
 An operation in a
sequence of operations
whose capacity is lower
than that of the other
operations
LO 5.6
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-23
Average cost per unit
Minimum
cost
Optimal
Output
rate
LO 5.6
Rate of output
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-24
 Economies of scale
 If output rate is less than the optimal level, increasing
the output rate results in decreasing average per unit
costs
 Diseconomies of scale
 If the output rate is more than the optimal level,
increasing the output rate results in increasing average
costs per unit
LO 5.6
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-25
 Economies of scale
 If output rate is less than the optimal level, increasing
the output rate results in decreasing average per unit
costs
 Reasons for economies of scale:
 Fixed costs are spread over a larger number of units
 Construction costs increase at a decreasing rate as facility size
increases
 Processing costs decrease due to standardization
LO 5.6
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-26
 Diseconomies of scale
 If the output rate is more than the optimal level, increasing the
output rate results in increasing average per unit costs
 Reasons for diseconomies of scale
 Distribution costs increase due to traffic congestion and
shipping from a centralized facility rather than multiple smaller
facilities
 Complexity increases costs
 Inflexibility can be an issue
 Additional levels of bureaucracy
LO 5.6
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-27
Average cost per unit
Minimum cost & optimal operating rate are
functions of size of production unit.
Small
plant
Medium
plant
Large
plant
Output rate
LO 5.6
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-28
 Constraint
 Something that limits the performance of a process or system in
achieving its goals
 Categories
 Market
 Resource
 Material
 Financial
 Knowledge or competency
 Policy
LO 5.7
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-29
1.
2.
3.
4.
5.
Identify the most pressing constraint
Change the operation to achieve maximum benefit, given
the constraint
Make sure other portions of the process are supportive of
the constraint
Explore and evaluate ways to overcome the constraint
Repeat the process until the constraint levels are at
acceptable levels
LO 5.7
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-30
 Alternatives should be evaluated from varying
perspectives
 Economic
 Is it economically feasible?
 How much will it cost?
 How soon can we have it?
 What will operating and maintenance costs be?
 What will its useful life be?
 Will it be compatible with present personnel and present
operations?
 Non-economic
 Public opinion
LO 5.8
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-31
 Techniques for Evaluating Alternatives
 Cost-volume analysis
 Financial analysis
 Decision theory
 Waiting-line analysis
 Simulation
LO 5.8
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-32
 Cost-volume analysis
 Focuses on the relationship between cost, revenue, and
volume of output
 Fixed Costs (FC)
 Tend to remain constant regardless of output volume
 Variable Costs (VC)
 Vary directly with volume of output
 VC = Quantity(Q) × variable cost per unit (v)
 Total Cost
 TC = FC + VC
 Total Revenue (TR)
 TR = revenue per unit (R) × Q
LO 5.8
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-33
 BEP
 The volume of output at which total cost and total
revenue are equal
 Profit (P) = TR – TC = R × Q – (FC + v × Q)
= Q(R – v) – FC
FC
QBEP =
R−v
LO 5.8
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-34
.
LO 5.8
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-35
 Capacity alternatives may involve step costs, which are
costs that increase stepwise as potential volume
increases
 The implication of such a situation is the possible occurrence of
multiple break-even quantities
LO 5.8
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-36
 Cost-volume analysis is a viable tool for comparing
capacity alternatives if certain assumptions are
satisfied
 One product is involved
 Everything produced can be sold
 The variable cost per unit is the same regardless of volume
 Fixed costs do not change with volume changes, or they are step
changes
 The revenue per unit is the same regardless of volume
 Revenue per unit exceeds variable cost per unit
LO 5.8
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-37
 Cash flow
 The difference between cash received from sales and
other sources and cash outflow for labor, material,
overhead, and taxes
 Present value
 The sum, in current value, of all future cash flow of an
investment proposal
LO 5.8
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-38
 Capacity planning impacts all areas of the organization
 It determines the conditions under which operations will have to function
 Flexibility allows an organization to be agile
 It reduces the organization’s dependence on forecast accuracy and reliability
 Many organizations utilize capacity cushions to achieve flexibility
 Bottleneck management is one way by which organizations can enhance
their effective capacities
 Capacity expansion strategies are important organizational considerations
 Expand-early strategy
 Wait-and-see strategy
 Capacity contraction is sometimes necessary
 Capacity disposal strategies become important under these
conditions
LO 5.8
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5-39
Decision Theory
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior 5s-1
written consent of McGraw-Hill Education.
You should be able to:
LO 5s.1
LO 5s.2
LO 5s.3
LO 5s.4
LO 5s.5
LO 5s.6
LO 5s.7
Outline the steps in the decision process
Name some causes of poor decisions
Describe and use techniques that apply to decision making
under uncertainty
Describe and use the expected-value approach
Construct a decision tree and use it to analyze a problem
Compute the expected value of perfect information
Conduct sensitivity analysis on a simple decision problem
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-2
 A general approach to decision making that is suitable
to a wide range of operations management decisions
 Capacity planning
 Product and service design
 Equipment selection
 Location planning
LO 5s.1
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-3
 Characteristics of decisions that are suitable for using
decision theory
 A set of possible future conditions that will have a
bearing on the results of the decision
 A list of alternatives from which to choose
 A known payoff for each alternative under each possible
future condition
LO 5s.1
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-4
1.
2.
3.
4.
5.
Identify the possible future states of nature
Develop a list of possible alternatives
Estimate the payoff for each alternative for each possible
future state of nature
If possible, estimate the likelihood of each possible future
state of nature
Evaluate alternatives according to some decision criterion
and select the best alternative
LO 5s.1
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-5

A table showing the expected payoffs for each
alternative in every possible state of nature
Possible Future Demand
Alternatives
Low
Moderate
High
Small facility
$10
$10
$10
Medium facility
7
12
12
Large Facility
(4)
2
16
• A decision is being made concerning which size facility
should be constructed
• The present value (in millions) for each alternative under
each state of nature is expressed in the body of the above
payoff table
LO 5s.1
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-6
 Steps:
1.
Identify the problem
2. Specify objectives and criteria for a solution
3. Develop suitable alternatives
4. Analyze and compare alternatives
5. Select the best alternative
6. Implement the solution
7. Monitor to see that the desired result is achieved
LO 5s.1
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-7
 Decisions occasionally turn out poorly due to
unforeseeable circumstances; however, this is not the
norm
 More frequently poor decisions are the result of a
combination of
 Mistakes in the decision process
 Bounded rationality
 Suboptimization
LO 5s.2
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-8
 Errors in the Decision Process

Failure to recognize the importance of each step

Skipping a step

Failure to complete a step before jumping to the next step

Failure to admit mistakes

Inability to make a decision
LO 5s.2
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-9
 Bounded rationality
 The limitations on decision making caused by costs,
human abilities, time, technology, and availability of
information
 Suboptimization
 The results of different departments each attempting to
reach a solution that is optimum for that department
LO 5s.2
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-10
 There are three general environment categories:
 Certainty
 Environment in which relevant parameters have known
values
 Risk
 Environment in which certain future events have
probabilistic outcomes
 Uncertainty
 Environment in which it is impossible to assess the likelihood
of various possible future events
LO 5s.3
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-11
 Sometimes we know the exact outcome or
environment. Under those situations, making a
decision is easy. For example, if Investment 1 gives a
return of 3.4% and Investment 2 gives a return of 5.6%,
then we know what to do.
 Uncertainty comes when there is a risk involved, for
instance, Investment 1 could be the return on a CD
which is guaranteed, but Investment 2 could be a
mutual fund whose returned can’t be guaranteed.
LO 5s.3
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-12
 Decisions are sometimes made under complete
uncertainty: No information is available on how likely
the various states of nature are.
 Decision criteria:
 Maximin
 Choose the alternative with the best of the worst possible payoffs
 Maximax
 Choose the alternative with the best possible payoff
 Laplace
 Choose the alternative with the best average payoff
 Minimax regret
 Choose the alternative that has the least of the worst regrets
LO 5s.3
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-13
Possible Future Demand
Alternatives
Low
Moderate
High
Small Facility
$10
$10
$10
Medium Facility
7
12
12
Large Facility
(4)
2
16
•The worst payoff for each alternative is
Small facility:
$10 million
Medium facility
$7 million
Large facility
-$4 million
•Choose to construct a small facility
LO 5s.3
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-14
Possible Future Demand
Alternatives
Low
Moderate
High
Small Facility
$10
$10
$10
Medium Facility
7
12
12
Large Facility
(4)
2
16
•The best payoff for each alternative is
Small facility:
$10 million
Medium facility
$12 million
Large facility
$16 million
•Choose to construct a large facility
LO 5s.3
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-15
Possible Future Demand
Alternatives
Low
Moderate
High
Small Facility
$10
$10
$10
Medium Facility
7
12
12
Large Facility
(4)
2
16
•The average payoff for each alternative is
Small facility:
(10 + 10 + 10) ÷ 3 = $10 million
Medium facility
(7 + 12 + 12) ÷ 3 = $10.33 million
Large facility
(−4 + 2 + 16) ÷ 3 = $4.67 million
•Choose to construct a medium facility
LO 5s.3
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-16
Possible Future Demand
Alternatives
Low
Moderate
High
Small Facility
$10
$10
$10
Medium Facility
7
12
12
Large Facility
(4)
2
16
•Construct a regret (or opportunity loss) table
•The difference between a given payoff and the best
payoff for a state of nature
Regrets
LO 5s.3
Alternatives
Low
Moderate
High
Small Facility
$0
$2
$6
Medium Facility
3
0
4
Large Facility
14
10
0
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-17
Regrets
Alternatives
Low
Moderate
High
Small Facility
$0
$2
$6
Medium Facility
3
0
4
Large Facility
14
10
0
•Identify the worst regret for each alternative
•Small facility
$6 million
•Medium facility
$4 million
•Large facility
$14 million
•Select the alternative with the minimum of the maximum
regrets
•Build a medium facility
LO 5s.3
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-18
 Decisions made under the condition that the
probability of occurrence for each state of nature can
be estimated
 A widely applied criterion is expected monetary value
(EMV)
 EMV
 Determine the expected payoff of each alternative, and choose
the alternative that has the best expected payoff
 This approach is most appropriate when the decision maker is
neither risk averse nor risk seeking
LO 5s.4
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-19
Possible Future Demand
Alternatives
Low (.30)
Moderate (.50)
High (.20)
Small Facility
$10
$10
$10
Medium Facility
7
12
12
Large Facility
(4)
2
16
EMVsmall = .30(10) +.50(10) +.20(10) = 10
EMVmedium = .30(7) + .50(12) + .20(12) = 10.5
EMVlarge = .30(-4) + .50(2) + .20(16) = $3
Build a medium facility
LO 5s.4
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-20
 Decision tree
 A schematic representation of the available alternatives and their
possible consequences
 Useful for analyzing sequential decisions
LO 5s.5
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-21
 Composed of
 Nodes
 Decisions – represented by square nodes
 Chance events – represented by circular nodes
 Branches
 Alternatives – branches leaving a square node
 Chance events – branches leaving a circular node
 Analyze from right to left
 For each decision, choose the alternative that will yield
the greatest return
 If chance events follow a decision, choose the alternative
that has the highest expected monetary value (or lowest
expected cost)
LO 5s.5
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-22
 A manager must decide on the size of a video arcade to construct. The manager
has narrowed the choices to two: large or small. Information has been collected
on payoffs, and a decision tree has been constructed. Analyze the decision tree
and determine which initial alternative (build small or build large) should be
chosen in order to maximize expected monetary value.
$40
$40
2
Overtime
$50
$55
1
($10)
2
$50
$70
LO 5s.5
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-23
$40
$40
2
Overtime
$50
$55
1
($10)
2
$50
$70
EVSmall = .4(40) + .6(55) = $49
EVLarge = .4(50) + .6(70) = $62
Build the large facility
LO 5s.5
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-24
 Expected value of perfect information (EVPI)
 The difference between the expected payoff with perfect
information and the expected payoff under risk
 Two methods for calculating EVPI
 EVPI = expected payoff under certainty – expected payoff under risk
 EVPI = minimum expected regret
LO 5s.6
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-25
Possible Future Demand
Alternatives
Low (.30)
Moderate (.50)
High (.20)
Small Facility
$10
$10
$10
Medium Facility
7
12
12
Large Facility
(4)
2
16
EVwith perfect information = .30(10) + .50(12) + .20(16) = $12.2
EMV = $10.5
EVPI = EVwith perfect information – EMV
= $12.2 – 10.5
= $1.7
You would be willing to spend up to $1.7 million to obtain
perfect information
LO 5s.6
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-26
Regrets
Alternatives
Low (.30)
Moderate (.50)
High (.20)
Small Facility
$0
$2
$6
Medium Facility
3
0
4
Large Facility
14
10
0
• Expected Opportunity Loss
• EOLSmall = .30(0) + .50(2) + .20(6) = $2.2
• EOLMedium = .30(3) + .50(0) + .20(4) = $1.7
• EOLLarge = .30(14) + .50(10) + .20(0) = $9.2
• The minimum EOL is associated with the building the
medium size facility. This is equal to the EVPI, $1.7
million.
LO 5s.6
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-27
 Sensitivity analysis
 Determining the range of probability for which an
alternative has the best expected payoff
 The approach illustrated is useful when there are two
states of nature
 It involves constructing a graph and then using algebra to
determine a range of probabilities over which a given solution
is best
LO 5s.7
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-28
State of
Nature
Alternative
#1
#2
Slope
Equation
A
4
12
12 – 4 = +8
4 + 8P(2)
B
16
2
2 – 16 = −14
16 – 14P(2)
C
12
8
8 − 12 = −4
12 – 4P(2)
LO 5s.7
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-29
16 − 14P(2) = 12 − 4P(2)
Rearranging terms yields
4 = 10P(2)
Solving yields P(2) = .40.
Thus, alternative B is best from P(2) = 0 up to
P(2) = .40. B and C are equivalent at P(2) = .40.
Similar analysis can be used for alternative A
and C
4 + 8P(2) = 12 − 4P(2 )
Solving yields P(2) = .67.
Thus, alternative C is best from P(2) > .40 up to
P(2) = .67, where A and C are equivalent. For
values of P(2) greater than .67 up to P(2) = 1.0,
A is best.
LO 5s.7
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5s-30

Purchase answer to see full
attachment