CHAPTER 2
Decision-Making Tools
By the end of this chapter, students will be able to:
1. Explain the decision-making process in operations management and identify the role of data, alternatives, and
states of nature.
2. Construct and analyze decision tools such as decision trees and decision tables to evaluate possible courses of
action.
3. Apply decision-making criteria under different environments (uncertainty, risk, and certainty), including
Maximax, Maximin, Equally Likely, and EMV.
4. Calculate and interpret the Expected Value of Perfect Information (EVPI) to determine the value of additional
information in decision making.
5. Evaluate how big data and quantitative models support managers in making logical, data-driven, and effective
operational decisions.
The Decision Process in Operations
Operations managers are not gamblers. But they are decision makers. To achieve the goals of their organizations,
managers must understand how decisions are made and know which decision-making tools to use. To a great
extent, the success or failure of both people and companies depends on the quality of their decisions. Overcoming
uncertainty is a manager’s challenge
What makes the difference between a good decision and a bad decision? A “good” decision—one that uses
analytic decision making—is based on logic and considers all available data and possible alternatives. It also
follows these six steps:
1. Clearly define the problem and the factors that influence it.
2. Develop specific and measurable objectives.
3. Develop a model—that is, a relationship between objectives and variables (which are measurable
quantities).
4. Evaluate each alternative solution based on its merits and drawbacks.
5. Select the best alternative.
6. Implement and evaluate the decision and then set a timetable for completion.
So analytic decision making requires models, objectives, and quantifiable variables, often in the form of
probabilities and payoffs. Such information is not always easy to obtain or derive from existing data. This
challenge exists because of either a lack of data or an overabundance of data. However, because data are now
easily generated and stored in digital form, we tend to have the latter—massive volumes of data. Data are
collected automatically from production processes, as well as from websites, credit cards, point-of-sale records,
and social media. Although this mass of data is a potential source of information, it requires sophistication in
how it is stored, processed, and analyzed. Big data is the term used to describe this huge amount of data, which
often cannot be efficiently processed by traditional data techniques.
Good decisions require data that can be analyzed and turned into information, decision makers appreciate the
potential of big data.
This module provides an introduction to the challenges facing managers by introducing two of the tools of
decision making—decision tables and decision trees. These two tools are used in numerous OM situations,
ranging from new-product analysis, to capacity planning, to location planning, to supply-chain disaster planning,
to scheduling, and to maintenance planning.
Fundamentals of Decision Making
Regardless of the complexity of a decision or the sophistication of the technique used to analyze it, all decision
makers are faced with alternatives and “states of nature.” The following notation will be used in this module:
1. Terms:
a. Alternative — A course of action or strategy that may be chosen by a decision maker (e.g., not carrying an
umbrella tomorrow).
b. State of nature — An occurrence or a situation over which the decision maker has little or no control (e.g.,
tomorrow’s weather).
2. 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.
To present a manager’s decision alternatives, we can develop decision trees using the above symbols. When
constructing a decision tree, we must be sure that all alternatives and states of nature are in their correct and
logical places and that we include all possible alternatives and states of nature.
A SIMPLE DECISION TREE
Getz Products Company is investigating the possibility of producing and marketing backyard storage sheds.
Undertaking this project would require the construction of either a large or a small manufacturing plant. The
market for the product produced—storage sheds—could be either favorable or unfavorable. Getz, of course, has
the option of not developing the new product line at all.
Getz decides to build a decision tree.
We never want to overlook the option of “doing nothing,” as that is usually a possible decision.
Decision Tables
We may also develop a decision or payoff table to help Getz Products define its alternatives. For any alternative
and a particular state of nature, there is a consequence or outcome, which is usually expressed as a monetary
value. This is called a conditional value.
Note that all of the alternatives in the example below are listed down the left side of the table, that states of nature
(outcomes) are listed across the top, and that conditional values (payoffs) are in the body of the decision table.
Decision table - A tabular means of analyzing decision alternatives and states of nature.
A DECISION TABLE
Getz Products now wishes to organize the following information into a table. With a favorable market, a large
facility will give Getz Products a net profit of $200,000. If the market is unfavorable, a $180,000 net loss will
occur. A small plant will result in a net profit of $100,000 in a favorable market, but a net loss of $20,000 will be
encountered if the market is unfavorable.
Types of Decision-Making Environments
The types of decisions people make depend on how much knowledge or information they have about the
situation. There are three decision-making environments:
1. Decision making under uncertainty
2. Decision making under risk
3. Decision making under certainty
Decision Making Under Uncertainty When there is complete uncertainty as to which state of nature in a
decision environment may occur (i.e., when we cannot even assess probabilities for each possible outcome), we
rely on three decision methods:
1. Maximax: This method finds an alternative that maximizes the maximum outcome for every alternative.
First, we find the maximum outcome within every alternative, and then we pick the alternative with the
maximum number. Because this decision criterion locates the alternative with the highest possible gain,
it has been called an “optimistic” decision criterion.
- A criterion that finds an alternative that maximizes the maximum outcome.
2. Maximin: This method finds the alternative that maximizes the minimum outcome for every alternative.
First, we find the minimum outcome within every alternative, and then we pick the alternative with the
maximum number. Because this decision criterion locates the alternative that has the least possible loss,
it has been called a “pessimistic” decision criterion.
- A criterion that finds an alternative that maximizes the minimum outcome
3. Equally likely: This method finds the alternative with the highest average outcome. First, we calculate the
average outcome for every alternative, which is the sum of all outcomes divided by the number of
outcomes. We then pick the alternative with the maximum number. The equally likely approach assumes
that each state of nature is equally likely to occur.
- A criterion that assigns equal probability to each state of nature
A DECISION TABLE ANALYSIS UNDER UNCERTAINTY
Getz Products Company would like to apply each of these three approaches now.
Decision Making Under Risk
Decision making under risk, a more common occurrence, relies on probabilities. Several possible states of nature
may occur, each with an assumed probability. The states of nature must be mutually exclusive and collectively
exhaustive and their probabilities must sum to 1. Given a decision table with conditional values and probability
assessments for all states of nature, we can determine the expected monetary value (EMV) for each alternative.
This figure represents the expected value or mean return for each alternative if we could repeat this decision (or
similar types of decisions) a large number of times.
The EMV for an alternative is the sum of all possible payoffs from the alternative, each weighted by the
probability of that payoff occurring:
EXPECTED MONETARY VALUE
Getz would like to find the EMV for each alternative.
Getz Products’ operations manager believes that the probability of a favorable market is 0.6, and that of an
unfavorable market is 0.4. He can now determine the EMV for each alternative.
1. EMV (A1) =
2. EMV (A2) =
3. EMV (A3) =
Decision Making Under Certainty
Now suppose that the Getz operations manager has been approached by a marketing research firm that proposes
to help him make the decision about whether to build the plant to produce storage sheds. The marketing
researchers claim that their technical analysis will tell Getz with certainty whether the market is favorable for the
proposed product. In other words, it will change Getz’s environment from one of decision making under risk to
one of decision making under certainty. This information could prevent Getz from making a very expensive
mistake. The marketing research firm would charge Getz $65,000 for the information.
What would you recommend? Should the operations manager hire the firm to make the study? Even if the
information from the study is perfectly accurate, is it worth $65,000? What might it be worth? Although some of
these questions are difficult to answer, determining the value of such perfect information can be very useful. It
places an upper bound on what you would be willing to spend on information, such as that being sold by a
marketing consultant.
Expected Value of Perfect Information (EVPI)
If a manager were able to determine which state of nature would occur, then he or she would know which decision
to make. Once a manager knows which decision to make, the payoff increases because the payoff is now a
certainty, not a probability. Because the payoff will increase with knowledge of which state of nature will occur,
this knowledge has value. Therefore, we now look at how to determine the value of this information. We call this
difference between the payoff under perfect information and the payoff under risk the expected value of perfect
information (EVPI).
EVPI = Expected value with perfect information - Maximum EMV
To calculate this value, we choose the best alternative for each state of nature and multiply its payoff times the
probability of occurrence of that state of nature:
EXPECTED VALUE OF PERFECT INFORMATION
The Getz operations manager would like to calculate the maximum that he would pay for information— that is, the
expected value of perfect information, or EVPI.
APPROACH
Two stage Process.
First, the expected value with perfect information (EVwPI) is computed. Then, using this information, the EVPI is
calculated.