Decision Making

Sales – Price Relationship Analysis

A workshop making lampshades finds that the number it can sell varies
depending on selling price.

It can sell 10 per week if the price is set at Rs. 80, but 50 per week if the
price is reduced to Rs. 40. The cost of production is Rs. 20 for each
lampshade and there are overheads of Rs. 60 per week.

Assume linear relationship between price and sales.

What should be the price to maximize his profit.

Sales – Price Relationship Analysis

2500

2000

1500
Rupees

1000

500

0
0 20 40 60 80
Sales

Revenue Cost Profit

 Inverse Costs

Maintenance department of a foundry wants to plan its annual expenditure on

equipment maintenance.

Currently it has a crew of 10 people. It costs the company Rs. 20000 per
month per crew member.

If department increases its crew size, it can make maintenance operations

more efficient. As a result breakdown costs will come down.

Data analysis showed that size of maintenance crew and breakdown loss
have a inverse relation as follows.
 Inverse Costs

Crew size 10 11 12 13 14 15

Ependiture 2400000 2640000 2880000 3120000 3360000 3600000

Breakdown loss 12000000 6000000 4000000 3000000 2400000 2000000

Total cost 14400000 8640000 6880000 6120000 5760000 5600000

Crew size 16 17 18 19 20

Ependiture 3840000 4080000 4320000 4560000 4800000

Breakdown loss 1900000 1800000 1700000 1600000 1500000

Total cost 5740000 5880000 6020000 6160000 6300000

 Inverse Costs

16000000
14000000
12000000
10000000
Cost

8000000
6000000
4000000
2000000
0
8 9 10 11 12 13 14 15 16 17 18 19 20 21
Crew size

Expenditure Breakdown loss Total cost

 Inventory Costs

Total cost = HC + OC
Annual cost

Holding cost (HC)

Ordering cost (OC)

Lot Size (Q)

Replacement Decisions
 Depreciation

Any equipment we use at work reduces in value year by year,

which is called as depreciation.

Calculation of depreciation is needed for many decision making

situations and one of them is replacement analysis.

There are two basic methods of depreciation calculation.

4. Straight line analysis

2. Declining Balance method

 Depreciation and Replacement
Analysis
A machine tool costs Rs. 300,000 when new.
Lets calculate the written down value after 1,2 and 3 years using
3. Straight line method with annual depreciation of Rs. 50,000
4. By declining Balance method with annual depreciation of 20 %

Approach 1: Straight line method

Capital cost = 3,00,000
Annual depreciation = 50,000
Value after 1st year = 2,50,000
Value after 2nd year = 2,00,000
Value after 3rd year = 1,50,000
 Depreciation and Replacement
Analysis
A machine tool costs Rs. 300,000 when new.
Lets calculate the written down value after 1,2 and 3 years using
3. Straight line method with annual depreciation of Rs. 50,000
4. By declining Balance method with annual depreciation of 20 %

Approach 2: Declining balance method

Capital cost = 3,00,000
Annual depreciation = 20%
Value after 1st year = 30,00,000 - 0.2 x 3,00,000 = 2,40,000
Value after 2nd year = 2,40,000 – 0.2 x 2,40,000 = 1,92,000
Value after 3rd year = 1,92,000 – 0.2 x 1,92,000 = 1,53,600
Equipment Replacement Decisions

Suppose a factory has a permanent need for an equipment, that wears

out over a period of several years. In the initial period of use, the
depreciation is likely to be high but maintenance costs will be low.
Towards the end of its useful life, the rate of depreciation may be slow but
maintenance costs will be high.

When will it be better to sell off the existing equipment and purchase a
new one ?
Equipment Replacement Decisions

maintenance
Year Depreciation
Cost
1 50000 6000
2 45000 7500
3 40000 12000
4 35000 20000
5 30000 34000
6 25000 50000
7 20000 70000
8 15000 90000

When will it be better to sell off the existing equipment and purchase a new one ?
Equipment Replacement Decisions

120000

100000

80000
Rupees

60000

40000

20000

0
0 2 4 6 8 10
Year
Depreciation Maintenence Total Cost
Decision making Under Uncertainty
Decision making Under Uncertainty

• A set of quantitative decision-making techniques for decision situations

where uncertainty exists

• States of nature
• events that may occur in the future
• decision maker is uncertain which state of nature will occur
• decision maker has no control over the states of nature
 Payoff Table

• A method of organizing & illustrating the payoffs from different

decisions given various states of nature

• A payoff is the outcome of the decision

 Payoff Table

States Of Nature
Decision a b
1 Payoff 1a Payoff 1b
2 Payoff 2a Payoff 2b
 Decision making Criteria

• Maximax criterion (optimistic)

• choose decision with the maximum of the maximum payoffs

• Maximin criterion (Pessimist)

• choose decision with the maximum of the minimum payoffs

• Minimax regret criterion

• choose decision with the minimum of the maximum regrets for
each alternative
 Decision making Criteria

• Hurwicz criterion
• choose decision in which decision payoffs are weighted by a
coefficient of optimism, α
• coefficient of optimism (α) is a measure of a decision maker’s
optimism, from 0 (completely pessimistic) to 1 (completely
optimistic)

• Equal likelihood (Laplace) criterion

• choose decision in which each state of nature is weighted
equally
Decision Making Example

Pay-Offs in Thousands of rupees

Alternative
A B C D
X 8 0 -10 6
Y -4 12 18 -2
Z 14 6 0 8

Alternative Minimum Pay-off Maximum Pay-off

X -10 8
Y -4 18
Z 0 14
Decision Making Example

Pay-Offs in Thousands of rupees

Alternative
A B C D
X 8 0 -10 6
Y -4 12 18 -2
Z 14 6 0 8

Alternative Minimum Pay-off Maximum Pay-off

X -10 8
Y -4 18
Z 0 14

Maximin Maximax
Minimax Regret Example

Strategic Events and Pay-offs

Altenatives A B C
S1 700 300 150
S2 500 450 200
S3 300 300 100

Strategic Events and Regrets

Altenatives A B C
S1 0 150 50
S2 200 0 0
S3 400 150 100
Minimax Regret Example

Strategic Events and Pay-offs

Altenatives A B C
S1 700 300 150
S2 500 450 200
S3 300 300 100

Strategic Events and Regrets Maximum

Altenatives A B C Regret
S1 0 150 50 150
S2 200 0 0 200
S3 400 150 100 400
Minimax Regret Example

Strategic Events and Pay-offs

Altenatives A B C
S1 700 300 150
S2 500 450 200
S3 300 300 100

Strategic Events and Regrets Maximum

Altenatives A B C Regret

S1 0 150 50 150
S2 200 0 0 200
S3 400 150 100 400
 Hurwicz Criterion

Step 1: Choose alfa and (1-alfa)

Step 2: Determine for each alternative,
h = (alfa) (max pay off) + (1-alfa) (minimum pay off)
Step 3: Select the alternative with maximum value of ‘h’

‘alfa’ is the coefficient of optimism. It is a measure of a decision

maker’s optimism, from 0 to 1 (completely optimistic)
(1-alfa) is the degree of pessimism
 Hurwicz Criterion Example
Take degree of optimism as 0.6

Strategic Events and Pay-offs

Altenativ A B C
S1 8000 4500 2000
S2 3500 4500 5000
S3 5000 5000 4000

For alternative S1, h = 0.6(8000)+0.4(2000) = 5600

 Hurwicz Criterion Example
Take degree of optimism as 0.6

Strategic Events and Pay-offs

h
Altenative A B C
S1 8000 4500 2000 5600
S2 3500 4500 5000 4400
S3 5000 5000 4000 4600
 Hurwicz Criterion Example
Take degree of optimism as 0.6

Strategic Events and Pay-offs

h
Altenativ A B C
S1 8000 4500 2000 5600
S2 3500 4500 5000 4400
S3 5000 5000 4000 4600
 Laplace Criterion Example

In this method we each state of nature is weighted equally.

In other words, probability of occurrence of events is considered to be
equal.

Step 1: Assign equal weights to each pay off of an alternative or strategy.

Step 2: Estimate the expected pay off for each alternative
Step 3: Select the alternative which has the maximum expected pay off
 Laplace Criterion Example

Events and Pay offs

Alternative
A B C D
1 4 0 -5 3
2 -2 6 9 1
3 7 3 2 4

Expected Pay off for Alternative 1:

0.25 (4) + 0.25 (0) +0.25 (-5) + 0.25 (3) = 0.5
 Laplace Criterion Example

Events and Pay offs Expected

Alternative
Pay off
A B C D
1 4 0 -5 3 0.5
2 -2 6 9 1 3.5
3 7 3 2 4 4.0

Expected Pay off for Alternative 1:

0.25 (4) + 0.25 (0) +0.25 (-5) + 0.25 (3) = 0.5
 Laplace Criterion Example

Events and Pay offs Expected

Alternative
Pay off
A B C D
1 4 0 -5 3 0.5
2 -2 6 9 1 3.5
3 7 3 2 4 4.0

Expected Pay off for Alternative 1:

0.25 (4) + 0.25 (0) +0.25 (-5) + 0.25 (3) = 0.5
Decision making With Probabilities
Decision making With Probabilities

Probabilities need to be assigned to events

Expected value is a weighted average of decision outcomes.

n
EV( x) = ∑ p( xi) xi
i=1
where
xi = outcome i
p( xi) = probability of outcome i
Expected Monetary Value Criterion

A store keeper stocks a perishable item. Shelf life of this item is one
month. Store keeper wants to determine the number of items he
should stock at the beginning of the month.
He buys the item for Rs. 30 and sells at Rs. 50.
He analyzes the trend for last two years i.e. 24 months. The
following table gives the sales during last 24 months.

Sales 10 11 12 13

Frequency 3 5 10 6
Expected Monetary Value Criterion

Sales 10 11 12 13

Frequency 3 5 10 6

Probability 0.125 0.208 0.417 0.250

Expected Monetary Value Criterion

Stock
Demand
10 11 12 13
10 200 170 140 110
11 200 220 190 160
12 200 220 240 210
13 200 220 240 260
Expected Monetary Value Criterion

Stock and conditional pay off

Demand
10 11 12 13
10 25.00 21.25 17.50 13.75
11 41.67 45.83 39.58 33.33
12 83.33 91.67 100.00 87.50
13 50.00 55.00 60.00 65.00
EMV 200.00 213.75 217.08 199.58
Expected Monetary Value Criterion

Stock and conditional pay off

Demand
10 11 12 13
10 25.00 21.25 17.50 13.75
11 41.67 45.83 39.58 33.33
12 83.33 91.67 100.00 87.50
13 50.00 55.00 60.00 65.00
EMV 200.00 213.75 217.08 199.58
Expected Regret Criterion
Stock and Regret
Demand
10 11 12 13
10 0 30 60 90
11 20 0 30 60
12 40 20 0 30
13 60 40 20 0

Stock and Conditional Regret

Demand
10 11 12 13
10 0.00 3.75 7.50 11.25
11 4.17 0.00 6.25 12.50
12 16.67 8.33 0.00 12.50
13 15.00 10.00 5.00 0.00
ER 35.83 22.08 18.75 36.25
Decision Trees
 Decision Trees

Bharat Oil Company (BOC) owns a land that may contain oil.
Geologist report shows a 25% chance of oil
Another company is offering to buy the land for Rs. 90 Cr
If BOC decides to drill, it will earn a profit of Rs. 700 Cr if oil is
found.
However, it will incur a loss of Rs. 100 Cr if oil is not found.
Should BOC drill or sell ?
 Decision Trees

700 Cr
(0.25) Oil
Expected
pay off is
100 Cr
Drill
(0.75) Dry -100 Cr

decision (0.25) Oil 90 Cr

Expected
Sell pay off is
90 Cr
(0.75) Dry 90 Cr
 Value of Perfect Information

In many decision making exercises it is possible to get more or extra

information about the events or state of nature.
But it will cost extra money.
Question : Is additional information worth the cost ?
 Value of Perfect Information

Continuing with the previous example,

A sesmic survey can tell whether the land is fairly likely or fairly unlikely
to have oil.
Cost of the survey is Rs. 30 Cr
Should BOC do the survey ?
 Value of Perfect Information

Expected pay off with perfect information is

= 0.25 (700) + 0.75 (90) = 242.5 Cr

Expected value of perfect information is

= Expected pay off with perfect information - Expected pay off without
perfect information
= 242.5 – 100 = 142.5 Cr.
If EVPI is less than the cost of survey, then don’t do the survey. It’s not
worth it.
In this case, 142.5 Cr. >> 30 Cr.
It is worthwhile doing the survey.
 Decision Trees

A firm is adding a new product line and must build a new plant. Demand will
either be favourable or unfavourable, with probabilities of 0.6 and 0.4,
respectively. If a large plant is built and demand is favourable the pay off is
estimated to be Rs. 1520 Cr. If the demand is unfavourable, the loss with larger
plant will be Rs. 20 Cr

If a medium sized plant is built and demand is unfavourable, the pay off is Rs.
760 Cr. If the demand proves to be favourable, the firm can maintain the medium
sized facility or expand it. Maintaining medium sized facility will result in to a pay
off of Rs. 950 Cr and expanding it will give a pay off of Rs 570 Cr.

Draw a decision tree for this problem

What should the management do to achieve the highest expected pay off ?
 Decision Trees
1520 Cr
(0.6) Fav

Large
(0.4) Un Fav -20 Cr

Expand 570 Cr
decision (0.6) Fav

Continue 950 Cr
Small

(0.4) Un Fav 760 Cr

0.6 (1520) – 0.4 (20) = 904 Cr Build a large Plant

0.6 (950) + 0.4 (760) = 874 Cr