PEAB ZC414 Production Planning and

Control

BITS Pilani
K K Birla Goa Campus
Dr. Varinder Singh
Lecture outline
2

Decision Analysis
– Decision Making without Probabilities
– Decision Making with Probabilities
– Expected Value of Perfect Information
– Sequential Decision Tree

BITS Pilani, K K Birla Goa Campus

 Decision Making
3

States of nature
– Events that may occur in the future
– Examples of states of nature:
• high or low demand for a product
• good or bad economic conditions
Decision making under uncertainty
– probabilities can NOT be assigned to the
occurrence of states of nature in the future
Decision making under risk
– probabilities can be assigned to the occurrence of
states of nature in the future

BITS Pilani, K K Birla Goa Campus

Decision Making Criteria
Under Uncertainty 4

Maximax
– Choose decision with the maximum of the
maximum payoffs
Maximin
– Choose decision with the maximum of the
minimum payoffs
Minimax regret
– Choose decision with the minimum of the
maximum regrets for each alternative

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 Decision Making Criteria
Under Uncertainty (cont.) 5

Hurwicz
– Choose decision in which decision payoffs are
weighted by a coefficient of optimism, alpha
– Coefficient of optimism is a measure of a
decision maker’s optimism, from 0 (completely
pessimistic) to 1 (completely optimistic)
Equal likelihood (La Place)
– Choose decision in which each state of nature is
weighted equally

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 A Textile Company
6

Considering option to Switch business area to move the product line to more economic goods

STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions

Switch business area $ 800,000 $ 500,000

Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000

Ref: Roberta Russell & Bernard W. Taylor, III

BITS Pilani, K K Birla Goa Campus
 Maximax Solution 7

STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions

Switch business area $ 800,000 $ 500,000

Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000

Switch business area $800,000

Status quo: 1,300,000  Maximum
Sell now: 320,000
Decision: status quo

Ref: Roberta Russell & Bernard W. Taylor, III

BITS Pilani, K K Birla Goa Campus
 Maximin Solution 8

STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions

Switch business area $ 800,000 $ 500,000

Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000

Switch business : $500,000  Maximum

Status quo: -150,000
Sell: 320,000
Decision: Switch business

Ref: Roberta Russell & Bernard W. Taylor, III

BITS Pilani, K K Birla Goa Campus
 Minimax Regret Solution 9

Good Foreign Poor Foreign

Competitive Conditions Competitive Conditions

$1,300,000 - 800,000 = 500,000 $500,000 - 500,000 = 0

1,300,000 - 1,300,000 = 0 500,000 - (-150,000)= 650,000
1,300,000 - 320,000 = 980,000 500,000 - 320,000= 180,000

Switch business: $500,000  Minimum

Status quo: 650,000
Sell: 980,000
Decision: Switch business

Ref: Roberta Russell & Bernard W. Taylor, III

BITS Pilani, K K Birla Goa Campus
 Hurwicz Criteria 10

STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions

Switch business $ 800,000 $ 500,000

Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000

Coefficient of optimism  = 0.3 1 -  = 0.7

Switch business: $800,000(0.3) + 500,000(0.7) = $590,000 Max

Status quo: 1,300,000(0.3) -150,000(0.7) = 285,000
Sell: 320,000(0.3) + 320,000(0.7) = 320,000
Decision: Switch business
Ref: Roberta Russell & Bernard W. Taylor, III
BITS Pilani, K K Birla Goa Campus
 Equal Likelihood Criteria 11

STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions

Switch business $ 800,000 $ 500,000

Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000

Two states of nature each weighted 0.50

Switch business: $800,000(0.5) + 500,000(0.5) = $650,000  Max
Status quo: 1,300,000(0.5) -150,000(0.5) = 575,000
Sell: 320,000(0.5) + 320,000(0.5) = 320,000
Decision: Switch business

Ref: Roberta Russell & Bernard W. Taylor, III

BITS Pilani, K K Birla Goa Campus
 Telecomp is a U.S.-based manufacturer of cellular telephones. It is
planning to build a new manufacturing and distribution facility in
12
either South Korea, China, Taiwan, Poland, or Mexico. The cost of
the facility will differ between countries and will even vary within
countries depending on the economic and political climate, including
monetary exchange rates. The company has estimated the facility
cost (in $ millions) in each country under three different future
economic/political climates as follows.
Economic/Political Climate
Country Decline Same Improve
South Korea 21.7 19.1 15.2
China 19.0 18.5 17.6
Taiwan 19.2 17.1 14.9
Poland 22.5 16.8 13.8
Mexico 25.0 21.2 12.5
Determine the best decision using different decision criteria.

BITS Pilani, K K Birla Goa Campus

 Solution 13

Decline same improve

minimin maximin hurwics0.4 eq likely
South
Korea 21.7 19.1 15.2 19.1 18.48
China 19 18.5 17.6 opt 18.44 18.183
Taiwan 19.2 17.1 14.9 17.48 16.896
Poland 22.5 16.8 13.8 19.02 17.523
Mexico 25 21.2 12.5 opt 20 19.371

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 Regret Table for minimax 14

Decline same improve

minimax
South
Korea 2.7 2.3 2.7 2.7
China 0 1.7 5.1 5.1
Taiwan 0.2 0.3 2.4 2.4
Poland 3.5 0 1.3 3.5
Mexico 6 4.4 0 6

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 Decision Making with
Probabilities 15

Risk involves assigning probabilities to

states of nature
Expected value
– a weighted average of decision outcomes in
which each future state of nature is
assigned a probability of occurrence

BITS Pilani, K K Birla Goa Campus

Expected value 16

n
EV (x) =  p(xi)xi
i =1

where

xi = outcome i
p(xi) = probability of outcome i

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 Decision Making with
Probabilities: Example 17

STATES OF NATURE
Good Foreign Poor Foreign
DECISION Competitive Conditions Competitive Conditions

Switch business $ 800,000 $ 500,000

Maintain status quo 1,300,000 -150,000
Sell now 320,000 320,000
p(good) = 0.70 p(poor) = 0.30
EV(switch business):$800,000(0.7) + 500,000(0.3) = $710,000
EV(status quo): 1,300,000(0.7) -150,000(0.3) = 865,000  Max
EV(sell): 320,000(0.7) + 320,000(0.3) = 320,000

Decision: status quo

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 Expected Value of
Perfect Information 18

EVPI
– maximum value of perfect information to the decision maker

Maximum amount that an investor would pay to

purchase perfect information

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 EVPI Example
19

 Good conditions will exist 70% of the time

 choose maintain status quo with payoff of $1,300,000
 Poor conditions will exist 30% of the time
 choose switch business with payoff of $500,000
 Expected value given perfect information, EVWPI
= $1,300,000 (0.70) + 500,000 (0.30)
= $1,060,000
 Recall that expected value without perfect
information, EVWOP was $865,000 (maintain
status quo)

EVPI= $1,060,000 - 865,000 = $195,000

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 Sequential
Decision Trees 20

 A graphical method for analyzing decision situations

that require a sequence of decisions over time
 Decision tree consists of
 Square nodes - indicating decision points
 Circles nodes - indicating states of nature
 Arcs - connecting nodes

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 Sequential
Decision Trees: Example 21

Exercise question
The management of State Union Bank was concerned about the potential
loss that might occur in the event of a physical catastrophe such as a
power failure or a fire. The bank estimated that the loss from one of these
incidents may result in interrupted service and drop in customer
satisfaction and losses could be very high. One project the bank is
considering is the installation of an emergency power generator at its
operations headquarters. The cost of the emergency generator is
$900,000, and if it is installed no losses from this type of incident will be
incurred. However, if the generator is not installed, there is a 10% chance
that a power outage will occur during the next year. If there is an outage,
there is a 0.04 probability that the resulting losses will be very large, or
approximately $90 million in lost earnings. Alternatively, it is estimated
that there is a 0.96 probability of only slight losses of around $2 million.
Using decision tree analysis, determine whether the bank should install
the new power generator.
Ref: Roberta Russell & Bernard W. Taylor, III
BITS Pilani, K K Birla Goa Campus
 22

Since cost of installation

($900,000) is greater than
expected value of not
installing ($552,000), do
not install an emergency
power generator

BITS Pilani, K K Birla Goa Campus

 Decision Tree Analysis (10 year horizon)
23
$ $3,000,000
0.60 Market growth
2
0.40
$800,000
$2,000,000
$
0.80
$ 6
$700,000
0.20
1 $ 4

$700,000
0.60 $1,300,000
$
3
0.40
0.30
$ 7
$
0.70 $1,000,000
5

$700,000

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 Sequential
Decision Trees: Case Study 24

Case:Transformer Replacement at Mountain States Electric Service

An electrical utility company serving several states in the Rocky Mountain
region is considering to replace some of its equipment at a generating
substation and is attempting to decide whether it should replace an older,
existing PCB transformer. (PCB is a toxic chemical known formally as
polychlorinated biphenyl.) Even though the PCB generator meets all
current regulations, if an incident occurred (such as a fire, and PCB
contamination caused harm to neighboring businesses or farms or to the
environment), the company would be liable for damages. Recent court
cases have shown that simply meeting utility regulations does not relieve
a utility of liability if an incident causes harm to others. Also, courts have
been awarding large damages to individuals and businesses harmed by
hazardous incidents. If the utility replaces the PCB transformer, no PCB
incidents will occur, and the only cost will be that of the transformer,
$85,000.

Ref: Roberta Russell & Bernard W. Taylor, III

BITS Pilani, K K Birla Goa Campus
 25

Alternatively, if the company decides to keep the existing PCB transformer, then
management estimates there is a 50-50 chance of there being a high likelihood of an
incident or a low likelihood of an incident. For the case in which there is a high likelihood
that an incident will occur, there is a 0.004 probability that a fire will occur sometime
during the remaining life of the transformer and a 0.996 probability that no fire will occur.
If a fire occurs, there is a 0.20 probability that it will be bad and the utility will incur a very
high cost of approximately $90 million for the cleanup, whereas there is a 0.80 probability
that the fire will be minor and a cleanup can be accomplished at a low cost of
approximately $8 million. If no fire occurs, then no cleanup costs will occur. For the case
in which there is a low likelihood of an incident occurring, there is a 0.001 probability that
a fire will occur during the life of the existing transformer and a 0.999 probability that a
fire will not occur. If a fire does occur, then the same probabilities exist for the incidence
of high and low cleanup costs, as well as the same cleanup costs, as indicated for the
previous case. Similarly, if no fire occurs, there is no cleanup cost. Perform a decision-
tree analysis of this problem for Mountain States Electric Service and indicate the
recommended solution. Is this the decision you believe the company should make?
Explain your reasons. Ref: Roberta Russell & Bernard W. Taylor, III
BITS Pilani, K K Birla Goa Campus
Thank You

BITS Pilani, K K Birla Goa Campus