Decision Making. Introduction What: Decision making tools Where: Making business decisions Why: We want to avoid making bad decisions.

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Presentation transcript:

Decision Making

Introduction What: Decision making tools Where: Making business decisions Why: We want to avoid making bad decisions

Steps in Decision Making Define the problem Develop specific objectives Develop a model Evaluate each alternative solution Select the best alternative Implement the decision

A Decision Example Should the Stampede Flapjack Company build a new factory to produce its new line of pancake mixes, or use part of its existing facility? The factory will cost $15M to build. Probability of successful product is 65%

Our Forecast If the factory is built, and if the new line is a success, sales will be worth $25M. If it is not a success, overall sales will be worth $5M. If the factory is not built, and if the new line is a success, sales will be worth $8M. If it is not a success, sales will be worth $6M.

A Decision Tree Construct Plant Existing Plant A Decision Node

Adding the Construction Outcomes Construct Plant Existing Plant Successful (65%) - $25M Unsuccessful (35%) - $5M

Adding the No Construction Outcomes Construct Plant Existing Plant Successful (65%) - $25M Unsuccessful (35%) - $5M Successful (65%) - $8M Unsuccessful (35%) - $2M

Expected Monetary Value (EMV) Successful (65%) - $25M Unsuccessful (35%) - $5M EMV = $25M x $5M x 0.35 = $18M

What is the Better Choice? Construct Plant Existing Plant Successful (65%) - $25M Unsuccessful (35%) - $5M Successful (65%) - $8M Unsuccessful (35%) - $6M $18M $7.3M

Result Construct Plant Existing Plant Successful (65%) - $25M Unsuccessful (35%) - $5M Successful (65%) - $8M Unsuccessful (35%) - $6M $18M $7.3M $18M

In Other Words… Because the result for building the factory gives us a higher EMV, we choose it. Because the EMV is greater than the cost of constructing the factory, we will build it.

A Decision Table SuccessfulUnsuccessful Construct$25M5M Do Not Con$8M$6M

Calculating EMV’s Successfulp Un- successful pEMV Construct$25M.65$5M.35$18M Existing$8M.65$6M.35$7.3M

Expected Value of Perfect Information (EVPI) What would we be willing to pay for perfect information – to know the future? EVPI = EV Under Certainty – Max EMV

Expected Value Under Certainty Expected Value Under Certainty = Best outcome for first state x probability of first state + Best outcome for second state x probability of second state

Expected Value Under Certainty Successfulp Un- successful pEMV Construct$25M.65$5M.35$18M Existing$8M.65$6M.35$7.3M

Expected Value Under Certainty EV = $25M x 65% + $6M x 35% EV = $18.35

Expected Value of Perfect Information EVPI = EV Under Certainty – Max EMV EVPI = $18.35M - $18M EVPI = 0.35M So we would pay, for example, a maximum of $350K for a marketing study

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