ISOM 2700: Operations Management

Session 6: Resource Management I

Dongwook Shin
Dept. ISOM, HKUST Business School
Course Roadmap
Bottleneck
Little’s law
Utilization

Control chart
Acceptance sampling
Six sigma

Maximize
Profits

Decision tree method

Linear programming

1
Learning Objectives: Resource
Management I

• Introduction to capacity planning

• Decision tree method

• Value of perfect information

2
Capacity Planning

Inputs Transformation
Outputs
Process
Labor Products
Facility &
Energy Services
Material
Information

Capacity = ?

3
Capacity Planning
• Capacity Planning is the practice of determining the
production capacity to meet uncertain demand

• Inadequate capacity
planning can lead to
the loss of customer
• Excess capacity can
drain the company’s
resources and prevent
investment into more
lucrative ventures

4
 Short-run Economies of Scale

Average
unit cost
of output
100-unit
plant
200-unit
plant 400-unit
300-unit
plant
plant

Volume

5
Long-run Economies of Scale

Average
unit cost
of output
Under-utilization Over-utilization

Best
operating
level

Volume

Economies of scale Diseconomies of scale

6
Capacity Planning: Beyond the Question
of How Much

• Maintaining system balance

• Subordinating non-bottleneck resources to the bottleneck

• Frequency of capacity additions

• Frequent expansion vs. Expanding capacity in large chunks

• External sources of capacity

• Outsourcing, sharing capacity

7
Learning Objectives: Resource
Management I

• Introduction to capacity planning

• Decision tree method

• Value of perfect information

8
 Glass Factory Example

A glass factory specializing in crystal is experiencing a

substantial backlog, and the firm's management is considering
three courses of action:

A) Subcontracting
B) Construct new facilities
C) Do nothing (no change)

The correct choice depends largely upon demand, which may

be low, medium, or high. By consensus, management
estimates the respective demand probabilities as 0.1, 0.5, and
0.4.
9
 Glass Factory Example

The management also estimates the profits when choosing

from the three alternatives (A, B, and C) under the differing
probable levels of demand. These profits, in thousands of
dollars are presented in the table below:

0.1 0.5 0.4

Low Medium High
A 10 50 90
B -120 25 200
C 20 40 60

10
Profit-Maximizing Alternative
• Let R x,y be the payoff under alternative x (A, B, or C)
and demand condition y (Low, Medium, High)
• Expected profit under alternative x
EVx = ! P y R(x, y)
y
0.1 0.5 0.4
EVx
Low Medium High
A 10 50 90 (0.1x10)+(0.5x50)+(0.4x90)=62
B -120 25 200 (0.1x(-120))+(0.5x25)+(0.4x200)=80.5
C 20 40 60 (0.1x20)+(0.5x40)+(0.4x60)=46

• Profit-maximizing alternative is B
11
 Decision Tree: 1. Display Decisions

A
B
C

Decision Point

12
 Decision Tree: 2. Add Financial Data

Event
High demand (0.4) $90k
Medium demand (0.5) $50k
Low demand (0.1) $10k

A High demand (0.4) $200k

B Medium demand (0.5) $25k
Low demand (0.1) -$120k
C
High demand (0.4) $60k
Decision Point Medium demand (0.5) $40k
Low demand (0.1) $20k
13
 Decision Tree: 3. Evaluate Outcome for
Each Decision

High demand (0.4) $90k

Medium demand (0.5) $50k
Low demand (0.1) $10k

(0.4×$90k) + (0.5×$50k)+(0.1×$10k)=$62k

Decision Point

14
Decision Tree: 4. Decision

High demand (0.4) $90k

$62k
Medium demand (0.5) $50k
Low demand (0.1) $10k

A High demand (0.4) $200k

$80.5k
B Medium demand (0.5) $25k
Low demand (0.1) -$120k
C
High demand (0.4) $60k
$46k
Medium demand (0.5) $40k
Low demand (0.1) $20k
15
Elements of Decision Tree
• Possible future conditions or
states of nature
• Probability of each future
condition
• Decision alternatives
• Outcome or payoff for each
alternative under every future
condition
• Decision criterion

16
Example: Hackers’ Computer Store

Due to increasing sales over the past

years, the management is considering
several options:
A. Move to new location
B. Expand store
C. Do nothing now, consider
expansion one year later

Besides your decision, the cost and revenue also depends upon
the future demand growth:
• Probability of strong demand = 0.55
• Probability of weak demand = 0.45
17
Payoff Table

Alternatives Revenue Cost Profit

Move to new location, strong 195,000 x 5 210,000 765,000
Move to new location, weak 115,000 x 5 210,000 365,000
Expand store, strong 190,000 x 5 87,000 863,000
Expand store, weak 100,000 x 5 87,000 413,000
Do nothing now, expand next 170,000 x 1+ 87,000 843,000
year if strong 190,000 x 4
Do nothing now, do not 170,000 x 5 0 850,000
expand next year if strong
Do nothing now, weak 105,000 x 5 0 525,000

18
Decision Tree
Strong demand (0.55)
$585K $765K
Move
Weak demand (0.45)
$365K

Strong demand (0.55)

$660.5K $863K
Expand
Weak demand (0.45)
$413K

Expand
$843K
Strong demand (0.55)
Do nothing Do nothing
$850K $850K
Weak demand (0.45)
$703.75K $525K
19
Learning Objectives: Resource
Management I

• Introduction to capacity planning

• Decision tree method

• Value of perfect information

20
Glass Factory Example Revisited
• Suppose we know the future demand before decision
making
• If demand=low, choose C
• If demand=medium, choose A
• If demand=high, choose B

0.1 0.5 0.4

Expected
Low Medium High
A 10 50 90
B -120 25 200
C 20 40 60
Best 20 50 200 (0.1x20)+(0.5x50)+(0.4x200)=107

21
Formal Explanation

• Optimal expected profit without perfect information

EV = maxx ! P y R(x, y)
y

• Expected profit with perfect information

EVPI = ! P y ⋅ maxx {R(x, y)}
y

• Value of perfect information = EVPI - EV

22
Hackers’ Computer Store Example
• If you know that the demand will be strong
• Your best decision is:
• Your profit is:

• If you know that the demand will be weak

• Your best decision is:
• Your profit is:

23
Value of Perfect Information
• If you know that the demand will be strong
• Your best decision is: Expand
• Your profit is: 863,000

• If you know that the demand will be weak

• Your best decision is: Do nothing
• Your profit is: 525,000

24
Value of Perfect Information
• How much are you willing to pay to know whether the
demand is weak or strong?
Value of Profit under Profit without
Perfect = Perfect − Perfect
Information Information Information

• You are willing to pay

7,150= 863,000×0.55+525,000×0.45 −703,750

25
Takeaways

• Use decision trees to evaluate capacity alternatives

• Next class: Resource Management II

26