MM3425 BUSINESS ANALYTICS

DECISION ANALYSIS

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Introduction
• Business analytics is about making better decisions.
• Decision analysis can be used to develop an optimal strategy:
• When a decision maker is faced with several decision alternatives and
an uncertain or risk-filled pattern of future events.
• For example: The State of North Carolina used decision analysis in
evaluating whether to implement a medical screening test to detect
metabolic disorders in newborns.
• A good decision analysis includes careful consideration of risk.

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Introduction
• Risk analysis helps to provide the probability information about the
favorable as well as the unfavorable outcomes that may occur.
• Decision analysis considers problems that involve reasonably few
decision alternatives and reasonably few possible future events.

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Problem Formulation
Payoff Tables
Decision Trees

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Problem Formulation
• The first step in the decision analysis process is problem
formulation:
• Create verbal statement of the problem.
• Identify the decision alternatives:
• The uncertain future events, referred to as chance events.
• The outcomes associated with each combination of decision alternative
and chance event outcome.

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Problem Formulation
Illustration: Pittsburgh Development Corporation (PDC):
• PDC commissioned preliminary architectural drawings for three
different projects:
• One with 30 condominiums.
• One with 60 condominiums.
• One with 90 condominiums.
• The financial success of the project depends on:
• The size of the condominium complex.
• The chance event concerning the demand for the condominiums.

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Problem Formulation
Illustration: Pittsburgh Development Corporation (PDC) (cont.):
• The statement of the PDC decision problem is to select the size of the
new luxury condominium project that will lead to the largest profit given
the uncertainty concerning the demand for the condominiums.
• Given the statement of the problem, it is clear that the decision is to
select the best size for the condominium complex.
• PDC has the following three decision alternatives:
d1  a small complex with 30 condominiums.
d2  a medium complex with 60 condominiums.
d3  a large complex with 90 condominiums.

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Problem Formulation
• In decision analysis, the possible outcomes for a chance event are the
states of nature.
• The states of nature are mutually exclusive (no more than one can occur)
and collectively exhaustive (at least one must occur).
• Thus, one and only one of the possible states of nature will occur.
• For PDC example: The chance event concerning the demand for the
condominiums has two states of nature:
s1  strong demand for the condominiums
s2  weak demand for the condominiums.

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Problem Formulation
Table 15.1: Payoff Table for the PDC Condominium Project ($ Millions)

Payoff Tables:
• Payoff is the outcome resulting from a specific combination of a decision alternative
and a state of nature.
• Payoff table is a table showing payoffs for all combinations of decision alternatives and
states of nature.

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Problem Formulation
Payoff Tables (cont.):

We will use the notation Vij to denote the payoff associated with decision
alternative i and state of nature j.

Using Table 15.1, V31  20 indicates that a payoff of $20 million occurs if the
decision is to build a large complex (d3 ) and the strong demand state of
nature (s1 ) occurs. (j = 1 to 2)

(i = 1 to 3) = V11 = V12
= V21 = V22
= V31 = V32

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Problem Formulation
Decision Tree:
A decision tree provides a graphical representation of the decision-making
process.
Shows the natural or logical progression that will occur over time.
Illustration: The topmost payoff of 8 indicates that an $8 million profit is
anticipated if PDC constructs a small condominium complex (d1 ) and
demand turns out to be strong (s1 ).

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Problem Formulation
Figure 15.1: Decision Tree for the
PDC Condominium Project ($
Millions)

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Problem Formulation
Decision Tree (cont.):
• The decision tree in Figure 15.1 shows:
• Four nodes, numbered 1–4.
• Nodes are used to represent decisions and
chance events.
• Squares are used to depict decision nodes,
circles are used to depict chance nodes.
• Node 1 is a decision node, and nodes 2, 3,
and 4 are chance nodes.

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Problem Formulation
Decision Tree (cont.):
• The branches connect the nodes; those leaving the decision node
correspond to the decision alternatives.
• The branches leaving each chance node correspond to the states of
nature.
• The outcomes (payoffs) are shown at the end of the states-of-nature
branches.

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Decision Analysis Without
Probabilities
Optimistic Approach
Conservative Approach
Minimax Regret Approach

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Decision Analysis without Probabilities

Decision analysis without probabilities is appropriate in situations:

• In which a simple best-case and worst-case analysis is sufficient.
• Where the decision maker has little confidence in his or her ability to
assess the probabilities.

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Decision Analysis without Probabilities

Optimistic Approach:
• The optimistic approach evaluates each decision alternative in terms of
the best payoff that can occur.
• The decision alternative that is recommended is the one that provides
the best possible payoff.
• For minimization problems, this approach leads to choosing the
alternative with the smallest payoff.

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Decision Analysis without Probabilities
Optimistic Approach (cont.):
• In the PDC problem, the optimistic approach would
lead the decision maker to choose the alternative
corresponding to the largest profit.
Table 15.2: Maximum Payoff For Each PDC Decision
Alternative

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Decision Analysis without Probabilities

Conservative Approach:
• The conservative approach evaluates each decision alternative in terms
of the worst payoff that can occur.
• The decision alternative recommended is the one that provides the best
of the worst possible payoffs.
• For problems involving minimization (for example, when the output
measure is cost), this approach identifies the alternative that will
minimize the maximum payoff.

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Decision Analysis without Probabilities
Conservative Approach (cont.):
• In the PDC problem, the conservative approach would
lead the decision maker to choose the alternative that
maximizes the minimum possible profit that could be
obtained.
Table 15.3: Minimum Payoff For Each PDC Decision
Alternative

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Decision Analysis without Probabilities

Minimax Regret Approach:

• Regret is the difference between the payoff associated with a particular
decision alternative and the payoff associated with the decision that
would yield the most desirable payoff for a given state of nature.
• Regret is often referred to as opportunity loss.
• Under the minimax regret approach, one would choose the decision
alternative that minimizes the maximum state of regret that could occur
over all possible states of nature.

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Decision Analysis without Probabilities
Minimax Regret Approach (cont.):
Using equation 15.1  and the payoffs in Table 15.1, the regret associated
with each combination of decision alternative di and state of nature s j
is computed.

= V11 = V12
= V21 = V22
= V31 = V32
V1* = 20 V2* = 7

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Decision Analysis without Probabilities
Table 15.4: Opportunity Loss, or Regret Table for
the PDC Condominium Project ($ Millions)

=|20-8| =|7-7|
=|20-14| =|7-5|
=|20-20| =|7 – (-9)|
V1* = 20 V 2* = 7

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Decision Analysis without Probabilities
Minimax Regret Approach (cont.):
• The next step in applying the minimax regret approach is to list the
maximum regret for each decision alternative.
• For the PDC problem, the alternative to construct the medium
condominium complex, with a corresponding maximum regret of $6
million, is the recommended minimax regret decision.
Table 15.5: Maximum Regret for Each PDC Decision Alternative

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Decision Analysis with
Probabilities
Expected Value Approach

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Decision Analysis with Probabilities

Figure 15.2: PDC Decision Tree

with State-of-Nature Branch
Probabilities

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Decision Analysis with Probabilities

Expected Value Approach:

• In decision-making situations where probability assessments for the
states of nature are available, we can use the expected value approach
to identify the best decision alternative.
• The expected value (EV) of a decision alternative is the sum of weighted
payoffs for the decision alternative.

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Decision Analysis with Probabilities
Figure 15.3: Applying the Expected
Calculate EV at Value Approach Using a Decision Tree
Chance Nodes 2, 3, 4 for the PDC Condominium Project

Select the best at

Decision Node 1

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Decision Analysis with Probabilities

Expected Value Approach (cont.):

• The weight for a payoff is the probability of the associated state of nature
and therefore the probability that the payoff will occur.
• Select the decision branch leading to the chance node with the best
expected value.
• The decision alternative associated with this branch is the recommended
decision.
• In practice, obtaining precise estimates of the probabilities for each state of
nature is often impossible, so historical data is preferred to use for
estimating the probabilities for the different states of nature.

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Decision Analysis with Sample
Information
Expected Value of Sample Information

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Decision Analysis with Sample Information

• Decision makers have the ability to collect additional information

about the states of nature.
• Additional information is obtained through experiments designed to
provide sample information about the states of nature.
• The preliminary or prior probability assessments for the states of
nature that are the best probability values available prior to
obtaining additional information.
• Posterior probabilities are revised probabilities after obtaining
additional information.

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Decision Analysis with Sample Information

• Illustration: PDC management is considering a 6-month market research

study designed to learn more about potential market acceptance of the
PDC condominium project, anticipating two results:
• Favorable report: A substantial number of the individuals contacted express
interest in purchasing a PDC condominium.
• Unfavorable report: Very few of the individuals contacted express interest in
purchasing a PDC condominium.
• A decision strategy is a sequence of decisions and chance outcomes in
which the decisions chosen depend on the yet-to-be-determined
outcomes of chance events.

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Decision Analysis with Sample Information
Figure 15.7: PDC Decision Tree After
Figure 15.5: The PDC Decision Tree Figure 15.6: The PDC Decision
Computing Expected Values at Chance
Including the Market Research Study Tree with Branch Probabilities Nodes 6 to 14

Calculate EV at
Provide Chance Nodes 6
probabilities to 14

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Decision Analysis with Sample Information
Figure 15.7: PDC Decision Tree After Figure 15.8: PDC Decision Tree After Figure 15.9: PDC Decision Tree
Computing Expected Values at Chance Choosing Best Decisions at Nodes 3, 4, Reduced to Two Decision
Nodes 6 to 14 and 5 Branches

(yet-to-be-determined outcome)
Select the best at
Decision Node 1

Select the best at Calculate EV at

Decision Nodes 3, Chance Node 2
4&5

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Decision Analysis with Sample Information
Figure 15.7: PDC Decision Tree After
Computing Expected Values at Chance
Nodes 6 to 14
• If the market research is favorable,
construct the large condominium
complex.
• If the market research is unfavorable,
construct the medium condominium
complex.

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Decision Analysis with Net Present Value

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
DECISION ANALYSIS WITH PROBABILITIES (without net present value
calculation)
■ The owner of Hackers Computer Store is evaluating three options
– Move to a new site
– Expand at current site
– Do nothing
■ The decision process includes the following assumptions and conditions
– Strong growth: 55% ; weak growth: 45%
– Moving to a new site cost is $210,000
■ Payoffs: strong growth = $195,000; weak growth = $115,000
– Expanding current site cost is $87,000 (in either this year or next year if strong
growth)
■ Payoffs: strong growth = $190,000; weak growth = $100,000
– Do nothing
■ Payoffs: strong growth = $170,000; weak growth = $105,000
– Business length = 5 years
21

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 38

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Revenue is generated in Year 1,Year 2,Year 3,Year 4 and Year 5

e.g.,
Revenue of moving to new location with strong growth
= Payoff x 5 = $195,000 x 5=$975,000
Alternative Revenue Cost Value

Move to new location Strong growth $ 975,000 $ 210,000 $ 765,000

Weak growth $ 575,000 $ 210,000 $ 365,000

Expand store Strong growth $ 950,000 $ 87,000 $ 863,000

Weak growth $ 500,000 $ 87,000 $ 413,000

Do nothing Strong growth Expand next year $ 930,000 $ 87,000 $ 843,000

Strong growth Do not expand next year $ 850,000 $ - $ 850,000

Weak growth $ 525,000 $ - $ 525,000

39

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Value
765000
EV(Move) = (765000 x 0.55) + (365000 x 0.45) = 585000
365000

863000
EV(Expand) = 660500
413000

843000

850000
EV(Do nothing) = 703750
3. Select the best 1. Select the best
525000

2. Calculate EV

Processing backward

40

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
NET PRESENT VALUE
■ Net present value (NPV) model
– Uses management’s minimum Is it the same to receive $100 today or
desired rate-of-return (discount rate) $100 one year later?
to compute the present value of all net
cash inflows
– + NPV: project meets minimum
desired rate of return and is eligible
for further consideration
– - NPV: project is rejected

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 DECISION ANALYSIS WITH PROBABILITIES (with net present value
calculation)
■ The owner of Hackers Computer Store is evaluating three options
– Expand to a new site
– Expand at current site
– Do nothing
■ The decision process includes the following assumptions and conditions
– Strong growth: 55% ; weak growth: 45%
– New site cost is $210,000
■ Payoffs: strong growth = $195,000; weak growth = $115,000
– Expanding current site cost is $87,000 (in either this year or next year if strong
growth)
■ Payoffs: strong growth = $190,000; weak growth = $100,000
– Do nothing
■ Payoffs: strong growth = $170,000; weak growth = $105,000
– Business length = 5 years
– Required rate of return = 16%
42

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Revenue is generated in Year 1,Year 2,Year 3,Year 4 and Year 5

e.g.,
Revenue of moving to new location with strong growth
= NPV of payoff in Year 1 + NPV of payoff in Year 2 + NPV of payoff in Year 3 + NPV of payoff in Year 4 + NPV of payoff in Year 5
= ($195,000/1.161) + ($195,000/1.162) + ($195,000/1.163) + ($195,000/1.164) + ($195,000/1.165) = $638,487
Alternative Revenue Cost Value

Move to new location Strong growth $ 638,487 $ 210,000 $ 428,487

Weak growth $ 376,544 $ 210,000 $ 166,544

Expand store Strong growth $ 622,116 $ 87,000 $ 535,116

Weak growth $ 327,429 $ 87,000 $ 240,429

Do nothing Strong growth Expand next year $ 604,874 $ 75,000 $ 529,874

Strong growth Do not expand next year $ 556,630 $ - $ 556,630

Weak growth $ 343,801 $ - $ 343,801

43

© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 1. Select the best

3. Select the best

2. Calculate EV
44

Processing backward
© 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.