u UNIVERSITATEA ROMANO-AMERICANA BUCURESTI MARIAN ZAHARIA BOGDAN POENARU Quantitative methods lecision making a wlMARIAN ZAHARIA BOGDAN POENARU Prof. univ. dr. Asist. univ. drd. Quantitative methods for decision making EDITURA UNIVERSITARA BUCURESTI, 2005FOREWORD System, model, simulation — usual words in our daily vocabulary — however, few of us are aware of the profound meaning of these expressions, and their use in decision making processes is still unsatisfying. Despite the fact that we live in a world of competition, in which a person’s success is based on a permanent competition with others and itself, few people realize the need for complementing the quantitative methods in the process of modeling and optimizing management decisions, in more tra- ditional fields, such as production and engineering, as well as in newer fields such as finance, marketing, or different services, in order to obtain competi- tive results. . The present work wishes to be a practical and theoretical immersion into the study of management decision-making modeling instruments. We have emphasized the understanding of basic concepts from a myriad of ap- plications. The theoretical concepts have been illustrated with many examples, in order to offer a strong knowledge base. The paper is addressed to both graduate and undergraduate students, managers from all levels and anyone interested in the study of business deci- sion-making methods. I wish to express my gratitude to the Rector of the Romanian-Ameri- can University, (ON SMEDESCU, Ph. D. and to the staff of the Department of Management of IT Systems where | teach the courses: “Modeling and simu- lating of economical processes” and “Operational research”. | would also want to thank the 3” students from the Department of Management of IT Systems my students in 2003/2004-university year. Spe- cial thanks must go to Alexandru Gheorghiu, whose strong support was felt throughout the writing of the present course. Fully aware of the fact that the book might still be perfected, we thank in advance to anyone who, through suggestions, critiques or observations, will contribute in rendering this book even better. Marian Zaharia Balea Lac, 2004Contents a - Volume 1 - 1. Decision — Basics ..........cccccccscssscssssescssessssssssseseseseeseees LT Definition and role ..........ccccccscscesssssscsevecsessceseseneceseeseereee LT Micro — Structure of Decisional Process ...........0e 12 Decision and Structure ............sscccrscesssressssessssnssssees sess 14 Decision and Continuity ...........ccsccsrssssecsesseseeeeeenee 15 Characteristics, Factors and Types of Decisions ........... 17 Decision Making Process .........c..ssssssssseesssssctecsesserceeee 21 Decision Modeling .........s.scecssssssssescssvssessseessesssssersnneeseene 29 Keywords .........csecsssressrnssrcseeeees sescaseescecsestecsscesssessossesesces OX 2. Linear Programming .............cccccssseessseersrenseneeeneeeene ID Assumptions and Steps to Formulating Models ............ 33 Illustrative Simple Linear Programming Models......... 37 Forms of Linear Programming ..........sccscccsreceessene 4 Feasible Solution. Basics .............:.000+ savessecescesnessseeores ww. 46 Graphical Soltions ..........ssccsssecssecsesesssesserensesseesseessseeese 4B Algebraic Solution — Simplex Method .............ssseerseeee- 55 Simplex Tableau ............sscssscssssessesseseeneesscesseoseesssssseesees SD KeyWords .........cccesceesessereeserseeres secessesecsecsessesscessssscsesseesons 72 QM Applications ...........sscccsscsseessesseescesnessessessersessesnsesnee 73 PrODleMS .......cceccscssssscscscsesceccecessessssesscssesescssceseccseceeeseteses TD 3. Transportation Problem ............ sseesccesenassnsseccesscssesesess 79 Illustrative Examples — set up the transportation tableaud ......cccccccscccsccescecccessteesceeesessecsssessessseessesreeeseereneee 8S Develop an Initial Solution ................. secsasssscessosacoeeneeees . 86 Determine and Evaluate the Optimum Solution .......... 92 Unbalanced Transport Problems ...............++- sesccseseeserereee 101 DOGENETACY ..........cecsersrsserseoncreroees seceeseesesnseeraccesscesssssssveres 102 Keywords. .........0.. sesccssesesensecnsscesers secessssscseecassceseessssssseeess 106 QM Applications ............cserseceeeesees secessessesesscsccsecesecess — LOT PLODIEMS. .........seesressscesssscsssesssseesssseseressnnsassssssvesesssocsrseees . 108 4. Decision Making under Risk .............ccsscsscseerererere 114The Risk in Decision Making .................++- seccseesecescesssveess Iustrative Examples ...............sssscsscssssscssssssssssscsonorsesnerses The Payoff Matrix under Risk ................. sesscccecessesscenenees Decisional Criteria under Risk ..................cssssssssssseessevseens KeyWOrdSs ........cccccscserscrnssnsscensccssssrensnesvnsscnonsosescsserscceneenes QM Applications. ...........csscsscssscerccvrrseersessccseereneesnseens Problems COO FOE FOES ECE ESS OOF OT OOOH SEES EEEESE EE HE SESESEESSS OSES SHOE EEHEDESEOHOE EEEES 5. Decision Making under Uncertainty. .............csessssoere The Uncertainty in Decision Making ...........sssssssscsssooees Mlustrative Examples ...............ccccssssecoreseressessesssnseessscessees The Payoff Matrix under Uncertainty .............ssessessree Decisional Criteria under Uncertainty .............csssssssees Keywords ......... covcercnerenccscsressesnsesssoseeeescnsousesscssensccssncesessees QM Applications. .........cccescesssseerenescrsssescsssereeseneeesensees Problems 260 OSS OP OSHS EE EEEEEEEEEOHEES OS EESEEESSOCECE SH SCP SEHSSEHEEEOHEE FE SESHEEEHESCECED 6. Decision Tree — AnallySis ...............srcccesserrssssssresonesssensos Two Multiple Stage Decisional Problems ..................00++ Structural Elements of Decisional Tree ..............00ssesesees Building Decisional Trees ............rssercccceserescseesseoesenres Evaluating Decisional Trees ............ssscssssssssrosssesoerrrsosees Illustrative Examples ..............scssccsscsesssnnssccseoss sonsccsecorseseees KRY WOTGS .........c.sccorsessrscecccsnscsnssesesvcoscvssensrecosassscsseeeesnseenes QM Applications ................ccssceeresserrsseesrcesrenessercesseeesaneeeses Problems .........cccsrsecscossecccccsssscsccesseereccsensneesssssnessessoosesssorsones Selected bibliography DOEEEOOS OSC CESS EE EE EE EE EE EOEE DS FOSS EOEESEOESEOEEHESEEEEEED 114 118 120 122 125 125 127 130 130 131 133 135 141 142 145 149 149 151 153 156 161 164 164 167 173CHAPTER 1 Decision — Basics Decision is an outstandingly important act for the development of any dynamic system. DEFINITION AND ROLE Decision has a strong operational character by deep and effective staff's (executing and leading) involvement in the achievement of their tasks. The emphasis, on this case, is on the staff's motivation. According to the level at which it is exercised, decisions represents the leader's conscious intervention, which fundaments the further evolution of the managed system. Decision means the assembly of processes through which the nature and contents of the system resources change, thus contributing to the modification of the objective needs system and aiming at accomplishing its social-economic optimum. In fact, decision-making means the process or the activity of selecting, according to certain criteria, a course of action which belongs to the set of possible alternatives. | A manager may choose from more possible variants based on significant information, affecting the other managers’ behavior and contributing to the achievement of the organization’s goals. In the managerial process, decisions play more roles: e decision is what establishes the plan-derived objectives, their ~ accomplishment, adopts the corresponding proposal a and the correcting actions; e by decisional processes the following occurs: the determination of each organizational part’s role within the organization, consequently, each employee’s role.12 Chapter 1 Practically, managerial decisions consist of a wide range of options, resulted from the variety and complexity of the real world’s processes that must be conducted by decision-making. This stresses upon the fact that the manager should know and be able to handle different situations, be familiar with the communication “arts” in order to be capable of making good and quick decisions. MICRO-STRUCTURE OF A DECISIONAL PROCESS Any decisional process involves the following basic elements: e the desired state (goal); the real state; the difference; the rhythm of modifying the real state; maintaining the admissible policies. The interaction among these elements is illustrated in Figure 1.1. Micro-structure of a Decisional Process THE RHYTHM OF MODIFICATION > REAL STATE OF THE REAL STATE THE DISIRED STATE (THE OBJECTIVE) SET OF ADMISSIBLE POLICIES DIFFERENCE —— (+) Desired state The desired state represents the decision-making factors goal and answer to the questions: “What is desired?” By its very nature, the desired state is represented by a measurable and determined element (constant or variable). :Decision - Basics 13 re ee Real state — The real state should constitute, in its turn, a measurable element represented by one or more state indicators (usually, performance indicators) which answer the question: “What is our present state?” In the real systems, the real state may be considered as a determined variable. Unlike these “exceptional” situations, the real state can be either a stochastic variable, or the measure of an uncertainty. This is due to considering only a limited number of factors in determining the system state, ~ on the one hand, or the reduced amount of data considered when analyzing the system that is the management object, on the other hand. Difference The difference is a variable which, by size and sign, provides the decisional factor with information related to the sense and value of the difference between the goal and the system’s real state. The difference answers the question: “Where do we stand in relation to the goal?” Set of admissible policies The set of admissible policies is fomed by the all the actions, procedures, algorithms and strategies considered applicable in relation with the system and the decision-making factor’s values. Mention should be made that procedures or actions considered admissible in one system may be unacceptable, illegal or immoral in other systems. A possible way to identify sets of admissible policies is, for instance, the attempt to answer the question: "What rules does the system have?” Rhythm of modifying The rhythm of modifying the real state is an action part within the decisional process and results from the choice, from the set of the admissible policies, of the desired state that allows drawing closer to the system, in the conditions of optimizing some indicators considered essential by the decisional factor (e.g. shortening the goal reaching time, cutting down costs, profit increase, risk decrease, gain maximization, etc.). Among the decision process elements enumerated above, two elements determine special problems resulted from the type and characteristics of the decisional process. e The first difficulty which the decisional factor encounters is the identification of the real state. Usually, this is the result of the statistically14 Chapter 1. processing of a_ significant amount of data and “inherits” the characteristics of the events related to the sequences of the analyzed data. e The second difficulty is that of choosing, from the set of admissible decisions, the one(s) that ensure(s) the optimization of the performances considered by the decisional factor. DECISION AND STRUCTURE The real world’s systems are complex economic systems whose manifestations are represented by the time evolution of their states. The state of a system is a measure of its structure and external connections at a certain moment, and the system structure is the result of its systems’ interconnections. The external interconnections of any system may exercise upon it influences to which it can or cannot react. From the point of view of the influencing capacity of its components, a real world’s system may be considered as having the following components: e The inner environment; e The influence-subjected outer environment; e The non-influence-subjected outer environment. Inner environment The inner environment, also called leading subsystem, is made of the totality of elements (variables) upon which the decisional can act directly. This subsystem is known and subject to change. For instance, within a firm which functions on a perfect competitive market, variables such as the number of employees, their salaries and production volume belong to the outer environment. influence-subjected outer environment The influence-subjected outer environment is made of the set of elements (variables) upon which the decisional factor can act only indirectly (by other subsystems that do not belong to him). For instance, within the firm mentioned above, the influence-subjected outer environment is constituted by the majority of elements that form the firm’s market. The market influences the firm by product demand or some product rejection, while the firm cannot directly act upon it. Thus, the decision factor (Administration Board) hopes to influence the market by launching new _ products, advertising, etc. but the market response depends on what the otherDecision - Basics 15 A competing firms do, on the one hand, and on that market consumers’ behavior, on the other hand, Non-influence-subjected outer environment The non-influence-subjected outer environment contains those system parts which directly influence the inner environment (the leading system), but upon which this cannot exert any influence. For instance, if the inner environment is represented by the firm, then the non-influence-subjected outer environment is represented by administrative, banking, etc. (variable) elements. Mention should be made that a system structure in the three subsystems strictly depends on the concrete conditions within which they act. For example, if we analyze a firm which functions on a perfect competing market, then the selling price of the products is determined by the market, that is, it belongs to the non-influence-subjected outer environment, if the market is an oligopoly competing one, the price belongs to the non- influence-subjected outer environment, while if the firm holds the monopoly on its products market, the price belongs to the inner environment (it can be directly modified by the firm’s leading system). Knowing exactly the inner structure of the systems within which the decisional processes take place is thus outstandingly important because a decisional factor must be aware of: e What can be modified directly? e What can be influenced (and how)? e What cannot be modified? DECISION AND CONTINUITY In time, the evolution of real systems is continuous only within certain periods of time determined by their structure as well as on their belonging to hierarchically superior systems characterized by their own discontinuity. Thus, for a certain time interval, according to the nature and level of the analyzed system, its structure may be considered invariant. However, for a long period of time, the evolution of one or more factors may lead to the necessity of operating some structural modifications in order to adopt some specific goals.16 Chapter 1 By analyzing the time behavior of an economic system (Figure 1.2), we notice that it is governed by two fundamental activities. The first activity is the leading one carried out during the periods between two consecutive structural modifications and is characterized by the fact that guiding the system behavior is performed by policies that do not affect the system structure. For instance, maintaining production at a certain level may be done by policies which relate to the human resource volume and materials involved in the production process. : Dynamics of the economic systems structure Discontinuity moments (structural modification) YP Se So MmMVCAOCDANVN : Constant Structural Periods DO-Decision - Basics 21 Non-programmable decisions They are decisions process based on variables which may not be quantified and the human factor has decisive role in making it. DECISION MAKING PROCESS | This is usually a complex and difficult process. One should keep in mind that the human resource is one of the most valuable within the organization, but, at the same time, the most complex. This explains the complexity of the decision-making process. That is why there are several solutions for decision-making, but only from the point of view suggested by different authors, mainly based on the experience gained in organizations. We shall approach some viewpoints that relate to the steps that should be taken when making a decision. The first perspective regarding the decision-making process is illustrated in Figure 1.4. The main steps are: e Problem analysis (analysis of the problem to solve). e Determination of the set of possible solutions (development of variant solutions). e Analysis of possible solutions. e Selection of optimal solution (selection of the most useful solution according to the established goal). e Decision implementation (applied of selected solution). e Review of results (analysis of the consequences of decision made). According to the complexity of the problem to solve, in the decision making process all the 10 sub-step present in Figure 1.4 may be taken gradually, or only some of them. Another approach starts from the question technique in order to build a logical process which leads to an easy and quick decision-making. Here is such a model: Analysis of the Situation (AS) « What situation are we dealing with? « What is the target? » Haw can the situation be described?22 Chapter 1 = What should be done immediately? How can the situation be structured? ‘What tasks result from this situation? What shall we do? ao In what sequence and for how long? o What methods can be used? o Whois in charge? o What actions are necessary? Analysis of the Problem (AP) What problem must be solved? Haw can the problem be divided? o What are the questions (what, when, where)? What do these questions result from? o What could it be? Which is the possible one? Which are the most likely? How can they be foreseen? . | Can we take a step now? Let’s do it! Should we plan a guarantee the activities? Should we make a decision? First, we must clarify the objective. ooo oc 00 Objective Planning What task of objective planning must be done? o Whatis the basic situation? What do we want to achieve? Which are short-term, medium-term and long-term objectives? Who is affected by them? What goals must be achieved? What steps should be taken in order to achieve these goals? What priorities do we settle? Are the decisions related to goal-achievement made? Is the examined situation specific to goals? Is problem-solving an essential condition for achieving the goals? May direct steps be taken in order to achieve the goals? Decision-making What decision must be made? | What goals or requirements must be met?Decision - Basics 23 Which one is necessary, vital, good? _ What alternatives do we have? o What characteristics does this alternative have? o Which alternative seems better? ' o Which alternatives are admissible? o Which altemative best suit the goals or requirements? o Which alternative will be fulfilled? Is it a strategic decision? If it is, does it verify the achievement? Should a planning activity be for ensured and elaborated? Should direct steps be taken for implementing this decision? Planning Activity What step should be taken? o For what purpose? What individual steps or activities are necessary? o In what sequence? o Whois in charge? What significant risks might appear during this plan interval? o What risks are obvious? How can these risks be diminished or eliminated? What preventive measures must be taken? How is the application of this planning activity controlled? Who is in change? What information systems must be established? 00000 Problem Solving and Actual Decision-Making Who will be involved in: o providing the necessary experience and expertise? o contributing to the synergetic effect? o organizing and control the application? o Communicating with other positions and people involved? Who makes the final decision? Who could support or prevent the application? How to guarantee the acceptation? How to make the impression? What should you do? Who should be proxy? When building these stages, one should be aware of the fact that “a good question is already half answered’.24 Chapter 1 Another way to approach the decisional process refers mainly to the following steps: e Problem definition: it is one of the most important phases of the decision-making process, since the following stage depends on it, so” it is essential that the problem to solve be correctly and completely defined. Identification of critical factors: it is tightly connected to the first stage as the critical result from the questions formulated when defining the problem. Elaboration of possible alternatives: all the possible solutions to the problem are sought. | Analysis of alternatives: advantages and disadvantages of each problem are considered. Selection of the best alternative: it is influenced by the manager's experience, testing of the suggested solution, expensive technique, or accomplishment of mathematical models and problem simulation. Solution implementation: involves the precise and _ concrete formulation of the selected alternative and its transmission to subordinates; putting the decision into practice is the next step. Establishment of the control and assessments system: this stage provides information regarding the real system’s reaction. Finally, the decisional process may be regarded as a continuous dynamic process having the following phases (Figure 1.5). The phases of decisional cycle are: * @e@e0@¢@¢ @ @ Problem definition. Data collection. Elaboration of alternative solutions. Evaluation of consequences. Select of the best solution. Implementation of solution. Assessment of results. In conclusion, the decision-making process is a continuous and complex one, which starts with asking the questions, continues with seeking and encouraging the activity of looking for creative answers and ends with the assessment of the suggested solution. Mention should be made that usually, in practice, little attention is paid to the assessment of the chosen solution consequences, although this is an important phase of decisional process.