01a Decision Making

Decision Making
Supplement A
© 2007 Pearson Education

Break-Even Analysis
 Break-even analysis is used to compare

processes by finding the volume at which two
different processes have equal total costs.
 Break-even point is the volume at which
total revenues equal total costs.
 Variable costs (c) are costs that vary
directly with the volume of output.
 Fixed costs (F) are those costs that remain
constant with changes in output level.
Break-Even Analysis
 “Q” is the volume of customers or units,

“c” is the unit variable cost, F is fixed
costs and p is the revenue per unit
 cQ is the total variable cost.
 Total cost = F + cQ
 Total revenue = pQ
 Break-even is where pQ = F + cQ
(Total revenue = Total cost)
Break-Even Analysis can
tell you…
 If a forecast sales volume is sufficient

to break even (no profit or no loss)
 How low variable cost per unit must be
to break even given current prices and
sales forecast.
 How low the fixed cost need to be to
break even.
 How price levels affect the break-even
volume.
Hospital Example
Example A.1
A hospital is considering a new procedure to be offered

at $200 per patient. The fixed cost per year would be
$100,000, with total variable costs of $100 per patient.
What is the break-even quantity for this service?
Q = F / (p - c) = 100,000 / (200-100) = 1,000 patients

Hospital Example
Example A.1 continued
400 –
300 – Quantity Total Annual Total Annual

Dollars (in thousands)
(patients) Cost ($) Revenue ($)

(Q) (100,000 + 100Q) (200Q)
200 – 0 100,000 0
2000 300,000 400,000
100 –
0–
| | | |
500 1000 1500 2000
Patients (Q)
Quantity Total Annual Total Annual
(Q) (100,000 + 100Q) (200Q)
0 100,000 0
2000 300,000 400,000
(2000, 400)
400 –
300 – Total annual revenues

200 –

100 – (patients) Cost ($) Revenue ($)
(Q) (100,000 + 100Q) (200Q)
0 100,000 0
0–
2000 300,000 400,000
| | | |
500 1000 1500 2000
Patients (Q)
(Q) (100,000 + 100Q) (200Q)
0 100,000 0
2000 300,000 400,000
(2000, 400)
400 –

(2000, 300)
200 – Total annual costs
100 –
Fixed costs
0–
| | | |
500 1000 1500 2000
Patients (Q)
(Q) (100,000 + 100Q) (200Q)
0 100,000 0
2000 300,000 400,000
(2000, 400)
400 –
Profits
(2000, 300)
Break-even quantity
100 –
Fixed costs
0 –Loss
| | | |
500 1000 1500 2000
Patients (Q)
Sensitivity Analysis
Example A.2
pQ – (F + cQ)
200(1500) 400
– [100,000
– + 100(1500)]
$50,000 Profits
300 –
Total annual revenues

Forecast = 1,500
100 –
Fixed costs
0 –Loss
| | | |
500 1000 1500 2000
Patients (Q)
Two Processes and
Make-or-Buy Decisions
 Breakeven analysis can be used to choose

between two processes or between an
internal process and buying those services or
materials.
 The solution finds the point at which the total
costs of each of the two alternatives are
equal.
 The forecast volume is then applied to see
which alternative has the lowest cost for that
volume.
Breakeven for
Two Processes
Example A.3

Fm – Fb
Q=
cb – cm
Breakeven for 12,000 – 2,400

Q=
Two Processes 2.0 – 1.5
Example A.3

Fm – Fb
Q=
cb – cm
Breakeven for Q = 19,200 salads

Two Processes
Example A.3

Preference Matrix
A Preference Matrix is a table that allows you to rate

an alternative according to several performance criteria.
The criteria can be scored on any scale as long as the

same scale is applied to all the alternatives being
compared.
Each score is weighted according to its perceived

importance, with the total weights typically equaling 100.
The total score is the sum of the weighted scores

(weight × score) for all the criteria. The manager can
compare the scores for alternatives against one another
Preference Matrix
Example A.4
Threshold score = 800
Performance Weight Score Weighted Score

Criterion (A ) ( B) (A x B )
Market potential
Unit profit margin
Operations compatibility
Competitive advantage
Investment requirement
Project risk

Preference Matrix

Criterion (A ) (B ) (A x B )
Market potential 30
Unit profit margin 20
Operations compatibility 20
Competitive advantage 15
Investment requirement 10
Project risk 5

Preference Matrix

Criterion (A ) (B ) (A x B )
Market potential 30 8
Unit profit margin 20 10
Operations compatibility 20 6
Competitive advantage 15 10
Investment requirement 10 2
Project risk 5 4

Preference Matrix

Criterion (A ) (B ) ( A x B)
Market potential 30 8 240
Unit profit margin 20 10 200
Operations compatibility 20 6 120
Competitive advantage 15 10 150
Investment requirement 10 2 20
Project risk 5 4 20

Preference Matrix

Criterion ( A) ( B) (A x B )
Project risk 5 4 20
Weighted score = 750

Preference Matrix
Score does not meet the
Threshold score = 800 threshold and is rejected.
Criterion ( A) ( B) (A x B )
Project risk 5 4 20
Weighted score = 750

Decision Theory
 Decision theory is a general approach to decision

making when the outcomes associated with alternatives
are often in doubt.
 A manager makes choices using the following process:
1. List the feasible alternatives

2. List the chance events (states of nature).
3. Calculate the payoff for each alternative
in each event.
4. Estimate the probability of each event.
(The total probabilities must add up to 1.)
5. Select the decision rule to evaluate the
alternatives.
Decision Rules
 Decision Making Under Uncertainty is when you are

unable to estimate the probabilities of events.
 Maximin: The best of the worst. A pessimistic approach.
 Maximax: The best of the best. An optimistic approach.
 Minimax Regret: Minimizing your regret (also pessimistic)
 Laplace: The alternative with the best weighted payoff
using assumed probabilities.
 Decision Making Under Risk is when one is able to
estimate the probabilities of the events.
 Expected Value: The alternative with the highest weighted
payoff using predicted probabilities.

Clemen’s Model of Decision Analysis
[adapted from Fig. 1.1]
 Identify the decision  Choose the best

situation & alternative
understand  Sensitivity analysis
objectives  Iterate or continue
 Identify alternatives the analysis?
 Decompose &  Implement chosen
model the problem alternative
 problem structure
 uncertainty
 preferences
O’Connor’s Model
ID the Develop Model DM’s

Decision; Influence Utility
Set Diagram
boundaries Structure &
for analysis Compute
ID Conduct Decision
Alternatives Sensitivity Tree or Run
Analysis M.C.
Develop
Simulation
Objective
Function Refine Compute
Influence EVPI
Diagram

MaxiMin Decision
Example A.6 a.
Events
(Uncertain Demand)
Alternatives Low High
Small facility 200 270
Large facility 160 800
Do nothing 0 0
1. Look at the payoffs for each alternative and identify the

lowest payoff for each.
2. Choose the alternative that has the highest of these.
(the maximum of the minimums)
MaxiMax Decision
Example A.6 b.
Events
(Uncertain Demand)
Do nothing 0 0
1. Look at the payoffs for each alternative and identify the

“highest” payoff for each.
2. Choose the alternative that has the highest of these.
(the maximum of the maximums)
Laplace
(Assumed equal probabilities)
Example A.6 c.
Multiply each payoff by the probability of
occurrence of its associated event.
Events
(0.5) (0.5)
Small facility 200 270 200*0.5 + 270*0.5 = 235
Large facility 160 800 160*0.5 + 800*0.5 = 480
Do nothing 0 0
Select the alternative with the highest weighted payoff.

MiniMax Regret
Example A.6 d.
Events
(Uncertain Demand)
Do nothing 0 0
Look at each payoff and ask yourself, “If I end up here, do

I have any regrets?”
Your regret, if any, is the difference between that payoff
and what you could have had by choosing a different
alternative, given the same state of nature (event).
MiniMax Regret
Example A.6 d. continued
Events
(Uncertain Demand)
Do nothing 0 0
If you chose a small If you chose a large facility and

facility and demand is demand is low, you have a regret of
low, you have zero 40. (The difference between the
regret. 160 you got and the 200 you could
have had.)

MiniMax Regret
Example A.6 d. continued
Events
(Uncertain Demand)
Do nothing 0 0
Regret Matrix Events

Building a large Alternatives Low High
MaxRegret
facility offers the Small facility 0 530 530
least regret. Large facility 40 0 40
Do nothing 200 800 800
Expected Value
Decision Making under Risk
Example A.7
Multiply each payoff by the probability of
occurrence of its associated event.
Events
(0.4) (0.6)
Small facility 200 270 200*0.4 + 270*0.6 = 242
Large facility 160 800 160*0.4 + 800*0.6 = 544
Do nothing 0 0
Select the alternative with the highest weighted payoff.

Decision Trees
 Decision Trees are schematic models

of alternatives available along with
their possible consequences.
 They are used in sequential decision
situations.
 Decision points are represented by
squares.
 Event points are represented by
circles.
Decision Trees
E1 & Probability
Payoff 1
E2 & Probability Payoff 2
1
e
tiv E3 & Probability Payoff 3
r na
lte
A Alternative 3
Payoff 1
Alternative 4
1 2y Payoff 2
i lit Alternative 5
1st A ab Possible
lt e b Payoff 3
decision rn o
at Pr 2nd decision
iv &
e E1
2
E2 & Probability
= Event node Payoff 1
E3 & Probability Payoff 2
= Decision node

Drawing the Tree
Example A.8
y
i lit
c
l fa
al
Sm
1
La
rg
e
fa
ci
lit
y

Drawing the Tree
Low demand [0.4]
$200
Hi
gh
y d
i lit [0 em
fac .6 an
] d
Don’t expand
l
al $223
Sm 2 Expand
$270
1
La
rg
e
fa
ci
lit
y

Completed Drawing
Example A.8
Low demand [0.4]
$200
Hi
gh
y d
i lit [0 em
ac .6 an Don’t expand
ll f ] d
a $223
Sm
2 Expand
$270
Do nothing
1
La $40
rg Advertise
e d Modest response [0.3]
fa an 3 $20
ci m
lit
y de .4]
w 0
Lo [ Sizable response [0.7]
$220
High demand [0.6]

© 2007 Pearson Education $800
Solving Decision #3
Example A.8
Low demand [0.4]
$200
Hi
gh
y d
i lit [0 em
ll f ] d
a $223
Sm
2 Expand
$270
Do nothing
1 0.3 x $20 = $6
La $40
rg Advertise
fa an 3 $20
ci m
lit
y de .4]
w 0
$6 + $154 = $160 $220
0.7 x $220 = $154
High demand [0.6]

Solving Decision #3
Example A.8
Low demand [0.4]
$200
Hi
gh
y d
i l it [0 em
c .6 an Don’t expand
l fa ] d
al $223
Sm 2 Expand
$270
Do nothing
1
La $40
rg Advertise
fa an 3 $20
ci m
lit
y d e .4 ]
w 0 $160
$160 $220
High demand [0.6]

Solving Decision #2
Example A.8
Low demand [0.4]
$200
Hi
gh
y d
i lit [0 em
ll f ] d
a $223
Sm
2 Expand Expanding has a
$270 $270 higher value.
Do nothing
1
La $40
rg Advertise
fa an 3 $20
ci m
lit
y de .4]
w 0 $160
$160 $220
High demand [0.6]

Solving Decision #1
Example A.8
Low demand [0.4]
$200 x 0.4 = $80
$242
Hi
gh
i lit
y d
[0 em
Don’t expand
$470
fac .6 an
] d
l
al $223
Sm 2 Expand
$270 $270 x 0.6 = $162
Do nothing
1
La $40
rg Advertise
fa an 3 $20
ci m
lit
y de .4]
w 0 $160
$160 $220
High demand [0.6]

Solving Decision #1
Example A.8
Low demand [0.4]
$200
$242
Hi
gh
y d
i lit [0 em
l f ] d
al $223
Sm 2 Expand
$270 Do nothing
$270
1
La $40
rg Advertise
fa an 3 $20
ci m
lit
y de .4]
w 0 $160
0.4 x $160 = $64 $160 $220
$544 High demand [0.6]

© 2007 Pearson Education $800 x 0.6 = $480
Solving Decision #1
Example A.8
Low demand [0.4]
$200
Hi
gh
y d
i lit $242 [0 em
l f ] d
al $223
Sm 2 Expand
$270 Do nothing
$270
1
La $40
rg Advertise
fa an 3 $20
$544 ci
lit
y
m
de .4]
w 0 $160
$160 $220
$544 High demand [0.6]

$800
Software Demo

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Decision Making

© 2007 Pearson Education

 Break-even analysis is used to compare

 “Q” is the volume of customers or units,

 If a forecast sales volume is sufficient

A hospital is considering a new procedure to be offered

What is the break-even quantity for this service?

Q = F / (p - c) = 100,000 / (200-100) = 1,000 patients

© 2007 Pearson Education

300 – Quantity Total Annual Total Annual

(patients) Cost ($) Revenue ($)

300 – Total annual revenues

Quantity Total Annual Total Annual

300 – Total annual revenues

200 – Total annual costs

200 – Total annual costs

Total annual revenues

 Breakeven analysis can be used to choose

© 2007 Pearson Education

Breakeven for 12,000 – 2,400

© 2007 Pearson Education

Breakeven for Q = 19,200 salads

© 2007 Pearson Education

A Preference Matrix is a table that allows you to rate

The criteria can be scored on any scale as long as the

Each score is weighted according to its perceived

The total score is the sum of the weighted scores

Threshold score = 800

Performance Weight Score Weighted Score

© 2007 Pearson Education

Threshold score = 800

Performance Weight Score Weighted Score

© 2007 Pearson Education

Threshold score = 800

Performance Weight Score Weighted Score

© 2007 Pearson Education

Threshold score = 800

Performance Weight Score Weighted Score

© 2007 Pearson Education

Threshold score = 800

Performance Weight Score Weighted Score

Weighted score = 750

© 2007 Pearson Education

Weighted score = 750

© 2007 Pearson Education

 Decision theory is a general approach to decision

1. List the feasible alternatives

 Decision Making Under Uncertainty is when you are

© 2007 Pearson Education

 Identify the decision  Choose the best

ID the Develop Model DM’s

© 2007 Pearson Education

1. Look at the payoffs for each alternative and identify the

1. Look at the payoffs for each alternative and identify the

Select the alternative with the highest weighted payoff.

© 2007 Pearson Education

Look at each payoff and ask yourself, “If I end up here, do

If you chose a small If you chose a large facility and

© 2007 Pearson Education

Regret Matrix Events

Select the alternative with the highest weighted payoff.

© 2007 Pearson Education

 Decision Trees are schematic models

© 2007 Pearson Education