7-1

Decision Making

Dr. T.Srinivas Rao

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-2
Rational Decision Making
8-step Process
1. Identification of problem
2. Identification of Decision Criteria

3. Allocation of weights to criteria

4. Development of alternatives

5. Analysis of alternatives

6. Decide on an alternative

7. Implementation of decision

8. Evaluation of decision

Irwin/McGraw-Hill 2
©The McGraw-Hill Companies, Inc., 2000
 7-3

The Decision-Making Process

Allocation of
Problem Identification of Weights to Development of
Identification Decision Criteria Criteria Alternatives

“My salespeople Price Reliability 10 Acer

need new computers” Weight Screen size 8 Compaq
Warranty Warranty 5 Gateway
Screen type Weight 5 HP
Reliability Price 4 Micromedia
Screen size Screen type 3 NEC
Sony
Toshiba

Analysis of Selection of an Implementation

Alternatives Alternative of an Alternative

RSWWPS
Acer 4 3 4 3 2 6 Acer 125 Evaluation
Compaq 3 4 5 2 6 7 Compaq 142 Gateway
of Decision
Gateway 9 6 7 7 8 2 Gateway 246
Effectiveness
HP 3 5 6 7 6 5 HP 174
Micromedia 2 2 3 4 5 4 Micromedia 103
NEC 3 45 6 7 2 NEC 151
Sony 7 56 4 2 8 Sony 192
Toshiba 3 45 6 7 3 Toshiba 154
Irwin/McGraw-Hill 3
©The McGraw-Hill Companies, Inc., 2000
 7-4

Example
A farmer with his wolf, goat, and cabbage come
to the edge of a river they wish to cross. There
is a boat at the river’s edge, but of course, only
the farmer can row. The boat can only handle
one animal/item in addition to the farmer. If the
wolf is ever left alone with the goat, the wolf
will eat the goat. If the goat is left alone with the
cabbage, the goat will eat the cabbage. What
should the farmer do to get across the river
with all his possessions?

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-5
3
The Decision Making Process
Step 1 Define the Problem or Opportunity

Step 2 Identify Limiting Factors

Step 3 Develop Potential Alternatives

Step 4 Analyze the Alternatives

Step 5 Select the Best Alternative

Step 6 Implement the Decision

Step 7 Establish a Control System

Irwin/McGraw-Hill 5 ©The McGraw-Hill Companies, Inc., 2000
 7-6
3
Defining the Problem or
Opportunity

Irwin/McGraw-Hill 6 ©The McGraw-Hill Companies, Inc., 2000

 7-7
3

Identifying Limiting Factors

Personnel Money

Facilities Equipment Time

Irwin/McGraw-Hill 7 ©The McGraw-Hill Companies, Inc., 2000

 7-8
3

Developing Potential Alternatives

Alternatives should…

Eliminate the problem

Correct the problem
Neutralize the problem
Maximize the opportunity

Irwin/McGraw-Hill 8 ©The McGraw-Hill Companies, Inc., 2000

 7-9
3

Analyzing the Alternatives

Does the alternative fit within

the limiting factors?

What are the consequences of

using this alternative?

Irwin/McGraw-Hill 9 ©The McGraw-Hill Companies, Inc., 2000

 7-10
3

Analyzing the Alternatives

Irwin/McGraw-Hill 10 ©The McGraw-Hill Companies, Inc., 2000

 7-11
Satisficing
 Decision-makers satisfice rather than maximize
[Simon]. They choose courses of action that are
``good enough''---that meet a certain minimal set
of requirements
 Theory of bounded rationality: human beings have
limited information processing capabilities
 Optimization may not be practical, particularly in a
multi-objective problem, yet knowing the optimal
solution for each objective and under various scenarios
can provide insight to make a good satisficing choice

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-12
Korn/Ferry Behavioral
Assessment Model
Dimension I: Information Use

High
Dimension II: Solution Focus
Maximizer
Level of d
a
Understanding Satisficer t UNI FOCUSED
a STYLE

Low d
Low High a
t MULTI FOCUSED
a STYLE
Amount of information Used

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-13

Evaluating Alternatives

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-14

Investment Appraisal
 Payback period
 NPV

 ARR

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-15

Quantitative Factors
 Provide a numerical basis for decision making –
reduces decisions to looking at a monetary value
placed on different choices, e.g.
 Forecasted sales figures
for the next 3 years
 The cost of a series of redundancies
against the longer term financial benefits
to the firm of this process

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-16

Quantitative Factors
 But: such data provides only part
of the story
 Other factors need to be taken into account,
particularly the effects of decisions on stakeholder
groups and their response to such decisions, e.g.
 The takeover of Manchester United by Malcolm Glazer might
make financial sense but the reaction of the supporters might
make the move unworkable

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-17

Qualitative Factors

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-18

Qualitative Factors
Qualitative factors look to take account of
these other issues
that may influence the outcome
of a decision
Can be wide ranging and especially need to
consider the impact
on human resources and
their response to decisions

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-19

SWOT
A decisions (for example, investment in a new
production plant) could be considered not only in
financial terms but also to apply other techniques of
decision making
to look at wider issues:
 A SWOT analysis might be part of this:

 Strengths

 Weaknesses

 Opportunities

 Threats

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-20

PEST
 Might also need to factor in other external issues that
might influence the decision making process which can
be summarised as:
 Political

 Economic

 Social

 Technological

 Political could be in its widest sense,

e.g. the internal politics of a firm as well as
the national and international political effect

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-21

PEST
 The decision to site a series of wind turbines in a coastal area
might be justified on financial grounds but:
 What is the reaction of the local community?

 Does government policy support such planning

developments?
 Are there social impacts – e.g. noise pollution, damage to eco-
systems, etc?
 Such factors may make the difference between success and
failure

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-22

Human Resources Management

 Impact on a firm’s human resources
is essential to consider,
in particular the effects on:
 Motivation

 Morale

 Recruitment and Retention

 May be difficulty to assess and measure

 May need to distinguish between short term effects and

long term

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-23

Stakeholder Analysis
 Wider impacts on stakeholder groups may also be
necessary, such stakeholders include:
 Employees
 Shareholders
 Managers
 Environment
 Local Community
 Suppliers
 Government
 Consumers

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-24

Marginal Costing

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-25
A Perfect Competitor
PRICE
COST MC
REVENUE

MR

QUANTITY

Recall that a perfect competitor faces a perfectly elastic demand curve

where D = P = AR = MR (if you can’t explain why return to CHAPT 4
in your workbook)
Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000
 7-26
A Perfect Competitor
PRICE
COST
REVENUE
MC

MR

QUANTITY
We can now illustrate on the graph of a perfect competitor both an MC curve and an
MR curve. A PC is said to be in equilibrium when it is producing at its profit
maximising position.

RULE: where MC = MR a firm will maximise its profits

WHY
Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000
 7-27

Think again about MARGINAL concepts

If MR is the addition to revenue when we sell one more unit and MC is the
addition to cost when we make one more unit then it follows that

MR minus MC is the addition to profit when we

produce/sell one more unit?
Example if the MR we gain from the last unit sold is $5 and that unit cost us
$4 to make then we added $1 to whatever profit we had made to that point.

Then if the last unit contributed an extra dollar to profit we should make and
sell a another unit because that too might contribute more to profit?
Agree?

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-28

Marginal Analysis
If you agree so far you will accept then that the PC should keep producing
units of output until MC = MR. That is the PROFIT MAXIMISING
level of output.

If MC < (less than) MR a PC should increase production

because there may be more profit to be added

If MC > (greater than) MR a PC should cut back production

because making these units leads to a negative marginal
profit which takes away from the profit made to that point.

THEREFORE the Profit Max point is where MR = MC.

(That is the key to understanding marginal analysis.)

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-29

A Perfect Competitor
PRICE
COST MC
REVENUE

Pe MR

Qmax QUANTITY

MR is equal to MC at a quantity of Qmax (another way of

saying the profit maximising quantity of output) and price Pe
Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000
 7-30

A Perfect Competitor
PRICE
COST MC
REVENUE

Pe MR

MC1

Q1 Qmax QUANTITY
At a quantity of Q1 you will see that the P (MR) received for that unit is higher than what
the unit costs to make. Because we are talking marginal, that unit contributes to
accumulated profits to date. The PC should keep producing beyond Q1
Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000
 7-31

A Perfect Competitor
PRICE
COST MC
REVENUE
MC2

Pe MR

Qmax Q2 QUANTITY
At a quantity of Q2 you will see that the P (MR) received for that unit is lower than what
the unit costs to make. Because we are talking marginal, that unit contributes negatively
to accumulated profits to date. The PC should lower their output below Q2
Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000
 7-32

Benefit Cost Ratio

 There are two ways of defining the relationship
between benefits and costs
 Benefit- Cost ratio: BCR= PVB/I

 Net Benefit- Cost Ratio: NBCR=(PVB-I)/I

 = BCR-1

 PVB= Present value of benefits

 I = Initial investment

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-33

 Illustration: Let us Rs100000

consider a project
which is being Year 1 25000
evaluated by a firm
that has a cost of Year 2 40000
capital of 12%
Year 3 40000

Year 4 50000

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-34

Cost Benefit Analysis

ss4 34 ©The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw-Hill
 7-35

 The benefit cost ratio

measures for this
project are

25000 40000 40000 50000

  
2 3
1.12 (1.12) (1.12) (1.12) 4
BCR   1.145
100,000
NBCR=BCR-1=0.145

When BCR Or NBCR Rule is

>1 >0 Accept
=1 =0 Indifferent
<1 <0 Reject

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-36

Problem1

 The expected cash flows Year Cash flow

of a project are as follows
 The cost of capital is 0 -100000
12%.
1 20000
 Calculate the followinga)
NPV 2 30000
 b) benefit-cost ratio

 c) IRR d) payback period

3 40000
e) discounted payback 4 50000
period.
5 30000
Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000
 7-37

Cost Benefit Analysis

Example of Costs and Benefits of the dam
Costs
 The dam is completed in five years at a cost of $200,000,000.
Inflation in the interim period is estimated to be 5%.

Discounted to
present value = 0.7352 x $0.2 billion
= $156,704,000
Benefit
 The dam will not start to provide benefits until the water is used for
irrigation and crop yields improve. Let us assume this will be in
seven years time and the value of this benefit is $100,000,000 per
year in future values. We will keep the same inflation rate for ease
of comparision.
ss4 37 ©The McGraw-Hill Companies, Inc., 2000
Irwin/McGraw-Hill
 7-38

Cost Benefit Analysis

Example of Costs and Benefits of the dam
Let us first assume a calculation period for the CBA only covers
seven years:
Discounted to
present value = 0.71068 x $0.1 billion
= $71,068,000

Conclusion:
Based on a seven year timespan
Costs = $157 million
Benefits = $71 million
Conclude that Project is not acceptable

ss4 38 ©The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw-Hill
 7-39
BASIS FOR SELECTION AMONG ALTERNATIVES

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-40

Reliance on the Past

Experience is the best teacher.

The lessons of experience may be entirely
inapplicable to the new problems. Good
decisions must be evaluate against future
events, while experience belongs to the
past

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-41

Experimentation

 Experimentation is often used in scientific

Enquiry.
 Try the various alternatives and see which is best

 Most expensive

 A firm may test a new product in a certain

market before expanding its sales nationwide.
 Organizational techniques are often tried in a
branch office or plant before being applied over
an entire company

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-42

Research and analysis

Solving a planning problem requires
breaking it into its component parts
and studying the various
quantitative and qualitative factors
In manufacturing airplanes, for
example if careful research did not
precede the building and testing of
the prototype airplane and its parts,
the resulting costs would be
enormous.

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-43
Prgrammed vs Non Programmed
decision making

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-44
Decision Making

Programmed Decision
 Routine, virtually automatic decision making that
follows established rules or guidelines.
 Managers have made the same decision many times
before
 Little ambiguity involved
 Lathe operators have specifications and rules that tell
them whether the part they made is acceptable, has to
be discarded or should be reworked.
 Reordering of standard Inventory items.

Irwin/McGraw-Hill 7-44
©The McGraw-Hill Companies, Inc., 2000
 7-45
A Programmed Decision Outline

Irwin/McGraw-Hill 45 ©The McGraw-Hill Companies, Inc., 2000

 7-46
Decision Making

Non-Programmed Decisions
 Nonroutine decision made in response to unusual or
novel opportunities and threats.
 Strategic decisions in general are non programmed
decisions, since they require subjective judgments
 The are no rules to follow since the decision is new.
 Decisions are made based on information, and a
manager’s intuition, and judgment.

Irwin/McGraw-Hill 7-46
©The McGraw-Hill Companies, Inc., 2000
 7-47

Decision Making
Intuition
 feelings, beliefs, and hunches that come readily to mind,
require little effort and information gathering and result
in on-the-spot decisions

Irwin/McGraw-Hill 7-47
©The McGraw-Hill Companies, Inc., 2000
 7-48

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-49

Acceptance Sampling
Plan
Fixed Inventory
ABC Analysis

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-50

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-51

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-52

Problems and Decisions ( cont’d)

Unstructured problems
* Problems that are new or unusual and for which
information is ambiguous or incomplete.
* Problems that will require custom-made solutions.
Non-programmed decisions
* Decision that are unique and nonrecurring.
* Decision that generate unique responses.

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-53

Types of Programmed Decisions

Policy
* a general guideline for making a decision
about a structured problem.
Procedure
* A series of interrelated steps that a manager
can use to respond ( applying a policy) to a
structured problem.
Rule
* an explicit statement that limits what a
manager or employee can or cannot do.
Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000
 7-54

Programmed vs. Non-programmed

Decisions
Characteristics Programmed Non-programmed
decisions decisions
Type of problem Structured Unstructured

Managerial level Lower level Upper level

Frequency Repetitive New,unusual

Information Readily available Ambiguous or

incomplete
Time frame for Short Relatively long
solution
Solution relies on Procedures,rules, and Judgment and creativity
policies
Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000
 7-55

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-56

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-57

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-58

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-59

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-60

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000

 7-61

Decision Making
Reasoned judgment
 decisions that take time and effort to make and result
from careful information gathering, generation of
alternatives, and evaluation of
alternatives

Irwin/McGraw-Hill 7-61
©The McGraw-Hill Companies, Inc., 2000