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Decision Making

Decision Making. 10 July 2001. Introduction. What: Decision making tools Where: Making business decisions Why: We want to avoid making bad decisions. Steps in Decision Making. Define the problem Develop specific objectives Develop a model Evaluate each alternative solution

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Decision Making

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  1. Decision Making 10 July 2001

  2. Introduction • What: Decision making tools • Where: Making business decisions • Why: We want to avoid making bad decisions

  3. Steps in Decision Making • Define the problem • Develop specific objectives • Develop a model • Evaluate each alternative solution • Select the best alternative • Implement the decision

  4. A Decision Example • Should the Stampede Flapjack Company build a new factory to produce its new line of pancake mixes, or use part of its existing facility? • The factory will cost $15M to build. • Probability of successful product is 65%

  5. Our Forecast • If the factory is built, and if the new line is a success, sales will be worth $25M. If it is not a success, overall sales will be worth $5M. • If the factory is not built, and if the new line is a success, sales will be worth $8M. If it is not a success, sales will be worth $6M.

  6. A Decision Tree A Decision Node Construct Plant Existing Plant

  7. Adding the Construction Outcomes Successful (65%) - $25M Unsuccessful (35%) - $5M Construct Plant Existing Plant

  8. Adding the No Construction Outcomes Successful (65%) - $25M Unsuccessful (35%) - $5M Construct Plant Successful (65%) - $8M Existing Plant Unsuccessful (35%) - $2M

  9. Expected Monetary Value (EMV) Successful (65%) - $25M Unsuccessful (35%) - $5M EMV = $25M x 0.65 + $5M x 0.35 = $18M

  10. What is the Better Choice? $18M Successful (65%) - $25M Unsuccessful (35%) - $5M Construct Plant $7.3M Successful (65%) - $8M Existing Plant Unsuccessful (35%) - $6M

  11. Result $18M Successful (65%) - $25M Unsuccessful (35%) - $5M Construct Plant $18M $7.3M Successful (65%) - $8M Existing Plant Unsuccessful (35%) - $6M

  12. In Other Words… • Because the result for building the factory gives us a higher EMV, we choose it. • Because the EMV is greater than the cost of constructing the factory, we will build it.

  13. A Decision Table

  14. Calculating EMV’s

  15. Expected Value of Perfect Information (EVPI) • What would we be willing to pay for perfect information – to know the future? • EVPI = EV Under Certainty – Max EMV

  16. Expected Value Under Certainty • Expected Value Under Certainty = • Best outcome for first state x probability of first state • + • Best outcome for second state x probability of second state

  17. Expected Value Under Certainty

  18. Expected Value Under Certainty • EV = $25M x 65% + $6M x 35% • EV = $18.35

  19. Expected Value of Perfect Information • EVPI = EV Under Certainty – Max EMV • EVPI = $18.35M - $18M • EVPI = 0.35M • So we would pay, for example, a maximum of $350K for a marketing study

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