Decision Making

In business, managers always make decisions in their operations from time to time.
For Instance:
Choosing what particular marketing strategy to be used in introducing a new product;
Determining how many sales representatives to be hired and;
Knowing what should be the selling price of a particular product; are situations which need
decisions.
Decision Making - the act of selecting a preferred course of action among alternatives.
Example: Making and implementing decisions are crucial parts of the management.
Remark: Decision makers should make careful evaluation of the different alternatives and select the best
alternative that would meet the requirement on solving the problem based on the criteria and in
accordance with the organizations objective
Steps in Decision Making
1. Identify the problem.
2. Determine the criteria that can solve the problem.
3. Search for different possible alternatives.
4. Evaluate each alternative.
5. Select the best alternative.
6. Implement the chosen alternative.
7. Monitor the implementation to ensure it is in accordance with the organizations objective.
Three decision environments that can be applied in decision making depending on the existing problem
of the decision maker:
1. Decision Making Under the Condition of Certainty
The decision maker knows which state of nature will occur. At this situation, he will decide
definitely on the best possible solution favorable to him since he knows exactly what will happen.
2. Decision Making Under the Condition of Uncertainty
When the decision maker has no information or estimates of the probability of the events, he
will decide using any of the different strategies under this condition. His choice of strategy in decision
making reveals his attitude based on his experience and the influence or persuasion of the people in his
environment. The following strategies are applicable under this condition:
Decision Making
a. Maximax Strategy use to select the maximum payoff for each alternative,
and then among the maximum payoffs choose the alternative with the
maximum payoffs. That is, the decision maker has to choose the alternative
with the maximum among the maximum payoffs. Hence, it is called
maximax which is also known as the optimistic approach.
Remark: In case the problem is cost minimization, to apply the preceding strategy, one has to choose the
minimum payoff for each alternative, then finally select the minimum. Thus, this is called minimin for
cost.

b. Maximin Strategy used to select the minimum payoff for each alternative then among the
minimum payoffs choose the alternative with the highest payoff. In other words, the decision maker has
to choose the alternative with the maximum among the minimum payoffs. Thus, it is called maximin
which is also known as the pessimistic approach.
Remark: In case the problem is minimization of cost, to apply the preceding strategy, one has to select
the miximum payoff for each alternative, then finally choose the minimum. Thus, this is called minimax
for cost.
c. Laplace Strategy used to select the alternative with the maximum average payoff. To compute the
value, simply determine the average payoff for each alternative and then choose the alternative with
the maximum average payoff (profit).
Remark: For cost problem, simply do the same then finally, choose the alternative with the minimum
average payoff.
d. Hurwicz Criterion of Realism the strategy is a middle ground criterion between the maximax and
maximin, that is, between optimism and pessimism. The decision maker can assign a value for
coefficient or index of optimism denoted by the Greek letter (alpha) with a value between 0 and 1. If
a person assigns as 1, that means that he is optimistic about nature.
Measure of Realism:
Where, is the coefficient or index of optimism.
Remark: Choose the maximum value of MR for profit (max MR) and minimum value of MR for cost (min
MR).
e. Minimax Regret Strategy
In business, we cannot do away with opportunity loss. What we would regret losing can be
determined for alternative payoff values.
- using this strategy, choose the alternative that would minimize the maximum regret.
- to apply the strategy, first determine the regret payoff for each alternative under each state of nature,
then determine the maximum regret or loss payoff for each alternative, and finally select the minimum
among the maximum regrets.
For Profit: Regret Value = Highest Column Entry Every column Entry
For Cost: Regret Value = Every Column Entry Lowest Column Entry
Remark: For payoff tables with states of nature written in columns and alternative written in rows.
3. Decision Making Under the Condition of Risk
- the decision maker does not know exactly which one among the different states of nature will occur
but can estimate that any one state will occur.
- he is making the assumptions on the probability of the occurrence of each state of nature.
Example: Consider the following problem:
RGV Company is planning to manufacture its own new PC based system, which intends to be
marketed by next year under its own brand. One particular concern of the company has something to do
with the keyboard that will be used in the system, which will be having a special feature on function
keys.

The following are the different decision alternatives identified by the management:
a. The company can manufacture its own unique keyboard.
b. The company can buy the keyboards from a local manufacturer.
c. The company can buy the keyboards from Japan.
The payoff table is given below. The profit contribution is in thousand pesos.
Alternatives

Future Sales Level

Low

Moderate

High

Manufacture

-30

20

110

Buy from Local

20

60

50

Buy from Japan

10

45

80

Note: The Decision maker has to consider the different costs and benefits of each of the given
alternatives. He has to assess the advantages and disadvantages of each. Manufacturing would require
major investment in the new production paraphernalia. Buying from local supplier would be better if
demand will not be as high as expected. However, buying from Japan would be of high quality but the
problem might be in delivery schedule.
The following are the decisions of the management applying the above mentioned strategies:
1. Decision Making Under the Condition of Certainty
If the management is certain that the condition of economy is LOW, the best decision is to buy
from local manufacturer.
If the condition of economy is MODERATE, the best decision is to buy the units from the local
manufacturer.
If the condition of economy is HIGH, the best decision is to manufacture.
2. Decision Making Under the Condition of Uncertainty
Considering the payoffs under each alternative and the different economic situations, which of
the three alternatives would you recommend?
Note: The answer to the above question depends on the attitude of the decision maker on how he
perceives each alternative under the economic demand situation. In the absence of information about
the likelihood or probability of occurrence on each alternative, the decision of the management will be
as follows:
a. Applying the Maximax Strategy, choose the maximum for every alternative,
then finally select the maximum.
Alternatives

Maximum

Manufacture

110

Buy from Local

60

Buy from Japan

80

Decision: Since the maximum among the three maximum values refers to the alternative of manufacture,
therefore RGV Company will manufacture its own unique keyboard.
b. Applying the Maximin Strategy, choose the minimum of each alternative
then finally, select the maximum.
Alternatives

Minimum

Manufacture

-30

Buy from Local

20

Buy from Japan

10

Decision: Since the maximum among the minimum payoffs refers to the decision on buying from local
suppliers, therefore RGV Company will buy the keyboards from local suppliers.
c. Applying the Laplace Strategy, get the average payoff for each alternative,
and finally choose the maximum.
Alternatives

Future Sales Level

Low

Moderate

High

Manufacture

-30

20

110

Buy from Local

20

60

50

Buy from Japan

10

45

80

The succeeding shows the row total (getting the sum of each alternative from different sales level and
row average, row total divided by the total number of columns).
Alternatives

Row Total

Row Average

Manufacture

100

33.33

Buy from Local

130

43.33

Buy from Japan

135

45.00

Decision (based on the table): The maximum average refers to the third alternative, which is to buy the
units from Japan
d. Applying Hurwicz Strategy with = 60% as coefficient of realism:
Manufacture = (0.60)(110) + (0.40)(-30) = 54
Buy from Local = (0.60)(60) + (0.40)(20) = 44
Buy from Japan = (0.60)(80) + (0.40)(10) = 52
Decision (based on the result of computation): The best alternative is to manufacture.

e. Applying the Minimax Regret Strategy - makes use of the concept on regret or known as opportunity
loss. That is, we are to analyze the payoff in each alternative if in case we have committed a decision,
which is not fitted to the actual economic situation. To employ this strategy, compute the opportunity
loss of each alternative under each economic condition by simply getting the difference of the highest
entry for each column and entry on each column
Alternative

Future Sales Level

Low

Moderate

High

Manufacture

-30

20

110

Buy from Local

20

60

50

Buy from Japan

10

45

80

REGRET TABLE
Alternatives

Future Sales Level

Maximum Regret

Low

Moderate

High

Manufacture

50

40

50

Buy from Local

60

60

Buy from Japan

10

15

30

30

The table reveals that if we only know that the future sales will be LOW, the best decision is to
buy from local suppliers. If the future sales will be MODERATE, the best decision alternative is also to
buy from local suppliers. However, once the sales demand will be high, it would be best for the company
to manufacture its own units.
Thus, applying the Minimax Strategy, the decision of the RGV company should be based on the
alternative with the minimum regret. Hence, evaluating the values under the Maximum Regret column,
the minimum is 30 indicating that the best decision under this strategy is to buy the units from Japan.
3. Decision Making Under Condition of Risk
Decision making under the condition of risk needs probability estimates of the occurrence of
each state of nature. The decision maker has to compute the chance of each event based on the existing
information and has to compute the expected value of each alternative or what he can expect to get for
every alternative considering the different states of nature. Finally, he has to decide the alternative that
can give the best payoff to him.
-to apply the strategy, the mathematical expectation (ME), or expected value (EV) has to be computed
by getting the product of the probability of an event and the amount to be received upon the
occurrence of that event. In symbols, let P represent the probability of an event and X represent the
amount of money to be received for that particular event, thus, the mathematical expected value is
computed as EV = P(X). In case an event has several possible outcomes with probabilities, denoted by

P1 , P2 , , Pn and if X denotes a discrete variable which can be represented by X , X , , X

1
2
n
then the expected value for this alternative would be the sum of the products of the expected value on
each state of nature computed based on the formula given: EV P X P ( X ) P X
1

Example: Considering the same problem, determine what alternative should be chosen by the decision
maker under this strategy.
Alternatives

Future Sales Level

Low

Moderate

High

Manufacture

-30

20

110

Buy from Local

20

60

50

Buy from Japan

10

45

80

Note: The payoff amount is in thousand of pesos.

Consider the table below showing the assessed probability on each state of nature.
State of Nature

Low

Moderate

High

Probability

25%

60%

15%

The expected value for each alternative can be computed as follows:

Alternatives
1. Manufacture
2. Buy from Local
3. Buy from Japan

Expected Value
EV = (0.25)(-30) + (0.60)(20) + (0.15)(110) = 21.0
EV = (0.25)(20) + (0.60)(60) + (0.15)(50) = 48.5
EV = (0.25)(10) + (0.60)(45) + (0.15)(80) = 41.5

Thus, using this strategy, the best decision is to buy from local supplier since it has the highest
expected value.
Remark: Most of the time managers make their decision under this strategy that is why their decisions
are always associated with risk. However, the information that they can get from different sources can
help lessen this risk.
The Expected Value of Perfect Information (EVPI)
Note: If the managers are able to determine which among the states of nature will occur, definitely, they
know which decision will be the best for the company. The payoff increases as we determine the
certainty of a particular expected value of perfect information.
The certainty of a particular expected value of perfect information can be determined using the
following methods:

Method 1: Take the difference between the expected payoff under certainty and the expected payoff
under condition of risk.
The following are the steps to compute the value of perfect information using Method 1:
1. Multiply the best payoff under each state of nature to its probability.
2. Get the sum of these combined weights.
3. Subtract the highest payoff of the result in decision making under the condition of risk from the sum
of the combined weights.
4. The difference is the value of perfect information.
EVPI = Expected Value Under Certainty Maximum EV Under Risk
Example: Consider again the preceding example:
Best Payoff Under Each State of Nature
State of Nature

Low

Moderate

High

Probability

25%

60%

15%

Manufacture
Buy from Local

110
20

60

Buy from Japan

(20 x 0.25) + (60 x 0.60) + (110 x 0.15) = 57.5 EV under certainty
The expected payoff under condition of risk is 48.5 and thus,
57.5 48.5 = 9.0 (EVPI)
Method 2: Find the expected regret value for each alternative then, EVPI is the smallest expected value.
Example: Consider again the preceding problem under the Minimax Regret Strategy
Alternatives

Future Sales Demand

Maximum Regret

Low

Moderate

High

Manufacture

50

40

50

Buy from Local

60

60

Buy From Japan

10

15

30

30

State of Nature

Low

Moderate

High

Probability

25%

60%

15%

The following are the steps to compute the value of perfect information using Method 2:
1. Multiply each entry by the probability value of each state of nature of every alternative.
2. Get the sum of these combined weights.
3. The lowest expected regret value is the EVPI.
Alternatives

Future Sales Level

Expected Value

Low
P = 0.25

Moderate
P = 0.60

High
P = 0.15

Manufacture

50

40

Buy from Local

60

Buy from Japan

10

15

30

Solution:
1. Manufacture:
2. Buy from Local:
3. Buy from Japan:

50(0.25) +40(0.60) + 0(0.15) = 36.5

0(0.25) + 0(0.60) + 60(0.15) = 9.0
10(0.25) + 15(0.60) + 30(0.15) = 16.0

Conclusion: Based on the computation, the lowest expected regret value is 9.0, which refers to our EVPI.
Exercise Set:
1. Next year, the lease contract of Parreos Grill Restaurant is to expire. Steve, the owner, must decide
whether to renew the contract for another five (5) years or relocate near the site of a proposed
restaurant. The City engineer is currently confused on the merits of granting approval to the restaurant.
A business consultant has estimated the present value of Parreos Grill Restaurant as shown below for
the two alternatives.
Alternatives

Approve

Disapprove

Renew the contract

Php 750,000

Php 4,500,000

Relocate the restaurant

Php 6,500,000

Php 300,000

What course of action would you recommend using each of the following strategies?
a. Maximax
e. Minimax Regret Strategy
b. Maximin
c. Laplace
d. Hurwicz (assume =75%)
2. Wash Me Laundry Center must decide to purchase one of the three washing machines displayed in
XYZ Appliance Center namely, Sharp, LG, and National. Each of these three machines can wash clothes at
different speed. The performance of each machine differs because of the technology applied by its

manufacturer. Based on the marketing survey result, customers demand for the centers service will be
high, medium, or low. Survey also reveals that the likelihood profit for each alternative is summarized in
the given table below. Values are in thousands of pesos.
Machines

High

Medium

Low

45%

30%

25%

Sharp

350

200

-100

LG

300

250

-60

National

450

150

-70

a. Compute the expected value of each brand.

b. Based on the expected value approach, which of the three brands will be the
best for Wash Me Laundry Center to purchase?
Decision Tree Analysis
- a systematic way of analyzing problems is through the use of a diagram.
- a schematic model of decision making showing the available alternatives
for the decision maker including the possible consequences.
Types of Nodes that can be used in Making the Tree Diagram
1. Square
- represents a decision point.
2. Circle
- represents a chance event.
Remark: The decision maker has the option on what to choose if it is a square, however, when it comes
to circle, the occurrence of event is beyond his control.