Solutions to Practice Problems for Decision Analysis

1. Luther Tai is thinking of buying a bankrupt private airport for $5 million. Assuming
he borrows the money, he expects to incur an annual cost of $500,000 to service his debt,
plus an additional cost of $200,000 per year to run the new venture. At a contemplated
landing fee of $100, the probabilities are 0.10, 0.50, and 0.40, respectively, that 6,000
planes, 7,000 planes, or 8,000 planes will land per year. Use a decision tree to determine
Luther’s optimal action, given his desire to maximize expected monetary value and
given the option not to make the investment at all.
First, we need a payoff table.
Basic Revenue Data:
States of Nature Probability Planes Revenue
s1 0.1 6000 $600,000
s2 0.5 7000 $700,000
s3 0.4 8000 $800,000
Basic Expense Data:
Debt Other Total
$500,000 $200,000 $700,000
Payoff Table:
States of Nature Revenue Expenses Net Income
s1 $600,000 $700,000 -$100,000
s2 $700,000 $700,000 $0
s3 $800,000 $700,000 +$100,000

Managerial Statistics 35 Prof. Juran

Now, we construct the decision tree:
6000 Planes 10.0%
-$100,000
Buy Airport TRUE Expected Value
0 $30,000
7000 Planes 50.0%
$0
8000 Planes 40.0%
$100,000
Luther Tai Expected Value
30000
6000 Planes 10.0%
$0
Don't Buy Airport FALSE Expected Value
0 0
7000 Planes 50.0%
$0
8000 Planes 40.0%
$0

On the basis of expected value, it looks like a good idea to buy the airport.
This is, of course, a simplistic model, in which we ignore the possibility that Luther will
have even better investments to consider. (This one has an expected annual return of
$30,000 / $700,000 = 4.3%.)

Managerial Statistics 36 Prof. Juran

2. Consider the following profit payoff table.
States of Nature
s1 s2 s3 s4
d1 14 9 10 5
Decision d2 11 10 8 7
Alternatives d3 9 10 10 11
d4 8 10 11 13
Suppose the decision maker obtains information that leads to four probability estimates:
P(s1) = 0.5, P(s2) = 0.2, P(s3) = 0.20, and P(s4) = 0.10.
(a) Use the expected value approach to determine the optimal decision.
The optimal decision alternative is d1, with an expected value of 11.3:
s1 50.0%
14
s2 20.0%
9
d1 TRUE Expected Value
0 11.3
s3 20.0%
10
s4 10.0%
5
s1 50.0%
11
s2 20.0%
10
d2 FALSE Expected Value
0 9.8
s3 20.0%
8
s4 10.0%
7
Problem 2 Expected Value
11.3
s1 50.0%
9
s2 20.0%
10
d3 FALSE Expected Value
0 9.6
s3 20.0%
10
s4 10.0%
11
s1 50.0%
8
s2 20.0%
10
d4 FALSE Expected Value
0 9.5
s3 20.0%
11
s4 10.0%
13

Managerial Statistics 37 Prof. Juran

(b) Now assume that the entries in the payoff table are costs; use the expected value
approach to determine the optimal decision.
The optimal decision alternative is d4, with an expected value of 9.5:
s1 50.0%
14
s2 20.0%
9
d1 FALSE Expected Value
0 11.3
s3 20.0%
10
s4 10.0%
5
s1 50.0%
11
s2 20.0%
10
d2 FALSE Expected Value
0 9.8
s3 20.0%
8
s4 10.0%
7
Problem 2 Expected Value
9.5
s1 50.0%
9
s2 20.0%
10
d3 FALSE Expected Value
0 9.6
s3 20.0%
10
s4 10.0%
11
s1 50.0%
8
s2 20.0%
10
d4 TRUE Expected Value
0 9.5
s3 20.0%
11
s4 10.0%
13

Managerial Statistics 38 Prof. Juran

3. The Bizri Manufacturing Company must decide whether it should purchase a component from
a supplier or manufacture the component at its Tuckahoe, New York, plant. If demand is high, it
would be to Bizri’s advantage to manufacture the component. However, if demand is low, Bizri’s
unit manufacturing cost will be high due to underutilization of equipment. The projected profit
figures in thousands of dollars for Bizri’s make-or-buy decision follow.
Demand
High Medium Low
Manufacture Component 100 40 -20
Decision Alternatives
Purchase Component 70 45 10
The states of nature have the following probabilities: P(high demand) = 0.30, P(medium
demand) = 0.35, and P(low demand) = 0.35.
(a) Use a decision tree to recommend a decision.
In this tree, we can see that the “purchase option has a higher expected profit ($40,250
as opposed to $37,000).
High 30.0%
100
Manufacture FALSE Manufacture
0 37.00
Medium 35.0%
40
Low 35.0%
-20
Bizri Make or Buy
40.25
High 30.0%
70
Purchase TRUE Purchase
0 40.25
Medium 35.0%
45
Low 35.0%
10

Managerial Statistics 39 Prof. Juran

The expected value calculations are as follows:
For manufacturing,

 
N
EV  d 1    P s j v1 j
j 1

  0.30 * $100 ,000    0.35 * $40 ,000    0.35 * $20 ,000 

 $30 ,000  $14 ,000  $7 ,000
 $37 ,000
For purchasing,

 
N
EV  d 2    P s j v2 j
j 1

  0.30 * $70 ,000    0.35 * $45,000    0.35 * $10 ,000 

 $21,000  $15,750  $3 ,500
 $40 ,250

(b) Use EVPI to determine whether Bizri should attempt to obtain a better estimate of
demand.
Demand Probabilities Net Profit Manufacture Net Profit Purchase Optimal Decision
High 0.30 $100,000 $70,000 Manufacture
Medium 0.35 $40,000 $45,000 Purchase
Low 0.35 $(20,000) $10,000 Purchase
We calculate the expected value with perfect information by summing up the probability-weighted best payoffs for
each state of nature.
EVwPI  0.30 * $100,000  0.35 * $45,000  0.35 * $10 ,000
 $30 ,000  $15 ,750  $3 ,500
 $49 ,250
The expected value of perfect information is $49,250 - $40,250 = $9,000.

Managerial Statistics 40 Prof. Juran

A test market study of the potential demand for the product is expected to indicate
either a favorable (I1) or unfavorable (I2) condition. The relevant conditional probabilities
follow.
P  I 1 s 1  =0.60 P  I 2 s 1  =0.40
P  I 1 s 2  =0.40 P  I 2 s 2  =0.60
P  I 1 s 3  =0.10 P  I 2 s 3  =0.90
(c) What is the probability that the market research report will be favorable?
Probabilities
States Prior Conditional Joint Posterior

  
P sj  I1 
sj P sj 
P I1 s j      
P s j  I1  P s j P I1 s j   
P sj I1 
P I 1 

High 0.30 0.60 0.180 0.507

Medium 0.35 0.40 0.140 0.394
Low 0.35 0.10 0.035 0.099
Total P I 1   0.355
The total probability of a favorable report is 35.5%.
Similarly, for the unfavorable report:
Probabilities
States Prior Conditional Joint Posterior

  
P sj  I2 
sj P sj 
P I2 sj      
P sj  I2  P sj P I2 sj   
P sj I2 
P I 2 

High 0.30 0.40 0.120 0.186

Medium 0.35 0.60 0.210 0.326
Low 0.35 0.90 0.315 0.488
Total P I 2   0.645
The total probability of an unfavorable report is 64.5%.

Managerial Statistics 41 Prof. Juran

 (d) What is Bizri’s optimal decision strategy?
In this tree diagram, we see that the best course of action is to manufacture if the report
is favorable, but to purchase if the report is unfavorable.
High 50.7%
100
Manufacture TRUE Manufacture
0 64.51
Medium 39.4%
40
Low 9.9%
-20
Favorable Report 35.5% Expected Value
0 64.51
High 50.7%
70
Purchase FALSE Purchase
0 54.23
Medium 39.4%
45
Low 9.9%
10
Bizri Expected Value
43.9

High 18.6%
100

Manufacture FALSE Manufacture

0 21.86
Medium 32.6%
40
Low 48.8%
-20
Unfavorable Report 64.5% Expected Value
32.56
High 18.6%
70
Purchase TRUE Purchase
0 32.56
Medium 32.6%
45
Low 48.8%
10

(e) What is the expected value of the market research information?

The expected value of the system with the report is $43,900. Without the report the
expected value was only $40,250, so the extra information is worth $3,650.

(f) What is the efficiency of the information?

$3,650/$9,000 = 0.4056, or about 41%.

Managerial Statistics 42 Prof. Juran

4. Witkowski TV Productions is considering a pilot for a comedy series for a major television
network. The network may reject the pilot and the series, or it may purchase the program for one
or two years. Witkowski may decide to produce the pilot or transfer the rights for the series to a
competitor for $100,000. Witkowski’s profits are summarized in the following profit ($1000s)
payoff table:
States of Nature
s1 = Reject s2 = 1 Year s3 = 2 Years
d1 -100 50 150
Produce Pilot
Sell to Competitor d2 100 100 100
(a) If the probability estimates for the states of nature are P(Reject) = 0.20, P(1 Year) =
0.30, and P(2 Years) = 0.50, what should Witkowski do?
On the basis of expected value, the best thing to do is to sell to the competitor:
Reject 20.0%
-100
Produce Pilot FALSE Expected Value
0 70
1 Year 30.0%
50
2 Years 50.0%
150
Witkowski Expected Value
100
Reject 20.0%
100
Sell to Competitor TRUE Expected Value
0 100
1 Year 30.0%
100
2 Years 50.0%
100

Managerial Statistics 43 Prof. Juran

For a consulting fee of $2,500, the O’Donnell agency will review the plans for the comedy series
and indicate the overall chance of a favorable network reaction.
P  I 1 s 1   0.30 P  I 2 s 1   0.70
P  I 1 s 2   0.60 P  I 2 s 2   0.40
P  I 1 s 3   0.90 P  I 2 s 3   0.10

(b) Show a decision tree to represent the revised problem.

A revised payoff table:
States of Nature
s1 = Reject s2 = 1 Year s3 = 2 Years

No d1 = Produce Pilot -100 50 150

Report
d2 = Sell to Competitor 100 100 100

d1 = Produce Pilot -102.5 47.5 147.5

I1 = Favorable Report
Get d2 = Sell to Competitor 97.5 97.5 97.5
Report
d1 = Produce Pilot -102.5 47.5 147.5
I2 = Unfavorable Report
d2 = Sell to Competitor 97.5 97.5 97.5
Probability calculations:
Probabilities
States Prior Conditional Joint Posterior

  
P sj  I1 
sj P sj 
P I1 s j      
P s j  I1  P s j P I1 s j   
P sj I1 
P I 1 

Reject 0.20 0.30 0.06 0.087

1 Year 0.30 0.60 0.18 0.261
2-Year 0.50 0.90 0.45 0.652
Total P I 1   0.69
The total probability of a favorable O’Donnell report is 69%.
Probabilities
States Prior Conditional Joint Posterior

  
P sj  I2 
sj P sj 
P I2 sj      
P sj  I2  P sj P I2 sj   
P sj I2 
P I 2 

Reject 0.20 0.70 0.14 0.452

1 Year 0.30 0.40 0.12 0.387
2-Year 0.50 0.10 0.05 0.161
Total P I 2   0.31
The total probability of an unfavorable O’Donnell report is 31%.

Managerial Statistics 44 Prof. Juran

 Reject 8.7%
-102.5

Produce Pilot TRUE Expected Value

0.0 99.7

1 Year 26.1%
47.5

2 Years 65.2%
147.5

Favorable 0.7 Expected Value

0.0 99.7

Reject 8.7%
97.5

Sell to Competitor FALSE Expected Value

0.0 97.5

1 Year 26.1%
97.5

2 Years 65.2%
97.5

Get O'Donnell Report FALSE Expected Value

0.0 99.0

Reject 45.2%
-102.5

Produce Pilot FALSE Expected Value

0.0 -4.1

1 Year 38.7%
47.5

2 Years 16.1%
147.5

Unfavorable 0.3 Expected Value

0.0 97.5

Reject 45.2%
97.5

Sell to Competitor TRUE Expected Value

0.0 97.5

1 Year 38.7%
97.5

2 Years 16.1%
97.5

Witkowski Expected Value

100.0

Do Not Get O'Donnell Report TRUE Expected Value

0.0 100.0

Reject 20.0%
-100.0

Produce Pilot FALSE Expected Value

0.0 70.0

1 Year 30.0%
50.0

2 Years 50.0%
150.0
1.0 Expected Value
0.0 100.0

Reject 20.0%
100.0

Sell to Competitor TRUE Expected Value

0.0 100.0

1 Year 30.0%
100.0

2 Years 50.0%
100.0

(c) What should Witkowski’s strategy be? What is the expected value of this strategy?
The best thing to do is to forget about O’Donnell and sell the rights for $100,000.

(d) What is the expected value of the O’Donnell agency’s sample information? Is the
information worth the $2,500 fee?
The information has no value; no matter what O’Donnell’s report says, it won’t affect
Witkowski’s decision or improve the expected value of the situation.

(e) What is the efficiency of the O’Donnell’s sample information?

Zero.

Managerial Statistics 45 Prof. Juran

5. Decelles Oil Company can drill for oil on a given site now (with equal probability of
s1 = finding oil or s2 = not finding oil) or sell its rights to the site for $10 million. If
Decelles drills and finds oil, a net payoff of $100 million is expected; if no oil is found,
that payoff equals –$15 million.
Alternatively, Decelles can instead contract for a $10 million seismic test, performed by
the geologic firm of Dempsey & McKenna. If the test predicts oil, the company can drill
(and get a net payoff of $90 million if oil is in fact found and of -$25 million if none is
found) or sell the rights for $20 million. If the Dempsey & McKenna test predicts no oil,
Decelles can drill (and get a net payoff of $90 million if oil is in fact found and of -$25
million if none is found) or sell the rights for $1 million.
Dempsey & McKenna’s track record is given below:
Subsequent Events
D&M Report Issued s1 = Oil is Found s2 = Oil is Not Found
I1 = Oil Expected P  I 1 s 1   0.60 P  I 1 s 2   0.20
I2 = Oil Not Expected P  I 2 s 1   0.40 P  I 2 s 2   0.80
(a) Use a decision tree to formulate the problem. What should Decelles do?
First, some preliminary analysis. Here is a payoff table:
States of Nature
Decision Alternatives I Sample Information Decision Alternatives II Find Oil Find No Oil
Drill 100 -15
No Report (None)
Sell 10 10
Drill 90 -25
Report Predicts Oil
Sell 20 20
Get Report
Drill 90 -25
Report Predicts No Oil
Sell 1 1
Here are the calculations for the various probabilities of finding oil:
Probabilities
States Prior Conditional Joint Posterior

  
P sj  I1 
sj P sj 
P I1 s j      
P s j  I1  P s j P I1 s j  
P sj I1   P I 1 

Oil 0.50 0.60 0.30 0.75

No Oil 0.50 0.20 0.10 0.25
Total P I 1   0.40
The total probability of a favorable report is 40%.

Managerial Statistics 46 Prof. Juran

Similarly, for the unfavorable report:
Probabilities
States Prior Conditional Joint Posterior

  
P sj  I2 
sj P sj 
P I2 sj   
P sj  I2  P sj P I2 sj     
P sj I2  P I 2 

Oil 0.50 0.40 0.20 0.333

No Oil 0.50 0.80 0.40 0.667
Total P I 2   0.60
The total probability of an unfavorable report is 60%.
Here is the decision tree, which suggests that the best course of action is to forget about
the report and just go ahead and drill.
Oil 75.0%
$90,000,000
Drill TRUE Expected Value
90 $61,250,090
No Oil 25.0%
-$25,000,000
Report Predicts Oil 40.0% Expected Value
0 $61,250,090
Oil 75.0%
$20,000,000
Sell FALSE Expected Value
$20,000,000 $20,000,000
No Oil 25.0%
$20,000,000
Get Report FALSE Expected Value
0 $32,500,090
Oil 33.3%
$90,000,000
Drill TRUE Expected Value
90 $13,333,423
No Oil 66.7%
-$25,000,000
Report Predicts No Oil 60.0% Expected Value
0 $13,333,423
Oil 33.3%
$1,000,000
Sell FALSE Expected Value
$1,000,000 $1,000,000
No Oil 66.7%
$1,000,000
Decelles Expected Value
$42,500,090
Oil 50.0%
$100,000,000
Drill TRUE Expected Value
90 $42,500,090
No Oil 50.0%
-$15,000,000

No Report TRUE Expected Value

0 $42,500,090
Oil 50.0%
$10,000,000
Sell FALSE Expected Value
$10,000,000 $10,000,000
No Oil 50.0%
$10,000,000

Managerial Statistics 47 Prof. Juran

(b) If Decelles decides not to hire Dempsey & McKenna, what is the expected value of
perfect information?
We calculate the expected value with perfect information by summing up the probability-weighted best payoffs for
each state of nature.
EVwPI  0.50 * $100 ,000 ,000  0.50 * $10 ,000 ,000
 $50 ,000 ,000  $5 ,000 ,000
 $55 ,000 ,000
The expected value of perfect information is $55,000,000 - $42,500,000 = $12,500,000.

(c) What is the expected value of the sample information from Dempsey & McKenna?
The expected value of the system with the report is $32,500,000. Without the report the
expected value is $42,500,000, so the extra information is actually worth negative
$10,000. Dempsey & McKenna would have to cut the price of their seismic test by more
than $10,000 for it to be worth buying.
It is conventional in these types of problems to assume that the decision maker is
rational, and will always decide to go with the decision alternative with the highest
expected value (in this case, not to get the sample information). It is also conventional to
round any information with a negative expected value up to zero. So we would say that
the test has no value, as opposed to saying that it has a negative expected value.
Another way to see the worthlessness of the test is to observe that the information from
the test doesn’t change our decision, no matter what the information turns out to be. In
the tree, we see that we would drill whether or not the report predicts oil.

(d) What is the efficiency of the sample information from Dempsey & McKenna?
The efficiency of this information is zero.

Managerial Statistics 48 Prof. Juran

6. Use the payoff table below for this question. Assume that P(s1) = 0.80 and P(s2) = 0.20.
s1 s2
d1 15 10
d2 10 12
d3 8 20
(a) Find the optimal decision using a decision tree.
s1 80.0%
15
d1 TRUE Expected Value
0 14
s2 20.0%
10
Expected Value
14
s1 80.0%
10
d2 FALSE Expected Value
0 10.4
s2 20.0%
12
s1 80.0%
8
d3 FALSE Expected Value
0 10.4
s2 20.0%
20

As you can see, the optimal decision is d1, assuming we want to maximize the value.

(b) Find the expected value of perfect information.

State of Nature Optimal Decision Value

s1 d1 15
s2 d3 20

EVwPI  0.80 * 15  0.20 * 20

 12  4
 16
The expected value of perfect information (the difference in expected value between
perfect information and no information) is 2.

Managerial Statistics 49 Prof. Juran

(c) Suppose some indicator information I is obtained with P(I|s1) = 0.20 and P(I|s2) =
0.75.
(i) Find the posterior probabilities P(s1|I) and P(s2|I).

Probabilities
States Prior Conditional Joint Posterior

  
P sj  I 
sj P sj 
P I sj      
P sj  I  P sj P I sj   
P sj I 
P I 

s1 0.80 0.20 0.16 0.516

s2 0.20 0.75 0.15 0.484
Total P I   0.31
The total probability of I is 31%.
The answer to the question is P(s1|I) = 0.516 and P(s2|I) = 0.484.
Similarly for I :
Probabilities
States Prior Conditional Joint Posterior

   
sj P sj 
P I sj      
P sj  I  P sj P I sj   
P sj I 
P sj  I
PI
s1 0.80 0.80 0.64 0.928
s2 0.20 0.25 0.05 0.072
 
Total P I  0.69
The total probability of I is 69%.

Managerial Statistics 50 Prof. Juran

 (ii) Recommend a decision alternative based on these probabilities.
s1 51.6%
15
d1 FALSE Expected Value
0 12.6

s2 48.4%
10
I 31.0% Expected Value
0 13.8

s1 51.6%
10
d2 FALSE Expected Value
0 11.0
s2 48.4%
12
s1 51.6%
8
d3 TRUE Expected Value
0 13.8

s2 48.4%
20
Expected Value
14.4
s1 92.8%
15
d1 TRUE Expected Value
0 14.6
s2 7.2%
10
Not I 69.0% Expected Value
0 14.6
s1 92.8%
10
d2 FALSE Expected Value
0 10.1
s2 7.2%
12
s1 92.8%
8
d3 FALSE Expected Value
0 8.9

s2 7.2%
20

The best course of action seems to be to get the sample information. Then, if I is true, go
with d3. If I is not true, then go with d1.

Managerial Statistics 51 Prof. Juran

7. Paulson Foods, Inc., produces Mystery Meat (a perishable food product) at a cost of
$10 per case. Mystery Meat sells for $15 per case. For planning purposes, the company
is considering possible demand of 100, 200, or 300 cases.
If demand is less than production, the excess production is lost. If demand is more than
production, the firm, in an attempt to maintain a good service image, will satisfy excess
demand with a special production run at a cost of $18 per case. Mystery Meat always
sells at $15 per case.
(a) Set up the payoff table for the Paulson Foods problem.
States of Nature
s1 s2 s3
100 cases 200 cases 300 cases
d1 = 100 (100*15) – [(100*10)] = $500 (200*15) – [(100*10) + (100*18)] = $200 (300*15) – [(100*10) + (200*18)] = -$100

d2 = 150 (100*15) – [(150*10)] = $0 (200*15) – [(150*10) + (50*18)] = $600 (300*15) – [(150*10) + (150*18)] = $300

d3 = 200 (100*15) – [(200*10)] = -$500 (200*15) – [(200*10)] = $1,000 (300*15) – [(200*10) + (100*18)] = $700

d4 = 250 (100*15) – [(250*10)] = -$1,000 (200*15) – [(250*10)] = $500 (300*15) – [(250*10) + (50*18)] = $1,100

d5 = 300 (100*15) – [(300*10)] = -$1,500 (200*15) – [(300*10)] = $0 (300*15) – [(300*10)] = $1,500

Managerial Statistics 52 Prof. Juran

(b) If P(100) = 0.20, P(200) = 0.20, and P(300) = 0.60, should the company produce 100,
200, or 300 cases?
The best decision, in terms of expected value, is to produce 300 cases of Mystery Meat.
The expected value of this decision is $600.
Demand = 100 20.0%
500
d1 FALSE Expected Value
0 80
Demand = 200 20.0%
200
Demand = 300 60.0%
-100
Demand = 100 20.0%
0
d2 FALSE Expected Value
0 300
Demand = 200 20.0%
600
Demand = 300 60.0%
300
Paulson Expected Value
600
Demand = 100 20.0%
-500
d3 FALSE Expected Value
0 520
Demand = 200 20.0%
1000
Demand = 300 60.0%
700
Demand = 100 20.0%
-1000
d4 FALSE Expected Value
0 560
Demand = 200 20.0%
500
Demand = 300 60.0%
1100
Demand = 100 20.0%
-1500
d5 TRUE Expected Value
0 600
Demand = 200 20.0%
0
Demand = 300 60.0%
1500

Managerial Statistics 53 Prof. Juran

(c) What is the expected value of perfect information?
Here is a simplified version of the payoff table, with the optimal decision alternative indicated for each state of
nature:
s1 s2 s3
100 200 300
d1 = 100 500 200 -100
d2 = 150 0 600 300
d3 = 200 -500 1000 700
d4 = 250 -1000 500 1100
d5 = 300 -1500 0 1500
Optimal Decision d1 d3 d5

EVwPI   0.20 * $500   0.20 * $1,000   0.60 * $1,500

 $100  $200  $900
 $1,200
The expected value of perfect information (the difference in expected value between
perfect information and no information) is $1,200 - $600 = $600.

(d) Say something intelligent about the riskiness of the various decision alternatives.
Even though d5 is the best choice for expected value, it is also the riskiest alternative, as
measured by standard deviation (see scatter plot below).
Each of the alternatives except for d1 is reasonable, depending on the decision maker’s
risk tolerance. For example d4 has a lower expected profit than d5, but is also
significantly less risky. For some people, that might be a more desirable choice. The
only unreasonable alternative is d1, because it is both riskier and less profitable than d2.
Note that d2 is the only alternative guaranteed not to ever lose money.
Risk vs. Return - Paulson Foods
$700

$600
Expected Return ($)

$500 Make 300 cases

Make 250 cases
$400
Make 200 cases
$300

$200 Make 150 cases

$100
Make 100 cases
$-
$- $200 $400 $600 $800 $1,000 $1,200 $1,400

Standard Deviation ($)

Managerial Statistics 54 Prof. Juran

8. Nomura Inc. has a contract with one of its customers, Mackenzie Tar & Grease to
supply a unique liquid chemical product that is used by Mackenzie in the manufacture
of a lubricant for aircraft engines. Because of the chemical process used by Nomura,
batch size for the liquid chemical product must be 1000 pounds.
Mackenzie has agreed to adjust manufacturing to the full batch quantities, and will
order either one, two, or three batches every three months. Since an aging process of
one month is necessary for the product, Nomura will have to make its production (how
much to make) decision before Mackenzie places an order. Thus, Nomura can list the
product demand alternatives of 1000, 2000, or 3000 pounds, but the exact demand is
unknown. Unfortunately, Nomura’s product cannot be stored more than two months
without degenerating into a viscous and highly corrosive toxic compound, linked in
laboratory tests to the Ebola virus.
Nomura’s manufacturing costs are $150 per pound, and the product sells at the fixed
contract price of $200 per pound. If Mackenzie orders more than Nomura has produced,
Nomura has agreed to absorb the added cost of filling the order by purchasing a higher
quality substitute product from Miyamoto, another chemical firm. The substitute
Miyamoto product, including transportation expenses, will cost Nomura $240 per
pound. Since the product cannot be stored more than two months, Nomura cannot
inventory excess production until Mackenzie’s next three-month order. Therefore, if
Mackenzie’s current order is less than Nomura has produced, the excess production
will be reprocessed and valued at $50 per pound.
The inventory decision in this problem is how much Nomura should produce given the costs and
the possible demands of 1000, 2000, and 3000 pounds. From historical data and an analysis of
Mackenzie’s future demands, Nomura has assessed the probability distribution for demand
shown in the table below.
Demand Probability
1000 0.30
2000 0.50
3000 0.20

Managerial Statistics 55 Prof. Juran

(a) Develop a payoff table for the Nomura problem.
States of Nature
s1 s2 s3
1000 pounds 2000 pounds 3000 pounds
[(2000*200)] – [(3000*200)] –
d1 = 1000 [(1000*200)] – [(1000*150)] = $50,000
[(1000*150)+(1000*240)] = $10,000 [(1000*150)+(2000*240)] = -$30,000
[(1000*200)+(1000*50)]– [(2000*150)] [(3000*200)] –
d2 = 2000 = -$50,000
[(2000*200)] – [(2000*150)] = $100,000
[(2000*150)+(1000*240)] = $60,000
[(1000*200)+(2000*50)]– [(3000*150)] [(2000*200)+(1000*50)] – [(3000*150)]
d3 = 3000 = -$150,000 = $0
[(3000*200)] – [(3000*150)] = $150,000

(b) How many batches should Nomura produce every three months?
The best course of action is to produce 2,000 pounds, with an expected value of $47,000.
s1 = Sell 1000 30.0%
$50,000
d1 = Make 1000 FALSE Expected Value
0 $14,000
s2 = Sell 2000 50.0%
$10,000
s3 = Sell 3000 20.0%
-$30,000
Nomura Expected Value
$47,000
s1 = Sell 1000 30.0%
-$50,000
d2 = Make 2000 TRUE Expected Value
0 $47,000
s2 = Sell 2000 50.0%
$100,000
s3 = Sell 3000 20.0%
$60,000
s1 = Sell 1000 30.0%
-$150,000
d3 = Make 3000 FALSE Expected Value
0 -$15,000
s2 = Sell 2000 50.0%
$0
s3 = Sell 3000 20.0%
$150,000

Managerial Statistics 56 Prof. Juran

(c) How much of a discount should Nomura be willing to allow Mackenzie for
specifying in advance exactly how many batches will be purchased?
This question is the same as asking for the expected value of perfect information.
Demand Probabilities Profit d1 Profit d2 Profit d3 Optimal Decision
1000 0.30 $50,000 -$50,000 -$150,000 d1
2000 0.50 $10,000 $100,000 $0 d2
3000 0.20 -$30,000 $60,000 $150,000 d3
We calculate the expected value with perfect information by summing up the probability-weighted best payoffs for
each state of nature.
EVwPI  0.30 * $50 ,000  0.50 * $100 ,000  0.20 * $150 ,000
 $15,000  $50 ,000  $30 ,000
 $95 ,000
The expected value of perfect information is $95,000 - $47,000 = $48,000.

Nomura has detected a pattern in the demand for the product based on Mackenzie’s previous
order quantity. Let
I1 = Mackenzie’s last order was 1000 pounds
I2 = Mackenzie’s last order was 2000 pounds
I3 = Mackenzie’s last order was 3000 pounds
The conditional probabilities are as follows:
P  I 1 s 1   0.10 P  I 2 s 1   0.40 P  I 3 s 1   0.50
P  I 1 s 2   0.22 P  I 2 s 2   0.68 P  I 3 s 2   0.10
P  I 1 s 3   0.80 P  I 2 s 3   0.20 P  I 3 s 3   0.00
(d) Develop an optimal decision strategy for Nomura.
If Mackenzie’s last order was for 1000 pounds:
Probabilities
States Prior Conditional Joint Posterior

  
P sj  I1 
sj P sj 
P I1 s j      
P s j  I1  P s j P I1 s j  
P sj I1  P I 1 
s1 0.30 0.10 0.030 0.100
s2 0.50 0.22 0.110 0.367
s3 0.20 0.80 0.160 0.533
Total P I 1   0.300
The total probability that Mackenzie’s last order was for 1000 pounds is 30%, which is
consistent with what we already know and reassures us that we have calculated the
joint probabilities correctly.

Managerial Statistics 57 Prof. Juran

Similarly, for I2 (that Mackenzie’s last order was for 2000 pounds):
Probabilities
States Prior Conditional Joint Posterior

  
P sj  I2 
sj P sj 
P I2 sj      
P sj  I2  P sj P I2 sj   
P sj I2 
P I 2 
s1 0.30 0.40 0.120 0.24
s2 0.50 0.68 0.340 0.68
s3 0.20 0.20 0.040 0.08
Total P I 2   0.500

Finally, for I3 (that Mackenzie’s last order was for 3000 pounds):
Probabilities
States Prior Conditional Joint Posterior

  
P sj  I3 
sj P sj 
P I3 sj      
P sj  I3  P sj P I3 sj   
P sj I3 
P I 3 
s1 0.30 0.50 0.15 0.75
s2 0.50 0.10 0.05 0.25
s3 0.20 0.00 0.00 0
Total P I 2   0.200
Using these probabilities, we can revise our decision tree (see next page).
The optimal strategy is to look at the most recent order, and then proceed as follows:
Mackenzie’s Last Order Next Production Run Expected Value
1000 3000 $65,000
2000 2000 $60,800
3000 1000 $40,000

(e) What is the expected value of sample information?

The expected value of this strategy is:
EVwSI  0.30 * $65 ,000  0.50 * $60 ,800  0.20 * $40 ,000
 $57 ,900
There fore, the expected value of the sample information is $57,900 – $47,000 = $10,900.

(f) What is the efficiency of the information for the most recent order?
$10,900 / $48,000 = 0.227, or 22.7%.

Managerial Statistics 58 Prof. Juran

Decision tree for Nomura:

Managerial Statistics 59 Prof. Juran

9. A quality-control procedure involves 100% inspection of parts received from a supplier.
Historical records indicate that the defect rates shown in the table below have been observed.
Percent Defective Probability
0 0.15
1 0.25
2 0.40
3 0.20
The cost to inspect 100% of the parts received is $250 for each shipment of 500 parts. If
the shipment is not 100% inspected, defective parts will cause rework problems later in
the production process. The rework cost is $25 for each defective part.
(a) Complete the following payoff table, where the entries represent the total cost of
inspection and rework.
Note that the total rework costs without inspection are $25 times the number of defective parts
(out of 500):
Defect Rate Number of Defective Parts Rework Cost
0% 0 $0
1% 5 $125
2% 10 $250
3% 15 $375

Percent Defective
0 1 2 3
100% Inspection $250 $250 $250 $250
Inspection
No Inspection $0 $125 $250 $375

(b) Karim Nazer, the plant manager, is considering eliminating the inspection process to
save the $250 inspection cost per shipment. Do you support this action? Why or why
not?
On the basis of expected value, Nazer is correct; the inspection is not cost-effective.

Managerial Statistics 60 Prof. Juran

(c) Show a decision tree representing this problem.
0% Defects 15.0%
$250
1% Defects 25.0%
$250
100% Inspection FALSE Expected Value
0 $250
2% Defects 40.0%
$250
3% Defects 20.0%
$250
Nazer Expected Value
$206
0% Defects 15.0%
$0
1% Defects 25.0%
$125
No Inspection TRUE Expected Value
0 $206
2% Defects 40.0%
$250
3% Defects 20.0%
$375

(d) Suppose a sample of five parts is selected from the shipment and one defect is
found. Let I = 1 defect in a sample of five. Use the binomial probability distribution
to compute P  I s 1  , P  I s 2  , P  I s 3  , and P  I s 4  , where the state of nature
identifies the value for p in the binomial distribution. (For example, if the state of
nature is s1, then the p in the binomial is 0.00, etc.)
% defective Probability of 1 Defective out of 5
n x  5
s1 0.00   p  1  p  n  x    0.00  1  1  0.00  4 = 0.0000
x  1
n x  5
s2 0.01   p  1  p  n  x    0.01  1  1  0.01  4 = 0.0480
x  1
n x  5
s3 0.02   p  1  p  n  x    0.02  1  1  0.02  4 = 0.0922
x  1
n x  5
s4 0.03   p  1  p  n  x    0.03  1  1  0.03  4 = 0.1328
x  1

Managerial Statistics 61 Prof. Juran

(e) If I occurs, what are the revised probabilities for the states of nature?
Probabilities
States Prior Conditional Joint Posterior

  
P sj  I 
sj P sj 
P I sj      
P sj  I  P sj P I sj   
P sj I 
P I 
s0 0.15 0.0000 0.0000 0.0000
s1 0.25 0.0480 0.0120 0.1591
s2 0.40 0.0922 0.0369 0.4889
s3 0.20 0.1328 0.0266 0.3520
Total P  I   0.0755

(f) Should the entire shipment be 100% inspected whenever one defect is found in a
sample of size five?
If this happens, then it is cost-effective to perform 100% inspection. Here is a decision
tree, conditional upon having found one defect in the test sample of five parts:
0% Defects 0.0%
$250
1% Defects 15.9%
$250
100% Inspection TRUE Expected Value
0 $250
2% Defects 48.9%
$250
3% Defects 35.2%
$250
Nazer Expected Value
$250
0% Defects 0.0%
$0
1% Defects 15.9%
$125
No Inspection FALSE Expected Value
0 $274
2% Defects 48.9%
$250
3% Defects 35.2%
$375

Managerial Statistics 62 Prof. Juran

Of course, this ignores the other possibility, that we will find zero defects out of the five
parts.1
Let’s analyze the probabilities associated with I2, the event that zero defects are found:
% defective Probability of 0 Defective out of 5
n x  5
s1 0.00   p  1  p  n  x    0.00  0  1  0.00  5 = 1.0000
x 0
n x  5
s2 0.01   p  1  p  n  x    0.01  0  1  0.01 5 = 0.9510
x 0
n x  5
s3 0.02   p  1  p  n  x    0.02  0  1  0.02  5 = 0.9039
x 0
n x  5
s4 0.03   p  1  p  n  x    0.03  0  1  0.03  5 = 0.8587
x 0

Probabilities
States Prior Conditional Joint Posterior

  
P sj  I2 
sj P sj 
P I2 sj      
P sj  I2  P sj P I2 sj  
P sj I2   P I 2 
s0 0.15 1.0000 0.1500 0.1629
s1 0.25 0.9510 0.2377 0.2581
s2 0.40 0.9039 0.3616 0.3926
s3 0.20 0.8587 0.1717 0.1865
Total P I 2   0.9211

The optimal strategy is to take the sample of five and see if there is at least one defect in
the sample. If not, accept the whole lot with no further inspection. If one defect is found,
then proceed with 100% inspection (see decision tree on the next page).

Information from Sample Decision Alternatives Expected Value Optimal Decision

d1 = 100% inspection $250.00
I1 = 1 defect found d1
d2 = no inspection $274.10
d1 = 100% inspection $250.00
I1 = 0 defects found d2
d2 = no inspection $200.33

1
We will ignore the probability of finding more than 1 out of five, which is less than 1% for all of the
percent defect rates in this problem.

Managerial Statistics 63 Prof. Juran

Decision tree for Karim Nazer problem:
0% Defects 0.0%
$250
1% Defects 15.9%
$250
100% Inspection TRUE Expected Value
0 $250.00
2% Defects 48.9%
$250
3% Defects 35.2%
$250
1 Defect Found 7.5% Expected Value
0 $250.00
0% Defects 0.0%
$0
1% Defects 15.9%
$125
No Inspection FALSE Expected Value
0 $274.10
2% Defects 48.9%
$250
3% Defects 35.2%
$375
Nazer Expected Value
$204.09
0% Defects 16.3%
$250
1% Defects 25.8%
$250
100% Inspection FALSE Expected Value
0 $250.00
2% Defects 39.3%
$250
3% Defects 18.6%
$250
0 Defects Found 92.1% Expected Value
0 $200.33
0% Defects 16.3%
$0
1% Defects 25.8%
$125
No Inspection TRUE Expected Value
0 $200.33
2% Defects 39.3%
$250
3% Defects 18.6%
$375

(g) What is the cost savings associated with having the sample information? In other
words, what is it worth to have the sample of five taken as opposed to having no
inspection or having 100% inspection?
As shown in the decision tree, there is a $250.00 - $204.09 = $45.91 expected cost
reduction when the sample of five is inspected.

Managerial Statistics 64 Prof. Juran