CH 15

1
Spreadsheet Modeling &

Decision Analysis:
A Practical Introduction to
Management Science, 3e
by Cliff Ragsdale
Spreadsheet Modeling and Decision Analysis, 3e, by Cliff Ragsdale. 2001 South-Western/Thomson Learning.

15-2
Decision Analysis
Chapter 15

15-3
Introduction to Decision Analysis

Models help managers gain insight and understanding,
but they cant make decisions.
Decision making often remains a difficult task due to:
uncertainty regarding the future
conflicting values or objectives
Consider the following example...

15-4
Deciding Between Job Offers
Company A
In a new industry that could boom or bust.
Low starting salary, but could increase rapidly.
Located near friends, family and favorite sports team.
Company B
Established firm with financial strength and commitment to
employees.
Higher starting salary but slower advancement opportunity.
Distant location, offering few cultural or sporting activities.
Which job would you take?

15-5
Good Decisions vs. Good Outcomes
A structured approach to decision making can
help us make good decisions, but cant
guarantee good outcomes.
Good decisions sometimes result in bad
outcomes.

15-6
Characteristics of Decision Problems
Alternatives - different courses of action intended to solve a problem.
Work for company A
Work for company B
Reject both offers and keep looking

Criteria - factors that are important to the decision maker and
influenced by the alternatives.
Salary
Career potential
Location

States of Nature - future events not under the decision makers control.
Company A grows
Company A goes bust
etc

15-7
An Example: Magnolia Inns
Hartsfield International Airport in Atlanta, Georgia, is one of
the busiest airports in the world.
It has expanded numerous times to accommodate increasing
air traffic.
Commercial development around the airport prevents it from
building additional runways to handle the future air traffic
demands.
Plans are being developed to build another airport outside the
city limits.

15-8
An Example: Magnolia Inns (cont)
Two possible locations for the new airport have been
identified, but a final decision is not expected to be
made for another year.
The Magnolia Inns hotel chain intends to build a new
facility near the new airport once its site is
determined.
Land values around the two possible sites for the new
airport are increasing as investors speculate that
property values will increase greatly in the vicinity of
the new airport.
See data in file Fig15-1.xls


15-9
The Decision Alternatives
1) Buy the parcel of land at location A.
2) Buy the parcel of land at location B.
3) Buy both parcels.
4) Buy nothing.

15-10
The Possible States of Nature
1) The new airport is built at location A.
2) The new airport is built at location B.

15-11
Constructing a Payoff Matrix
See file Fig15-1.xls

15-12
Decision Rules
If the future state of nature (airport location) were
known, it would be easy to make a decision.
Failing this, a variety of nonprobabilistic decision
rules can be applied to this problem:
Maximax
Maximin
Minimax regret
No decision rule is always best and each has its
own weaknesses.

15-13
The Maximax Decision Rule
Identify the maximum payoff for each alternative.
Choose the alternative with the largest maximum
payoff.
Weakness
Consider the following payoff matrix
State of Nature
Decision 1 2 MAX
A 30 -10000 30
<--maximum
B 29 29 29


15-14
The Maximin Decision Rule
Identify the minimum payoff for each alternative.
Choose the alternative with the largest minimum
payoff.
Weakness
State of Nature
Decision 1 2 MIN
A 1000 28 28

B 29 29 29
<--maximum

15-15
The Minimax Regret Decision Rule
Compute the possible regret for each alternative under
each state of nature.
Identify the maximum possible regret for each
alternative.
Choose the alternative with the smallest maximum
regret.

15-16
Anomalies with the Minimax Regret Rule
State of Nature
Decision 1 2
A 9 2
B 4 6
State of Nature
Decision 1 2 MAX
A 0 4 4
<--minimum
B 5 0 5

The regret matrix is:
Note that we prefer A to B.
Now lets add an alternative...

15-17
Adding an Alternative
State of Nature
Decision 1 2
A 9 2
B 4 6
C 3 9
State of Nature
Decision 1 2 MAX
A 0 7 7

B 5 3 5
<--minimum
C 6 0 6
The regret matrix is:
Now we prefer B to A?

15-18
Probabilistic Methods
Sometimes, the states of nature can be assigned probabilities
that represent their likelihood of occurrence.
For decision problems that occur more than once, we can often
estimate these probabilities from historical data.
Other decision problems (such as the Magnolia Inns problem)
represent one-time decisions where historical data for estimating
probabilities dont exist.
In these cases, probabilities are often assigned subjectively
based on interviews with one or more domain experts.
Highly structured interviewing techniques exist for soliciting
probability estimates that are reasonably accurate and free of the
unconscious biases that may impact an experts opinions.
We will focus on techniques that can be used once appropriate
probability estimates have been obtained.

15-19
Expected Monetary Value
Selects alternative with the largest expected monetary
value (EMV)
EMV
i ij
j
j
r p =

r i j
ij
= payoff for alternative under the th state of nature
p j
j
= the probability of the th state of nature
EMV
i
is the average payoff wed receive if we faced
the same decision problem numerous times and
always selected alternative i.

15-20
EMV Caution
The EMV rule should be used with caution in one-time
decision problems.
Weakness
State of Nature
Decision 1 2 EMV
A 15,000 -5,000 5,000
<--maximum
B 5,000 4,000 4,500

Probability 0.5 0.5

15-21
Expected Regret or Opportunity Loss
Selects alternative with the smallest expected regret or
opportunity loss (EOL)
EOL
i ij
j
j
g p =

g i j
ij
= regret for alternative under the th state of nature
p j
j
= the probability of the th state of nature
The decision with the largest EMV will also have the
smallest EOL.

15-22
The Expected Value of Perfect Information

Suppose we could hire a consultant who could predict the
future with 100% accuracy.
With such perfect information, Magnolia Inns average
payoff would be:
EV with PI = 0.4*$13 + 0.6*$11 = $11.8 (in millions)
Without perfect information, the EMV was $3.4 million.
The expected value of perfect information is therefore,
EV of PI = $11.8 - $3.4 = $8.4 (in millions)
In general, EV of PI = EV with PI - maximum EMV
It will always be the case that, EV of PI = minimum EOL

15-23
A Decision Tree for Magnolia Inns
0
1
2
3
4
Buy A
-18
Buy B
-12
Buy A&B
-30
Buy nothing
0
Land Purchase Decision Airport Location
A
B
A
B
B
B
A
A
Payoff
13
-12
-8
11
5
-1
0
0
31
6
4
23
35
29
0
0

15-24
Rolling Back A Decision Tree
0
1
2
3
4
Buy A
-18
Buy B
-12
Buy A&B
-30
Buy nothing
0
A
B
A
B
B
B
A
A
Payoff
13
-12
-8
11
5
-1
0
0
31
6
4
23
35
29
0
0
0.4
0.6
0.4
0.6
0.4
0.6
0.4
0.6
EMV=-2
EMV=3.4
EMV=1.4
EMV= 0
EMV=3.4

15-25
Alternate Decision Tree
0
1
2
3
Buy A
-18
Buy B
-12
Buy A&B
-30
Buy nothing
0
A
B
A
B
B
A
Payoff
13
-12
-8
11
5
-1
31
6
4
23
35
29
0.4
0.6
0.4
0.6
0.4
0.6
EMV=-2
EMV=3.4
EMV=1.4
EMV=3.4
0

15-26
Using TreePlan
TreePlan is an Excel add-in for decision trees.

15-27
About TreePlan
TreePlan is a shareware product developed by
Dr. Mike Middleton at the University of San
Francisco and distributed with this textbook at no
charge to you.
If you like this software package and plan to use
for more than 30 days, you are expected to pay a
nominal registration fee. Details on registration
are available near the end of the TreePlan help
file.

15-28
Multi-stage Decision Problems
Many problems involve a series of decisions
Example
Should you go out to dinner tonight?
If so,
How much will you spend?
Where will you go?
How will you get there?
Multi-stage decisions can be analyzed using
decision trees

15-29
Multi-Stage Decision Example: COM-TECH

Steve Hinton, owner of COM-TECH, is considering whether
or not to apply for a $85,000 OSHA research grant for using
wireless communications technology to enhance safety in
the coal industry.
Steve would spend approximately $5,000 preparing the
grant proposal and estimates a 50-50 chance of actually
receiving the grant.
If awarded the grant, Steve would then need to decide
whether to use microwave, cellular, or infrared
communications technology.

15-30
COM-TECH (continued)
Steve would need to acquire some new equipment
depending on which technology is used. The cost of
the equipment is summarized as:
Technology Equipment Cost
Microwave $4,000
Cellular $5,000
Infrared $4,000
Steve knows he will also spend money in R&D, but
he doesnt know exactly what the R&D costs will be.

15-31
COM-TECH (continued)
Steve needs to synthesize all the factors in this problem to
decide whether or not to submit a grant proposal to OSHA.

Cost Prob. Cost Prob.
Microwave $30,000 0.4 $60,000 0.6
Cellular $40,000 0.8 $70,000 0.2
Infrared $40,000 0.9 $80,000 0.1
Best Case Worst Case

Steve estimates the following best case and worst case R&D
costs and probabilities, based on his expertise in each area.

15-32
Analyzing Risk in a Decision Tree
How sensitive is the decision in the COM-TECH
problem to changes in the probability estimates?
We can use Solver to determine the smallest
probability of receiving the grant for which Steve
should still be willing to submit the proposal.
Lets go back to file Fig15-26.xls...

15-33
Risk Profiles
A risk profile summarizes the make-up of an EMV.
The $13,500 EMV for COM-TECH was created as follows:
Event Probability Payoff
Receive grant, Low R&D costs 0.5*0.9=0.45 $36,000
Receive grant, High R&D costs 0.5*0.1=0.05 -$4,000
Dont receive grant 0.5 -$5,000
EMV $13,500
This can also be summarized in a decision tree.

15-34
Using Sample Information
in Decision Making
We can often obtain information about the
possible outcomes of decisions before the
decisions are made.
This sample information allows us to refine
probability estimates associated with various
outcomes.

15-35
Example: Colonial Motors
Colonial Motors (CM) needs to determine whether to build
a large or small plant for a new car it is developing.
The cost of constructing a large plant is $25 million and
the cost of constructing a small plant is $15 million.
CM believes a 70% chance exists that demand for the
new car will be high and a 30% chance that it will be low.
The payoffs (in millions of dollars) are summarized below.
Demand
Factory Size High Low
Large $175 $95
Small $125 $105
See decision tree in file Fig15-32.xls

15-36
Including Sample Information
Before making a decision, suppose CM conducts a
consumer attitude survey (with zero cost).
The survey can indicate favorable or unfavorable attitudes
toward the new car. Assume:
P(favorable response) = 0.67
P(unfavorable response) = 0.33
If the survey response is favorable, this should increase
CMs belief that demand will be high. Assume:
P(high demand | favorable response)=0.9
P(low demand | favorable response)=0.1

15-37
Including Sample Information (cont)
If the survey response is unfavorable, this should
increase CMs belief that demand will be low.
Assume:
P(low demand | unfavorable response)=0.7
P(high demand | unfavorable response)=0.3
See decision tree in file Fig15-33.xls

15-38
The Expected Value of Sample Information
How much should CM be willing to pay to conduct the
consumer attitude survey?
Expected Value of
Sample Information
Expected Value with
Sample Information
Expected Value without
Sample Information
=
-
In the CM example,
E.V. of Sample Info. = $126.82 - $126 = $0.82 million


15-39
Computing Conditional Probabilities
Conditional probabilities (like those in the CM example) are
often computed from joint probability tables.

High Demand Low Demand Total
Favorable Response 0.600 0.067 0.667
Unfavorable Response 0.100 0.233 0.333
Total 0.700 0.300 1.000
The joint probabilities indicate:
P(F H) 0.6, P(F L) = 0.067
P(U H) = 0.1, P(U L) 0.233
=
=
The marginal probabilities indicate:
P(F) 0.667, P(U) = 0.333
P(H) = 0.700, P(L) 0.300
=
=

15-40
Computing Conditional Probabilities (contd)
In general,
P(A| B) =
P(A B)
P(B)
So we have,
P(H| F) =
P(H F)
P(F)
= =
0 60
0 667
0 90
.
.
.
P(L| F) =
P(L F)
P(F)
= =
0 067
0 667
010
.
.
.
P(H| U) =
P(H U)
P(U)
= =
010
0 333
0 30
.
.
.
P(L| U) =
P(L U)
P(U)
= =
0 233
0 333
0 70
.
.
.
High Low
Demand Demand Total
Favorable Response 0.600 0.067 0.667
Unfavorable Response 0.100 0.233 0.333
Total 0.700 0.300 1.000

15-41
Bayess Theorem
Bayess Theorem provides another definition of conditional
probability that is sometimes helpful.
P(A| B) =
P(B|A)P(A)
P(B|A)P(A) + P(B| A)P(A)
For example,
P(H|F) =
P(F|H)P(H)
P(F|H)P(H) +P(F|L)P(L)
=
+
=
( . )( . )
( . )( . ) ( . )( . )
.
0857 070
0857 070 0223 030
090

15-42
Utility Theory
Sometimes the decision with the highest EMV is not the
most desired or most preferred alternative.
Consider the following payoff table,
State of Nature
Decision 1 2 EMV
A 150,000 -30,000 60,000 <--maximum
B 70,000 40,000 55,000
Probability 0.5 0.5
Decision makers have different attitudes toward risk:
Some might prefer decision alternative A,
Others would prefer decision alternative B.
Utility Theory incorporates risk preferences in the decision
making process.

15-43
Common Utility Functions
0.00
0.25
0.50
0.75
1.00
Utility
Payoff
risk averse
risk neutral
risk seeking

15-44
Constructing Utility Functions

Assign utility values of 0 to the worst payoff and 1 to the
best.
For the previous example,
U(-$30,000)=0 and U($150,000)=1
To find the utility associated with a $70,000 payoff identify
the value p at which the decision maker is indifferent
between:
Alternative 1: Receive $70,000 with certainty.
Alternative 2: Receive $150,000 with probability p and
lose $30,000 with probability (1-p).

15-45
Constructing Utility Functions (contd)
If decision maker is indifferent when p=0.8:
U($70,000)=U($150,000)*0.8+U(-30,000)*0.2
=1*0.8+0*0.2=0.8
When p=0.8, the expected value of Alternative 2 is:
$150,000*0.8 + $30,000*0.2 = $114,000
The decision maker is risk averse. (Willing to accept
$70,000 with certainty versus a risky situation with an
expected value of $114,000.)

15-46
Constructing Utility Functions (contd)
If we repeat this process with different values in Alternative 1, the
decision makers utility function emerges (e.g., if U($40,000)=0.65):
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
0.80
0.90
1.00
-30 -20 -10 0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150
Payoff (in $1,000s)
Utility

15-47
Comments

Certainty Equivalent -- the amount that is equivalent
in the decision makers mind to a situation involving
risk.
(e.g., $70,000 was equivalent to Alternative 2 with p = 0.8)

Risk Premium -- the EMV the decision maker is
willing to give up to avoid a risky decision.
(e.g., Risk premium = $114,000-$70,000 = $44,000)

15-48
Using Utilities to Make Decisions
Replace monetary values in payoff tables with utilities.
Consider the following utility table from the earlier example,
State of Nature Expected
Decision 1 2 Utility
A 1 0 0.500
B 0.8 0.65 0.725 <--maximum
Probability 0.5 0.5
Decision B provides the greatest utility even though it the
payoff table indicated it had a smaller EMV.

15-49
-0.80
-0.60
-0.40
-0.20
0.00
0.20
0.40
0.60
0.80
1.00
-50 -25 0 25 50 75 100 125 150 175 200 225 250 275 300 325 350
x
U(x)
R=100 R=200
R=300
The Exponential Utility Function
The exponential utility function is often used to model classic
risk averse behavior: U( ) = 1-
- / R
x e
x

15-50
Incorporating Utilities in TreePlan
TreePlan will automatically convert monetary values to utilities
using the exponential utility function.
First determine a value for the risk tolerance parameter R.
R is equivalent to the maximum value of Y for which the decision
maker is willing to accept the following gamble:
Win $Y with probability 0.5,
Lose $Y/2 with probability 0.5.
Note that R must be expressed in the same units as the payoffs!
In Excel, insert R in a cell named RT.
(Note: RT must be outside the rectangular range containing the decision tree!)
On TreePlans Options dialog box select, Use Exponential Utility
Function

15-51
Multicriteria Decision Making
Decision problem often involve two or more
conflicting criterion or objectives:
Investing: risk vs. return
Choosing Among Job Offers: salary, location, career
potential, etc.
Selecting a Camcorder: price, warranty, zoom, weight,
lighting, etc.
Choosing Among Job Applicants: education,
experience, personality, etc.
Well consider two techniques for these types of
problems:
The Multicriteria Scoring Model
The Analytic Hierarchy Process (AHP)

15-52
The Multicriteria Scoring Model
Score (or rate) each alternative on each criterion.
Assign weights the criterion reflecting their relative
importance.
w s
i
i
ij
For each alternative j, compute a weighted average

score as:
w
i
= weight for criterion i
s
ij
= score for alternative i on criterion j

15-53
The Analytic Hierarchy Process (AHP)

Provides a structured approach for determining the
scores and weights in a multicriteria scoring model.
Well illustrate AHP using the following example:
A company wants to purchase a new payroll and
personnel records information system.
Three systems are being considered (X, Y and Z).
Three criteria are relevant:
Price
User support
Ease of use

15-54
Pairwise Comparisons
The first step in AHP is to create a pairwise comparison matrix for
each alternative on each criterion using the following values:
Value Preference
1 Equally Preferred
2 Equally to Moderately Preferred
3 Moderately Preferred
4 Moderately to Strongly Preferred
5 Strongly Preferred
6 Strongly to Very Strongly Preferred
7 Very Strongly Preferred
8 Very Strongly to Extremely eferred
9 Extremely Preferred
P
ij
= extent to which we prefer alternative i to j on a given criterion.
We assume P
ji
= 1/P
ij

See price comparisons in file Fig15-43.xls

15-55
Normalization & Scoring
To normalize a pairwise comparison matrix,
1) Compute the sum of each column,
2) Divide each entry in the matrix by its column sum.
The score (s
j
) for each alternative is given by the
average of each row in the normalized comparison
matrix.

15-56
Consistency
We can check to make sure the decision maker was
consistent in making the comparisons.
The consistency measure for alternative i is:
C
P s
s
i
ij j
j
i
=

where
P
ij
= pairwise comparison of alternative i to j
s
j
= score for alternative j
If the decision maker was perfectly consistent, each
C
i
should equal to the number of alternatives in the
problem.

15-57
Consistency (contd)
Typically, some inconsistency exists.
The inconsistency is not deemed a problem provided the
Consistency Ratio (CR) is no more than 10%
CR
CI
RI
0.10 = s
where,
CI =
C
i
n
i
n n

|
\
|
.
| / ( ) 1
n = the number of alternatives
RI = 0.00 0.58 0.90 1.12 1.24 1.32 1.41
for n = 2 3 4 5 6 7 8

15-58
Obtaining Remaining Scores & Weights

This process is repeated to obtain scores for the
other criterion as well as the criterion weights.
The scores and weights are then used as inputs
to a multicriteria scoring model in the usual way.

15-59
End of Chapter 15

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Spreadsheet Modeling &

For each alternative j, compute a weighted average

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