MGT503: Operations Research: Unit-I

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Unit I (6 Sessions):
Operations Research: -Uses, Scope and Applications of Operation Research in managerial decision-making.
Decision-making environments:- Decision-making under certainty, uncertainty and risk situations; Decision tree approach and
its applications.

O.R. HISTORY: ORIGIN & DEVELOPMENT

The term Operation Research was coined by McClosky & Trehten in 1940 in U.K. Operations Research
came into existence during World War II, when the British and American military management called
upon a group of scientists with diverse educational background to develop and apply a scientific
approach to deal with strategic and tactical problems of various military operations. The objective was
to allocate scarce resources in an effective manner to various military operations and to the activities
within each operation. The name Operations Research (OR) came directly from the context in which it
was used and developed, viz., research on military operations. The effectiveness of operation research
in military operations attracted the industrial managers to solve their complex problems of business &
industry.
During the 50s, Operations Research achieved recognition as a subject for study in the universities.
Since then the subject has gained increasing importance for the students of Management, Public
Administration, Behavioral Sciences, Engineering, Mathematics, Economics and Commerce, etc. Today,
Operations Research is also widely used in regional planning, transportation, public health,
communication etc., besides military and industrial operations. In 1957 the international federation of
O.R. Societies was established.
O.R. HISTORY: O.R. IN INDIA
In India, Operations Research came into existence in 1949 with the opening of an Operations Research
Unit at the Regional Research Laboratory at Hyderabad and also in the Defense Science Laboratory at
Delhi which devoted itself to the problems of stores, purchase and planning.For national planning and
survey, an Operations Research Unit was established in 1953 at the India Statistical Institute, Calcutta.
Towards the application of O.R. in India, Prof. Mahalonobis made the first important application. He
formulated second five-year plan with the help of O.R. techniques. In 1957, Operations Research
Society of India was formed. It became a member of the International federation of O.R. Societies in
1959.
O.R. : MEANING & DEFINITION
OR is a relatively new discipline, its content & boundaries are not yet fixed. Therefore, proposing a
formal definition of the term OR is a difficult task. It is a scientific approach to determine the optimum
(best) solution to a decision problem under the constraints of limited resources, using the mathematical
techniques to model, analyze, and solve the problem. Operation Research begins when some
mathematical & quantitative technique are used to substantiate the decision being taken.
OR has been variously described as the science of use, quantitative common sense. Scientific approach
to decision-making problems, etc. But only a few are commonly used and widely accepted namely:
According to Pocock: OR is scientific methodology- analytical, experimental, quantitative- which, by
assessing the overall implication of various alternative courses of action in a management system,
provides an improved basis for management decisions.
According to P.M. Morse and G.E. Kimball:O.R. is a scientific method of providing executive
departments with a quantitative basis for decisions under their control.
According to Churchman, Ackoff and Arnoff: O.R. is the application of scientific methods,
techniques and tools to problems involving the operations of a system so as to provide those in control
of the system with optimum solutions to the problem.
According to D.W. Miller and M.K. Starr: O.R. is applied decision theory. It uses many scientific,
mathematical or logical means to attempt to cope with the problems that confront the executive when
he tries to achieve a thorough-going rationality in dealing with his decision problems.
According to H.M. Wagner: O.R. is a scientific approach to problems solving for executive
management.
According to H.A. Taha: O.R. is a scientific knowledge through interdisciplinary team effort for the
purpose of determining the best utilization of limited resources.

By Pashupati Nath Verma

MGT503: Operations Research: Unit-I

1. Addresses Managerial Decision Making

2. Employs Scientific Methods/methodologies
3. Uses Inter-disciplinary Team Approach
4. Objective Orientation
5. Orientation for Systems Approach
6. Searches for Optimality/Optimum Solutions
7. Largely uses Models for decision making
Managerial Decision Making
Decision making is a key responsibility of a
manager. OR help managers to take decisions in
complex situations. OR helps manager to take
better decisions by facilitating
1. with Optimal Decisions
2. Systematic Decisions Making approach
3. Inter-disciplinary approach in decision
making
4. Removing subjectivity in decision making
Further, OR helps manager to take quick
decisions in most of the situation by the use of
1. Predetermined method or model
2. Computer programmes
Inter-disciplinary Team Approach
Operations research (also referred to as decision
science,
or
management
science)
is
an
interdisciplinary mathematical science Employing
techniques, such as
mathematical modeling,
statistical analysis, and
mathematical optimization.
Because of its focus on practical applications,
operations research has overlap with other
disciplines, notably
industrial engineering&operations management,
and draws on psychology&organization science.
OR requires team approach to solve a problem as
managerial problems have economical, physical,
psychological, sociological & technological aspects
thus requires team of people with blend of these
areas.
Objective oriented
1. OR Techniques are objective oriented to
locate best possible solution to the problem
at hand.
2. OR Techniques objective is to find the best
possible solution among all available
feasible alternatives.
Searches for Optimality/Optimum Solutions
1. OR Techniques are used to locate best
possible solution to the problem at hand.
2. OR Techniques find the optimal solution
among all available feasible alternatives.

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O.R. : FEATURES/CHARACTERISTICS

Scientific Methods/methodologies
OR uses scientific methods to find the solution of
any problem. Solutions obtained in such a manner
will be
1. Accurate
2. Verifiable &
3. Credible
Scientific methods in OR consists of one or more
phases among the following three phases:
1. Judgment Phase:
Determination of the operation,
Establishment of the objectives and
values related to the operation,
Determination
of
the
suitable
measures of effectiveness and
Formulation of the problems relative to
the objectives.
2. Research Phase
Operations and data collection for a
better understanding of the problems.
Formulation of hypothesis and model.
Observation and experimentation to
test the hypothesis on the basis of
additional data.
Analysis of the available information
and verification of the hypothesis
using pre- established measure of
effectiveness.
Prediction of various results and
consideration of alternative methods.
3. Action Phase
Making recommendation for action.
System Approach
1. The OR methods seek to optimize the overall system(and not a part thereof )
according to the weighted objectives and
to achieve maximum compatibility of its
parts.
2. When dealing with Operations Research
problems, one has to consider the entire
system, and characteristics or subsystems, the inter-relationship between
sub-systems and then analyze the problem,
search for a suitable model and get the
solution for the problem. Hence we say
Operations
Research
is
a
Systems
Approach.

Uses Models
1. OR uses models on a very wide level.
2. Primarily, it develops model to represent a particular environment and then uses this model to
optimize the system.

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MGT503: Operations Research: Unit-I

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OBJECTIVE& SCOPE OF OPERATIONS

RESEARCH
The objective of Operations Research is to provide a scientific basis to the decision maker
for solving the problems involving the interaction of various components of an organization
by employing a team of scientists from various disciplines, all working together for finding
a solution which is in the best interest of the organization as a whole. The best solution
thus obtained is known as optimal decision.
SCOPE OF OR
The scope aspect of any subject indicates the limit of application of the subject matter/techniques of
the subject to the various fields to solve the variety of the problems. But we have studied in the
objective, that the subject Operations Research will give scientific base for the executives to take
decisions or to solve the problems of the systems under their control. The system may be business,
industry, government or defense. Below are some indicative areas where OR is used:
Industry
Defense Operations
Economic Planning & Development
Agriculture
Traffic Control etc.
Application Area of OR Techniques
Some of the industrial/ government/ business problems which can be analyzed by Operation Research
approach have been arranged functional area wise as follows: FINANCE AND ACCOUNTING:
Divided policies, investment and portfolio management, auditing balance sheet, cash
flow analysis.
Break-even analysis, capital budgeting, cost allocation and control, financial planning.
Claim and complaint procedure, public accounting.
MARKETING:
Selection of product mix, marketing planning, exports planning
Sales effort allocation and assignment.
Advertising and media planning.
PURCHASING, PROCUREMENT AND EXPLORATION:
Optimal buying and recording under price quantity discount.
Bidding policies.
Transportation planning.
Vendor analysis.
Replacement policies.
PRODUCTION MANAGEMENT:
Facilities Planning
Manufacturing
Maintenance and project scheduling
PERSONNEL MANAGEMENT:
Manpower planning, wage/salary administration
Skills and wages balancing
Scheduling of training programmers
TECHNIQUES AND GENERAL MANAGEMENT:
Decision support system and MIS; forecasting
Organizational design and control
Project Management, strategic planning
GOVERNMENT:
Economic planning, natural resources, social planning, energy
Urban and housing problem
Military, police, pollution control etc.

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MGT503: Operations Research: Unit-I

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MODELING IN OPERATIONS RESEARCH

A Model is a simplified, but valid, representation of some specific operation or process or environment.
Models are integrated part of the O.R. Most operations research studies involve the construction of a
model to optimize operation, process & system.
Models must be both tractable, capable of being solved, and valid, representative of the original
situation. These dual goals are often contradictory and are not always attainable. It is generally true
that the most powerful solution methods can be applied to the simplest, or most abstract, model. Some
widely Used Model in OR:
Linear Programming, Transportation & Assignment Model
Sequencing Model, Queuing Model, Inventory Model, Replacement Model etc.
Type of Model
1. By Functions: Descriptive, Predictive & Normative (prescriptive)
2. By Structure: Iconic (physical), Analogue, & mathematical (Symbolic)
3. By Nature of environment: Deterministic & probabilistic
4. By Problem Variable: Dynamic & Static
Steps in Constructing a Model
1. Problem environment analysis and formulation : One has to study the system in all aspects, if
necessary make relevant assumptions, have the decision for which he is constructing the model
in mind and formulate the model.
2. Model construction and assumptions: Identify the main variables and constraints and relate
them logically to arrive at a model.
3. Testing the model: After the formulation, before using check the model for its validity.
Advantages of a Good Model
1. A model provides logical and systematic approach to the problem.
2. It provides the analyst a base for understanding the problem and think of methods of solving.
3. The model will avoid the duplication work in solving the problem.
4. Models fix the limitation and scope of an activity.
5. Models help the analyst to find newer ways of solving the problem.
6. Models saves resources like money, time etc.
7. Model helps analyst to make complexities of a real environment simple.
8. Risk of tampering the real object is reduced, when a model of the real system is subjected to
experimental analysis.
9. Models provide distilled economic descriptions and explanations of the operation of the system
they represent.
10. Modeling in Operations research
Characteristics of a Good Model
1. The number of parameters considered in a model should be less to understand the problem
easily.
2. A good model should be flexible to accommodate any necessary information during the stages
of building the model.
3. A model must take less time to construct.
4. A model may be accompanied by lower and upper bounds of parametric values.
Limitations of a Model
1. Models are constructed only to understand the problem and attempt to solve the problem; they
are not to be considered as real problem or system in absolute sense.
2. The validity of any model can be verified by conducting the experimental analysis and with
relevant data characteristics.
General Solution Methods for OR Models
1. There are three methods of solving an operations research problem. They are:
2. Analytical Methods (Deductive Methods): use mathematical techniques such as differential
calculus, probability theory etc. to find the solution. Examples are problems of inventory models.
3. Iterative Methods (Numerical Methods): This is trial and error method. When we have large
number of variables, and we cannot use classical methods successfully, we use iterative
process. e.g. Simplex Methods.
4. Monte-Carlo Method: This method is based on random sampling of variable's values from a
distribution of the variable. This uses sampling technique. A table of random numbers must be
available to solve the problems. In fact it is a simulation process.

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MGT503: Operations Research: Unit-I

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DECISION THEORY
DECISION & DECISION MAKING ENVIRONMENT:
Decision may be defined as choosing a particular course of action or strategy on some rational basis.
Decision Making Environment is the set of all uncontrollable future events under study in which
specific decisions have to be taken.
Managerial Decision making is a complex process and Decisions making may be classified on the
basis of decision making environment.Depending on the degree of certainty of Expected
uncontrollable future events Decision Making may be classified as follows:
Decision making under certainty
Decision making under Uncertainty and
Decision making under risk.
Decision Theory/Analysis: It is an analytical & systematic approach of comparing decision
alternatives in term of expected outcome.Expected outcome always depends upon:
Decision Alternative (Viable Alternative strategies)
State of Nature (Set of future events)
Payoffs resulting from different combination viable alternatives & future events.
Decision Alternatives: The decision alternatives are the different possible strategies which the
decision maker can employ.
State of Nature: The states of nature refer to uncontrollable future events (not under the
control of the decision maker), which will ultimately affect decision results.
Payoffs: A payof is the outcome (profit or loss) associated with a specific combination of a
decision alternative and state of nature. Payoffs can be expressed in terms of profit, cost, time,
distance or any other appropriate measure. Payoff matrix: The outcomes of all possible
combinations of decision alternatives and states of nature constitute a payof matrix or
payoftable.
EXAMPLE 1: CAL CONDOMINIUM COMPLEX:A developer must decide how large a luxury
condominium complex to build small, medium, or large. The profitability of this complex depends
upon the future level of demand for the complexs condominiums.
For the above decision making situation we can define
States of nature: The states of nature could be defined as low demand and high demand.
Alternatives: CAL could decide to build a small, medium,or large condominium complex.
Payoffs: The profit for each alternative under each potential
state of nature is going to be
determined.

EXAMPLE 2: LINDAS INVESTMENT DECISION:Consider an artificial example where someone, say

Linda, is thinking of investing in the stock market. Suppose she is considering four alternatives:
investing $8000, investing $4000, investing $2000, or $1000. These are the four choices that are within
her control. The consequences of her investment, in terms of her profit or loses, are dependent on the
market and beyond her control. Linda might draw up a payof table as follows:

For the above decision making situation we have

States of nature: The states of nature are Strong, Fair & Poor Market condition.
Alternatives:Linda could decide to invest $8000, $4000, $2000, or $1000.

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MGT503: Operations Research: Unit-I

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Payoffs: The profits for each alternative under each potential state of nature are given in cells.

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MGT503: Operations Research: Unit-I

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DECISION MAKING UNDER UNCERTAINTY

If the decision maker does not know with certainty which state of nature will occur, then he/she is said
to be making decision under uncertainty.
Decision criteria under situation of uncertainty are governed by the attitude of the decision maker that
whether decision makers attitude is optimistic or conservative and so on.
The five commonly used criteria for decision making under uncertainty are:
1. The optimistic approach (Maximax or Minimin)
2. The conservative approach (Maximin or Minimax)
3. The minimax regret approach
4. Equally likely (Laplace criterion)
5. Criterion of realism with (Hurwicz criterion)
OPTIMISTIC (MAXIMAX OR MINMIN) APPROACH:
The maximax (minmin) criterion is based on extrem optimism.If decision maker do not want to miss a
single opportunity to maximize his profit (or minimize the cost, as the case may be) then decision
maker choose the alternative which maximizes his profit (minimizes cost) in pay off table. The
optimistic approach would be used by an optimistic decision maker.
Under this criterion, the decision with the largest possible payoff is chosen. If the payoff table was in
terms of costs, the decision with the lowest cost would be chosen.
Illustration: in case of Example 2, If Linda is extremely optimistic investor; she would search for
maximum of maximum possible payoff for each investment decision as follows:

Max Payoff column represent the maximum possible payoff by any investment decision.Maximax
Payoff column represent maximum of maximum payoff by all different alternative decision.So, Maximax
decision is investment of $8000 & Maximax Payoff=$1600.
CONSERVATIVE (MAXIMIN OR MINIMAX) APPROACH:
The conservative approach would be used by a conservative decision maker. In this approach, for each
decision the minimum payoff is listed and then the decision corresponding to the maximum of these
minimum payoffs is selected. (Hence, the minimum possible payoff is maximized.)If the payoff was in
terms of costs, the maximum costs would be determined for each decision and then the decision
corresponding to the minimum of these maximum costs is selected. (Hence, the maximum possible
cost is minimized.)
Illustration: in case of Example 2, If Linda is conservative investor; she would ensure she would urn
not less than some specific amount & search for maximum of minimum possible payoff for each
investment decision as follows:

Min Payoff column represent the minimum possible payoff by any investment decision.Maximin
Payoff column represent maximum of minimum payoff by all different alternative decision.So, Maximin
decision is investment of $4000 & Maximin Payoff=$200.

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MGT503: Operations Research: Unit-I

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MINIMAX REGRET APPROACH:

The minimax regret approach requires the construction of a regret table or an opportunity loss
table.The opportunity loss is the difference between the actual payoff that occurs for a state of nature
and the optimal payoff for the same state of nature. Thus, opportunity loss table can be constructed by
calculating the difference between each payoff and the largest payoff for that state of nature. Using
this regret table, the maximum regret for each possible decision is listed. Under this approach, the
decision chosen is the one corresponding to the minimum of the maximum regrets.
Illustration: in case of Example 2,If Linda is an investor who wants to minimize her opportunity Loss;
she would ensure that for each state of nature maximum opportunity loss of each state must be
minimum for her decision.

Max Regret column represent the maximum possible regret by any investment decision. Minmax
Regret column represent minimum of maximumregret by all different alternative decision. So, Minimax
Regret=$100 & Minimax Regret decision would be investing $8000.
EQUALLY LIKELY (LAPLACE) CRITERION:
In this criteria decision maker has an equally likely attitude about every state of nature.Equally likely,
also called Laplace, criterion finds decision alternative with highest average payoff. In this method
decision maker calculate average payoff for every alternative.Then pick alternative with maximum
average payoff.This approach is also known as Bayes criterion or criterion of rationality.
Illustration: For Lindas case under consideration, working table is given below:

Maximum Average Payoff=833.33 and investing $8000 will be the decision according to Laplace
Criterion.
CRITERION OF REALISM (HURWICZ):
This criterion suggests that a rational decision maker should be neither completely optimistic nor
pessimistic and therefore must display a mixture of both.Often called weighted average, the criterion of
realism (or Hurwicz) decision criterion is a compromise between optimistic and a pessimistic decision.
The procedure is as follows:
1. First, select coefficient of realism, with a value between 0 and 1. When is close to 1,
decision maker is optimistic about future, and when is close to 0, decision maker is
pessimistic about future.
2. Payoff, h= x (maximum payoff) + (1-) x (minimum payoff)*
3. Select an alternative with best anticipated weighted average payoff value.
Illustration:Again consider the case of Linda.

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MGT503: Operations Research: Unit-I

If Linda uses Huwicz Criterion she would go for $8000 investment for coefficient of optimism =0.6, as
for this decision h is maximum.

DECISION MAKING UNDER RISK

Decision-making Under Risk describes a situation in which each strategy results in more than one
outcome or payoffs and the manager attaches a probability measure to these payoffs.
The following assumptions are to be made while making decision under risk:
Availability of more than one strategies,
The existence of more than one states of nature,
The relevant outcomes and
The probability distribution of outcomes associated with each strategy.
There are several rules to identify the optimal strategy in decision making under risk viz.
1. Maximum Likelihood Criterion
2. Maximum Expected Value Criterion
3. Bayesian Decision Rule
4. Decision Trees Approach
MAXIMUM LIKELIHOOD CRITERION:
Under this criteria decision maker take the decision based on the outcome of the most likelihood event.
In this method, a particular decision alternative is chosen if it results to most favorable outcome in most
likelihood state of nature.
This is a crude method and ignores the all other state of nature which may have more consequential
outcomes.This method must be adopted, only when most likelihood event has a very high degree
probability of happening and if not happened, consequents are not very unfavorable.
Illustration:In Lindas case if probabilities associated with different market condition viz.: Strong, Fair,
and Poor are 0.0.3, 0.6 & 0.1 then we have following table according to maximum likelihood approach.

Maximum Likelihood Payoff=800 and investing $8000 will be the decision according to Maximum
Likelihood Criterion.
EXPECTED VALUE CRITERION:
If probabilistic information regarding the states of nature is available, one may use Expected Value
Approach.Here the expected return for each decision is calculated by summing the products of the
payoff under each state of nature and the probability of the respective state of nature occurring.
The expected value (EV) of decision alternative dican be defined as:
N

EV (d i )

P(s )V
j

ij

j 1

Where:N = the number of states of nature

P(sj) = the probability of state of nature sj

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MGT503: Operations Research: Unit-I

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Vij = the value corresponding to decision alternative di and state of nature sj

Decision with optimal expected value is to be chosen for implementation.
The expected value criterion is useful generally in two cases:
Long run planning is appropriate, and decision situations repeat themselves.
The decision maker is risk neutral.
There are three approaches to calculate value under this criterion:
a. Expected Monetary Value (EMV)
b. Expected Opportunity Loss (EOL)
c. Expected Value of Perfect Information (EVPI)

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Expected Monetary Value (EMV)

The expected monetary value of a decision alternative , say di ,is calculates as
N

EMV (d i )

P(s ) P (Pr obability Payoff )

j

ij

j 1

Where:N = the number of states of nature

P(sj) = the probability of state of nature sj
Pij = the payoff corresponding to decision alternative di and state of nature sj
Decision alternative with maximum expected monetary value is to be chosen for implementation.
EMV Criterion may be summarized as below:
Step1: Construct Payoff Matrix
Step2: Calculate EMV(di) for each alternative decision using above formula.
Step3: Select decision with optimal EMV (di).
Expected Opportunity Loss (EOL)
Sometimes instead off maximizing EMV we try to minimize Expected opportunity Loss (EOL). The
expected opportunity Loss of a decision alternative , say di ,is calculates as
N

EOL (d i )

P(s ) I ( Pr obabilty
j

ij

Oppotunity Loss )

j 1

Where:

N = the number of states of nature

P(sj) = the probability of state of nature sj
Iij = the Opportunity Loss corresponding to decision
alternative di and state
of nature sj
Decision alternative with minimum eexpected opportunity Lossis to be chosen for implementation.
Expected Value of Perfect Information (EVPI)
The criteria of EMV or EOL are based on prior analysis of probability distribution of state of nature.
However, prior probability distribution is not perfect indicator of future possibilities.Hence decision
maker tries to make future information more perfect & reliable through test marketing, market surveys
or experimentation so as to maximize firms profit or minimize its opportunity loss. The EVPI provides
an expected upper bound which may be incurred to obtain such additional information.
The expected value of perfect information (EVPI) is the increase in the expected profit that would result
if one knew with certainty which state of nature would occur.
Steps in Calculating EVPI
Step1- Calculate EPPI (Expected Payoff with Perfect Information) by multiplying
maximum payoff of each event with respective probabilities & then adding them.
Step 2- Calculate EMV Under Uncertainty.
Step3 Get EVPI=EPPI-EMV

P ( s j ) MaxP Max EMV

ij
j 1
i

EVPI
EVPI

( Pr obabilty

EVPI EPPI MaxEMV

Max Payoff ) Max EMV

The EVPI is calculates as

Where:N = the number of states of nature

P(sj) = the probability of state of nature sj
Pij = the Opportunity Loss corresponding to decision
nature sj

alternative

di

and

state

of

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Expected Monetary Value (EMV) Example 1: A Television dealer finds that the cost of a TV set in
stock for a week is Rs.30 and the cost of a unit shortage is Rs.70.
for one particular model of TV
set the probability distribution of weekly sales is as follows:
Weekly Sales (TV
Sets)

Probability

0.1

0.1

0.2

0.25

0.15

0.15

.05

How many units per week should the dealer order?

Solution: The total cost (Shortage + Carrying) for quantity demanded for sales & stock available in a
week, will be given by
Total Cost
= 70x(Sales-Stock) if Sales>Stock (Shortage)
70x(Sales-Stock)
=30x(Stock-Sales)
if Sales<Stock (Overstocking)
=70x(4-1)
Note that 70 is shortage cost & 30 is holding cost.
=210
The Cost table will be as follows:

EMV=pxcost
=.1x30+.1x0+.2
x70
+.3x140+.2x210
+.2x280+.1x350
=143

30x(Stock-Sales)=30x(6-2)=120

Green Values are representing Total Cost in case of overstocking and Red Values represent Total Cost in
case of Shortage.
EMV Column represents expected monetary cost for case of each decision alternative calculated as
below:
Decision
Alternative:
Stock=0,
EMV0=pxcost=0.1x0+0.1x70+0.2x140+0.3x210+0.2x280+0.2x350+0.1x420=203
Decision
Alternative:
Stock=1,
EMV1=pxcost=0.1x30+0.1x0+0.2x70+0.3x140+0.2x210+0.2x280+0.1x350=143
Decision
Alternative:
Stock=2,
EMV2=pxcost=0.1x60+0.1x30+0.2x0+0.3x70+0.2x140+0.2x210+0.1x280=93
Similarly we can get
Decision Alternative: Stock=3, EMV3=pxcost=63
Decision Alternative: Stock=4, EMV4=pxcost=58
Decision Alternative: Stock=5, EMV5=pxcost=68
Decision Alternative: Stock=6, EMV6=pxcost=93
Here in this case Optimal EMV will be 58 as dealer would like to minimize his expected total cost. Thus
dealer should order 4 units per week.
Expected Monetary Value (EMV) Example 2: A Newspaper boy has the following probabilities of
selling a magazine
Copies Sold
10
11
12
13
14
Probability

0.10

0.15

0.20

0.25

0.30

Cost of a copy is Rs.30 & the sale price is Rs.50. He cannot return the unsold copies. How many copies
should he order?
Solution:The payoffs from sold quantity & unsold stock will be given by (50-30)xOder
Payoff= (50-30) x Order
If Sales>=Order =20x10
200
Payoff=50xSales30xOrder
If Sales<Order
The Payoff table will be as follows:

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MGT503: Operations Research: Unit-I

50xSales30xOrder==500x1030x11=170

EMV Column represents expected monetary payoff for case of each decision alternative calculated as
below:
Decision
Alternative:
Order=10,
EMV10=pxPayoff=0.1x200+0.15x200+0.2x200+0.25x200+0.3x200=200.00
Decision
Alternative:
Order=11,
EMV11=pxPayoff=0.1x170+0.15x220+0.2x220+0.25x220+0.3x220=215.00
Decision
Alternative:
Order=12,
EMV12=pxPayoff=0.1x140+0.15x190+0.2x240+0.25x240+0.3x240=225.50
Similarly we can get
Decision Alternative: Order=13, EMV13=pxPayoff=220.00
Decision Alternative: Order=14, EMV14=pxPayoff=205.00
Here in this case Optimal EMV will be 222.5 as one would like to maximize his expected payoff. So,
ordering 12 copies will be optimal decision on the basis of EMV.

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MGT503: Operations Research: Unit-I

Payoff Table

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Expected Opportunity Loss (EOL) Example3: In previous problem, if we use criteria of EOL then
Opportunity Loss Table will be prepared instead of Payoff table as follows:
Opportunity Loss table

Note that
Opportunity Loss
=Max. Payoff in a state of Nature- Actual Payoff in that state of nature arising due
to specific decision
=Column Maximum Value-Cell Value
EOL Table will be

EOL have been calculated by using formula EOL=Probability x Opportunity Loss.

Here in this case Optimal EOL will be 27.5 as one would like to minimize his expected opportunity loss.
So, ordering 12 copies will be optimal decision on the basis of EOL.
Expected Value of Perfect Information (EVPI) Example 4: The Payoff table with perfect
information will be as follows:

Note that in table maximum payoff for each state of nature has been considered as in case of perfect
information decision maker will choose that decision which is maximizing his payoff. Further MaxEMV
has been taken from solution of example 2.

By Pashupati Nath Verma

MGT503: Operations Research: Unit-I

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EVPI=27.5 Signifies the additional expected amount of money which one can get if he/she has perfect
information about future state of nature and thus can invest up to this additional money to get perfect
information.

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MGT503: Operations Research: Unit-I

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DECISION TREE

The Payoff Table approach is useful for a

non-sequential or single stage. But, many
real-world decision problems consists of a
sequence of dependent decisions.Decision
Trees are useful in analyzing such multistage decision processes.
WHAT IS A DECISION TREE?
A Decision Tree is a chronological
representation of the decision
process.
A Visual Representation of Choices,
Consequences, Probabilities, and
Opportunities.
A
Way
of
Breaking
Down
Complicated Situations Down to
Easier-to-Understand Scenarios.
The tree is mainly composed of
nodes and branches.

DECISION TREE: COMPONENTS

Decisions: are choices that a manager has at a
particular time point to choose. Generally, it is
denoted by a Square Node, with few arc emanating
from it to show choices available & costs associated
with them.
State of Nature: are various uncontrollable
situations that may arise. , it is denoted by a
CircleNode, with few arc emanating from it to show
various possible situation that may arise with the
probability associated with them.
Sequence of events:are the various sequences
resulting from specific combination of decision
choices & state of nature at various stage of decision
making.
Consequences/Outcomes: are the final utility or
cost of an specific sequence of event.

DECISION TREES: NOTATION

A box
A Decision Node is used to
show a
choice that the
manager has to make.
A circle
A Chance Node is used
to show that
a
probability
outcome will occur.
Lines
decision
probability

connect outcomes to their

alternative/choice
or
outcome.

STEPS FOR BUILDING DECISION TREE:

1. Determine the essential decisions and uncertainties.
2. Place the decisions and uncertainties in the appropriate temporal sequence.
3. Start the tree with a decision node representing the first decision.
4. Select a representative (but not necessarily exhaustive) number of possible choices for the decision
node.
5. For each choice, draw a chance node representing the first uncertain event that follows the initial
decision.
6. Select a representative (but not necessarily exhaustive) number of possible states for the chance
node.
7. Continue to expand the tree with additional decision nodes and chance nodes until the overall
outcome can be evaluated.
ROLLBACK PROCEDURE FOR ANALYZING TREES:Whereas we build the tree left to right, to reflect
the temporal sequence in which a decision is followed by a chance event, we evaluate the tree in the
reverse direction.At each chance node, we can calculate the expected payoff represented by the
probability distribution at the node.This value becomes associated with the corresponding action
branch of the decision node. Then, at the decision node, we calculate the largest expected payoff to
determine the best action.This process of making the calculations is usually referred to as rolling back
the tree.
1. Start from the last set of nodesthose leading to the ends of the paths.
2. For each chance node, calculate the expected payoff as a probability-weighted average of the
values corresponding to its branches.
3. Replace each chance node by its expected value.
4. For each decision node, find the best expected value (maximum benefit or minimum cost) among
the choices corresponding to its branches.
5. Replace each decision node by the best value, and note which choice is best.
6. Continue evaluating chance nodes and decision nodes, backward in sequence, until the optimal
outcome at the first node is determined.
7. Construct its risk profile.
DECISION TREE: EXAMPLE1:MARYS FACTORY Mary is a manager of a gadget factory. Her factory
has been quite successful the past three years. She is wondering whether or not it is a good idea to
expand her factory this year. The cost to expand her factory is $1.5M. If she does nothing and the
economy stays good and people continue to buy lots of gadgets she expects $3M in revenue; while only
$1M if the economy is bad. If she expands the factory, she expects to receive $6M if economy is good
and $2M if economy is bad. She also assumes
that there is a 40% chance of a good
economy and a 60% chance of a bad
economy. Draw a Decision Tree showing these
choices. Also tell what should Mary do?
SOLUTION:
MARYS FACTORY: DECISION TREE & ITS
ANALYSIS
Net EMVExpand=EMVExpand- Decision Cost=3.6
1.5 = $2.1M
Net EMVNo Expand= EMVNo Expand- Decision Cost =
$1.8M
$2.1 > 1.8, therefore Marry should expand
the factory

By Pashupati Nath Verma

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MGT503: Operations Research: Unit-I

By Pashupati Nath Verma

MGT503: Operations Research: Unit-I

Decision

Page18

Note: Although the previouscase is a regular single stage decision making situation and can be solved
by using payoff table as below:
State of Nature
Opti
mal
Payoff Table
Good
Bad
Net EMV
EMV
Economy
Economy
Probability
0.4
0.6
0.4x4.5+0.6x0.
Expand
6-1.5=4.5
2-1.5=0.5
2.1
5=2.1
0.4x3+0.6x1=1
Dont Expand
3-0=3
1-0=1
.8
As Optimal EMV is associated with expansion so Mary should expand.
DECISION TREE: EXAMPLE2:JOES GARAGE : Joes garage is considering hiring another mechanic.
The mechanic would cost them an additional $50,000 / year in salary and benefits. If there are a lot of
accidents in Provenance this year, they anticipate making an additional $70,000 in net revenue. If
there are not a lot of accidents, they could lose $20,000 off of last years total net revenues. Because
of all the ice on the roads, Joe thinks that there will be a 70% chance of a lot of accidents and a 30%
chance of fewer accidents. Assume if he doesnt expand he will have the same revenue as last
year.Draw a decision tree for Joe and tell him what he should do.
SOLUTION:
JOES GARAGE: PREPARING DECISION TREE& ANALYSISN IT

Net EMV of Hire Mechanic =.7(70,000) + .3(- $20,000) - 50,000 = - $7,000

Net EMV of Dont Hire = 0
Therefore Joe should not hire the mechanic
DECISION TREE: EXAMPLE3: Sarah King, president of King Electronics, Inc., has two design options
for her new line of high resolution cathode-ray tubes (CRTs) for computer-aided design workstations.
The life cycle sales forecast for the CRT is 100000 units. Design option A has a 0.90 probability of
yielding 59 good CRTs per 100 and a .10 probability of yielding 64 Good CRTs per 100. This design will
cost $1000000Design option B has 0.80 probability of yielding 64 good units per 100 and a 0.20
probability of yielding 59 good units per 100. This design will cost $1350000. Good or bad, each CRT
will cost $75. Each good CRT will sell for $150. Bad CRTs are destroyed and have no salvage value.
Because units break up when thrown in the trash, there is little disposal cost. Therefore, we ignore any
disposal costs in this problem. Prepare decision tree to analyse situation. Whaich design would you go
for?
SOLUTION:
KING ELECTRONICS: DECISION TREE& ITS ANALYSIS

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MGT503: Operations Research: Unit-I

Page19

Net EMVA=4030500.00-1000000.00=3030500.00
Net EMVB=4725000.00-1000000.00=3725000.00
As Net EMVB>Net EMVA thus design option B is more relevant in this case. Note that we have not
considered manufacturing cost as it is irrelevant cost.
DECISION TREE: EXAMPLE4: DRILLING WELL: Mr. Sinha has to decide whether or not to drill a well
on his farm. In his village, only 40% of the wells drilled were successful at 200 feet of depth. Some of
the farmers who did not get water at 200 feet drilled further up to 250 feet but only 20% struck water
at 250 feet. Cost of drillings is Rs. 50/- per foot. Mr. Sinha estimated that he would pay Rs. 18000/during a 5-year period in the present value terms, if he continues to buy water from the neighbour
rather than go for the well which would have life of 5 years. Mr. Sinha has three decisions to make: (a)
Should he drill up to 200 feet? (b) If no water is found at 200 feet, should he drill up to 250 feet? (c)
Should he continue to buy water from his neighbour? Draw up an appropriate decision tree and
determine its optimal decision.
SOLUTION:
DRILL OR NOT TO DRILL: PREPARING DECISION TREE
This is a multi-stage decision making situation which can not be analyzed in regular tabular form. We
must have to use decision tree approach in this case:
Decision has to be taken in two stages
1. Initially we have to decide on whether drill up to 200 ft or not (Denoted by Decision Node 1 in
tree)
2. If drilling is chosen at first stage & no water struck at 200 ft then we have to decide again on
further drilling (denoted by decision node 2 in tree )
At each stages of decision of drilling there are two chance nodes
1. After choosing to drill at first stage there is a chance of getting or not getting the water
(Denoted by Chance node A in decision tree)
2. On choosing to drill at second stage there are again chances of getting or not getting the water
(Denoted by Chance node B in decision tree)

DRILL OR NOT TO DRILL: ROLLING BACK TO ANALYZE DECISION TREE

Net EMV at Chance Node B=EMV(B)-Decision Cost =0.8*0+0.2*18000-2500=Rs1100

Optimal EMV at Decision Node 2=Max{1100,0}=1100
Net EMV at Chance Node A=EMV(A)-Decision Cost =0.4*18000+0.6*1100-10000=(-)Rs2140
Optimal EMV at Decision Node 1=Max{-2140,0}=0
On the basis of above analysis following can be conclude:

By Pashupati Nath Verma

MGT503: Operations Research: Unit-I

Page20

a- Mr. Sinha should not drill at all as Net EMV of drilling is less than that of not drilling at decision node
1.
b- If Mr. Sinha has drilled up to 200 feet & hehas not got water then he must have to drill further for 50
more feet as at decision node 2 as net EMV of drilling is more than that of not drilling.
c- Mr. Sinha should continue to buy water from his neighbor.

By Pashupati Nath Verma

MGT503: Operations Research: Unit-I

Page21

DECISION TREE: EXAMPLE5: DRILLING WELLA farm owner is seriously considering of drilling farm
well. In the past, only 70% of wells drilled were successful at 200 feet of depth in the area. Moreover,
on finding no water at 200 ft., some persons drilled it further up to 250 feet but only 20% struck water
at 250 ft. The prevailing cost of drilling is Rs. 50 per feet. The farm owner has estimated that in case he
loss not get his own well, he will have to pay Rs. 15,000 over the next 10 years (in PV terms) to buy
water from the neighbor. The following decisions can be optimal: (i) do not drill any well, (ii) drill up to
200 ft. (iii) if no water is found at 200 ft., drill further up to 250 ft. Draw a decision tree diagram and
suggest appropriate decision at every decision node.
SOLUTION:
DRILL OR NOT TO DRILL: PREPARING DECISION TREE
This is a multi-stage decision making situation which can not be analyzed in regular tabular form. We
must have to use decision tree approach in this case:
Decision has to be taken in two stages
1. Initially we have to decide on whether drill up to 200 ft or not (Denoted by Decision Node 1
in tree)
2. If drilling is chosen at first stage & no water struck at 200 ft then we have to decide again on
further drilling (denoted by decision node 2 in tree )
At each stages of decision of drilling there are two chance nodes
1. After choosing to drill at first stage there is a chance of getting or not getting the water
(Denoted by Chance node A in decision tree)
2. On choosing to drill at second stage there are again chances of getting or not getting the
water (Denoted by Chance node B in decision tree)

DRILL OR NOT TO DRILL: ROLLING

ANALYZE DECISION TREE

BACK

NET EMV AT
CHANCE
B=EMV(B)-DECISION COST =0.8*0+0.2*15000-2500=RS500
OPTIMAL EMV AT DECISION NODE 2=MAX{500,0}=500
NET EMV AT CHANCE NODE A=EMV(A)-DECISION COST =0.7*15000+0.3*500-10000=RS650
OPTIMAL EMV AT DECISION NODE 1=MAX{650,0}=650

TO

NODE

The above calculation of net EMV shows owner must drill well, and if he does not get water at 200 ft
owner must drill further up to 250 ft.

By Pashupati Nath Verma