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Module: Decision Analysis

Solution to Practice Problems

1) Case Study – How Many Machines to Install

1) The questions of the case can be easily answered from the decision tree given below:

Facts of the case:

As each machine produces 300 kgs, the decision alternatives available for consideration
are to install 4 Machines, 5 Machines, 6 Machines, 7 Machines or 8 Machines.

The profit per machine is = 20-12 = Rs. 8 lacs (Profit without fixed cost-Fixed Cost)
For every machine in excess of demand, the fixed cost to be incurred = Rs. 12 lacs.

If your decision proposal is to have 4 machines, the states of nature (demand) could be 4,
5, 6, 7, or 8 machines. Since the supply is equal to or less than the demand, the profit you
will get is 32 lacs (4 machines multiplied by 8 lacs) for all states of nature.
If your alternative is to have 5 machines, and the demand is only 4 machines, you will get
a profit of Rs. 32 lacs for the 4 machines – Rs. 12 lacs for the one excess machine
remaining idle. That is the net profit will become = Rs. 20 Lacs. Applying this logic, the
consequences in terms of pay offs are worked out and shown in the extremity of each
branch of the states of nature (demand) emanating from circles corresponding to each
decision alternative emanating from the square box.

The best option is to install 5 or 6 machines. Both these alternatives give the same
maximum EMV of 38. Please see in the tree, the EMV values are shaded. Hence the
EMV optimum = Rs. 38 lacs.

Even though installing 5 or 6 machines produce the same EMV, keeping in mind the
long-term perspective, I Would go for installing 6 machines. This is because the machine
cost may increase in the coming years. Hence, my optimum decision is to install 6
Machines.

The maximum consulting fee that could be offered to the agency can be obtained by
calculating EVPI. EVPI = EPPI-EMVoptimum.

Look at the tree. When the demand is 4 machines, the best decision is to have 4 machines
that produce a profit of Rs. 32 lacs. The rest of the options produce less than Rs. 32 lacs.

Likewise, when the demand is 5 machines, the best decision is to have 5 machines that
produce a profit of Rs. 40 lacs. When the demand is 6 machines, the best decision is to
have 6 machines that produce a profit of Rs. 48 lacs. When the demand is 7 machines, the
best decision is to have 7 machines that produce a profit of Rs. 56 lacs. When the demand
is 8 machines, the best decision is to have 8 machines that produce a profit of Rs. 64 lacs.
Multiplying these pay offs by the corresponding probabilities of states of nature, you get,
EPPI = 32(0.1)+40(0.3)+48(0.3)+56(0.2)+64(0.1) = Rs. lacs

EVPI = EPPI-EMVoptimum =47.20-38 =Rs. 9.20 lacs. This is the maximum consulting
fee that can be given as a last resort. In other words, any amount negotiated with the
agency that is less than Rs 9.2 lacs will improve your profit kitty.

2) Case Study-Should Lambda Maintain Existing Price or Follow Competition?

For answering both the parts, the decision tree should be properly drawn. This is given
below:
Volume Pay Off
Decision Tree for Problem 2 9000 $92000
.1 0) )
54(0 . 20
$ 2( 0 7000 36000
$5
6 $ 5 0 (0.25)
$ 5 5000 -20000
at $-43800 $46(0.30)
r ice
tain P $44
(0.1 2000 -104000
R e 5)
0 -160000
Fo
ll ow 10000 100000
Co .1 0) )
m pet 4( 0 .2 0
itio $5 (0 10000 80000
n 5 2
$ (0.25)
$50
$47000 $46(0.30) 10000 60000
$44 10000 20000
(0.1
5)
10000 0
Facts of the Case:

Variable Cost for Product Z is $28 per unit


Total Fixed Cost = $160000

a) The best choice is to follow competition with regard to charging price. The EMV
optimum is shaded and is = $47000.

b) If Lambda is adamant about sticking to the existing price of $56, not only it loses
volume but also incurs an overall expected loss of $-43800. The pay off for each branch
is calculated in a logical fashion. For example, look at the first state of nature when the
competitor charges $54 and Lambda stick to $56, the volume drops to 9000 units. The
contribution for 9000 units is = 9000(Selling Price-Variable Cost) = 9000(56-28) =
$252000. If you subtract the fixed cost of $160000 from this amount, you get a profit of
$92000. Likewise, all the rest of the pay offs have been calculated and shown at the
extremity of each branch. It is also interesting to observe that every pay off under the
alternative that says “Follow Competition” is greater than every corresponding pay off
under the alternative that says “Retain Price at $56”. All factors considered, it is way of
wisdom to Follow Competition.

3) Case Study- Launch or not to Launch

Let us first construct the Joint Probability Table and Posterior Probability Table that will
be handy in Calculations.

Joint Probability Table


States of Nature Agency Agency Agency Marginal
predicts predicts predicts Probability of
High Sales Medium Sales Low Sales States of Nature
High Sales 0.28 0.08 0.04 0.40
Medium sales 0.06 0.18 0.06 0.30
Low Sales 0.03 0.06 0.21 0.30
Marginal 0.37 0.32 0.31 1.00
Probability of
Agency Prediction

Posterior Probability Table


Posterior Given Agency Predicts
Probability of High Sales Medium sales Low Sales
High Sales
Medium sales
Low Sales

The revised (posterior) probability of High sales given Agency predicts High Sales
=0.28/0.37 =0.76. Extending this logic, the posterior probability table above has been
completed. This is nothing but the conditional probability of Bayes’ method.

Decision Tree for Problem 3 Pay Off


($million)
Agency Predicts High(0.76)
5
Medium(0.16) 2
Sales h
unc 3.72 Low(0.08) -5
7) La
.3
y High(0 Do Not Launch -1
e nc 3.72 High(0.25) 5
A g M ed(
for 0.3 ch Medium(0.56) 2
G o 2) Laun 1.42 Low(0.19) -5
1.52 1.42
Do Not Launch -1
High(0.13) 5
Lo

No Medium(0.19) 2
ch -2.37
w

Ag
(0

un Low(0.68) -5
en La
.3

cy
1)

-1 Do Not Launch -1
High(0.4)
Launch Medium(0.3) 6
2.1 Low(0.3) 3
2.1 -4
Do Not Launch
0
a) Look at the tree without going to the agency option. If the product is launched, you get
an EMV of $2.1million. If it is not launched, you get $0. Hence, the decision is to launch
the product and the EMVoptimum is $2.1 million.

b) The marketing manager should not take the help of the agency because overall he gets
an EMV of $1.52 million (two decimal places) which is less than the EMVoptimum of $2.1
million without going to the agency.

c) EVPI = EPPI-EMVoptimum = 3.3-2.1 =$1.2 million.

Please note that EPPI = 6*0.4+3*0.3+0*0.3 =$3.3 million.


EVSI =EPSI-EMVoptimum =1.52-2.1 = -$0.58million. There is no point going to the
agency. You are better off without the help of agency.