Situation
David Chang is the owner of a small electronics company. In six months, a
proposal is due for an electronic timing system for the 2016 Olympic Games.
For several years, Chang’s company has been developing a new
microprocessor referred to as the X-32. The X-32 is a breakthrough component
that would allow Chang to develop a timing system that would be superior to
any product currently on the market. However, progress in R&D has been
slow, and Chang is unsure about whether his staff can complete the X-32
microprocessor in time.
If they continue the R&D and succeed in developing the X-32, there is an
excellent chance that Chang’s company will win the $1 million Olympic
contract. If they continue the R&D but do not successfully complete the X-32,
there is a small chance they will still be able to win the same contract with an
alternative, inferior timing system that is a modification of one already
developed. If they do not continue R&D, there is no chance to win the
contract.
If he continues the project, Chang must invest $200K in R&D expenses. In
addition, making a proposal requires developing a prototype timing system at
an additional cost of $50K. Finally, if Chang wins the contract, the finished
product will cost an additional $150K to produce.
© 2013, Charles E. Noon, Ph.D.
1
Structuring the Decision Situation
Decision Tree: a tool for representing,
evaluating, and communicating a decision
process. A decision tree is constructed using
branches and nodes.
Symbols:
Square represents a decision node.
Circle represents an uncertain event node
Triangle represents a terminal node.
© 2013, Charles E. Noon, Ph.D.
2
Structuring the Decision Situation
Make
Proposal
R&D
Succeeds
Win
Lose
Don’t Make
Proposal
Continue
Make
Proposal
R&D
Fails
Abandon
Win
Lose
Don’t Make
Proposal
© 2013, Charles E. Noon, Ph.D.
3
Structuring the Decision Situation
+850K
Make
Proposal
R&D
Succeeds
Win
-50K
Lose
Don’t Make
Proposal
Continue
+850K
-200K
Make
Proposal
R&D
Fails
Abandon
Win
-50K
Lose
Don’t Make
Proposal
© 2013, Charles E. Noon, Ph.D.
4
Structuring the Decision Situation
+850K
Make
Proposal
R&D
Succeeds
.40
-50K
.90
.10
Lose
Don’t Make
Proposal
Continue
+850K
-200K
Make
Proposal
.60
R&D
Fails
Abandon
Win
-50K
.05
Win
.95
Lose
Don’t Make
Proposal
© 2013, Charles E. Noon, Ph.D.
5
Structuring the Decision Situation
+850K
Make
Proposal
R&D
Succeeds
.40
-50K
.90
.10
Lose
Don’t Make
Proposal
Continue
Make
Proposal
.60
R&D
Fails
0
-50K
.05
© 2013, Charles E. Noon, Ph.D.
+600K
Win
.95
Lose
Don’t Make
Proposal
-250K
-200K
+850K
-200K
Abandon
Win
+600K
-250K
-200K
6
Structuring the Decision Situation
Make
Proposal
R&D
Succeeds
.40
Win
.90
.10
Lose
Don’t Make
Proposal
-250K
-200K
Continue
+600K
Make
Proposal
.60
R&D
Fails
Abandon
+600K
0
.05
Win
.95
Lose
Don’t Make
Proposal
© 2013, Charles E. Noon, Ph.D.
-250K
-200K
7
“Abandon” Strategy 1
“Abandon”
Make
Proposal
Strategy 1
R&D
Succeeds
.40
Win
.90
.10
Lose
Don’t Make
Proposal
-250K
-200K
Continue
+600K
Make
Proposal
.60
R&D
Fails
Abandon
+600K
0
.05
Win
.95
Lose
Don’t Make
Proposal
© 2013, Charles E. Noon, Ph.D.
-250K
-200K
8
“Continue; Make: Make” Strategy 2
“Continue ; Make ; Make”
Strategy 2
Make
Proposal
R&D
Succeeds
.40
Win
.90
.10
Lose
Don’t Make
Proposal
-250K
-200K
Continue
+600K
Make
Proposal
.60
R&D
Fails
Abandon
+600K
0
.05
Win
.95
Lose
Don’t Make
Proposal
© 2013, Charles E. Noon, Ph.D.
-250K
-200K
9
“Continue ; Make ; Don’t Make” Make
Proposal
Strategy 3
R&D
Succeeds
.40
Win
.90
.10
Lose
Don’t Make
Proposal
-250K
-200K
Continue
+600K
Make
Proposal
.60
R&D
Fails
Abandon
+600K
0
.05
Win
.95
Lose
Don’t Make
Proposal
© 2013, Charles E. Noon, Ph.D.
-250K
-200K
10
Uncertainty in Net Cash Flow
$60
.50
1.00
$20
or
EMV=$20
EMV=$30
.50
$0
Expected Monetary Value (EMV) = the sum of
the payoffs times their probabilities.
© 2013, Charles E. Noon, Ph.D.
11
Uncertainty in Net Cash Flow
Gain
of $60K
+ $60K
.50
.50
.40
.40
Loss
of $25K
.10
- $25K
.10
Gain
of $30K
+ $30K
EMV = .50(60) - .40(25) +.10(30) = $23K
© 2013, Charles E. Noon, Ph.D.
12
Evaluating According to EMV
Make
Proposal
R&D
Succeeds
.40
Win
.90
.10
Lose
Don’t Make
Proposal
-250K
-200K
Continue
+600K
Make
Proposal
.60
R&D
Fails
Abandon
+600K
0
.05
Win
.95
Lose
Don’t Make
Proposal
© 2013, Charles E. Noon, Ph.D.
-250K
-200K
13
Evaluating According to EMV
Make
Proposal
R&D
Succeeds
.40
515K
Win
.90
.10
Lose
Don’t Make
Proposal
-250K
-200K
Continue
+600K
Make
Proposal
.60
R&D
Fails
Abandon
+600K
0
-207.5K
.05
Win
.95
Lose
Don’t Make
Proposal
© 2013, Charles E. Noon, Ph.D.
-250K
-200K
14
Evaluating According to EMV
Make
Proposal
R&D
Succeeds
515K
.40
515K
Win
.90
.10
Lose
Don’t Make
Proposal
+600K
-250K
-200K
Continue
+600K
Make
Proposal
.60
R&D
Fails
-207.5K
.05
Win
.95
Lose
-250K
-200K
Abandon
0
Don’t Make
Proposal
© 2013, Charles E. Noon, Ph.D.
-200K
15
Evaluating According to EMV
Make
Proposal
R&D
Succeeds
515K
.40
515K
Win
.90
.10
Lose
Don’t Make
Proposal
+600K
-250K
-200K
Continue
+600K
86K
Make
Proposal
.60
R&D
Fails
-207.5K
.05
Win
.95
Lose
-250K
-200K
Abandon
0
Don’t Make
Proposal
© 2013, Charles E. Noon, Ph.D.
-200K
16
Evaluating According to EMV
Make
Proposal
R&D
Succeeds
515K
.40
515K
Win
.90
.10
Lose
Don’t Make
Proposal
+600K
-250K
-200K
Continue
+600K
86K
Make
Proposal
.60
R&D
Fails
-207.5K
.05
Win
.95
Lose
-250K
-200K
Abandon
0
Don’t Make
Proposal
© 2013, Charles E. Noon, Ph.D.
-200K
17
“Continue; Make; Don’t Make Strategy with highest EMV
“Continue ; Make ; Don’t Make”
Strategy with
highest EMV
Make
Proposal
R&D
Succeeds
515K
.40
515K
Win
.90
.10
Lose
Don’t Make
Proposal
+600K
-250K
-200K
Continue
+600K
86K
Make
Proposal
.60
R&D
Fails
-207.5K
.05
Win
.95
Lose
-250K
-200K
Abandon
0
Don’t Make
Proposal
© 2013, Charles E. Noon, Ph.D.
-200K
18
“Continue ; Make ; Make”
Make
Proposal
Strategy with R&D
Succeeds
2nd highest
515K
EMV
.40
515K
Win
.90
.10
Lose
Don’t Make
Proposal
+600K
-250K
-200K
Continue
+600K
81.5K
Make
Proposal
.60
R&D
Fails
-207.5K
.05
Win
.95
Lose
-250K
-207.5K
Abandon
0
Don’t Make
Proposal
© 2013, Charles E. Noon, Ph.D.
-200K
19