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DECISION THEORY
AND THE NORMAL DISTRIBUTION
LEARNING
OBJECTIVE
3. Perform marginal analysis where products have a constant marginal profit and loss.
MODULE
M3.1
M3.2
M3.3
OUTLINE
Introduction
Break-Even Analysis and the Normal Distribution
Expected Value of Perfect Information and the
Normal Distribution
M3-2
M3.1
INTRODUCTION
M3.2
In Chapters 3 and 4 in your text we look at examples that deal with only a small number of
states of nature and decision alternatives. But what if there were 50, 100, or even 1,000s of
states and/or alternatives? If you used a decision tree or decision table, solving the problem
would be virtually impossible. This module shows how decision theory can be extended to
handle problems of such magnitude.
We begin with the case of a firm facing two decision alternatives under conditions of
numerous states of nature. The normal probability distribution, which is widely applicable
in business decision making, is first used to describe the states of nature.
fixed cost
f
=
price/unit variable cost/unit
s v
(M3-1)
So in Barclays case,
break-even point (games) =
$36,000
$36,000
=
$10 $4
$6
For a detailed explanation of the break-even equation, see Appendix M3.1 at the end of this module.
M3-3
Any demand for the new game that exceeds 6,000 units will result in a profit, whereas
a demand less than 6,000 units will cause a loss. For example, if it turns out that demand is
11,000 games of Strategy, Barclays profit would be $30,000.
Revenue (11,000 games $10/game)
Less expenses
Fixed cost
Variable cost
(11,000 games $4/game)
Total expense
Profit
$110,000
$36,000
$44,000
$80,000
$30,000
If demand is exactly 6,000 games (the break-even point), you should be able to compute for
yourself that profit equals $0.
Rudy Barclay now has one useful piece of information that will help him make the
decision about introducing the new product. If demand is less than 6,000 units, a loss will
be incurred. But actual demand is not known. Rudy decides to turn to the use of a probability distribution to estimate demand.
Actual demand for the new game can be at any level0 units, 1 unit, 2 units, 3 units, up to
many thousands of units. Rudy needs to establish the probability of various levels of
demand in order to proceed.
In many business situations the normal probability distribution is used to estimate the
demand for a new product. It is appropriate when sales are symmetric around the mean
expected demand and follow a bell-shaped distribution. Figure M3.1 illustrates a typical
normal curve that we discussed at length in Chapter 2. Each curve has a unique shape that
depends on two factors: the mean of the distribution () and the standard deviation of the
distribution ().
For Rudy Barclay to use the normal distribution in decision making, he must be able to
specify values for and . This isnt always easy for a manager to do directly, but if he or she
has some idea of the spread, an analyst can determine the appropriate values. In the Barclay
example, Rudy might think that the most likely sales figure is 8,000 but that demand might
go as low as 5,000 or as high as 11,000. Sales could conceivably go even beyond those limits;
say, there is a 15% chance of being below 5,000 and another 15% chance of being above
11,000.
FIGURE M3.1
Shape of a Typical Normal
Distribution
Standard Deviation of
Demand (Describes Spread )
M3-4
FIGURE M3.2
15% Chance
Demand Exceeds
11,000 Games
X
5,000
8,000
11,000
Demand (Games)
Because this is a symmetric distribution, Rudy decides that a normal curve is appropriate. In Chapter 2, we demonstrate how to take the data in a normal curve such as Figure
M3.2 and compute the value of the standard deviation. The formula for calculating the
number of standard deviations that any value of demand is away from the mean is
Z =
demand
(M3-2)
where Z is the number of standard deviations above or below the mean, . It is provided in
the table in Appendix A at the end of this text.
We see that the area under the curve to the left of 11,000 units demanded is 85% of the
total area, or 0.85. From Appendix A, the Z value for 0.85 is approximately 1.04. This means
that a demand of 11,000 units is 1.04 standard deviations to the right of the mean, .
With = 8,000, Z = 1.04, and a demand of 11,000, we can easily compute .
Z =
demand
or
1.04 =
11,000 8,000
or
1.04 = 3,000
or
=
3,000
= 2,885 units
1.04
At last, we can state that Barclays demand appears to be normally distributed, with a
mean of 8,000 games and a standard deviation of 2,885 games. This allows us to answer
some questions of great financial interest to management, such as what the probability is of
breaking even. Recalling that the break-even point is 6,000 games of Strategy, we must find
the number of standard deviations from 6,000 to the mean.
Z =
=
break-even point
6,000 8,000
2,000
=
= 0.69
2,885
2,885
This is represented in Figure M3.3. Because Appendix A is set up to handle only positive Z
values, we can find the Z value for +0.69, which is 0.7549 or 75.49% of the area under the
M3-5
FIGURE M3.3
Probability of Breaking
Even for Barclays
New Game
Break-Even
6,000 Units
curve. The area under the curve for 0.69 is just 1 minus the area computed for +0.69, or
1 0.7549. Thus, 24.51% of the area under the curve is to the left of the break-even point
of 6,000 units. Hence,
Computing the probability of
making a profit.
Computing EMV.
In addition to knowing the probability of suffering a loss with Strategy, Barclay is concerned about the expected monetary value (EMV) of producing the new game. He knows,
of course, that the option of not developing Strategy has an EMV of $0. That is, if the game
is not produced and marketed, his profit will be $0. If, however, the EMV of producing the
game is greater than $0, he will recommend the more profitable strategy.
To compute the EMV for this strategy, Barclay uses the expected demand, , in the following linear profit function:
EMV = (price/unit variable cost/unit) (mean demand) fixed costs
= ($10 $4)(8,000 units) $36,000
= $48,000 $36,000
= $12,000
(M3-3)
M3-6
Rudy has two choices at this point. He can recommend that the firm proceed with the
new game; if so, he estimates there is a 75% chance of at least breaking even and an EMV of
$12,000. Or, he might prefer to do further marketing research before making a decision.
This brings up the subject of the expected value of perfect information.
M3.3
$6(6,000 X)
$0
(M3-4)
where
K = loss per unit when sales are below the break-even point
X = sales in units
M3-7
sales values. These numbers would be multiplied and added together, a very lengthy and
tedious task.
When we assume that there are an infinite (or very large) number of possible sales values that follow a normal distribution, the calculations are much easier. Indeed, when the
unit normal loss integral is used, EOL can be computed as follows:
EOL = KN (D )
(M3-5)
where
EOL = expected opportunity loss
K = loss per unit when sales are below the break-even point
= standard deviation of the distribution
N ( D) = value for the unit normal loss integral in Appendix M3.2 for a given value of D
D =
break-even point
(M3-6)
where
= absolute value sign
= mean sales
Here is how Rudy can compute EOL for his situation:
K = $6
= 2,885
D=
8,000 6,000
= 0.69 = 0.60 + 0.09
2,885
Now refer to the unit normal loss integral table. Look in the 0.6 row and read over to the
0.9 column. This is N(0.69), which is 0.1453.
N(0.69) = 0.1453
Therefore,
EOL = KN (0.69)
= ($6)(2,885)(0.1453) = $2,515.14
EVPI and EOL are equivalent.
Because EVPI and minimum EOL are equivalent, the EVPI is also $2,515.14. This is
the maximum amount that Rudy should be willing to spend on additional marketing
information.
The relationship between the opportunity loss function and the normal distribution is
shown in Figure M3.4. This graph shows both the opportunity loss and the normal distribution with a mean of 8,000 games and a standard deviation of 2,885. To the right of the
break-even point we note that the loss function is 0. To the left of the break-even point, the
opportunity loss function increases at a rate of $6 per unit, hence the slope of 6. The use
of Appendix M3.2 and Equation M3-5 allows us to multiply the $6 unit loss times each of
the probabilities between 6,000 units and 0 units and to sum these multiplications.
M3-8
FIGURE M3.4
Barclays Opportunity Loss
Function
8,000 Games
Loss ($)
Normal Distribution
8,000
2,885
Slope 6
6,000
X
Demand (Games)
SUMMARY
In this module we look at decision theory problems that
involve many states of nature and alternatives. As an alternative to decision tables and decision trees, we demonstrate
how to use the normal distribution to solve break-even
problems and find the EMV and EVPI. We need to know
the mean and standard deviation of the normal distribution and to be certain that it is the appropriate probability
distribution to apply. Other continuous distributions can
also be used, but they are beyond the level of this module.
GLOSSARY
Break-Even Analysis. The analysis of relationships between
profit, costs, and demand level.
Unit Normal Loss Integral. A table that is used in the determination of EOL and EVPI.
KEY EQUATIONS
(M3-1) Break-even point (in units)
=
$0
for X > break-even point
fixed cost
f
=
price/unit variable cost/unit s v
The formula that provides the volume at which total revenue equals total costs.
demand
(M3-2) Z =
D=
break-even point
Solved Problems
M3-9
SOLVED PROBLEMS
Solved Problem M3-1
Terry Wagner is considering self-publishing a book on yoga. She has been teaching yoga for more than 20
years. She believes that the fixed costs of publishing the book will be about $10,000. The variable costs are
$5.50, and the price of the yoga book to bookstores is expected to be $12.50. What is the break-even
point for Terry?
Solution
This problem can be solved using the break-even formulas in the module, as follows:
Break-even point in units =
=
$10,000
$12.50 $5.50
$10,000
$7
= 1, 429 units
Solved Problem M3-2
The annual demand for a new electric product is expected to be normally distributed with a mean of
16,000 and a standard deviation of 2,000. The break-even point is 14,000 units. For each unit less than
14,000, the company will lose $24. Find the expected opportunity loss.
Solution
The expected opportunity loss (EOL) is
EOL = KN (D )
We are given the following:
K = loss per unit = $24
= 16,000
= 2,000
Using Equation M3-6, we find
D=
break-even point
16,000 14,000
=
=1
2,000
M3-10
SELF TEST
Before taking the self-test, refer back to the learning objectives at the beginning of the module and
the glossary at the end of the module.
Use the key at the back of the book to correct your answers.
Restudy pages that correspond to any questions that you answered incorrectly or material you feel
uncertain about.
1. Another name for break-even analysis is
a. normal analysis.
b. variable cost analysis.
c. cost-volume analysis.
d. standard analysis.
e. probability analysis.
2. The break-even point is the quantity at which
a. total variable cost equals total fixed cost.
b. total revenue equals total variable cost.
c. total revenue equals total fixed cost.
d. total revenue equals total cost.
3. If demand is greater than the break-even point, then
a. profit will equal zero.
b. profit will be greater than zero.
c. profit will be negative.
d. total fixed cost will equal total variable cost.
4. If the break-even point is less than the mean, the Z value
will
a. be negative.
b. equal zero.
c. be positive.
d. be impossible to calculate.
M3-14
M3-15
M3-16
M3-17
M3-18
M3-19
M3-11
M3-12
BIBLIOGRAPHY
Drenzer, Z. and G. O. Wesolowsky, The Expected Value of Perfect
Information in Facility Location, Operations Research
(MarchApril 1980): 395402.
fixed cost
price/unit variable cost/unit
M3-13
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