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R E V I S E D
T H I R T E E N T H
E D I T I O N
AN INTRODUCTION TO
MANAGEMENT SCIENCE QUANTITATIVE APPROACHES TO DECISION MAKING
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R E V I S E D
T H I R T E E N T H
E D I T I O N
AN INTRODUCTION TO
MANAGEMENT SCIENCE QUANTITATIVE APPROACHES TO DECISION MAKING David R. Anderson University of Cincinnati
Dennis J. Sweeney University of Cincinnati
Thomas A. Williams Rochester Institute of Technology
Jeffrey D. Camm University of Cincinnati
Kipp Martin University of Chicago
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An Introduction to Management Science: Quantitative Approaches to Decision Making, Revised Thirteenth Edition David R. Anderson, Dennis J. Sweeney, Thomas A. Williams, Jeffrey D. Camm, & Kipp Martin VP/Editorial Director: Jack W. Calhoun Publisher: Joe Sabatino Senior Acquisitions Editor: Charles McCormick, Jr. Developmental Editor: Maggie Kubale Editorial Assistant: Courtney Bavaro Marketing Communications Manager: Libby Shipp Marketing Manager: Adam Marsh Content Project Manager: Jacquelyn K Featherly Media Editor: Chris Valentine Manufacturing Coordinator: Miranda Klapper Production House/Compositor: MPS Limited, a Macmillan Company Senior Art Director: Stacy Jenkins Shirley Internal Designer: Michael Stratton/Chris Miller Design Cover Designer: Craig Ramsdell Cover Images: © Getty Images/GlowImages
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Dedication To My Parents Ray and Ilene Anderson DRA To My Parents James and Gladys Sweeney DJS To My Parents Phil and Ann Williams TAW To My Wife Karen Camm JDC To My Wife Gail Honda KM
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Brief Contents
Preface xxv About the Authors xxix Chapter 1 Introduction 1 Chapter 2 An Introduction to Linear Programming 28 Chapter 3 Linear Programming: Sensitivity Analysis and Interpretation of Solution 92 Chapter 4 Linear Programming Applications in Marketing, Finance, and Operations Management 153 Chapter 5 Advanced Linear Programming Applications 214 Chapter 6 Distribution and Network Models 255 Chapter 7 Integer Linear Programming 317 Chapter 8 Nonlinear Optimization Models 365 Chapter 9 Project Scheduling: PERT/CPM 412 Chapter 10 Inventory Models 453 Chapter 11 Waiting Line Models 502 Chapter 12 Simulation 542 Chapter 13 Decision Analysis 602 Chapter 14 Multicriteria Decisions 659 Chapter 15 Time Series Analysis and Forecasting 703 Chapter 16 Markov Processes 761 Chapter 17 Linear Programming: Simplex Method On Website Chapter 18 Simplex-Based Sensitivity Analysis and Duality On Website Chapter 19 Solution Procedures for Transportation and Assignment Problems On Website Chapter 20 Minimal Spanning Tree On Website Chapter 21 Dynamic Programming On Website Appendixes 787 Appendix A Building Spreadsheet Models 788 Appendix B Areas for the Standard Normal Distribution 815 Appendix C Values of eⴚλ 817 Appendix D References and Bibliography 818 Appendix E Self-Test Solutions and Answers to Even-Numbered Problems 820 Index 853
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Contents
Preface xxv About the Authors xxix
Chapter 1
Introduction 1
1.1 Problem Solving and Decision Making 3 1.2 Quantitative Analysis and Decision Making 4 1.3 Quantitative Analysis 6 Model Development 7 Data Preparation 10 Model Solution 11 Report Generation 12 A Note Regarding Implementation 12 1.4 Models of Cost, Revenue, and Profit 14 Cost and Volume Models 14 Revenue and Volume Models 15 Profit and Volume Models 15 Breakeven Analysis 16 1.5 Management Science Techniques 16 Methods Used Most Frequently 18 Summary 19 Glossary 19 Problems 20 Case Problem Scheduling a Golf League 23 Appendix 1.1 Using Excel for Breakeven Analysis 24
Chapter 2
An Introduction to Linear Programming 28
2.1 A Simple Maximization Problem 30 Problem Formulation 31 Mathematical Statement of the Par, Inc., Problem 33 2.2 Graphical Solution Procedure 35 A Note on Graphing Lines 44 Summary of the Graphical Solution Procedure for Maximization Problems 46 Slack Variables 47 2.3 Extreme Points and the Optimal Solution 48 2.4 Computer Solution of the Par, Inc., Problem 50 Interpretation of Computer Output 51
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2.5 A Simple Minimization Problem 52 Summary of the Graphical Solution Procedure for Minimization Problems 54 Surplus Variables 55 Computer Solution of the M&D Chemicals Problem 56 2.6 Special Cases 57 Alternative Optimal Solutions 57 Infeasibility 58 Unbounded 60 2.7 General Linear Programming Notation 62 Summary 64 Glossary 65 Problems 66 Case Problem 1 Workload Balancing 82 Case Problem 2 Production Strategy 83 Case Problem 3 Hart Venture Capital 84 Appendix 2.1 Solving Linear Programs with LINGO 85 Appendix 2.2 Solving Linear Programs with Excel 87
Chapter 3
Linear Programming: Sensitivity Analysis and Interpretation of Solution 92
3.1 Introduction to Sensitivity Analysis 94 3.2 Graphical Sensitivity Analysis 95 Objective Function Coefficients 95 Right-Hand Sides 100 3.3 Sensitivity Analysis: Computer Solution 103 Interpretation of Computer Output 103 Cautionary Note on the Interpretation of Dual Values 106 The Modified Par, Inc., Problem 106 3.4 Limitations of Classical Sensitivity Analysis 110 Simultaneous Changes 111 Changes in Constraint Coefficients 112 Nonintuitive Dual Values 112 3.5 The Electronic Communications Problem 116 Problem Formulation 117 Computer Solution and Interpretation 118 Summary 122 Glossary 123 Problems 123 Case Problem 1 Product Mix 145 Case Problem 2 Investment Strategy 146 Case Problem 3 Truck Leasing Strategy 147 Appendix 3.1 Sensitivity Analysis with Excel 148 Appendix 3.2 Sensitivity Analysis with LINGO 150
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Chapter 4
Linear Programming Applications in Marketing, Finance, and Operations Management 153
4.1 Marketing Applications 154 Media Selection 155 Marketing Research 158 4.2 Financial Applications 161 Portfolio Selection 161 Financial Planning 164 4.3 Operations Management Applications 168 A Make-or-Buy Decision 168 Production Scheduling 172 Workforce Assignment 179 Blending Problems 183 Summary 188 Problems 189 Case Problem 1 Planning an Advertising Campaign 202 Case Problem 2 Phoenix Computer 203 Case Problem 3 Textile Mill Scheduling 204 Case Problem 4 Workforce Scheduling 205 Case Problem 5 Duke Energy Coal Allocation 207 Appendix 4.1 Excel Solution of Hewlitt Corporation Financial Planning Problem 210
Chapter 5
Advanced Linear Programming Applications 214
5.1 Data Envelopment Analysis 215 Evaluating the Performance of Hospitals 216 Overview of the DEA Approach 216 DEA Linear Programming Model 217 Summary of the DEA Approach 222 5.2 Revenue Management 223 5.3 Portfolio Models and Asset Allocation 229 A Portfolio of Mutual Funds 229 Conservative Portfolio 230 Moderate Risk Portfolio 232 5.4 Game Theory 236 Competing for Market Share 236 Identifying a Pure Strategy Solution 238 Identifying a Mixed Strategy Solution 239 Summary 247 Glossary 247 Problems 248
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Chapter 6
Distribution and Network Models 255
6.1 Transportation Problem 256 Problem Variations 260 A General Linear Programming Model 262 6.2 Assignment Problem 263 Problem Variations 266 A General Linear Programming Model 267 6.3 Transshipment Problem 268 Problem Variations 274 A General Linear Programming Model 274 6.4 Shortest-Route Problem 276 A General Linear Programming Model 279 6.5 Maximal Flow Problem 279 6.6 A Production and Inventory Application 283 Summary 286 Glossary 287 Problems 288 Case Problem 1 Solutions Plus 305 Case Problem 2 Distribution System Design 306 Appendix 6.1 Excel Solution of Transportation, Assignment, and Transshipment Problems 308
Chapter 7
Integer Linear Programming 317
7.1 Types of Integer Linear Programming Models 319 7.2 Graphical and Computer Solutions for an All-Integer Linear Program 321 Graphical Solution of the LP Relaxation 322 Rounding to Obtain an Integer Solution 322 Graphical Solution of the All-Integer Problem 323 Using the LP Relaxation to Establish Bounds 323 Computer Solution 324 7.3 Applications Involving 0-1 Variables 325 Capital Budgeting 325 Fixed Cost 326 Distribution System Design 329 Bank Location 334 Product Design and Market Share Optimization 337 7.4 Modeling Flexibility Provided by 0-1 Integer Variables 341 Multiple-Choice and Mutually Exclusive Constraints 341 k out of n Alternatives Constraint 342 Conditional and Corequisite Constraints 342 A Cautionary Note About Sensitivity Analysis 344
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Summary 344 Glossary 345 Problems 346 Case Problem 1 Textbook Publishing 357 Case Problem 2 Yeager National Bank 358 Case Problem 3 Production Scheduling with Changeover Costs 359 Appendix 7.1 Excel Solution of Integer Linear Programs 360 Appendix 7.2 LINGO Solution of Integer Linear Programs 361
Chapter 8
Nonlinear Optimization Models 365
8.1 A Production Application—Par, Inc., Revisited 367 An Unconstrained Problem 367 A Constrained Problem 368 Local and Global Optima 371 Dual Values 374 8.2 Constructing an Index Fund 374 8.3 Markowitz Portfolio Model 379 8.4 Blending: The Pooling Problem 382 8.5 Forecasting Adoption of a New Product 387 Summary 392 Glossary 392 Problems 393 Case Problem 1 Portfolio Optimization with Transaction Costs 402 Case Problem 2 CAFE Compliance in the Auto Industry 405 Appendix 8.1 Solving Nonlinear Problems with LINGO 408 Appendix 8.2 Solving Nonlinear Problems with Excel Solver 409
Chapter 9
Project Scheduling: PERT/CPM 412
9.1 Project Scheduling with Known Activity Times 413 The Concept of a Critical Path 414 Determining the Critical Path 416 Contributions of PERT/CPM 420 Summary of the PERT/CPM Critical Path Procedure 421 9.2 Project Scheduling with Uncertain Activity Times 422 The Daugherty Porta-Vac Project 423 Uncertain Activity Times 423 The Critical Path 425 Variability in Project Completion Time 428 9.3 Considering Time-Cost Trade-Offs 431 Crashing Activity Times 432 Linear Programming Model for Crashing 434
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Summary 436 Glossary 437 Problems 438 Case Problem R. C. Coleman 448 Appendix 9.1 Using Microsoft Office Project 450
Chapter 10
Inventory Models 453
10.1 Economic Order Quantity (EOQ) Model 454 The How-Much-to-Order Decision 459 The When-to-Order Decision 460 Sensitivity Analysis for the EOQ Model 461 Excel Solution of the EOQ Model 462 Summary of the EOQ Model Assumptions 463 10.2 Economic Production Lot Size Model 464 Total Cost Model 465 Economic Production Lot Size 467 10.3 Inventory Model with Planned Shortages 467 10.4 Quantity Discounts for the EOQ Model 472 10.5 Single-Period Inventory Model with Probabilistic Demand 474 Johnson Shoe Company 475 Nationwide Car Rental 479 10.6 Order-Quantity, Reorder Point Model with Probabilistic Demand 480 The How-Much-to-Order Decision 481 The When-to-Order Decision 482 10.7 Periodic Review Model with Probabilistic Demand 484 More Complex Periodic Review Models 487 Summary 488 Glossary 489 Problems 491 Case Problem 1 Wagner Fabricating Company 498 Case Problem 2 River City Fire Department 499 Appendix 10.1 Development of the Optimal Order Quantity (Q*) Formula for the EOQ Model 500 Appendix 10.2 Development of the Optimal Lot Size (Q*) Formula for the Production Lot Size Model 501
Chapter 11
Waiting Line Models 502
11.1 Structure of a Waiting Line System 504 Single-Channel Waiting Line 504 Distribution of Arrivals 504 Distribution of Service Times 506
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11.2
11.3
11.4 11.5 11.6 11.7
11.8
11.9
Queue Discipline 507 Steady-State Operation 507 Single-Channel Waiting Line Model with Poisson Arrivals and Exponential Service Times 508 Operating Characteristics 508 Operating Characteristics for the Burger Dome Problem 509 Managers’ Use of Waiting Line Models 510 Improving the Waiting Line Operation 510 Excel Solution of Waiting Line Model 511 Multiple-Channel Waiting Line Model with Poisson Arrivals and Exponential Service Times 512 Operating Characteristics 513 Operating Characteristics for the Burger Dome Problem 515 Some General Relationships for Waiting Line Models 517 Economic Analysis of Waiting Lines 519 Other Waiting Line Models 520 Single-Channel Waiting Line Model with Poisson Arrivals and Arbitrary Service Times 521 Operating Characteristics for the M/G/1 Model 521 Constant Service Times 523 Multiple-Channel Model with Poisson Arrivals, Arbitrary Service Times, and No Waiting Line 524 Operating Characteristics for the M/G/k Model with Blocked Customers Cleared 524 Waiting Line Models with Finite Calling Populations 526 Operating Characteristics for the M/M/1 Model with a Finite Calling Population 527 Summary 529 Glossary 531 Problems 531 Case Problem 1 Regional Airlines 539 Case Problem 2 Office Equipment, Inc. 540
Chapter 12
Simulation 542
12.1 Risk Analysis 545 PortaCom Project 545 What-If Analysis 545 Simulation 547 Simulation of the PortaCom Project 554 12.2 Inventory Simulation 558 Butler Inventory Simulation 561 12.3 Waiting Line Simulation 563 Hammondsport Savings Bank ATM Waiting Line 563 Customer Arrival Times 564
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Customer Service Times 565 Simulation Model 565 Hammondsport Savings Bank ATM Simulation 569 Simulation with Two ATMs 570 Simulation Results with Two ATMs 572 12.4 Other Simulation Issues 574 Computer Implementation 574 Verification and Validation 575 Advantages and Disadvantages of Using Simulation 575 Summary 576 Glossary 577 Problems 578 Case Problem 1 Tri-State Corporation 585 Case Problem 2 Harbor Dunes Golf Course 587 Case Problem 3 County Beverage Drive-Thru 589 Appendix 12.1 Simulation with Excel 590 Appendix 12.2 Simulation Using Crystal Ball 597
Chapter 13
Decision Analysis 602
13.1 Problem Formulation 604 Influence Diagrams 605 Payoff Tables 605 Decision Trees 606 13.2 Decision Making Without Probabilities 607 Optimistic Approach 607 Conservative Approach 607 Minimax Regret Approach 608 13.3 Decision Making with Probabilities 610 Expected Value of Perfect Information 613 13.4 Risk Analysis and Sensitivity Analysis 615 Risk Analysis 615 Sensitivity Analysis 616 13.5 Decision Analysis with Sample Information 620 Influence Diagram 620 Decision Tree 621 Decision Strategy 623 Risk Profile 627 Expected Value of Sample Information 629 Efficiency of Sample Information 630 13.6 Computing Branch Probabilities 630 Summary 634 Glossary 635 Problems 637 Case Problem 1 Property Purchase Strategy 651
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Case Problem 2 Lawsuit Defense Strategy 652 Appendix 13.1 Decision Analysis with Treeplan 653
Chapter 14
Multicriteria Decisions 659
14.1 Goal Programming: Formulation and Graphical Solution 660 Developing the Constraints and the Goal Equations 661 Developing an Objective Function with Preemptive Priorities 663 Graphical Solution Procedure 664 Goal Programming Model 667 14.2 Goal Programming: Solving More Complex Problems 668 Suncoast Office Supplies Problem 668 Formulating the Goal Equations 669 Formulating the Objective Function 670 Computer Solution 671 14.3 Scoring Models 674 14.4 Analytic Hierarchy Process 679 Developing the Hierarchy 680 14.5 Establishing Priorities Using AHP 680 Pairwise Comparisons 681 Pairwise Comparison Matrix 682 Synthesization 684 Consistency 685 Other Pairwise Comparisons for the Car Selection Problem 687 14.6 Using AHP to Develop an Overall Priority Ranking 688 Summary 690 Glossary 690 Problems 691 Case Problem EZ Trailers, Inc. 700 Appendix 14.1 Scoring Models with Excel 701
Chapter 15
Time Series Analysis and Forecasting 703
15.1 Time Series Patterns 705 Horizontal Pattern 705 Trend Pattern 707 Seasonal Pattern 709 Trend and Seasonal Pattern 710 Cyclical Pattern 713 Selecting a Forecasting Method 713 15.2 Forecast Accuracy 713 15.3 Moving Averages and Exponential Smoothing 717 Moving Averages 717 Weighted Moving Averages 720 Exponential Smoothing 721
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15.4 Trend Projection 726 Linear Trend 726 Nonlinear Trend 730 15.5 Seasonality 733 Seasonality Without Trend 734 Seasonality and Trend 737 Models Based on Monthly Data 739 Summary 740 Glossary 741 Problems 741 Case Problem 1 Forecasting Food and Beverage Sales 751 Case Problem 2 Forecasting Lost Sales 751 Appendix 15.1 Forecasting with Excel Data Analysis Tools 753 Appendix 15.2 Forecasting with Excel Solver 754 Appendix 15.3 Forecasting with LINGO 759
Chapter 16
Markov Processes 761
16.1 Market Share Analysis 763 16.2 Accounts Receivable Analysis 771 Fundamental Matrix and Associated Calculations 772 Establishing the Allowance for Doubtful Accounts 774 Summary 776 Glossary 776 Problems 777 Case Problem Dealer’s Absorbing State Probabilities in Blackjack 781 Appendix 16.1 Matrix Notation and Operations 782 Appendix 16.2 Matrix Inversion with Excel 785
Chapter 17
Linear Programming: Simplex Method On Website
17.1 An Algebraic Overview of the Simplex Method 17-2 Algebraic Properties of the Simplex Method 17-3 Determining a Basic Solution 17-3 Basic Feasible Solution 17-4 17.2 Tableau Form 17-5 17.3 Setting up the Initial Simplex Tableau 17-7 17.4 Improving the Solution 17-10 17.5 Calculating the Next Tableau 17-12 Interpreting the Results of an Iteration 17-15 Moving Toward a Better Solution 17-15 Interpreting the Optimal Solution 17-18 Summary of the Simplex Method 17-19
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17.6 Tableau Form: The General Case 17-20 Greater-Than-or-Equal-to Constraints 17-20 Equality Constraints 17-24 Eliminating Negative Right-Hand-Side Values 17-25 Summary of the Steps to Create Tableau Form 17-26 17.7 Solving a Minimization Problem 17-27 17.8 Special Cases 17-29 Infeasibility 17-29 Unboundedness 17-31 Alternative Optimal Solutions 17-32 Degeneracy 17-33 Summary 17-35 Glossary 17-36 Problems 17-37
Chapter 18
Simplex-Based Sensitivity Analysis and Duality On Website
18.1 Sensitivity Analysis with the Simplex Tableau 18-2 Objective Function Coefficients 18-2 Right-Hand-Side Values 18-6 Simultaneous Changes 18-13 18.2 Duality 18-14 Economic Interpretation of the Dual Variables 18-16 Using the Dual to Identify the Primal Solution 18-18 Finding the Dual of Any Primal Problem 18-18 Summary 18-20 Glossary 18-21 Problems 18-21
Chapter 19
Solution Procedures for Transportation and Assignment Problems On Website
19.1 Transportation Simplex Method: A Special-Purpose Solution Procedure 19-2 Phase I: Finding an Initial Feasible Solution 19-2 Phase II: Iterating to the Optimal Solution 19-7 Summary of the Transportation Simplex Method 19-17 Problem Variations 19-17 19.2 Assignment Problem: A Special-Purpose Solution Procedure 19-18 Finding the Minimum Number of Lines 19-21 Problem Variations 19-21 Glossary 19-25 Problems 19-26
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Chapter 20
Minimal Spanning Tree On Website
A Minimal Spanning Tree Algorithm 20-2 Glossary 20-5 Problems 20-5
Chapter 21 21.1 21.2 21.3 21.4
Dynamic Programming On Website
A Shortest-Route Problem 21-2 Dynamic Programming Notation 21-6 The Knapsack Problem 21-10 A Production and Inventory Control Problem 21-16 Summary 21-20 Glossary 21-21 Problems 21-22 Case Problem Process Design 21-26
Appendixes 787
Appendix A Appendix B Appendix C Appendix D Appendix E Index 853
Building Spreadsheet Models 788 Areas for the Standard Normal Distribution 815 Values of eⴚλ 817 References and Bibliography 818 Self-Test Solutions and Answers to Even-Numbered Problems 820
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Preface
We are very excited to publish the revised thirteenth edition of a text that has been a leader in the field for over 20 years. The purpose of this revised thirteenth edition, as with previous editions, is to provide undergraduate and graduate students with a sound conceptual understanding of the role that management science plays in the decision-making process. The text describes many of the applications where management science is used successfully. Former users of this text have told us that the applications we describe have led them to find new ways to use management science in their organizations. An Introduction to Management Science is applications oriented and continues to use the problem-scenario approach that is a hallmark of every edition of the text. Using the problem-scenario approach, we describe a problem in conjunction with the management science model being introduced. The model is then solved to generate a solution and recommendation to management. We have found that this approach helps to motivate the student by not only demonstrating how the procedure works, but also how it contributes to the decision-making process. From the very first edition we have been committed to the challenge of writing a textbook that would help make the mathematical and technical concepts of management science understandable and useful to students of business and economics. Judging from the responses from our teaching colleagues and thousands of students, we have successfully met the challenge. Indeed, it is the helpful comments and suggestions of many loyal users that have been a major reason why the text is so successful. Throughout the text we have utilized generally accepted notation for the topic being covered so those students who pursue study beyond the level of this text should be comfortable reading more advanced material. To assist in further study, a references and bibliography section is included at the back of the book.
CHANGES IN THE REVISED THIRTEENTH EDITION The thirteenth edition of Management Science is a major revision. We are very excited about it and want to tell you about some of the changes we have made and why. In addition to the major revisions described in the remainder of this section, this revised edition of the thirteenth edition has been updated to incorporate Microsoft® Office Excel® 2010. This involves some changes in the user interface of Excel and major changes in the interface and functionality of Excel Solver. The Solver in Excel 2010 is more reliable than in previous editions and offers new alternatives such as a multistart option for difficult nonlinear problems.
New Member of the ASWM Team Prior to getting into the content changes, we want to announce that we are adding a new member to the ASWM author team. His name is Jeffrey Camm. Jeff received his Ph.D. from Clemson University. He has been at the University of Cincinnati since 1984, and has been a visiting scholar at Stanford University and a visiting professor of business administration at the Tuck School of Business at Dartmouth College. Jeff has published over 30 papers in the general area of optimization applied to problems in operations management. At the University of Cincinnati, he was named the Dornoff Fellow of Teaching Excellence and
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he was the 2006 recipient of the INFORMS Prize for the Teaching of Operations Research Practice. He currently serves as editor-in-chief of Interfaces, and is on the editorial board of INFORMS Transactions on Education. We welcome Jeff to the new ASWCM team and expect the new ideas from Jeff will make the text even better in the years to come. In preparing this thirteenth edition, we have been careful to maintain the overall format and approach of the previous edition. However, based on our classroom experiences and suggestions from users of previous editions, a number of changes have been made to enhance the text.
Made the Book Less Reliant on Specific Software The first eight chapters on optimization no longer use output from The Management Scientist software. All figures illustrating computer output are generic and are totally independent of software selection. This provides flexibility for the instructor. In addition, we provide appendices that describe how to use Excel Solver and LINGO. For every model illustrated in the text we have both Excel and LINGO files available at the website. Prior users of The Management Scientist wishing to upgrade to similar software should consider using LINGO. This will be an easy transition and LINGO is far more flexible than The Management Scientist. The documented LINGO models (not available in MS 12e), available at the website, will aide in the transition. Excel Solver and LINGO have an advantage over The Management Scientist in that they do not require the user to move all variables to the left-hand side of the constraint. This eliminates the need to algebraically manipulate the model and allows the student to enter the model in the computer in its more natural form. For users wishing to use The Management Scientist, it will continue to be available on the website for the text.
New Appendix A: Building Spreadsheet Models This appendix will prove useful to professors and students wishing to solve optimization models with Excel Solver. The appendix also contains a section on the principles of good spreadsheet modeling and a section on auditing tips. Exercises are also provided.
Chapter 15 Thoroughly Revised Chapter 15, Times Series Analysis and Forecasting, has been thoroughly revised. The revised chapter is more focused on time series data and methods. A new section on forecast accuracy has been added and there is more emphasis on curve fitting. A new section on nonlinear trend has been added. In order to better integrate this chapter with the text, we show how finding the best parameter values in forecasting models is an application of optimization, and illustrate with Excel Solver and LINGO.
New Project Management Software In Chapter 9, Project Scheduling: PERT/CPM, we added an appendix on Microsoft Office Project. This popular software is a valuable aid for project management and is software that the student may well encounter on the job. This software is available on the CD that is packaged with every new copy of the text.
Chapter 3 Significantly Revised We significantly revised Chapter 3, Linear Programming: Sensitivity Analysis and Interpretation of Solution. The material is now presented in a more up-to-date fashion and emphasizes the ease of using software to analyze optimization models.
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New Management Science in Action, Cases, and Problems Management Science in Action is the name of the short summaries that describe how the material covered in a chapter has been used in practice. In this edition you will find numerous Management Science in Action vignettes, cases, and homework problems.
Other Content Changes A variety of other changes, too numerous to mention individually, have been made throughout the text in responses to suggestions of users and our students.
COMPUTER SOFTWARE INTEGRATION We have been careful to write the text so that it is not dependent on any particular software package. But, we have included materials that facilitate using our text with several of the more popular software packages. The following software and files are available on the website for the text: • • • •
LINGO trial version, LINGO and Excel Solver models for every optimization model presented in the text, Microsoft® Excel worksheets for most of the examples used throughout the text, TreePlanTM Excel add-in for decision analysis and manual.
Microsoft Project is provided on the CD that is packaged with every new copy of the text.
FEATURES AND PEDAGOGY We have continued many of the features that appeared in previous editions. Some of the important ones are noted here.
Annotations Annotations that highlight key points and provide additional insights for the student are a continuing feature of this edition. These annotations, which appear in the margins, are designed to provide emphasis and enhance understanding of the terms and concepts being presented in the text.
Notes and Comments At the end of many sections, we provide Notes and Comments designed to give the student additional insights about the statistical methodology and its application. Notes and Comments include warnings about or limitations of the methodology, recommendations for application, brief descriptions of additional technical considerations, and other matters.
Self-Test Exercises Certain exercises are identified as self-test exercises. Completely worked-out solutions for those exercises are provided in an appendix at the end of the text. Students can attempt the self-test exercises and immediately check the solution to evaluate their understanding of the concepts presented in the chapter.
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ACKNOWLEDGMENTS We owe a debt to many of our academic colleagues and friends for their helpful comments and suggestions during the development of this and previous editions. Our associates from organizations who supplied several of the Management Science in Action vignettes make a major contribution to the text. These individuals are cited in a credit line associated with each vignette. We are also indebted to our senior acquisitions editor, Charles McCormick, Jr.; our marketing communications manager, Libby Shipp; our developmental editor, Maggie Kubale; our content project manager, Jacquelyn K Featherly; our media editor, Chris Valentine; and others at Cengage Business and Economics for their counsel and support during the preparation of this text. We also wish to thank Lynn Lustberg, Project Manager at MPS Content Services for her help in manuscript preparation. David R. Anderson Dennis J. Sweeney Thomas A. Williams Jeffrey D. Camm Kipp Martin
About the Authors
David R. Anderson. David R. Anderson is Professor Emeritus of Quantitative Analysis in the College of Business Administration at the University of Cincinnati. Born in Grand Forks, North Dakota, he earned his B.S., M.S., and Ph.D. degrees from Purdue University. Professor Anderson has served as Head of the Department of Quantitative Analysis and Operations Management and as Associate Dean of the College of Business Administration. In addition, he was the coordinator of the College’s first Executive Program. At the University of Cincinnati, Professor Anderson has taught introductory statistics for business students as well as graduate-level courses in regression analysis, multivariate analysis, and management science. He has also taught statistical courses at the Department of Labor in Washington, D.C. He has been honored with nominations and awards for excellence in teaching and excellence in service to student organizations. Professor Anderson has coauthored ten textbooks in the areas of statistics, management science, linear programming, and production and operations management. He is an active consultant in the field of sampling and statistical methods. Dennis J. Sweeney. Dennis J. Sweeney is Professor Emeritus of Quantitative Analysis and Founder of the Center for Productivity Improvement at the University of Cincinnati. Born in Des Moines, Iowa, he earned a B.S.B.A. degree from Drake University and his M.B.A. and D.B.A. degrees from Indiana University, where he was an NDEA Fellow. During 1978–79, Professor Sweeney worked in the management science group at Procter & Gamble; during 1981–82, he was a visiting professor at Duke University. Professor Sweeney served as Head of the Department of Quantitative Analysis and as Associate Dean of the College of Business Administration at the University of Cincinnati. Professor Sweeney has published more than thirty articles and monographs in the area of management science and statistics. The National Science Foundation, IBM, Procter & Gamble, Federated Department Stores, Kroger, and Cincinnati Gas & Electric have funded his research, which has been published in Management Science, Operations Research, Mathematical Programming, Decision Sciences, and other journals. Professor Sweeney has coauthored ten textbooks in the areas of statistics, management science, linear programming, and production and operations management. Thomas A. Williams. Thomas A. Williams is Professor Emeritus of Management Science in the College of Business at Rochester Institute of Technology. Born in Elmira, New York, he earned his B.S. degree at Clarkson University. He did his graduate work at Rensselaer Polytechnic Institute, where he received his M.S. and Ph.D. degrees. Before joining the College of Business at RIT, Professor Williams served for seven years as a faculty member in the College of Business Administration at the University of Cincinnati, where he developed the undergraduate program in information systems and then served as its coordinator. At RIT he was the first chairman of the Decision Sciences Department. He teaches courses in management science and statistics, as well as graduate courses in regression and decision analysis.
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About the Authors
Professor Williams is the coauthor of eleven textbooks in the areas of management science, statistics, production and operations management, and mathematics. He has been a consultant for numerous Fortune 500 companies and has worked on projects ranging from the use of data analysis to the development of large-scale regression models. Jeffrey D. Camm. Jeffrey D. Camm is Professor of Quantitative Analysis and Head of the Department of Quantitative Analysis and Operations Management at the University of Cincinnati. Dr. Camm earned a Ph.D. in management science from Clemson University and a B.S. in mathematics from Xavier University. He has been at the University of Cincinnati since 1984, has been a visiting scholar at Stanford University, and a visiting professor of business administration at the Tuck School of Business at Dartmouth College. Dr. Camm has published over 30 papers in the general area of optimization applied to problems in operations management and his research has been funded by the Air Force Office of Scientific Research, the Office of Naval Research, and the U.S. Department of Energy. He was named the Dornoff Fellow of Teaching Excellence by the University of Cincinnati College of Business and he was the 2006 recipient of the INFORMS Prize for the Teaching of Operations Research Practice. He currently serves as editor-in-chief of Interfaces, and is on the editorial board of INFORMS Transactions on Education. Kipp Martin. Kipp Martin is Professor of Operations Research and Computing Technology at the Booth School of Business, University of Chicago. Born in St. Bernard, Ohio, he earned a B.A. in mathematics, an MBA, and a Ph.D. in management science from the University of Cincinnati. While at the University of Chicago, Professor Martin has taught courses in management science, operations management, business mathematics, and information systems. Research interests include incorporating Web technologies such as XML, XSLT, XQuery, and Web Services into the mathematical modeling process; the theory of how to construct good mixed integer linear programming models; symbolic optimization; polyhedral combinatorics; methods for large scale optimization; bundle pricing models; computing technology; and database theory. Professor Martin has published in INFORMS Journal of Computing, Management Science, Mathematical Programming, Operations Research, The Journal of Accounting Research, and other professional journals. He is also the author of The Essential Guide to Internet Business Technology (with Gail Honda) and Large Scale Linear and Integer Optimization.
CHAPTER Introduction CONTENTS 1.1
PROBLEM SOLVING AND DECISION MAKING
1.2
QUANTITATIVE ANALYSIS AND DECISION MAKING
1.3
QUANTITATIVE ANALYSIS Model Development Data Preparation Model Solution Report Generation A Note Regarding Implementation
1.4
MODELS OF COST, REVENUE, AND PROFIT Cost and Volume Models Revenue and Volume Models Profit and Volume Models Breakeven Analysis
1.5
MANAGEMENT SCIENCE TECHNIQUES Methods Used Most Frequently
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Chapter 1
According to Irv Lustig of IBM ILOG, Inc., solution methods developed today are 10,000 times faster than the ones used 15 years ago.
Management science, an approach to decision making based on the scientific method, makes extensive use of quantitative analysis. A variety of names exists for the body of knowledge involving quantitative approaches to decision making; in addition to management science, two other widely known and accepted names are operations research and decision science. Today, many use the terms management science, operations research, and decision science interchangeably. The scientific management revolution of the early 1900s, initiated by Frederic W. Taylor, provided the foundation for the use of quantitative methods in management. But modern management science research is generally considered to have originated during the World War II period, when teams were formed to deal with strategic and tactical problems faced by the military. These teams, which often consisted of people with diverse specialties (e.g., mathematicians, engineers, and behavioral scientists), were joined together to solve a common problem by utilizing the scientific method. After the war, many of these team members continued their research in the field of management science. Two developments that occurred during the post–World War II period led to the growth and use of management science in nonmilitary applications. First, continued research resulted in numerous methodological developments. Probably the most significant development was the discovery by George Dantzig, in 1947, of the simplex method for solving linear programming problems. At the same time these methodological developments were taking place, digital computers prompted a virtual explosion in computing power. Computers enabled practitioners to use the methodological advances to solve a large variety of problems. The computer technology explosion continues, and personal computers can now be used to solve problems larger than those solved on mainframe computers in the 1990s. As stated in the Preface, the purpose of the text is to provide students with a sound conceptual understanding of the role that management science plays in the decision-making process. We also said that the text is applications oriented. To reinforce the applications nature of the text and provide a better understanding of the variety of applications in which management science has been used successfully, Management Science in Action articles are presented throughout the text. Each Management Science in Action article summarizes an application of management science in practice. The first Management Science in Action in this chapter, Revenue Management at American Airlines, describes one of the most significant applications of management science in the airline industry.
Introduction
MANAGEMENT SCIENCE IN ACTION REVENUE MANAGEMENT AT AMERICAN AIRLINES* One of the great success stories in management science involves the work done by the operations research (OR) group at American Airlines. In 1982, Thomas M. Cook joined a group of 12 operations research analysts at American Airlines. Under Cook’s guidance, the OR group quickly grew to a staff of 75 professionals who developed models and conducted studies to support senior management decision making. Today the OR group is called Sabre and employs 10,000 professionals worldwide. One of the most significant applications developed by the OR group came about because of the deregulation of the airline industry in the late
1970s. As a result of deregulation, a number of low-cost airlines were able to move into the market by selling seats at a fraction of the price charged by established carriers such as American Airlines. Facing the question of how to compete, the OR group suggested offering different fare classes (discount and full fare) and in the process created a new area of management science referred to as yield or revenue management. The OR group used forecasting and optimization techniques to determine how many seats to sell at a discount and how many seats to hold for full fare. Although the initial implementation was relatively crude, the group continued to improve
Problem Solving and Decision Making
3
the forecasting and optimization models that drive the system and to obtain better data. Tom Cook counts at least four basic generations of revenue management during his tenure. Each produced in excess of $100 million in incremental profitability over its predecessor. This revenue management system at American Airlines generates nearly $1 billion annually in incremental revenue.
Today, virtually every airline uses some sort of revenue management system. The cruise, hotel, and car rental industries also now apply revenue management methods, a further tribute to the pioneering efforts of the OR group at American Airlines and its leader, Thomas M. Cook.
1.1
1.1
*Based on Peter Horner, “The Sabre Story,” OR/MS Today (June 2000).
PROBLEM SOLVING AND DECISION MAKING Problem solving can be defined as the process of identifying a difference between the actual and the desired state of affairs and then taking action to resolve the difference. For problems important enough to justify the time and effort of careful analysis, the problemsolving process involves the following seven steps: 1. 2. 3. 4. 5. 6. 7.
Identify and define the problem. Determine the set of alternative solutions. Determine the criterion or criteria that will be used to evaluate the alternatives. Evaluate the alternatives. Choose an alternative. Implement the selected alternative. Evaluate the results to determine whether a satisfactory solution has been obtained.
Decision making is the term generally associated with the first five steps of the problemsolving process. Thus, the first step of decision making is to identify and define the problem. Decision making ends with the choosing of an alternative, which is the act of making the decision. Let us consider the following example of the decision-making process. For the moment assume that you are currently unemployed and that you would like a position that will lead to a satisfying career. Suppose that your job search has resulted in offers from companies in Rochester, New York; Dallas, Texas; Greensboro, North Carolina; and Pittsburgh, Pennsylvania. Thus, the alternatives for your decision problem can be stated as follows: 1. 2. 3. 4.
Accept the position in Rochester. Accept the position in Dallas. Accept the position in Greensboro. Accept the position in Pittsburgh.
The next step of the problem-solving process involves determining the criteria that will be used to evaluate the four alternatives. Obviously, the starting salary is a factor of some importance. If salary were the only criterion of importance to you, the alternative selected as “best” would be the one with the highest starting salary. Problems in which the objective is to find the best solution with respect to one criterion are referred to as single-criterion decision problems. Suppose that you also conclude that the potential for advancement and the location of the job are two other criteria of major importance. Thus, the three criteria in your decision problem are starting salary, potential for advancement, and location. Problems that involve more than one criterion are referred to as multicriteria decision problems. The next step of the decision-making process is to evaluate each of the alternatives with respect to each criterion. For example, evaluating each alternative relative to the
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Chapter 1
Introduction
TABLE 1.1 DATA FOR THE JOB EVALUATION DECISION-MAKING PROBLEM
Alternative 1. Rochester 2. Dallas 3. Greensboro 4. Pittsburgh
Starting Salary $48,500 $46,000 $46,000 $47,000
Potential for Advancement Average Excellent Good Average
Job Location Average Good Excellent Good
starting salary criterion is done simply by recording the starting salary for each job alternative. Evaluating each alternative with respect to the potential for advancement and the location of the job is more difficult to do, however, because these evaluations are based primarily on subjective factors that are often difficult to quantify. Suppose for now that you decide to measure potential for advancement and job location by rating each of these criteria as poor, fair, average, good, or excellent. The data that you compile are shown in Table 1.1. You are now ready to make a choice from the available alternatives. What makes this choice phase so difficult is that the criteria are probably not all equally important, and no one alternative is “best” with regard to all criteria. Although we will present a method for dealing with situations like this one later in the text, for now let us suppose that after a careful evaluation of the data in Table 1.1, you decide to select alternative 3; alternative 3 is thus referred to as the decision. At this point in time, the decision-making process is complete. In summary, we see that this process involves five steps: 1. 2. 3. 4. 5.
Define the problem. Identify the alternatives. Determine the criteria. Evaluate the alternatives. Choose an alternative.
Note that missing from this list are the last two steps in the problem-solving process: implementing the selected alternative and evaluating the results to determine whether a satisfactory solution has been obtained. This omission is not meant to diminish the importance of each of these activities, but to emphasize the more limited scope of the term decision making as compared to the term problem solving. Figure 1.1 summarizes the relationship between these two concepts.
1.2
QUANTITATIVE ANALYSIS AND DECISION MAKING Consider the flowchart presented in Figure 1.2. Note that it combines the first three steps of the decision-making process under the heading of “Structuring the Problem” and the latter two steps under the heading “Analyzing the Problem.” Let us now consider in greater detail how to carry out the set of activities that make up the decision-making process. Figure 1.3 shows that the analysis phase of the decision-making process may take two basic forms: qualitative and quantitative. Qualitative analysis is based primarily on the manager’s judgment and experience; it includes the manager’s intuitive “feel” for the problem and is more an art than a science. If the manager has had experience with similar
1.2
5
Quantitative Analysis and Decision Making
FIGURE 1.1 THE RELATIONSHIP BETWEEN PROBLEM SOLVING AND DECISION MAKING
Define the Problem Identify the Alternatives Determine the Criteria Problem Solving
Decision Making
Evaluate the Alternatives Choose an Alternative Implement the Decision
Decision
Evaluate the Results
problems or if the problem is relatively simple, heavy emphasis may be placed upon a qualitative analysis. However, if the manager has had little experience with similar problems, or if the problem is sufficiently complex, then a quantitative analysis of the problem can be an especially important consideration in the manager’s final decision. When using the quantitative approach, an analyst will concentrate on the quantitative facts or data associated with the problem and develop mathematical expressions that FIGURE 1.2 AN ALTERNATE CLASSIFICATION OF THE DECISION-MAKING PROCESS
Analyzing the Problem
Structuring the Problem
Define the Problem
Identify the Alternatives
Determine the Criteria
Evaluate the Alternatives
Choose an Alternative
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Introduction
FIGURE 1.3 THE ROLE OF QUALITATIVE AND QUANTITATIVE ANALYSIS Analyzing the Problem
Structuring the Problem Define the Problem
Identify the Alternatives
Qualitative Analysis
Determine the Criteria
Summary and Evaluation
Make the Decision
Quantitative Analysis
Quantitative methods are especially helpful with large, complex problems. For example, in the coordination of the thousands of tasks associated with landing Apollo 11 safely on the moon, quantitative techniques helped to ensure that more than 300,000 pieces of work performed by more than 400,000 people were integrated smoothly.
Try Problem 4 to test your understanding of why quantitative approaches might be needed in a particular problem.
1.3
describe the objectives, constraints, and other relationships that exist in the problem. Then, by using one or more quantitative methods, the analyst will make a recommendation based on the quantitative aspects of the problem. Although skills in the qualitative approach are inherent in the manager and usually increase with experience, the skills of the quantitative approach can be learned only by studying the assumptions and methods of management science. A manager can increase decision-making effectiveness by learning more about quantitative methodology and by better understanding its contribution to the decision-making process. A manager who is knowledgeable in quantitative decision-making procedures is in a much better position to compare and evaluate the qualitative and quantitative sources of recommendations and ultimately to combine the two sources in order to make the best possible decision. The box in Figure 1.3 entitled “Quantitative Analysis” encompasses most of the subject matter of this text. We will consider a managerial problem, introduce the appropriate quantitative methodology, and then develop the recommended decision. In closing this section, let us briefly state some of the reasons why a quantitative approach might be used in the decision-making process: 1. The problem is complex, and the manager cannot develop a good solution without the aid of quantitative analysis. 2. The problem is especially important (e.g., a great deal of money is involved), and the manager desires a thorough analysis before attempting to make a decision. 3. The problem is new, and the manager has no previous experience from which to draw. 4. The problem is repetitive, and the manager saves time and effort by relying on quantitative procedures to make routine decision recommendations.
QUANTITATIVE ANALYSIS From Figure 1.3, we see that quantitative analysis begins once the problem has been structured. It usually takes imagination, teamwork, and considerable effort to transform a rather general problem description into a well-defined problem that can be approached via quantitative analysis. The more the analyst is involved in the process of structuring the problem,
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Quantitative Analysis
the more likely the ensuing quantitative analysis will make an important contribution to the decision-making process. To successfully apply quantitative analysis to decision making, the management scientist must work closely with the manager or user of the results. When both the management scientist and the manager agree that the problem has been adequately structured, work can begin on developing a model to represent the problem mathematically. Solution procedures can then be employed to find the best solution for the model. This best solution for the model then becomes a recommendation to the decision maker. The process of developing and solving models is the essence of the quantitative analysis process.
Model Development Models are representations of real objects or situations and can be presented in various forms. For example, a scale model of an airplane is a representation of a real airplane. Similarly, a child’s toy truck is a model of a real truck. The model airplane and toy truck are examples of models that are physical replicas of real objects. In modeling terminology, physical replicas are referred to as iconic models. A second classification includes models that are physical in form but do not have the same physical appearance as the object being modeled. Such models are referred to as analog models. The speedometer of an automobile is an analog model; the position of the needle on the dial represents the speed of the automobile. A thermometer is another analog model representing temperature. A third classification of models—the type we will primarily be studying—includes representations of a problem by a system of symbols and mathematical relationships or expressions. Such models are referred to as mathematical models and are a critical part of any quantitative approach to decision making. For example, the total profit from the sale of a product can be determined by multiplying the profit per unit by the quantity sold. If we let x represent the number of units sold and P the total profit, then, with a profit of $10 per unit, the following mathematical model defines the total profit earned by selling x units:
P = 10x
(1.1)
The purpose, or value, of any model is that it enables us to make inferences about the real situation by studying and analyzing the model. For example, an airplane designer might test an iconic model of a new airplane in a wind tunnel to learn about the potential flying characteristics of the full-size airplane. Similarly, a mathematical model may be used to make inferences about how much profit will be earned if a specified quantity of a particular product is sold. According to the mathematical model of equation (1.1), we would expect selling three units of the product (x ⫽ 3) would provide a profit of P ⫽ 10(3) ⫽ $30. In general, experimenting with models requires less time and is less expensive than experimenting with the real object or situation. A model airplane is certainly quicker and less expensive to build and study than the full-size airplane. Similarly, the mathematical model in equation (1.1) allows a quick identification of profit expectations without actually requiring the manager to produce and sell x units. Models also have the advantage of reducing the risk associated with experimenting with the real situation. In particular, bad designs or bad decisions that cause the model airplane to crash or a mathematical model to project a $10,000 loss can be avoided in the real situation. The value of model-based conclusions and decisions is dependent on how well the model represents the real situation. The more closely the model airplane represents the real
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Chapter 1
Herbert A. Simon, a Nobel Prize winner in economics and an expert in decision making, said that a mathematical model does not have to be exact; it just has to be close enough to provide better results than can be obtained by common sense.
airplane, the more accurate the conclusions and predictions will be. Similarly, the more closely the mathematical model represents the company’s true profit-volume relationship, the more accurate the profit projections will be. Because this text deals with quantitative analysis based on mathematical models, let us look more closely at the mathematical modeling process. When initially considering a managerial problem, we usually find that the problem definition phase leads to a specific objective, such as maximization of profit or minimization of cost, and possibly a set of restrictions or constraints, such as production capacities. The success of the mathematical model and quantitative approach will depend heavily on how accurately the objective and constraints can be expressed in terms of mathematical equations or relationships. A mathematical expression that describes the problem’s objective is referred to as the objective function. For example, the profit equation P ⫽ 10x would be an objective function for a firm attempting to maximize profit. A production capacity constraint would be necessary if, for instance, 5 hours are required to produce each unit and only 40 hours of production time are available per week. Let x indicate the number of units produced each week. The production time constraint is given by
Introduction
5x … 40
(1.2)
The value of 5x is the total time required to produce x units; the symbol ⱕ indicates that the production time required must be less than or equal to the 40 hours available. The decision problem or question is the following: How many units of the product should be scheduled each week to maximize profit? A complete mathematical model for this simple production problem is Maximize P = 10x objective function subject to (s.t.) 5x … 40 f constraints x Ú 0 The x ⱖ 0 constraint requires the production quantity x to be greater than or equal to zero, which simply recognizes the fact that it is not possible to manufacture a negative number of units. The optimal solution to this model can be easily calculated and is given by x ⫽ 8, with an associated profit of $80. This model is an example of a linear programming model. In subsequent chapters we will discuss more complicated mathematical models and learn how to solve them in situations where the answers are not nearly so obvious. In the preceding mathematical model, the profit per unit ($10), the production time per unit (5 hours), and the production capacity (40 hours) are environmental factors that are not under the control of the manager or decision maker. Such environmental factors, which can affect both the objective function and the constraints, are referred to as uncontrollable inputs to the model. Inputs that are controlled or determined by the decision maker are referred to as controllable inputs to the model. In the example given, the production quantity x is the controllable input to the model. Controllable inputs are the decision alternatives specified by the manager and thus are also referred to as the decision variables of the model. Once all controllable and uncontrollable inputs are specified, the objective function and constraints can be evaluated and the output of the model determined. In this sense, the output of the model is simply the projection of what would happen if those particular
1.3
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Quantitative Analysis
FIGURE 1.4 FLOWCHART OF THE PROCESS OF TRANSFORMING MODEL INPUTS INTO OUTPUT
Uncontrollable Inputs (Environmental Factors)
Controllable Inputs (Decision Variables)
Mathematical Model
Output (Projected Results)
environmental factors and decisions occurred in the real situation. A flowchart of how controllable and uncontrollable inputs are transformed by the mathematical model into output is shown in Figure 1.4. A similar flowchart showing the specific details of the production model is shown in Figure 1.5. As stated earlier, the uncontrollable inputs are those the decision maker cannot influence. The specific controllable and uncontrollable inputs of a model depend on the particular problem or decision-making situation. In the production problem, the production time available (40) is an uncontrollable input. However, if it were possible to hire more employees or use overtime, the number of hours of production time would become a controllable input and therefore a decision variable in the model. Uncontrollable inputs can either be known exactly or be uncertain and subject to variation. If all uncontrollable inputs to a model are known and cannot vary, the model is referred to as a deterministic model. Corporate income tax rates are not under the influence of the manager and thus constitute an uncontrollable input in many decision models. Because these rates are known and fixed (at least in the short run), a mathematical model with corporate income tax rates as the only uncontrollable input would be a deterministic FIGURE 1.5 FLOWCHART FOR THE PRODUCTION MODEL Uncontrollable Inputs 10 Profit per Unit ($) 5 Production Time per Unit (Hours) 40 Production Capacity (Hours)
Value for the Production Quantity (x = 8)
Max 10 (8) s.t. 5 (8) ≤ 40 8 ≥ 0
Controllable Input
Mathematical Model
Profit = 80 Time Used = 40 Output
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Chapter 1
Introduction
model. The distinguishing feature of a deterministic model is that the uncontrollable input values are known in advance. If any of the uncontrollable inputs are uncertain and subject to variation, the model is referred to as a stochastic or probabilistic model. An uncontrollable input to many production planning models is demand for the product. A mathematical model that treats future demand—which may be any of a range of values—with uncertainty would be called a stochastic model. In the production model, the number of hours of production time required per unit, the total hours available, and the unit profit were all uncontrollable inputs. Because the uncontrollable inputs were all known to take on fixed values, the model was deterministic. If, however, the number of hours of production time per unit could vary from 3 to 6 hours depending on the quality of the raw material, the model would be stochastic. The distinguishing feature of a stochastic model is that the value of the output cannot be determined even if the value of the controllable input is known because the specific values of the uncontrollable inputs are unknown. In this respect, stochastic models are often more difficult to analyze.
Data Preparation Another step in the quantitative analysis of a problem is the preparation of the data required by the model. Data in this sense refer to the values of the uncontrollable inputs to the model. All uncontrollable inputs or data must be specified before we can analyze the model and recommend a decision or solution for the problem. In the production model, the values of the uncontrollable inputs or data were $10 per unit for profit, 5 hours per unit for production time, and 40 hours for production capacity. In the development of the model, these data values were known and incorporated into the model as it was being developed. If the model is relatively small and the uncontrollable input values or data required are few, the quantitative analyst will probably combine model development and data preparation into one step. In these situations the data values are inserted as the equations of the mathematical model are developed. However, in many mathematical modeling situations, the data or uncontrollable input values are not readily available. In these situations the management scientist may know that the model will need profit per unit, production time, and production capacity data, but the values will not be known until the accounting, production, and engineering departments can be consulted. Rather than attempting to collect the required data as the model is being developed, the analyst will usually adopt a general notation for the model development step, and then a separate data preparation step will be performed to obtain the uncontrollable input values required by the model. Using the general notation c = profit per unit a = production time in hours per unit b = production capacity in hours the model development step of the production problem would result in the following general model: Max s.t.
cx ax … b x Ú 0
1.3
Quantitative Analysis
11
A separate data preparation step to identify the values for c, a, and b would then be necessary to complete the model. Many inexperienced quantitative analysts assume that once the problem has been defined and a general model developed, the problem is essentially solved. These individuals tend to believe that data preparation is a trivial step in the process and can be easily handled by clerical staff. Actually, this assumption could not be further from the truth, especially with large-scale models that have numerous data input values. For example, a small linear programming model with 50 decision variables and 25 constraints could have more than 1300 data elements that must be identified in the data preparation step. The time required to prepare these data and the possibility of data collection errors will make the data preparation step a critical part of the quantitative analysis process. Often, a fairly large database is needed to support a mathematical model, and information systems specialists may become involved in the data preparation step.
Model Solution Once the model development and data preparation steps are completed, we can proceed to the model solution step. In this step, the analyst will attempt to identify the values of the decision variables that provide the “best” output for the model. The specific decision-variable value or values providing the “best” output will be referred to as the optimal solution for the model. For the production problem, the model solution step involves finding the value of the production quantity decision variable x that maximizes profit while not causing a violation of the production capacity constraint. One procedure that might be used in the model solution step involves a trial-and-error approach in which the model is used to test and evaluate various decision alternatives. In the production model, this procedure would mean testing and evaluating the model under various production quantities or values of x. Note, in Figure 1.5, that we could input trial values for x and check the corresponding output for projected profit and satisfaction of the production capacity constraint. If a particular decision alternative does not satisfy one or more of the model constraints, the decision alternative is rejected as being infeasible, regardless of the objective function value. If all constraints are satisfied, the decision alternative is feasible and a candidate for the “best” solution or recommended decision. Through this trial-and-error process of evaluating selected decision alternatives, a decision maker can identify a good—and possibly the best—feasible solution to the problem. This solution would then be the recommended decision for the problem. Table 1.2 shows the results of a trial-and-error approach to solving the production model of Figure 1.5. The recommended decision is a production quantity of 8 because the feasible solution with the highest projected profit occurs at x ⫽ 8. Although the trial-and-error solution process is often acceptable and can provide valuable information for the manager, it has the drawbacks of not necessarily providing the best solution and of being inefficient in terms of requiring numerous calculations if many decision alternatives are tried. Thus, quantitative analysts have developed special solution procedures for many models that are much more efficient than the trial-and-error approach. Throughout this text, you will be introduced to solution procedures that are applicable to the specific mathematical models that will be formulated. Some relatively small models or problems can be solved by hand computations, but most practical applications require the use of a computer. Model development and model solution steps are not completely separable. An analyst will want both to develop an accurate model or representation of the actual problem situation and to be able to find a solution to the model. If we approach the model development
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Introduction
TABLE 1.2 TRIAL-AND-ERROR SOLUTION FOR THE PRODUCTION MODEL OF FIGURE 1.5 Decision Alternative (Production Quantity) x
Projected Profit
Total Hours of Production
Feasible Solution? (Hours Used ◊ 40)
0 2 4 6 8 10 12
0 20 40 60 80 100 120
0 10 20 30 40 50 60
Yes Yes Yes Yes Yes No No
Try Problem 8 to test your understanding of the concept of a mathematical model and what is referred to as the optimal solution to the model.
step by attempting to find the most accurate and realistic mathematical model, we may find the model so large and complex that it is impossible to obtain a solution. In this case, a simpler and perhaps more easily understood model with a readily available solution procedure is preferred even if the recommended solution is only a rough approximation of the best decision. As you learn more about quantitative solution procedures, you will have a better idea of the types of mathematical models that can be developed and solved. After a model solution is obtained, both the management scientist and the manager will be interested in determining how good the solution really is. Even though the analyst has undoubtedly taken many precautions to develop a realistic model, often the goodness or accuracy of the model cannot be assessed until model solutions are generated. Model testing and validation are frequently conducted with relatively small “test” problems that have known or at least expected solutions. If the model generates the expected solutions, and if other output information appears correct, the go-ahead may be given to use the model on the full-scale problem. However, if the model test and validation identify potential problems or inaccuracies inherent in the model, corrective action, such as model modification and/or collection of more accurate input data, may be taken. Whatever the corrective action, the model solution will not be used in practice until the model has satisfactorily passed testing and validation.
Report Generation An important part of the quantitative analysis process is the preparation of managerial reports based on the model’s solution. In Figure 1.3, we see that the solution based on the quantitative analysis of a problem is one of the inputs the manager considers before making a final decision. Thus, the results of the model must appear in a managerial report that can be easily understood by the decision maker. The report includes the recommended decision and other pertinent information about the results that may be helpful to the decision maker.
A Note Regarding Implementation As discussed in Section 1.2, the manager is responsible for integrating the quantitative solution with qualitative considerations in order to make the best possible decision. After completing the decision-making process, the manager must oversee the implementation
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Quantitative Analysis
and follow-up evaluation of the decision. The manager should continue to monitor the contribution of the model during the implementation and follow-up. At times this process may lead to requests for model expansion or refinement that will cause the management scientist to return to an earlier step of the quantitative analysis process. Successful implementation of results is of critical importance to the management scientist as well as the manager. If the results of the quantitative analysis process are not correctly implemented, the entire effort may be of no value. It doesn’t take too many unsuccessful implementations before the management scientist is out of work. Because implementation often requires people to do things differently, it often meets with resistance. People want to know, “What’s wrong with the way we’ve been doing it?” and so on. One of the most effective ways to ensure successful implementation is to include users throughout the modeling process. A user who feels a part of identifying the problem and developing the solution is much more likely to enthusiastically implement the results. The success rate for implementing the results of a management science project is much greater for those projects characterized by extensive user involvement. The Management Science in Action, Quantitative Analysis at Merrill Lynch, discusses some of the reasons behind the success Merrill Lynch realized from using quantitative analysis.
MANAGEMENT SCIENCE IN ACTION QUANTITATIVE ANALYSIS AT MERRILL LYNCH* Merrill Lynch, a brokerage and financial services firm with more than 56,000 employees in 45 countries, serves its client base through two business units. The Merrill Lynch Corporate and Institutional Client Group serves more than 7000 corporations, institutions, and governments. The Merrill Lynch Private Client Group (MLPC) serves approximately 4 million households, as well as 225,000 small to mid-sized businesses and regional financial institutions, through more than 14,000 financial consultants in 600-plus branch offices. The management science group, established in 1986, has been part of MLPC since 1991. The mission of this group is to provide high-end quantitative analysis to support strategic management decisions and to enhance the financial consultant–client relationship. The management science group has successfully implemented models and developed systems for asset allocation, financial planning, marketing information technology, database marketing, and portfolio performance measurement.Although technical expertise and objectivity are clearly important factors in any analytical group, the management science group attributes much of its success to communications skills, teamwork, and consulting skills. Each project begins with face-to-face meetings with the client. A proposal is then prepared to outline
the background of the problem, the objectives of the project, the approach, the required resources, the time schedule, and the implementation issues. At this stage, analysts focus on developing solutions that provide significant value and are easily implemented. As the work progresses, frequent meetings keep the clients up to date. Because people with different skills, perspectives, and motivations must work together for a common goal, teamwork is essential. The group’s members take classes in team approaches, facilitation, and conflict resolution. They possess a broad range of multifunctional and multidisciplinary capabilities and are motivated to provide solutions that focus on the goals of the firm. This approach to problem solving and the implementation of quantitative analysis has been a hallmark of the management science group. The impact and success of the group translates into hard dollars and repeat business. The group received the annual Edelman award given by the Institute for Operations Research and the Management Sciences for effective use of management science for organizational success. *Based on Russ Labe, Raj Nigam, and Steve Spence, “Management Science at Merrill Lynch Private Client Group,” Interfaces 29, no. 2 (March/April 1999): 1–14.
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Introduction
NOTES AND COMMENTS 1. Developments in computer technology have increased the availability of management science techniques to decision makers. Many software packages are now available for personal computers. Microsoft Excel, and LINGO are widely used in management science courses and in industry.
1.4
2. Various chapter appendices provide step-bystep instructions for using Excel and LINGO to solve problems in the text. Microsoft Excel has become the most used analytical modeling software in business and industry. We recommend that you read Appendix A, Building Spreadsheet Models, located in the back of this text.
MODELS OF COST, REVENUE, AND PROFIT Some of the most basic quantitative models arising in business and economic applications are those involving the relationship between a volume variable—such as production volume or sales volume—and cost, revenue, and profit. Through the use of these models, a manager can determine the projected cost, revenue, and/or profit associated with an established production quantity or a forecasted sales volume. Financial planning, production planning, sales quotas, and other areas of decision making can benefit from such cost, revenue, and profit models.
Cost and Volume Models The cost of manufacturing or producing a product is a function of the volume produced. This cost can usually be defined as a sum of two costs: fixed cost and variable cost. Fixed cost is the portion of the total cost that does not depend on the production volume; this cost remains the same no matter how much is produced. Variable cost, on the other hand, is the portion of the total cost that is dependent on and varies with the production volume. To illustrate how cost and volume models can be developed, we will consider a manufacturing problem faced by Nowlin Plastics. Nowlin Plastics produces a variety of compact disc (CD) storage cases. Nowlin’s bestselling product is the CD-50, a slim, plastic CD holder with a specially designed lining that protects the optical surface of the disc. Several products are produced on the same manufacturing line, and a setup cost is incurred each time a changeover is made for a new product. Suppose that the setup cost for the CD-50 is $3000. This setup cost is a fixed cost that is incurred regardless of the number of units eventually produced. In addition, suppose that variable labor and material costs are $2 for each unit produced. The cost-volume model for producing x units of the CD-50 can be written as
C(x) = 3000 + 2x
where x = production volume in units C(x) = total cost of producing x units
(1.3)
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15
Models of Cost, Revenue, and Profit
Once a production volume is established, the model in equation (1.3) can be used to compute the total production cost. For example, the decision to produce x ⫽ 1200 units would result in a total cost of C(1200) ⫽ 3000 ⫹ 2(1200) ⫽ $5400. Marginal cost is defined as the rate of change of the total cost with respect to production volume. That is, it is the cost increase associated with a one-unit increase in the production volume. In the cost model of equation (1.3), we see that the total cost C(x) will increase by $2 for each unit increase in the production volume. Thus, the marginal cost is $2. With more complex total cost models, marginal cost may depend on the production volume. In such cases, we could have marginal cost increasing or decreasing with the production volume x.
Revenue and Volume Models Management of Nowlin Plastics will also want information on the projected revenue associated with selling a specified number of units. Thus, a model of the relationship between revenue and volume is also needed. Suppose that each CD-50 storage unit sells for $5. The model for total revenue can be written as
R(x) = 5x
(1.4)
where x = sales volume in units R(x) = total revenue associated with selling x units Marginal revenue is defined as the rate of change of total revenue with respect to sales volume. That is, it is the increase in total revenue resulting from a one-unit increase in sales volume. In the model of equation (1.4), we see that the marginal revenue is $5. In this case, marginal revenue is constant and does not vary with the sales volume. With more complex models, we may find that marginal revenue increases or decreases as the sales volume x increases.
Profit and Volume Models One of the most important criteria for management decision making is profit. Managers need to be able to know the profit implications of their decisions. If we assume that we will only produce what can be sold, the production volume and sales volume will be equal. We can combine equations (1.3) and (1.4) to develop a profit-volume model that will determine the total profit associated with a specified production-sales volume. Total profit, denoted P(x), is total revenue minus total cost; therefore, the following model provides the total profit associated with producing and selling x units: P(x) = R(x) - C(x) = 5x - (3000 + 2x) = - 3000 + 3x
(1.5)
Thus, the profit-volume model can be derived from the revenue-volume and cost-volume models.
16
Chapter 1
Introduction
Breakeven Analysis Using equation (1.5), we can now determine the total profit associated with any production volume x. For example, suppose that a demand forecast indicates that 500 units of the product can be sold. The decision to produce and sell the 500 units results in a projected profit of P(500) = - 3000 + 3(500) = -1500 In other words, a loss of $1500 is predicted. If sales are expected to be 500 units, the manager may decide against producing the product. However, a demand forecast of 1800 units would show a projected profit of P(1800) = - 3000 + 3(1800) = 2400 This profit may be enough to justify proceeding with the production and sale of the product. We see that a volume of 500 units will yield a loss, whereas a volume of 1800 provides a profit. The volume that results in total revenue equaling total cost (providing $0 profit) is called the breakeven point. If the breakeven point is known, a manager can quickly infer that a volume above the breakeven point will result in a profit, whereas a volume below the breakeven point will result in a loss. Thus, the breakeven point for a product provides valuable information for a manager who must make a yes/no decision concerning production of the product. Let us now return to the Nowlin Plastics example and show how the total profit model in equation (1.5) can be used to compute the breakeven point. The breakeven point can be found by setting the total profit expression equal to zero and solving for the production volume. Using equation (1.5), we have P(x) = - 3000 + 3x = 0 3x = 3000 x = 1000 Try Problem 12 to test your ability to determine the breakeven point for a quantitative model.
1.5
With this information, we know that production and sales of the product must be greater than 1000 units before a profit can be expected. The graphs of the total cost model, the total revenue model, and the location of the breakeven point are shown in Figure 1.6. In Appendix 1.1 we also show how Excel can be used to perform a breakeven analysis for the Nowlin Plastics production example.
MANAGEMENT SCIENCE TECHNIQUES In this section we present a brief overview of the management science techniques covered in this text. Over the years, practitioners have found numerous applications for the following techniques: Linear Programming Linear programming is a problem-solving approach developed for situations involving maximizing or minimizing a linear function subject to linear constraints that limit the degree to which the objective can be pursued. The production model developed in Section 1.3 (see Figure 1.5) is an example of a simple linear programming model. Integer Linear Programming Integer linear programming is an approach used for problems that can be set up as linear programs, with the additional requirement that some or all of the decision variables be integer values.
1.5
17
Management Science Techniques
Revenue and Cost ($)
FIGURE 1.6 GRAPH OF THE BREAKEVEN ANALYSIS FOR NOWLIN PLASTICS
Total Revenue R (x) = 5 x
10,000
Profit
8000 6000
Fixed Cost Total Cost C(x) = 3000 + 2 x
4000 Loss 2000
Breakeven Point = 1000 Units 0
400
800
1200 1600 Production Volume
2000
x
Distribution and Network Models A network is a graphical description of a problem consisting of circles called nodes that are interconnected by lines called arcs. Specialized solution procedures exist for these types of problems, enabling us to quickly solve problems in such areas as transportation system design, information system design, and project scheduling. Nonlinear Programming Many business processes behave in a nonlinear manner. For example, the price of a bond is a nonlinear function of interest rates; the quantity demanded for a product is usually a nonlinear function of the price. Nonlinear programming is a technique that allows for maximizing or minimizing a nonlinear function subject to nonlinear constraints. Project Scheduling: PERT/CPM In many situations, managers are responsible for planning, scheduling, and controlling projects that consist of numerous separate jobs or tasks performed by a variety of departments, individuals, and so forth. The PERT (Program Evaluation and Review Technique) and CPM (Critical Path Method) techniques help managers carry out their project scheduling responsibilities. Inventory Models Inventory models are used by managers faced with the dual problems of maintaining sufficient inventories to meet demand for goods and, at the same time, incurring the lowest possible inventory holding costs. Waiting-Line or Queueing Models Waiting-line or queueing models have been developed to help managers understand and make better decisions concerning the operation of systems involving waiting lines. Simulation Simulation is a technique used to model the operation of a system. This technique employs a computer program to model the operation and perform simulation computations. Decision Analysis Decision analysis can be used to determine optimal strategies in situations involving several decision alternatives and an uncertain or risk-filled pattern of events. Goal Programming Goal programming is a technique for solving multicriteria decision problems, usually within the framework of linear programming. Analytic Hierarchy Process This multicriteria decision-making technique permits the inclusion of subjective factors in arriving at a recommended decision.
18
Chapter 1
Introduction
Forecasting Forecasting methods are techniques that can be used to predict future aspects of a business operation. Markov Process Models Markov process models are useful in studying the evolution of certain systems over repeated trials. For example, Markov processes have been used to describe the probability that a machine, functioning in one period, will function or break down in another period.
Methods Used Most Frequently Our experience as both practitioners and educators has been that the most frequently used management science techniques are linear programming, integer programming, network models (including transportation and transshipment models), and simulation. Depending upon the industry, the other methods in the preceding list are used more or less frequently. Helping to bridge the gap between the manager and the management scientist is a major focus of the text. We believe that the barriers to the use of management science can best be removed by increasing the manager’s understanding of how management science can be applied. The text will help you develop an understanding of which management science techniques are most useful, how they are used, and, most importantly, how they can assist managers in making better decisions. The Management Science in Action, Impact of Operations Research on Everyday Living, describes some of the many ways quantitative analysis affects our everyday lives. MANAGEMENT SCIENCE IN ACTION IMPACT OF OPERATIONS RESEARCH ON EVERYDAY LIVING* Mark Eisner, associate director of the School of Operations Research and Industrial Engineering at Cornell University, once said that operations research “is probably the most important field nobody’s ever heard of.” The impact of operations research on everyday living over the past 20 years is substantial. Suppose you schedule a vacation to Florida and use Orbitz to book your flights. An algorithm developed by operations researchers will search among millions of options to find the cheapest fare. Another algorithm will schedule the flight crews and aircraft used by the airline. If you rent a car in Florida, the price you pay for the car is determined by a mathematical model that seeks to maximize revenue for the car rental firm. If you do some shopping on your trip and decide to ship your purchases home using UPS, another algorithm tells UPS which truck to put the packages on, the route the truck should follow, and where the packages
should be placed on the truck to minimize loading and unloading time. If you enjoy watching college basketball, operations research plays a role in which games you see. Michael Trick, a professor at the Tepper School of Business at Carnegie-Mellon, designed a system for scheduling each year’s Atlantic Coast Conference men’s and women’s basketball games. Even though it might initially appear that scheduling 16 games among the nine men’s teams would be easy, it requires sorting through hundreds of millions of possible combinations of possible schedules. Each of those possibilities entails some desirable and some undesirable characteristics. For example, you do not want to schedule too many consecutive home games, and you want to ensure that each team plays the same number of weekend games. *Based on Virginia Postrel, “Operations Everything,” The Boston Globe, June 27, 2004.
NOTES AND COMMENTS The Institute for Operations Research and the Management Sciences (INFORMS) and the Decision Sciences Institute (DSI) are two professional soci-
eties that publish journals and newsletters dealing with current research and applications of operations research and management science techniques.
19
Glossary
SUMMARY This text is about how management science may be used to help managers make better decisions. The focus of this text is on the decision-making process and on the role of management science in that process. We discussed the problem orientation of this process and in an overview showed how mathematical models can be used in this type of analysis. The difference between the model and the situation or managerial problem it represents is an important point. Mathematical models are abstractions of real-world situations and, as such, cannot capture all the aspects of the real situation. However, if a model can capture the major relevant aspects of the problem and can then provide a solution recommendation, it can be a valuable aid to decision making. One of the characteristics of management science that will become increasingly apparent as we proceed through the text is the search for a best solution to the problem. In carrying out the quantitative analysis, we shall be attempting to develop procedures for finding the “best” or optimal solution.
GLOSSARY Problem solving The process of identifying a difference between the actual and the desired state of affairs and then taking action to resolve the difference. Decision making The process of defining the problem, identifying the alternatives, determining the criteria, evaluating the alternatives, and choosing an alternative. Single-criterion decision problem A problem in which the objective is to find the “best” solution with respect to just one criterion. Multicriteria decision problem A problem that involves more than one criterion; the objective is to find the “best” solution, taking into account all the criteria. Decision The alternative selected. Model A representation of a real object or situation. Iconic model
A physical replica, or representation, of a real object.
Analog model Although physical in form, an analog model does not have a physical appearance similar to the real object or situation it represents. Mathematical model Mathematical symbols and expressions used to represent a real situation. Constraints Restrictions or limitations imposed on a problem. Objective function A mathematical expression that describes the problem’s objective. Uncontrollable inputs The environmental factors or inputs that cannot be controlled by the decision maker. Controllable inputs The inputs that are controlled or determined by the decision maker. Decision variable
Another term for controllable input.
Deterministic model A model in which all uncontrollable inputs are known and cannot vary. Stochastic (probabilistic) model A model in which at least one uncontrollable input is uncertain and subject to variation; stochastic models are also referred to as probabilistic models.
20
Chapter 1
Introduction
Optimal solution The specific decision-variable value or values that provide the “best” output for the model. Infeasible solution A decision alternative or solution that does not satisfy one or more constraints. Feasible solution A decision alternative or solution that satisfies all constraints. Fixed cost The portion of the total cost that does not depend on the volume; this cost remains the same no matter how much is produced. Variable cost The portion of the total cost that is dependent on and varies with the volume. Marginal cost
The rate of change of the total cost with respect to volume.
Marginal revenue Breakeven point
The rate of change of total revenue with respect to volume. The volume at which total revenue equals total cost.
PROBLEMS 1. Define the terms management science and operations research. 2. List and discuss the steps of the decision-making process. 3. Discuss the different roles played by the qualitative and quantitative approaches to managerial decision making. Why is it important for a manager or decision maker to have a good understanding of both of these approaches to decision making? 4. A firm just completed a new plant that will produce more than 500 different products, using more than 50 different production lines and machines. The production scheduling decisions are critical in that sales will be lost if customer demands are not met on time. If no individual in the firm has experience with this production operation and if new production schedules must be generated each week, why should the firm consider a quantitative approach to the production scheduling problem? 5. What are the advantages of analyzing and experimenting with a model as opposed to a real object or situation? 6. Suppose that a manager has a choice between the following two mathematical models of a given situation: (a) a relatively simple model that is a reasonable approximation of the real situation, and (b) a thorough and complex model that is the most accurate mathematical representation of the real situation possible. Why might the model described in part (a) be preferred by the manager? 7. Suppose you are going on a weekend trip to a city that is d miles away. Develop a model that determines your round-trip gasoline costs. What assumptions or approximations are necessary to treat this model as a deterministic model? Are these assumptions or approximations acceptable to you? 8. Recall the production model from Section 1.3: Max s.t.
10x 5x … 40 x Ú 0
Suppose the firm in this example considers a second product that has a unit profit of $5 and requires 2 hours of production time for each unit produced. Use y as the number of units of product 2 produced.
21
Problems
a. b. c. d. e.
Show the mathematical model when both products are considered simultaneously. Identify the controllable and uncontrollable inputs for this model. Draw the flowchart of the input-output process for this model (see Figure 1.5). What are the optimal solution values of x and y? Is the model developed in part (a) a deterministic or a stochastic model? Explain.
9. Suppose we modify the production model in Section 1.3 to obtain the following mathematical model: Max s.t.
10x ax … 40 x Ú 0
where a is the number of hours of production time required for each unit produced. With a ⫽ 5, the optimal solution is x ⫽ 8. If we have a stochastic model with a ⫽ 3, a ⫽ 4, a ⫽ 5, or a ⫽ 6 as the possible values for the number of hours required per unit, what is the optimal value for x? What problems does this stochastic model cause? 10. A retail store in Des Moines, Iowa, receives shipments of a particular product from Kansas City and Minneapolis. Let x = number of units of the product received from Kansas City y = number of units of the product received from Minneapolis a. Write an expression for the total number of units of the product received by the retail store in Des Moines. b. Shipments from Kansas City cost $0.20 per unit, and shipments from Minneapolis cost $0.25 per unit. Develop an objective function representing the total cost of shipments to Des Moines. c. Assuming the monthly demand at the retail store is 5000 units, develop a constraint that requires 5000 units to be shipped to Des Moines. d. No more than 4000 units can be shipped from Kansas City, and no more than 3000 units can be shipped from Minneapolis in a month. Develop constraints to model this situation. e. Of course, negative amounts cannot be shipped. Combine the objective function and constraints developed to state a mathematical model for satisfying the demand at the Des Moines retail store at minimum cost. 11. For most products, higher prices result in a decreased demand, whereas lower prices result in an increased demand. Let d = annual demand for a product in units p = price per unit Assume that a firm accepts the following price-demand relationship as being realistic: d = 800 - 10p where p must be between $20 and $70. a. How many units can the firm sell at the $20 per-unit price? At the $70 per-unit price? b. Show the mathematical model for the total revenue (TR), which is the annual demand multiplied by the unit price.
22
Chapter 1
Introduction
c. Based on other considerations, the firm’s management will only consider price alternatives of $30, $40, and $50. Use your model from part (b) to determine the price alternative that will maximize the total revenue. d. What are the expected annual demand and the total revenue corresponding to your recommended price? 12. The O’Neill Shoe Manufacturing Company will produce a special-style shoe if the order size is large enough to provide a reasonable profit. For each special-style order, the company incurs a fixed cost of $1000 for the production setup. The variable cost is $30 per pair, and each pair sells for $40. a. Let x indicate the number of pairs of shoes produced. Develop a mathematical model for the total cost of producing x pairs of shoes. b. Let P indicate the total profit. Develop a mathematical model for the total profit realized from an order for x pairs of shoes. c. How large must the shoe order be before O’Neill will break even? 13. Micromedia offers computer training seminars on a variety of topics. In the seminars each student works at a personal computer, practicing the particular activity that the instructor is presenting. Micromedia is currently planning a two-day seminar on the use of Microsoft Excel in statistical analysis. The projected fee for the seminar is $300 per student. The cost for the conference room, instructor compensation, lab assistants, and promotion is $4800. Micromedia rents computers for its seminars at a cost of $30 per computer per day. a. Develop a model for the total cost to put on the seminar. Let x represent the number of students who enroll in the seminar. b. Develop a model for the total profit if x students enroll in the seminar. c. Micromedia has forecasted an enrollment of 30 students for the seminar. How much profit will be earned if their forecast is accurate? d. Compute the breakeven point. 14. Eastman Publishing Company is considering publishing a paperback textbook on spreadsheet applications for business. The fixed cost of manuscript preparation, textbook design, and production setup is estimated to be $80,000. Variable production and material costs are estimated to be $3 per book. Demand over the life of the book is estimated to be 4000 copies. The publisher plans to sell the text to college and university bookstores for $20 each. a. What is the breakeven point? b. What profit or loss can be anticipated with a demand of 4000 copies? c. With a demand of 4000 copies, what is the minimum price per copy that the publisher must charge to break even? d. If the publisher believes that the price per copy could be increased to $25.95 and not affect the anticipated demand of 4000 copies, what action would you recommend? What profit or loss can be anticipated? 15. Preliminary plans are under way for the construction of a new stadium for a major league baseball team. City officials have questioned the number and profitability of the luxury corporate boxes planned for the upper deck of the stadium. Corporations and selected individuals may buy the boxes for $100,000 each. The fixed construction cost for the upperdeck area is estimated to be $1,500,000, with a variable cost of $50,000 for each box constructed. a. What is the breakeven point for the number of luxury boxes in the new stadium? b. Preliminary drawings for the stadium show that space is available for the construction of up to 50 luxury boxes. Promoters indicate that buyers are available and that all 50 could be sold if constructed. What is your recommendation concerning the construction of luxury boxes? What profit is anticipated?
Case Problem
23
Scheduling a Golf League
16. Financial Analysts, Inc., is an investment firm that manages stock portfolios for a number of clients. A new client is requesting that the firm handle an $80,000 portfolio. As an initial investment strategy, the client would like to restrict the portfolio to a mix of the following two stocks:
Stock Oil Alaska Southwest Petroleum
Price/ Share $50 $30
Maximum Estimated Annual Return/Share $6 $4
Possible Investment $50,000 $45,000
Let x = number of shares of Oil Alaska y = number of shares of Southwest Petroleum a. Develop the objective function, assuming that the client desires to maximize the total annual return. b. Show the mathematical expression for each of the following three constraints: (1) Total investment funds available are $80,000. (2) Maximum Oil Alaska investment is $50,000. (3) Maximum Southwest Petroleum investment is $45,000. Note: Adding the x ⱖ 0 and y ⱖ 0 constraints provides a linear programming model for the investment problem. A solution procedure for this model will be discussed in Chapter 2. 17. Models of inventory systems frequently consider the relationships among a beginning inventory, a production quantity, a demand or sales, and an ending inventory. For a given production period j, let sj-1 xj dj sj
= = = =
ending inventory from the previous period (beginning inventory for period j ) production quantity in period j demand in period j ending inventory for period j
a. Write the mathematical relationship or model that describes how these four variables are related. b. What constraint should be added if production capacity for period j is given by Cj? c. What constraint should be added if inventory requirements for period j mandate an ending inventory of at least Ij?
Case Problem
SCHEDULING A GOLF LEAGUE
Chris Lane, the head professional at Royal Oak Country Club, must develop a schedule of matches for the couples’ golf league that begins its season at 4:00 P.M. tomorrow. Eighteen couples signed up for the league, and each couple must play every other couple over the course of the 17-week season. Chris thought it would be fairly easy to develop a
24
Chapter 1
Introduction
schedule, but after working on it for a couple of hours, he has been unable to come up with a schedule. Because Chris must have a schedule ready by tomorrow afternoon, he asked you to help him. A possible complication is that one of the couples told Chris that they may have to cancel for the season. They told Chris they will let him know by 1:00 P.M. tomorrow whether they will be able to play this season.
Managerial Report Prepare a report for Chris Lane. Your report should include, at a minimum, the following items: 1. A schedule that will enable each of the 18 couples to play every other couple over the 17-week season. 2. A contingency schedule that can be used if the couple that contacted Chris decides to cancel for the season.
Appendix 1.1
USING EXCEL FOR BREAKEVEN ANALYSIS
In Section 1.4 we introduced the Nowlin Plastics production example to illustrate how quantitative models can be used to help a manager determine the projected cost, revenue, and/or profit associated with an established production quantity or a forecasted sales volume. In this appendix we introduce spreadsheet applications by showing how to use Microsoft Excel to perform a quantitative analysis of the Nowlin Plastics example. Refer to the worksheet shown in Figure 1.7. We begin by entering the problem data into the top portion of the worksheet. The value of 3000 in cell B3 is the fixed cost, the value FIGURE 1.7 FORMULA WORKSHEET FOR THE NOWLIN PLASTICS PRODUCTION EXAMPLE A 1 Nowlin Plastics 2 3 Fixed Cost 4 5 Variable Cost Per Unit 6 7 Selling Price Per Unit 8 9 10 Models 11 12 Production Volume 13 14 Total Cost 15 16 Total Revenue 17 18 Total Profit (Loss)
B
3000 2 5
800 =B3+B5*B12 =B7*B12 =B16-B14
Appendix 1.1
25
Using Excel for Breakeven Analysis
of 2 in cell B5 is the variable labor and material costs per unit, and the value of 5 in cell B7 is the selling price per unit. As discussed in Appendix A, whenever we perform a quantitative analysis using Excel, we will enter the problem data in the top portion of the worksheet and reserve the bottom portion for model development. The label “Models” in cell A10 helps to provide a visual reminder of this convention. Cell B12 in the models portion of the worksheet contains the proposed production volume in units. Because the values for total cost, total revenue, and total profit depend upon the value of this decision variable, we have placed a border around cell B12 and screened the cell for emphasis. Based upon the value in cell B12, the cell formulas in cells B14, B16, and B18 are used to compute values for total cost, total revenue, and total profit (loss), respectively. First, recall that the value of total cost is the sum of the fixed cost (cell B3) and the total variable cost. The total variable cost—the product of the variable cost per unit (cell B5) and the production volume (cell B12)—is given by B5*B12. Thus, to compute the value of total cost we entered the formula =B3+B5*B12 in cell B14. Next, total revenue is the product of the selling price per unit (cell B7) and the number of units produced (cell B12), which is entered in cell B16 as the formula =B7*B12. Finally, the total profit (or loss) is the difference between the total revenue (cell B16) and the total cost (cell B14). Thus, in cell B18 we have entered the formula =B16-B14. The worksheet shown in Figure 1.8 shows the formulas used to make these computations; we refer to it as a formula worksheet. To examine the effect of selecting a particular value for the production volume, we entered a value of 800 in cell B12. The worksheet shown in Figure 1.8 shows the values obtained by the formulas; a production volume of 800 units results in a total cost of $4600, a total revenue of $4000, and a loss of $600. To examine the effect of other production volumes, we only need to enter a different value into cell B12. To examine the FIGURE 1.8 SOLUTION USING A PRODUCTION VOLUME OF 800 UNITS FOR THE NOWLIN PLASTICS PRODUCTION EXAMPLE
WEB
file
Nowlin
A 1 Nowlin Plastics 2 3 Fixed Cost 4 5 Variable Cost Per Unit 6 7 Selling Price Per Unit 8 9 10 Models 11 12 Production Volume 13 14 Total Cost 15 16 Total Revenue 17 18 Total Profit (Loss)
B
$3,000 $2 $5
800 $4,600 $4,000 ⫺$600
26
Chapter 1
Introduction
effect of different costs and selling prices, we simply enter the appropriate values in the data portion of the worksheet; the results will be displayed in the model section of the worksheet. In Section 1.4 we illustrated breakeven analysis. Let us now see how Excel’s Goal Seek tool can be used to compute the breakeven point for the Nowlin Plastics production example.
Determining the Breakeven Point Using Excel’s Goal Seek Tool The breakeven point is the production volume that results in total revenue equal to total cost and hence a profit of $0. One way to determine the breakeven point is to use a trial-anderror approach. For example, in Figure 1.8 we saw that a trial production volume of 800 units resulted in a loss of $600. Because this trial solution resulted in a loss, a production volume of 800 units cannot be the breakeven point. We could continue to experiment with other production volumes by simply entering different values into cell B12 and observing the resulting profit or loss in cell B18. A better approach is to use Excel’s Goal Seek tool to determine the breakeven point. Excel’s Goal Seek tool allows the user to determine the value for an input cell that will cause the value of a related output cell to equal some specified value (called the goal). In the case of breakeven analysis, the “goal” is to set Total Profit to zero by “seeking” an appropriate value for Production Volume. Goal Seek will allow us to find the value of production volume that will set Nowlin Plastics’ total profit to zero. The following steps describe how to use Goal Seek to find the breakeven point for Nowlin Plastics: Step 1. Select the Data tab at the top of the Ribbon Step 2. Select What-If Analysis in the Data Tools group Step 3. Select Goal Seek in What-if Analysis Step 4. When the Goal Seek dialog box appears: Enter B18 in the Set cell box Enter 0 in the To value box Enter B12 in the By changing cell box Click OK
FIGURE 1.9 GOAL SEEK DIALOG BOX FOR THE NOWLIN PLASTICS PRODUCTION EXAMPLE
Appendix 1.1
27
Using Excel for Breakeven Analysis
FIGURE 1.10 BREAKEVEN POINT FOUND USING EXCEL’S GOAL SEEK TOOL FOR THE NOWLIN PLASTICS PRODUCTION EXAMPLE A 1 Nowlin Plastics 2 3 Fixed Cost 4 5 Variable Cost Per Unit 6 7 Selling Price Per Unit 8 9 10 Models 11 12 Production Volume 13 14 Total Cost 15 16 Total Revenue 17 18 Total Profit (Loss)
B
$3,000 $2 $5
1000 $5,000 $5,000 $0
The completed Goal Seek dialog box is shown in Figure 1.9, and the worksheet obtained after selecting OK is shown in Figure 1.10. The Total Profit in cell B18 is zero, and the Production Volume in cell B12 has been set to the breakeven point of 1000.
CHAPTER
2
An Introduction to Linear Programming CONTENTS 2.1
A SIMPLE MAXIMIZATION PROBLEM Problem Formulation Mathematical Statement of the Par, Inc., Problem
2.2
GRAPHICAL SOLUTION PROCEDURE A Note on Graphing Lines Summary of the Graphical Solution Procedure for Maximization Problems Slack Variables
2.3
EXTREME POINTS AND THE OPTIMAL SOLUTION
2.4
COMPUTER SOLUTION OF THE PAR, INC., PROBLEM Interpretation of Computer Output
2.5
A SIMPLE MINIMIZATION PROBLEM Summary of the Graphical Solution Procedure for Minimization Problems Surplus Variables Computer Solution of the M&D Chemicals Problem
2.6
SPECIAL CASES Alternative Optimal Solutions Infeasibility Unbounded
2.7
GENERAL LINEAR PROGRAMMING NOTATION
Chapter 2
An Introduction to Linear Programming
29
Linear programming is a problem-solving approach developed to help managers make decisions. Numerous applications of linear programming can be found in today’s competitive business environment. For instance, Eastman Kodak uses linear programming to determine where to manufacture products throughout their worldwide facilities, and GE Capital uses linear programming to help determine optimal lease structuring. Marathon Oil Company uses linear programming for gasoline blending and to evaluate the economics of a new terminal or pipeline. The Management Science in Action, Timber Harvesting Model at MeadWestvaco Corporation, provides another example of the use of linear programming. Later in the chapter another Management Science in Action illustrates how the Hanshin Expressway Public Corporation uses linear programming for traffic control on an urban toll expressway in Osaka, Japan. To illustrate some of the properties that all linear programming problems have in common, consider the following typical applications: 1. A manufacturer wants to develop a production schedule and an inventory policy that will satisfy sales demand in future periods. Ideally, the schedule and policy will enable the company to satisfy demand and at the same time minimize the total production and inventory costs. 2. A financial analyst must select an investment portfolio from a variety of stock and bond investment alternatives. The analyst would like to establish the portfolio that maximizes the return on investment. 3. A marketing manager wants to determine how best to allocate a fixed advertising budget among alternative advertising media such as radio, television, newspaper, and magazine. The manager would like to determine the media mix that maximizes advertising effectiveness. 4. A company has warehouses in a number of locations throughout the United States. For a set of customer demands, the company would like to determine how much each warehouse should ship to each customer so that total transportation costs are minimized. MANAGEMENT SCIENCE IN ACTION TIMBER HARVESTING MODEL AT MEADWESTVACO CORPORATION* MeadWestvaco Corporation is a major producer of premium papers for periodicals, books, commercial printing, and business forms. The company also produces pulp and lumber, designs and manufactures packaging systems for beverage and other consumables markets, and is a world leader in the production of coated board and shipping containers. Quantitative analyses at MeadWestvaco are developed and implemented by the company’s Decision Analysis Department. The department assists decision makers by providing them with analytical tools of quantitative methods as well as personal analysis and recommendations. MeadWestvaco uses quantitative models to assist with the long-range management of the company’s timberland. Through the use of large-scale linear programs, timber harvesting plans are developed to cover a substantial time horizon. These models consider wood market conditions,
mill pulpwood requirements, harvesting capacities, and general forest management principles. Within these constraints, the model arrives at an optimal harvesting and purchasing schedule based on discounted cash flow. Alternative schedules reflect changes in the various assumptions concerning forest growth, wood availability, and general economic conditions. Quantitative methods are also used in the development of the inputs for the linear programming models. Timber prices and supplies as well as mill requirements must be forecast over the time horizon, and advanced sampling techniques are used to evaluate land holdings and to project forest growth. The harvest schedule is then developed using quantitative methods. *Based on information provided by Dr. Edward P. Winkofsky.
30
Chapter 2
Linear programming was initially referred to as “programming in a linear structure.” In 1948 Tjalling Koopmans suggested to George Dantzig that the name was much too long; Koopmans suggested shortening it to linear programming. George Dantzig agreed and the field we now know as linear programming was named.
These examples are only a few of the situations in which linear programming has been used successfully, but they illustrate the diversity of linear programming applications. A close scrutiny reveals one basic property they all have in common. In each example, we were concerned with maximizing or minimizing some quantity. In example 1, the manufacturer wanted to minimize costs; in example 2, the financial analyst wanted to maximize return on investment; in example 3, the marketing manager wanted to maximize advertising effectiveness; and in example 4, the company wanted to minimize total transportation costs. In all linear programming problems, the maximization or minimization of some quantity is the objective. All linear programming problems also have a second property: restrictions, or constraints, that limit the degree to which the objective can be pursued. In example 1, the manufacturer is restricted by constraints requiring product demand to be satisfied and by the constraints limiting production capacity. The financial analyst’s portfolio problem is constrained by the total amount of investment funds available and the maximum amounts that can be invested in each stock or bond. The marketing manager’s media selection decision is constrained by a fixed advertising budget and the availability of the various media. In the transportation problem, the minimum-cost shipping schedule is constrained by the supply of product available at each warehouse. Thus, constraints are another general feature of every linear programming problem.
2.1
An Introduction to Linear Programming
A SIMPLE MAXIMIZATION PROBLEM Par, Inc., is a small manufacturer of golf equipment and supplies whose management has decided to move into the market for medium- and high-priced golf bags. Par’s distributor is enthusiastic about the new product line and has agreed to buy all the golf bags Par produces over the next three months. After a thorough investigation of the steps involved in manufacturing a golf bag, management determined that each golf bag produced will require the following operations: 1. 2. 3. 4.
Cutting and dyeing the material Sewing Finishing (inserting umbrella holder, club separators, etc.) Inspection and packaging
The director of manufacturing analyzed each of the operations and concluded that if the company produces a medium-priced standard model, each bag will require ⁷⁄₁₀ hour in the cutting and dyeing department, ¹⁄₂ hour in the sewing department, 1 hour in the finishing department, and ¹⁄₁₀ hour in the inspection and packaging department. The more expensive deluxe model will require 1 hour for cutting and dyeing, ⁵⁄₆ hour for sewing, ²⁄₃ hour for finishing, and ¹⁄₄ hour for inspection and packaging. This production information is summarized in Table 2.1. Par’s production is constrained by a limited number of hours available in each department. After studying departmental workload projections, the director of manufacturing estimates that 630 hours for cutting and dyeing, 600 hours for sewing, 708 hours for finishing, and 135 hours for inspection and packaging will be available for the production of golf bags during the next three months. The accounting department analyzed the production data, assigned all relevant variable costs, and arrived at prices for both bags that will result in a profit contribution1 of $10 for 1
From an accounting perspective, profit contribution is more correctly described as the contribution margin per bag; for example, overhead and other shared costs have not been allocated.
2.1
31
A Simple Maximization Problem
TABLE 2.1 PRODUCTION REQUIREMENTS PER GOLF BAG Production Time (hours) Standard Bag Deluxe Bag ⁷⁄₁₀ 1 ¹⁄₂ ⁵⁄₆ ²⁄₃ 1 ¹⁄₁₀ ¹⁄₄
Department Cutting and Dyeing Sewing Finishing Inspection and Packaging
It is important to understand that we are maximizing profit contribution, not profit. Overhead and other shared costs must be deducted before arriving at a profit figure.
every standard bag and $9 for every deluxe bag produced. Let us now develop a mathematical model of the Par, Inc., problem that can be used to determine the number of standard bags and the number of deluxe bags to produce in order to maximize total profit contribution.
Problem Formulation Problem formulation, or modeling, is the process of translating the verbal statement of a problem into a mathematical statement. Formulating models is an art that can only be mastered with practice and experience. Even though every problem has some unique features, most problems also have common features. As a result, some general guidelines for model formulation can be helpful, especially for beginners. We will illustrate these general guidelines by developing a mathematical model for the Par, Inc., problem. Understand the Problem Thoroughly We selected the Par, Inc., problem to introduce linear programming because it is easy to understand. However, more complex problems will require much more thinking in order to identify the items that need to be included in the model. In such cases, read the problem description quickly to get a feel for what is involved. Taking notes will help you focus on the key issues and facts. Describe the Objective
The objective is to maximize the total contribution to profit.
Describe Each Constraint Four constraints relate to the number of hours of manufacturing time available; they restrict the number of standard bags and the number of deluxe bags that can be produced. Constraint 1: Number of hours of cutting and dyeing time used must be less than or equal to the number of hours of cutting and dyeing time available. Constraint 2: Number of hours of sewing time used must be less than or equal to the number of hours of sewing time available. Constraint 3: Number of hours of finishing time used must be less than or equal to the number of hours of finishing time available. Constraint 4: Number of hours of inspection and packaging time used must be less than or equal to the number of hours of inspection and packaging time available. Define the Decision Variables The controllable inputs for Par, Inc., are (1) the number of standard bags produced, and (2) the number of deluxe bags produced. Let S = number of standard bags D = number of deluxe bags In linear programming terminology, S and D are referred to as the decision variables.
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Chapter 2
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Write the Objective in Terms of the Decision Variables Par’s profit contribution comes from two sources: (1) the profit contribution made by producing S standard bags, and (2) the profit contribution made by producing D deluxe bags. If Par makes $10 for every standard bag, the company will make $10S if S standard bags are produced. Also, if Par makes $9 for every deluxe bag, the company will make $9D if D deluxe bags are produced. Thus, we have Total Profit Contribution = 10S + 9D Because the objective—maximize total profit contribution—is a function of the decision variables S and D, we refer to 10S + 9D as the objective function. Using “Max” as an abbreviation for maximize, we write Par’s objective as follows: Max 10S + 9D Write the Constraints in Terms of the Decision Variables Constraint 1: a
Hours of cutting and Hours of cutting and b … a b dyeing time used dyeing time available
Every standard bag Par produces will use ⁷⁄₁₀ hour cutting and dyeing time; therefore, the total number of hours of cutting and dyeing time used in the manufacture of S standard bags is ⁷⁄₁₀ S. In addition, because every deluxe bag produced uses 1 hour of cutting and dyeing time, the production of D deluxe bags will use 1D hours of cutting and dyeing time. Thus, the total cutting and dyeing time required for the production of S standard bags and D deluxe bags is given by Total hours of cutting and dyeing time used ⁷⁄₁₀ S 1D The units of measurement on the left-hand side of the constraint must match the units of measurement on the right-hand side.
The director of manufacturing stated that Par has at most 630 hours of cutting and dyeing time available. Therefore, the production combination we select must satisfy the requirement
⁷⁄₁₀ S 1D 630
(2.1)
Constraint 2: a
Hours of sewing Hours of sewing b … a b time used time available
From Table 2.1, we see that every standard bag manufactured will require ¹⁄₂ hour for sewing, and every deluxe bag will require ⁵⁄₆ hour for sewing. Because 600 hours of sewing time are available, it follows that ¹⁄₂ S ⁵⁄₆ D 600
(2.2)
2.1
33
A Simple Maximization Problem
Constraint 3: a
Hours of finishing Hours of finishing b … a b time used time available
Every standard bag manufactured will require 1 hour for finishing, and every deluxe bag will require ²⁄₃ hour for finishing. With 708 hours of finishing time available, it follows that
1S ²⁄₃ D 708
(2.3)
Constraint 4: a
Hours of inspection and Hours of inspection and b … a b packaging time used packaging time available
Every standard bag manufactured will require ¹⁄₁₀ hour for inspection and packaging, and every deluxe bag will require ¹⁄₄ hour for inspection and packaging. Because 135 hours of inspection and packaging time are available, it follows that
¹⁄₁₀ S ¹⁄₄ D 135
(2.4)
We have now specified the mathematical relationships for the constraints associated with the four departments. Have we forgotten any other constraints? Can Par produce a negative number of standard or deluxe bags? Clearly, the answer is no. Thus, to prevent the decision variables S and D from having negative values, two constraints,
S Ú 0
and
D Ú 0
(2.5)
must be added. These constraints ensure that the solution to the problem will contain nonnegative values for the decision variables and are thus referred to as the nonnegativity constraints. Nonnegativity constraints are a general feature of all linear programming problems and may be written in the abbreviated form: Try Problem 24(a) to test your ability to formulate a mathematical model for a maximization linear programming problem with less-than-or-equal-to constraints.
S, D Ú 0
Mathematical Statement of the Par, Inc., Problem The mathematical statement or mathematical formulation of the Par, Inc., problem is now complete. We succeeded in translating the objective and constraints of the problem into a
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Chapter 2
An Introduction to Linear Programming
set of mathematical relationships referred to as a mathematical model. The complete mathematical model for the Par problem is as follows: Max 10S 9D subject to (s.t.) ⁷⁄₁₀ S 1D 630 Cutting and dyeing ¹⁄₂ S ⁵⁄₆ D 600 Sewing 1S ²⁄₃ D 708 Finishing ¹⁄₁₀ S ¹⁄₄ D 135 Inspection and packaging S, D 0
Try Problem 1 to test your ability to recognize the types of mathematical relationships that can be found in a linear program.
(2.6)
Our job now is to find the product mix (i.e., the combination of S and D) that satisfies all the constraints and, at the same time, yields a value for the objective function that is greater than or equal to the value given by any other feasible solution. Once these values are calculated, we will have found the optimal solution to the problem. This mathematical model of the Par problem is a linear programming model, or linear program. The problem has the objective and constraints that, as we said earlier, are common properties of all linear programs. But what is the special feature of this mathematical model that makes it a linear program? The special feature that makes it a linear program is that the objective function and all constraint functions are linear functions of the decision variables. Mathematical functions in which each variable appears in a separate term and is raised to the first power are called linear functions. The objective function (10S 9D) is linear because each decision variable appears in a separate term and has an exponent of 1. The amount of production time required in the cutting and dyeing department (⁷⁄₁₀ S 1D) is also a linear function of the decision variables for the same reason. Similarly, the functions on the left-hand side of all the constraint inequalities (the constraint functions) are linear functions. Thus, the mathematical formulation of this problem is referred to as a linear program. Linear programming has nothing to do with computer programming. The use of the word programming here means “choosing a course of action.” Linear programming involves choosing a course of action when the mathematical model of the problem contains only linear functions.
NOTES AND COMMENTS 1. The three assumptions necessary for a linear programming model to be appropriate are proportionality, additivity, and divisibility. Proportionality means that the contribution to the objective function and the amount of resources used in each constraint are proportional to the value of each decision variable. Additivity means that the value of the objective function and the total resources used can be found by summing the objective function contribution and the resources used for all decision variables. Divisibility means that the
decision variables are continuous. The divisibility assumption plus the nonnegativity constraints mean that decision variables can take on any value greater than or equal to zero. 2. Management scientists formulate and solve a variety of mathematical models that contain an objective function and a set of constraints. Models of this type are referred to as mathematical programming models. Linear programming models are a special type of mathematical programming model in that the objective function and all constraint functions are linear.
2.2
2.2
35
Graphical Solution Procedure
GRAPHICAL SOLUTION PROCEDURE A linear programming problem involving only two decision variables can be solved using a graphical solution procedure. Let us begin the graphical solution procedure by developing a graph that displays the possible solutions (S and D values) for the Par problem. The graph (Figure 2.1) will have values of S on the horizontal axis and values of D on the vertical axis. Any point on the graph can be identified by the S and D values, which indicate the position of the point along the horizontal and vertical axes, respectively. Because every point (S, D) corresponds to a possible solution, every point on the graph is called a solution point. The solution point where S 0 and D 0 is referred to as the origin. Because S and D must be nonnegative, the graph in Figure 2.1 only displays solutions where S 0 and D 0. Earlier, we saw that the inequality representing the cutting and dyeing constraint is ⁷⁄₁₀ S 1D 630
To show all solution points that satisfy this relationship, we start by graphing the solution points satisfying the constraint as an equality. That is, the points where ⁷⁄₁₀ S 1D 630. Because the graph of this equation is a line, it can be obtained by identifying two points that satisfy the equation and then drawing a line through the points. Setting S 0 and solving for D, we see that the point (S 0, D 630) satisfies the equation. To find a second point satisfying this equation, we set D 0 and solve for S. By doing so, we obtain FIGURE 2.1 SOLUTION POINTS FOR THE TWO-VARIABLE PAR, INC., PROBLEM D 1200
A solution point with S = 200 and D = 800
Number of Deluxe Bags
1000
(200, 800)
800
600 A solution point with S = 400 and D = 300 400 (400, 300) 200
200
400
600
800
1000
Number of Standard Bags
1200
S
Chapter 2
An Introduction to Linear Programming
⁷⁄₁₀ S 1(0) 630, or S 900. Thus, a second point satisfying the equation is (S 900,
D 0). Given these two points, we can now graph the line corresponding to the equation ⁷⁄₁₀ S 1D 630
This line, which will be called the cutting and dyeing constraint line, is shown in Figure 2.2. We label this line “C & D” to indicate that it represents the cutting and dyeing constraint line. Recall that the inequality representing the cutting and dyeing constraint is ⁷⁄₁₀ S 1D 630
Can you identify all of the solution points that satisfy this constraint? Because all points on the line satisfy ⁷⁄₁₀ S 1D 630, we know any point on this line must satisfy the constraint. But where are the solution points satisfying ⁷⁄₁₀ S 1D 630? Consider two solution points: (S 200, D 200) and (S 600, D 500). You can see from Figure 2.2 that the first solution point is below the constraint line and the second is above the constraint line. Which of these solutions will satisfy the cutting and dyeing constraint? For the point (S 200, D 200), we see that ⁷⁄₁₀ S 1D ⁷⁄₁₀ (200) 1(200) 340
FIGURE 2.2 THE CUTTING AND DYEING CONSTRAINT LINE D 1200
1000
Number of Deluxe Bags
36
800 (0, 630) 600 7/ 10
400
S+
(600, 500) 1D
=
63
(200, 200)
200
C
200
400
600
&
D
800
(900, 0) 1000
Number of Standard Bags
1200
1400
S
2.2
37
Graphical Solution Procedure
Because the 340 hours is less than the 630 hours available, the (S 200, D 200) production combination, or solution point, satisfies the constraint. For the point (S 600, D 500), we have ⁷⁄₁₀ S 1D ⁷⁄₁₀ (600) 1(500) 920
Can you graph a constraint line and find the solution points that are feasible? Try Problem 2.
The 920 hours is greater than the 630 hours available, so the (S 600, D 500) solution point does not satisfy the constraint and is thus not feasible. If a solution point is not feasible for a particular constraint, then all other solution points on the same side of that constraint line are not feasible. If a solution point is feasible for a particular constraint, then all other solution points on the same side of the constraint line are feasible for that constraint. Thus, one has to evaluate the constraint function for only one solution point to determine which side of a constraint line is feasible. In Figure 2.3 we indicate all points satisfying the cutting and dyeing constraint by the shaded region. We continue by identifying the solution points satisfying each of the other three constraints. The solutions that are feasible for each of these constraints are shown in Figure 2.4. Four separate graphs now show the feasible solution points for each of the four constraints. In a linear programming problem, we need to identify the solution points that satisfy all the constraints simultaneously. To find these solution points, we can draw all four constraints on one graph and observe the region containing the points that do in fact satisfy all the constraints simultaneously.
FIGURE 2.3 FEASIBLE SOLUTIONS FOR THE CUTTING AND DYEING CONSTRAINT, REPRESENTED BY THE SHADED REGION D 1200
Number of Deluxe Bags
1000
800
Cutting and Dyeing Constraint (C & D)
600 7/ 10
400
S+
1D
=6 30
200
C
200
400
600
&
D
800
1000
Number of Standard Bags
1200
1400
S
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Chapter 2
An Introduction to Linear Programming
FIGURE 2.4 FEASIBLE SOLUTIONS FOR THE SEWING, FINISHING, AND INSPECTION AND PACKAGING CONSTRAINTS, REPRESENTED BY THE SHADED REGIONS D
1000
1000 (0, 720)
800
=6
200
400
600
800
200
(1200, 0)
1000
1200
S
1400
ing
ish
Se wi ng
200
400 Fin
00
08
5/ 6D
600
=7
400
+
Finishing Constraint
D
1/ 2S
800
2 /3
Sewing Constraint
(0, 1062)
+
600
Number of Deluxe Bags
1200
1S
Number of Deluxe Bags
D 1200
200
Number of Standard Bags
400
600
(708, 0) 800
1000
1200
1400
S
Number of Standard Bags
D 1200
Number of Deluxe Bags
1000 800
Inspection and Packaging Constraint (I & P)
(0, 540)
600
1/ 10 S
400
+ 1/
4D
=1
35 I&
200
200
400
600
800
P
1000
(1350, 0) 1200
1400
S
Number of Standard Bags
Try Problem 7 to test your ability to find the feasible region given several constraints.
The graphs in Figures 2.3 and 2.4 can be superimposed to obtain one graph with all four constraints. This combined-constraint graph is shown in Figure 2.5. The shaded region in this figure includes every solution point that satisfies all the constraints simultaneously. Solutions that satisfy all the constraints are termed feasible solutions, and the shaded region is called the feasible solution region, or simply the feasible region. Any solution point on the boundary of the feasible region or within the feasible region is a feasible solution point. Now that we have identified the feasible region, we are ready to proceed with the graphical solution procedure and find the optimal solution to the Par, Inc., problem. Recall that the optimal solution for a linear programming problem is the feasible solution that provides
2.2
39
Graphical Solution Procedure
FIGURE 2.5 COMBINED-CONSTRAINT GRAPH SHOWING THE FEASIBLE REGION FOR THE PAR, INC., PROBLEM D 1200
ing ish Fin
Number of Deluxe Bags
1000
800
Se wi
ng
600
400 Feasible Region
200
C
&
I&
D
P
S 0
200
400
600
800
1000
1200
1400
Number of Standard Bags
the best possible value of the objective function. Let us start the optimizing step of the graphical solution procedure by redrawing the feasible region on a separate graph. The graph is shown in Figure 2.6. One approach to finding the optimal solution would be to evaluate the objective function for each feasible solution; the optimal solution would then be the one yielding the largest value. The difficulty with this approach is the infinite number of feasible solutions; thus, because one cannot possibly evaluate an infinite number of feasible solutions, this trial-and-error procedure cannot be used to identify the optimal solution. Rather than trying to compute the profit contribution for each feasible solution, we select an arbitrary value for profit contribution and identify all the feasible solutions (S, D) that yield the selected value. For example, which feasible solutions provide a profit contribution of $1800? These solutions are given by the values of S and D in the feasible region that will make the objective function 10S + 9D = 1800 This expression is simply the equation of a line. Thus, all feasible solution points (S, D) yielding a profit contribution of $1800 must be on the line. We learned earlier in this section how to graph a constraint line. The procedure for graphing the profit or objective function line is the same. Letting S 0, we see that D must be 200; thus, the solution
Chapter 2
An Introduction to Linear Programming
FIGURE 2.6 FEASIBLE REGION FOR THE PAR, INC., PROBLEM D 600
Number of Deluxe Bags
40
400
Feasible Region
200
200
400
600
800
S
Number of Standard Bags
point (S 0, D 200) is on the line. Similarly, by letting D 0, we see that the solution point (S 180, D 0) is also on the line. Drawing the line through these two points identifies all the solutions that have a profit contribution of $1800. A graph of this profit line is presented in Figure 2.7. Because the objective is to find the feasible solution yielding the largest profit contribution, let us proceed by selecting higher profit contributions and finding the solutions yielding the selected values. For instance, let us find all solutions yielding profit contributions of $3600 and $5400. To do so, we must find the S and D values that are on the following lines: 10S + 9D = 3600 and 10S + 9D = 5400 Using the previous procedure for graphing profit and constraint lines, we draw the $3600 and $5400 profit lines as shown on the graph in Figure 2.8. Although not all solution points on the $5400 profit line are in the feasible region, at least some points on the line are, and it is therefore possible to obtain a feasible solution that provides a $5400 profit contribution. Can we find a feasible solution yielding an even higher profit contribution? Look at Figure 2.8, and see what general observations you can make about the profit lines already drawn. Note the following: (1) the profit lines are parallel to each other, and (2) higher
2.2
41
Graphical Solution Procedure
FIGURE 2.7 $1800 PROFIT LINE FOR THE PAR, INC., PROBLEM D
Number of Deluxe Bags
600
400
(0, 200) Profit Line 10S + 9D = 1800
200
(180, 0)
200
400
600
800
S
Number of Standard Bags
FIGURE 2.8 SELECTED PROFIT LINES FOR THE PAR, INC., PROBLEM D
400 10 S + 9D
S
=
10
54
+
00
9D
200
=
10 9D
00
+
36
S
Number of Deluxe Bags
600
= 00
18
200
400 Number of Standard Bags
600
800
S
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Chapter 2
An Introduction to Linear Programming
profit lines are obtained as we move farther from the origin. These observations can also be expressed algebraically. Let P represent total profit contribution. The objective function is P 10S 9D Solving for D in terms of S and P, we obtain
9D 10S P D ¹⁰⁄₉ S ¹⁄₉ P
(2.7)
Equation (2.7) is the slope-intercept form of the linear equation relating S and D. The coefficient of S, ¹⁰⁄₉ , is the slope of the line, and the term ¹⁄₉ P is the D intercept (i.e., the value of D where the graph of equation (2.7) crosses the D axis). Substituting the profit contributions of P 1800, P 3600, and P 5400 into equation (2.7) yields the following slope-intercept equations for the profit lines shown in Figure 2.8: For P 1800, D ¹⁰⁄₉ S 200 For P 3600, D ¹⁰⁄₉ S 400 For P 5400, D ¹⁰⁄₉ S 600 Can you graph the profit line for a linear program? Try Problem 6.
The slope (¹⁰⁄₉ ) is the same for each profit line because the profit lines are parallel. Further, we see that the D intercept increases with larger profit contributions. Thus, higher profit lines are farther from the origin. Because the profit lines are parallel and higher profit lines are farther from the origin, we can obtain solutions that yield increasingly larger values for the objective function by continuing to move the profit line farther from the origin in such a fashion that it remains parallel to the other profit lines. However, at some point we will find that any further outward movement will place the profit line completely outside the feasible region. Because solutions outside the feasible region are unacceptable, the point in the feasible region that lies on the highest profit line is the optimal solution to the linear program. You should now be able to identify the optimal solution point for this problem. Use a ruler or the edge of a piece of paper, and move the profit line as far from the origin as you can. What is the last point in the feasible region that you reach? This point, which is the optimal solution, is shown graphically in Figure 2.9. The optimal values of the decision variables are the S and D values at the optimal solution. Depending on the accuracy of the graph, you may or may not be able to determine the exact S and D values. Based on the graph in Figure 2.9, the best we can do is conclude that the optimal production combination consists of approximately 550 standard bags (S) and approximately 250 deluxe bags (D).
2.2
43
Graphical Solution Procedure
FIGURE 2.9 OPTIMAL SOLUTION FOR THE PAR, INC., PROBLEM D
Number of Deluxe Bags
ne Li it of 8 Pr 766 um = im D ax 9 M S+ 10
600
400
Optimal Solution
200
200
400
600
800
S
Number of Standard Bags
A closer inspection of Figures 2.5 and 2.9 shows that the optimal solution point is at the intersection of the cutting and dyeing and the finishing constraint lines. That is, the optimal solution point is on both the cutting and dyeing constraint line ⁷⁄₁₀ S 1D 630
(2.8)
1S ²⁄₃ D 708
(2.9)
and the finishing constraint line
Thus, the optimal values of the decision variables S and D must satisfy both equations (2.8) and (2.9) simultaneously. Using equation (2.8) and solving for S gives ⁷⁄₁₀ S 630 1D
or S 900 ¹⁰⁄₇ D
(2.10)
44
Chapter 2
An Introduction to Linear Programming
Substituting this expression for S into equation (2.9) and solving for D provides the following: 1(900 ¹⁰⁄₇ D) ²⁄₃ D 708 900 ¹⁰⁄₇ D ²⁄₃ D 708 900 ³⁰⁄₂₁D ¹⁴⁄₂₁ D 708 ¹⁶⁄₂₁ D 192 192 D 252 ¹⁶⁄₂₁ Using D 252 in equation (2.10) and solving for S, we obtain S 900 ¹⁰⁄ ₇ (252) 900 360 540 Although the optimal solution to the Par, Inc., problem consists of integer values for the decision variables, this result will not always be the case.
The exact location of the optimal solution point is S 540 and D 252. Hence, the optimal production quantities for Par, Inc., are 540 standard bags and 252 deluxe bags, with a resulting profit contribution of 10(540) 9(252) $7668. For a linear programming problem with two decision variables, the exact values of the decision variables can be determined by first using the graphical solution procedure to identify the optimal solution point and then solving the two simultaneous constraint equations associated with it.
A Note on Graphing Lines Try Problem 10 to test your ability to use the graphical solution procedure to identify the optimal solution and find the exact values of the decision variables at the optimal solution.
An important aspect of the graphical method is the ability to graph lines showing the constraints and the objective function of the linear program. The procedure we used for graphing the equation of a line is to find any two points satisfying the equation and then draw the line through the two points. For the Par, Inc., constraints, the two points were easily found by first setting S 0 and solving the constraint equation for D. Then we set D 0 and solved for S. For the cutting and dyeing constraint line ⁷⁄₁₀ S 1D 630
this procedure identified the two points (S 0, D 630) and (S 900, D 0). The cutting and dyeing constraint line was then graphed by drawing a line through these two points. All constraints and objective function lines in two-variable linear programs can be graphed if two points on the line can be identified. However, finding the two points on the line is not always as easy as shown in the Par, Inc., problem. For example, suppose a company manufactures two models of a small handheld computer: the Assistant (A) and the Professional (P). Management needs 50 units of the Professional model for its own salesforce, and expects sales of the Professional to be at most one-half of the sales of the Assistant. A constraint enforcing this requirement is P 50 ¹⁄₂ A or 2P - 100 … A
2.2
45
Graphical Solution Procedure
or 2P - A … 100 Using the equality form and setting P 0, we find the point (P 0, A 100) is on the constraint line. Setting A 0, we find a second point (P 50, A 0) on the constraint line. If we have drawn only the nonnegative (P 0, A 0) portion of the graph, the first point (P 0, A 100) cannot be plotted because A 100 is not on the graph. Whenever we have two points on the line but one or both of the points cannot be plotted in the nonnegative portion of the graph, the simplest approach is to enlarge the graph. In this example, the point (P 0, A 100) can be plotted by extending the graph to include the negative A axis. Once both points satisfying the constraint equation have been located, the line can be drawn. The constraint line and the feasible solutions for the constraint 2P A 100 are shown in Figure 2.10. As another example, consider a problem involving two decision variables, R and T. Suppose that the number of units of R produced had to be at least equal to the number of units of T produced. A constraint enforcing this requirement is R Ú T or R - T Ú 0 FIGURE 2.10 FEASIBLE SOLUTIONS FOR THE CONSTRAINT 2P A 100 A 300
2P
100
–A
=1
00
200
(50, 0) 0
100
(0, –100) –100
200
300
P
46
Chapter 2
Can you graph a constraint line when the origin is on the constraint line? Try Problem 5.
To find all solutions satisfying the constraint as an equality, we first set R 0 and solve for T. This result shows that the origin (T 0, R 0) is on the constraint line. Setting T 0 and solving for R provides the same point. However, we can obtain a second point on the line by setting T equal to any value other than zero and then solving for R. For instance, setting T 100 and solving for R, we find that the point (T 100, R 100) is on the line. With the two points (R 0, T 0) and (R 100, T 100), the constraint line R T 0 and the feasible solutions for R T 0 can be plotted as shown in Figure 2.11.
An Introduction to Linear Programming
Summary of the Graphical Solution Procedure for Maximization Problems For additional practice in using the graphical solution procedure, try Problem 24(b), 24(c), and 24(d).
As we have seen, the graphical solution procedure is a method for solving two-variable linear programming problems such as the Par, Inc., problem. The steps of the graphical solution procedure for a maximization problem are summarized here: 1. Prepare a graph of the feasible solutions for each of the constraints. 2. Determine the feasible region by identifying the solutions that satisfy all the constraints simultaneously. 3. Draw an objective function line showing the values of the decision variables that yield a specified value of the objective function. 4. Move parallel objective function lines toward larger objective function values until further movement would take the line completely outside the feasible region. 5. Any feasible solution on the objective function line with the largest value is an optimal solution.
FIGURE 2.11 FEASIBLE SOLUTIONS FOR THE CONSTRAINT R T 0 T 300
–
T
=
200
R
(100, 100) 100 (0, 0)
100
200
300
R
2.2
47
Graphical Solution Procedure
Slack Variables In addition to the optimal solution and its associated profit contribution, Par’s management will probably want information about the production time requirements for each production operation. We can determine this information by substituting the optimal solution values (S 540, D 252) into the constraints of the linear program.
Constraint Cutting and dyeing Sewing Finishing Inspection and packaging
Can you identify the slack associated with a constraint? Try Problem 24(e).
Hours Required for S ⴝ 540 and D ⴝ 252 ⁷⁄₁₀(540) 1(252) 630 ¹⁄₂(540) ⁵⁄₆(252) 480 1(540) ²⁄₃(252) 708 ¹⁄₁₀(540) ¹⁄₄(252) 117
Hours Available 630 600 708 135
Unused Hours 0 120 0 18
Thus, the complete solution tells management that the production of 540 standard bags and 252 deluxe bags will require all available cutting and dyeing time (630 hours) and all available finishing time (708 hours), while 600 480 120 hours of sewing time and 135 117 18 hours of inspection and packaging time will remain unused. The 120 hours of unused sewing time and 18 hours of unused inspection and packaging time are referred to as slack for the two departments. In linear programming terminology, any unused capacity for a constraint is referred to as the slack associated with the constraint. Often variables, called slack variables, are added to the formulation of a linear programming problem to represent the slack, or idle capacity. Unused capacity makes no contribution to profit; thus, slack variables have coefficients of zero in the objective function. After the addition of four slack variables, denoted S1, S2, S3, and S4, the mathematical model of the Par, Inc., problem becomes Max s.t.
10S 9D 0S1 0S2 0S3 0S4 ⁷⁄₁₀ S 1D 1S1 ¹⁄₂ S ⁵⁄₆ D 1S2
1S ²⁄₃D ¹⁄₁₀ S ¹⁄₄D
630 600 1S3 708 1S4 135
S, D, S1, S2, S3, S4 0 Can you write a linear program in standard form? Try Problem 18.
Whenever a linear program is written in a form with all constraints expressed as equalities, it is said to be written in standard form. Referring to the standard form of the Par, Inc., problem, we see that at the optimal solution (S 540 and D 252), the values for the slack variables are Constraint Cutting and dyeing Sewing Finishing Inspection and packaging
Value of Slack Variable S1 0 S2 120 S3 0 S4 18
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Chapter 2
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Could we have used the graphical solution to provide some of this information? The answer is yes. By finding the optimal solution point on Figure 2.5, we can see that the cutting and dyeing and the finishing constraints restrict, or bind, the feasible region at this point. Thus, this solution requires the use of all available time for these two operations. In other words, the graph shows us that the cutting and dyeing and the finishing departments will have zero slack. On the other hand, the sewing and the inspection and packaging constraints are not binding the feasible region at the optimal solution, which means we can expect some unused time or slack for these two operations. As a final comment on the graphical analysis of this problem, we call your attention to the sewing capacity constraint as shown in Figure 2.5. Note, in particular, that this constraint did not affect the feasible region. That is, the feasible region would be the same whether the sewing capacity constraint were included or not, which tells us that enough sewing time is available to accommodate any production level that can be achieved by the other three departments. The sewing constraint does not affect the feasible region and thus cannot affect the optimal solution; it is called a redundant constraint. NOTES AND COMMENTS 1. In the standard-form representation of a linear programming model, the objective function coefficients for slack variables are zero. This zero coefficient implies that slack variables, which represent unused resources, do not affect the value of the objective function. However, in some applications, unused resources can be sold and contribute to profit. In such cases, the corresponding slack variables become decision variables representing the amount of unused resources to be sold. For each of these variables, a nonzero coefficient in the objective function would reflect the profit associated with selling a unit of the corresponding resource.
2.3
2. Redundant constraints do not affect the feasible region; as a result, they can be removed from a linear programming model without affecting the optimal solution. However, if the linear programming model is to be re-solved later, changes in some of the data might make a previously redundant constraint a binding constraint. Thus, we recommend keeping all constraints in the linear programming model even though at some point in time one or more of the constraints may be redundant.
EXTREME POINTS AND THE OPTIMAL SOLUTION Suppose that the profit contribution for Par’s standard golf bag is reduced from $10 to $5 per bag, while the profit contribution for the deluxe golf bag and all the constraints remain unchanged. The complete linear programming model of this new problem is identical to the mathematical model in Section 2.1, except for the revised objective function: Max 5S + 9D How does this change in the objective function affect the optimal solution to the Par, Inc., problem? Figure 2.12 shows the graphical solution of this new problem with the revised objective function. Note that without any change in the constraints, the feasible region does not change. However, the profit lines have been altered to reflect the new objective function. By moving the profit line in a parallel manner toward higher profit values, we find the optimal solution as shown in Figure 2.12. The values of the decision variables at this point
2.3
49
Extreme Points and the Optimal Solution
FIGURE 2.12 OPTIMAL SOLUTION FOR THE PAR, INC., PROBLEM WITH AN OBJECTIVE FUNCTION OF 5S 9D D
Number of Deluxe Bags
600
Optimal Solution (S = 300, D = 420)
400
Ma
(0, 300)
xim
um
Pro
fit L
ine
5S
200
+9
D=
: 5S
+9 D
=5
280
270
(540, 0)
200
400
600
800
S
Number of Standard Bags
are S 300 and D 420. The reduced profit contribution for the standard bag caused a change in the optimal solution. In fact, as you may have suspected, we are cutting back the production of the lower-profit standard bags and increasing the production of the higherprofit deluxe bags. What observations can you make about the location of the optimal solutions in the two linear programming problems solved thus far? Look closely at the graphical solutions in Figures 2.9 and 2.12. Notice that the optimal solutions occur at one of the vertices, or “corners,” of the feasible region. In linear programming terminology, these vertices are referred to as the extreme points of the feasible region. The Par, Inc., feasible region has five vertices, or five extreme points (see Figure 2.13). We can now formally state our observation about the location of optimal solutions as follows: For additional practice in identifying the extreme points of the feasible region and determining the optimal solution by computing and comparing the objective function value at each extreme point, try Problem 13.
The optimal solution to a linear program can be found at an extreme point of the feasible region.2 This property means that if you are looking for the optimal solution to a linear program, you do not have to evaluate all feasible solution points. In fact, you have to consider
2
We will discuss in Section 2.6 the two special cases (infeasibility and unboundedness) in linear programming that have no optimal solution, and for which this statement does not apply.
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Chapter 2
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FIGURE 2.13 THE FIVE EXTREME POINTS OF THE FEASIBLE REGION FOR THE PAR, INC., PROBLEM D 600
Number of Deluxe Bags
5
4 400
3
Feasible Region
200
1 0
2 200
400
600
800
S
Number of Standard Bags
only the feasible solutions that occur at the extreme points of the feasible region. Thus, for the Par, Inc., problem, instead of computing and comparing the profit contributions for all feasible solutions, we can find the optimal solution by evaluating the five extreme-point solutions and selecting the one that provides the largest profit contribution. Actually, the graphical solution procedure is nothing more than a convenient way of identifying an optimal extreme point for two-variable problems.
2.4 In January 1952 the first successful computer solution of a linear programming problem was performed on the SEAC (Standards Eastern Automatic Computer). The SEAC, the first digital computer built by the National Bureau of Standards under U.S. Air Force sponsorship, had a 512-word memory and magnetic tape for external storage.
COMPUTER SOLUTION OF THE PAR, INC., PROBLEM Computer programs designed to solve linear programming problems are now widely available. After a short period of familiarization with the specific features of the package, users are able to solve linear programming problems with few difficulties. Problems involving thousands of variables and thousands of constraints are now routinely solved with computer packages. Some of the leading commercial packages include CPLEX, Gurobi, LINGO, MOSEK, Risk Solver for Excel, and Xpress-MP. Packages are also available for free download. A good example is Clp (COIN-OR linear programming). The solution to Par, Inc. is shown in Figure 2.14. The authors have chosen to make this book flexible and not rely on a specific linear programming package. Hence, the output in Figure 2.14 is generic and is not an actual printout from a particular software package. The output provided in Figure 2.14 is typical of most linear programming packages. We use this output format throughout the text. At the website for this course two linear programming packages are provided. A description of the packages is provided in the appendices. In Appendix 2.1 we show how to solve the Par, Inc., problem using LINGO. In Appendix 2.2 we
2.4
51
Computer Solution of the Par, Inc., Problem
FIGURE 2.14 THE SOLUTION FOR THE PAR, INC., PROBLEM Optimal Objective Value =
WEB
file
7668.00000
Variable -------------S D
Value --------------540.00000 252.00000
Reduced Cost ----------------0.00000 0.00000
Constraint -------------1 2 3 4
Slack/Surplus --------------0.00000 120.00000 0.00000 18.00000
Dual Value ----------------4.37500 0.00000 6.93750 0.00000
Variable ---------S D
Objective Coefficient -----------10.00000 9.00000
Allowable Increase ---------3.50000 5.28571
Allowable Decrease ---------3.70000 2.33333
Constraint ---------1 2 3 4
RHS Value -----------630.00000 600.00000 708.00000 135.00000
Allowable Increase ---------52.36364 Infinite 192.00000 Infinite
Allowable Decrease ---------134.40000 120.00000 128.00000 18.00000
Par
show how to formulate a spreadsheet model for the Par, Inc., problem and use Excel Solver to solve the problem.
Interpretation of Computer Output Let us look more closely at the output in Figure 2.14 and interpret the computer solution provided for the Par, Inc., problem. The optimal solution to this problem will provide a profit of $7668. Directly below the objective function value, we find the values of the decision variables at the optimal solution. We have S 540 standard bags and D 252 deluxe bags as the optimal production quantities. Recall that the Par, Inc., problem had four less-than-or-equal-to constraints corresponding to the hours available in each of four production departments. The information shown in the Slack/Surplus column provides the value of the slack variable for each of the departments. This information is summarized here: Constraint Number 1 2 3 4
Constraint Name Cutting and dyeing Sewing Finishing Inspection and packaging
Slack 0 120 0 18
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From this information, we see that the binding constraints (the cutting and dyeing and the finishing constraints) have zero slack at the optimal solution. The sewing department has 120 hours of slack or unused capacity, and the inspection and packaging department has 18 hours of slack or unused capacity. The rest of the output in Figure 2.14 can be used to determine how changes in the input data impact the optimal solution. We shall defer discussion of reduced costs, dual values, allowable increases and decreases of objective function coefficients and right-hand-side values until Chapter 3, when we study the topic of sensitivity analysis. NOTES AND COMMENTS Linear programming solvers are now a standard feature of most spreadsheet packages. In Appendix 2.2 we show how spreadsheets can be used
2.5
to solve linear programs by using Excel to solve the Par, Inc., problem.
A SIMPLE MINIMIZATION PROBLEM M&D Chemicals produces two products that are sold as raw materials to companies manufacturing bath soaps and laundry detergents. Based on an analysis of current inventory levels and potential demand for the coming month, M&D’s management specified that the combined production for products A and B must total at least 350 gallons. Separately, a major customer’s order for 125 gallons of product A must also be satisfied. Product A requires 2 hours of processing time per gallon and product B requires 1 hour of processing time per gallon. For the coming month, 600 hours of processing time are available. M&D’s objective is to satisfy these requirements at a minimum total production cost. Production costs are $2 per gallon for product A and $3 per gallon for product B. To find the minimum-cost production schedule, we will formulate the M&D Chemicals problem as a linear program. Following a procedure similar to the one used for the Par, Inc., problem, we first define the decision variables and the objective function for the problem. Let A = number of gallons of product A B = number of gallons of product B With production costs at $2 per gallon for product A and $3 per gallon for product B, the objective function that corresponds to the minimization of the total production cost can be written as Min 2 A + 3B Next, consider the constraints placed on the M&D Chemicals problem. To satisfy the major customer’s demand for 125 gallons of product A, we know A must be at least 125. Thus, we write the constraint 1A Ú 125 For the combined production for both products, which must total at least 350 gallons, we can write the constraint 1A + 1B Ú 350
2.5
53
A Simple Minimization Problem
Finally, for the limitation of 600 hours on available processing time, we add the constraint 2 A + 1B … 600 After adding the nonnegativity constraints (A, B 0), we arrive at the following linear program for the M&D Chemicals problem: Min s.t.
2 A + 3B 1A Ú 125 1 A + 1B Ú 350 2 A + 1B … 600 A, B Ú 0
Demand for product A Total production Processing time
Because the linear programming model has only two decision variables, the graphical solution procedure can be used to find the optimal production quantities. The graphical solution procedure for this problem, just as in the Par problem, requires us to first graph the constraint lines to find the feasible region. By graphing each constraint line separately and then checking points on either side of the constraint line, the feasible solutions for each constraint can be identified. By combining the feasible solutions for each constraint on the same graph, we obtain the feasible region shown in Figure 2.15. FIGURE 2.15 THE FEASIBLE REGION FOR THE M&D CHEMICALS PROBLEM B
400 1A
300
2A +1 B=
0 35 = tion B c + 1 rodu P
600
Gallons of Product B
500
A = 125
ime gT
sin
ces
Pro
600
200
100
100
200
300
400
Gallons of Product A
500
600
A
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To find the minimum-cost solution, we now draw the objective function line corresponding to a particular total cost value. For example, we might start by drawing the line 2A 3B 1200. This line is shown in Figure 2.16. Clearly, some points in the feasible region would provide a total cost of $1200. To find the values of A and B that provide smaller total cost values, we move the objective function line in a lower left direction until, if we moved it any farther, it would be entirely outside the feasible region. Note that the objective function line 2A 3B 800 intersects the feasible region at the extreme point A 250 and B 100. This extreme point provides the minimum-cost solution with an objective function value of 800. From Figures 2.15 and 2.16, we can see that the total production constraint and the processing time constraint are binding. Just as in every linear programming problem, the optimal solution occurs at an extreme point of the feasible region.
Summary of the Graphical Solution Procedure for Minimization Problems Can you use the graphical solution procedure to determine the optimal solution for a minimization problem? Try Problem 31.
The steps of the graphical solution procedure for a minimization problem are summarized here: 1. Prepare a graph of the feasible solutions for each of the constraints. 2. Determine the feasible region by identifying the solutions that satisfy all the constraints simultaneously.
FIGURE 2.16 GRAPHICAL SOLUTION FOR THE M&D CHEMICALS PROBLEM B 600
Gallons of Product B
500
400
300
2A
200
+3
B=
12
00
2A
100
Optimal Solution (A = 250, B = 100) 0
100
200
+3 B=
80
300
400
Gallons of Product A
500
600
A
2.5
55
A Simple Minimization Problem
3. Draw an objective function line showing the values of the decision variables that yield a specified value of the objective function. 4. Move parallel objective function lines toward smaller objective function values until further movement would take the line completely outside the feasible region. 5. Any feasible solution on the objective function line with the smallest value is an optimal solution.
Surplus Variables The optimal solution to the M&D Chemicals problem shows that the desired total production of A B 350 gallons has been achieved by using all available processing time of 2A 1B 2(250) 1(100) 600 hours. In addition, note that the constraint requiring that product A demand be met has been satisfied with A 250 gallons. In fact, the production of product A exceeds its minimum level by 250 125 125 gallons. This excess production for product A is referred to as surplus. In linear programming terminology, any excess quantity corresponding to a constraint is referred to as surplus. Recall that with a constraint, a slack variable can be added to the left-hand side of the inequality to convert the constraint to equality form. With a constraint, a surplus variable can be subtracted from the left-hand side of the inequality to convert the constraint to equality form. Just as with slack variables, surplus variables are given a coefficient of zero in the objective function because they have no effect on its value. After including two surplus variables, S1 and S2, for the constraints and one slack variable, S3, for the constraint, the linear programming model of the M&D Chemicals problem becomes Min s.t.
2 A + 3B + 0S1 + 0S2 + 0S3 1A - 1S1 = 125 1 A + 1B - 1S2 = 350 2 A + 1B + 1S3 = 600 A, B, S1, S2, S3 Ú 0
Try Problem 35 to test your ability to use slack and surplus variables to write a linear program in standard form.
All the constraints are now equalities. Hence, the preceding formulation is the standardform representation of the M&D Chemicals problem. At the optimal solution of A 250 and B 100, the values of the surplus and slack variables are as follows: Constraint Demand for product A Total production Processing time
Value of Surplus or Slack Variables S1 125 S2 0 S3 0
Refer to Figures 2.15 and 2.16. Note that the zero surplus and slack variables are associated with the constraints that are binding at the optimal solution—that is, the total production and processing time constraints. The surplus of 125 units is associated with the nonbinding constraint on the demand for product A. In the Par, Inc., problem all the constraints were of the type, and in the M&D Chemicals problem the constraints were a mixture of and types. The number and types of constraints encountered in a particular linear programming problem depend on
56
Try Problem 34 to practice solving a linear program with all three constraint forms.
Chapter 2
An Introduction to Linear Programming
the specific conditions existing in the problem. Linear programming problems may have some constraints, some constraints, and some constraints. For an equality constraint, feasible solutions must lie directly on the constraint line. An example of a linear program with two decision variables, G and H, and all three constraint forms is given here: Min s.t.
2G + 2H 1G + 3H … 12 3G + 1H Ú 13 1G - 1H = 3 G, H Ú 0
The standard-form representation of this problem is Min s.t.
2G + 2H + 0S1 + 0S2 1G + 3H + 1S1 = 12 3G + 1H - 1S2 = 13 1G - 1H = 3 G, H, S1, S2 Ú 0
The standard form requires a slack variable for the constraint and a surplus variable for the constraint. However, neither a slack nor a surplus variable is required for the third constraint because it is already in equality form. When solving linear programs graphically, it is not necessary to write the problem in its standard form. Nevertheless, you should be able to compute the values of the slack and surplus variables and understand what they mean, because the values of slack and surplus variables are included in the computer solution of linear programs. A final point: The standard form of the linear programming problem is equivalent to the original formulation of the problem. That is, the optimal solution to any linear programming problem is the same as the optimal solution to the standard form of the problem. The standard form has not changed the basic problem; it has only changed how we write the constraints for the problem.
Computer Solution of the M&D Chemicals Problem The optimal solution to M&D is given in Figure 2.17. The computer output shows that the minimum-cost solution yields an objective function value of $800. The values of the decision variables show that 250 gallons of product A and 100 gallons of product B provide the minimum-cost solution. The Slack/Surplus column shows that the constraint corresponding to the demand for product A (see constraint 1) has a surplus of 125 units. This column tells us that production of product A in the optimal solution exceeds demand by 125 gallons. The Slack/Surplus values are zero for the total production requirement (constraint 2) and the processing time limitation (constraint 3), which indicates that these constraints are binding at the optimal solution. We will discuss the rest of the computer output that appears in Figure 2.17 in Chapter 3 when we study the topic of sensitivity analysis.
2.6
57
Special Cases
FIGURE 2.17 THE SOLUTION FOR THE M&D CHEMICALS PROBLEM Optimal Objective Value =
WEB
file
M&D
2.6
800.00000
Variable -------------A B
Value --------------250.00000 100.00000
Reduced Cost ----------------0.00000 0.00000
Constraint -------------1 2 3
Slack/Surplus --------------125.00000 0.00000 0.00000
Dual Value ----------------0.00000 4.00000 -1.00000
Variable ---------A B
Objective Coefficient -----------2.00000 3.00000
Allowable Increase ---------1.00000 Infinite
Allowable Decrease ---------Infinite 1.00000
Constraint ---------1 2 3
RHS Value -----------125.00000 350.00000 600.00000
Allowable Increase ---------125.00000 125.00000 100.00000
Allowable Decrease ---------Infinite 50.00000 125.00000
SPECIAL CASES In this section we discuss three special situations that can arise when we attempt to solve linear programming problems.
Alternative Optimal Solutions From the discussion of the graphical solution procedure, we know that optimal solutions can be found at the extreme points of the feasible region. Now let us consider the special case in which the optimal objective function line coincides with one of the binding constraint lines on the boundary of the feasible region. We will see that this situation can lead to the case of alternative optimal solutions; in such cases, more than one solution provides the optimal value for the objective function. To illustrate the case of alternative optimal solutions, we return to the Par, Inc., problem. However, let us assume that the profit for the standard golf bag (S) has been decreased to $6.30. The revised objective function becomes 6.3S 9D. The graphical solution of this problem is shown in Figure 2.18. Note that the optimal solution still occurs at an extreme point. In fact, it occurs at two extreme points: extreme point 嘷 4 (S 300, D 420) and extreme point 嘷 3 (S 540, D 252). The objective function values at these two extreme points are identical; that is, 6.3S 9D 6.3(300) 9(420) 5670
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FIGURE 2.18 PAR, INC., PROBLEM WITH AN OBJECTIVE FUNCTION OF 6.3S 9D (ALTERNATIVE OPTIMAL SOLUTIONS) D 600
Number of Deluxe Bags
5
4 (300, 420) 400
6.3 S 200
+9 D
3 (540, 252)
=3 78 0
6.3 S
1 0
+9
D
=5 67 0
2 200
400
600
800
S
Number of Standard Bags
and 6.3S 9D 6.3(540) 9(252) 5670 Furthermore, any point on the line connecting the two optimal extreme points also provides an optimal solution. For example, the solution point (S 420, D 336), which is halfway between the two extreme points, also provides the optimal objective function value of 6.3S 9D 6.3(420) 9(336) 5670 A linear programming problem with alternative optimal solutions is generally a good situation for the manager or decision maker. It means that several combinations of the decision variables are optimal and that the manager can select the most desirable optimal solution. Unfortunately, determining whether a problem has alternative optimal solutions is not a simple matter.
Infeasibility Problems with no feasible solution do arise in practice, most often because management’s expectations are too high or because too many restrictions have been placed on the problem.
Infeasibility means that no solution to the linear programming problem satisfies all the constraints, including the nonnegativity conditions. Graphically, infeasibility means that a feasible region does not exist; that is, no points satisfy all the constraints and the nonnegativity conditions simultaneously. To illustrate this situation, let us look again at the problem faced by Par, Inc. Suppose that management specified that at least 500 of the standard bags and at least 360 of the deluxe bags must be manufactured. The graph of the solution region may now be constructed to reflect these new requirements (see Figure 2.19). The shaded area in the lower
2.6
59
Special Cases
FIGURE 2.19 NO FEASIBLE REGION FOR THE PAR, INC., PROBLEM WITH MINIMUM PRODUCTION REQUIREMENTS OF 500 STANDARD AND 360 DELUXE BAGS D Points Satisfying Minimum Production Requirements Minimum S
Number of Deluxe Bags
600
400
Minimum D
Points Satisfying Departmental Constraints
200
200
400
600
800
S
Number of Standard Bags
left-hand portion of the graph depicts those points satisfying the departmental constraints on the availability of time. The shaded area in the upper right-hand portion depicts those points satisfying the minimum production requirements of 500 standard and 360 deluxe bags. But no points satisfy both sets of constraints. Thus, we see that if management imposes these minimum production requirements, no feasible region exists for the problem. How should we interpret infeasibility in terms of this current problem? First, we should tell management that given the resources available (i.e., production time for cutting and dyeing, sewing, finishing, and inspection and packaging), it is not possible to make 500 standard bags and 360 deluxe bags. Moreover, we can tell management exactly how much of each resource must be expended to make it possible to manufacture 500 standard and 360 deluxe bags. Table 2.2 shows the minimum amounts of resources that must be available, the amounts currently available, and additional amounts that would be required to accomplish this level of production. Thus, we need 80 more hours for cutting and dyeing, 32 more hours for finishing, and 5 more hours for inspection and packaging to meet management’s minimum production requirements. If, after reviewing this information, management still wants to manufacture 500 standard and 360 deluxe bags, additional resources must be provided. Perhaps by hiring another person to work in the cutting and dyeing department, transferring a person from elsewhere in the plant to work part-time in the finishing department, or having the sewing people help out periodically with the inspection and packaging, the resource requirements can be met. As you can see, many possibilities are available for corrective management action, once we discover the lack of a feasible solution. The important thing to realize is that linear programming
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TABLE 2.2 RESOURCES NEEDED TO MANUFACTURE 500 STANDARD BAGS AND 360 DELUXE BAGS
Operation Cutting and dyeing Sewing Finishing Inspection and packaging
Minimum Required Resources (hours) ⁷⁄₁₀(500) 1(360) 710 ¹⁄₂(500) ⁵⁄₆(360) 550 1(500) ²⁄₃(360) 740 ¹⁄₁₀(500) ¹⁄₄(360) 140
Available Resources (hours) 630 600 708 135
Additional Resources Needed (hours) 80 None 32 5
analysis can help determine whether management’s plans are feasible. By analyzing the problem using linear programming, we are often able to point out infeasible conditions and initiate corrective action. Whenever you attempt to solve a problem that is infeasible using either LINGO or Excel Solver, you will get an error message indicating that the problem is infeasible. In this case you know that no solution to the linear programming problem will satisfy all constraints, including the nonnegativity conditions. Careful inspection of your formulation is necessary to try to identify why the problem is infeasible. In some situations, the only reasonable approach is to drop one or more constraints and re-solve the problem. If you are able to find an optimal solution for this revised problem, you will know that the constraint(s) that was omitted, in conjunction with the others, is causing the problem to be infeasible.
Unbounded The solution to a maximization linear programming problem is unbounded if the value of the solution may be made infinitely large without violating any of the constraints; for a minimization problem, the solution is unbounded if the value may be made infinitely small. This condition might be termed managerial utopia; for example, if this condition were to occur in a profit maximization problem, the manager could achieve an unlimited profit. However, in linear programming models of real problems, the occurrence of an unbounded solution means that the problem has been improperly formulated. We know it is not possible to increase profits indefinitely. Therefore, we must conclude that if a profit maximization problem results in an unbounded solution, the mathematical model doesn’t represent the real-world problem sufficiently. Usually, what has happened is that a constraint has been inadvertently omitted during problem formulation. As an illustration, consider the following linear program with two decision variables, X and Y: Max s.t.
20X + 10Y 1X
Ú 2 1Y … 5 X, Y Ú 0
In Figure 2.20 we graphed the feasible region associated with this problem. Note that we can only indicate part of the feasible region because the feasible region extends indefinitely in the direction of the X axis. Looking at the objective function lines in Figure 2.20, we see that the solution to this problem may be made as large as we desire. That is, no matter what solution we pick, we will always be able to reach some feasible solution with a larger value. Thus, we say that the solution to this linear program is unbounded.
2.6
61
Special Cases
FIGURE 2.20 EXAMPLE OF AN UNBOUNDED PROBLEM Y 20
15
10 Objective function increases without limit. 5 Feasible Region
5
10
20
X
20X
20X
0Y
+1
0Y
40
=2
60
=8
=1
0Y
+1
+1
20X
Can you recognize whether a linear program involves alternative optimal solutions or infeasibility, or is unbounded? Try Problems 42 and 43.
15
Whenever you attempt to solve a problem that is unbounded using either LINGO or Excel Solver you will get a message telling you that the problem is unbounded. Because unbounded solutions cannot occur in real problems, the first thing you should do is to review your model to determine whether you incorrectly formulated the problem. In many cases, this error is the result of inadvertently omitting a constraint during problem formulation.
NOTES AND COMMENTS 1. Infeasibility is independent of the objective function. It exists because the constraints are so restrictive that no feasible region for the linear programming model is possible. Thus, when you encounter infeasibility, making changes in the coefficients of the objective function will not help; the problem will remain infeasible. 2. The occurrence of an unbounded solution is often the result of a missing constraint. However,
a change in the objective function may cause a previously unbounded problem to become bounded with an optimal solution. For example, the graph in Figure 2.20 shows an unbounded solution for the objective function Max 20X 10Y. However, changing the objective function to Max 20X 10Y will provide the optimal solution X 2 and Y 0 even though no changes have been made in the constraints.
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An Introduction to Linear Programming
GENERAL LINEAR PROGRAMMING NOTATION In this chapter we showed how to formulate linear programming models for the Par, Inc., and M&D Chemicals problems. To formulate a linear programming model of the Par, Inc., problem we began by defining two decision variables: S number of standard bags and D number of deluxe bags. In the M&D Chemicals problem, the two decision variables were defined as A number of gallons of product A and B number of gallons of product B. We selected decision-variable names of S and D in the Par, Inc., problem and A and B in the M&D Chemicals problem to make it easier to recall what these decision variables represented in the problem. Although this approach works well for linear programs involving a small number of decision variables, it can become difficult when dealing with problems involving a large number of decision variables. A more general notation that is often used for linear programs uses the letter x with a subscript. For instance, in the Par, Inc., problem, we could have defined the decision variables as follows: x1 = number of standard bags x 2 = number of deluxe bags In the M&D Chemicals problem, the same variable names would be used, but their definitions would change: x1 = number of gallons of product A x 2 = number of gallons of product B A disadvantage of using general notation for decision variables is that we are no longer able to easily identify what the decision variables actually represent in the mathematical model. However, the advantage of general notation is that formulating a mathematical model for a problem that involves a large number of decision variables is much easier. For instance, for a linear programming model with three decision variables, we would use variable names of x1, x2, and x3; for a problem with four decision variables, we would use variable names of x1, x2, x3, and x4, and so on. Clearly, if a problem involved 1000 decision variables, trying to identify 1000 unique names would be difficult. However, using the general linear programming notation, the decision variables would be defined as x1, x2, x3, . . . , x1000. To illustrate the graphical solution procedure for a linear program written using general linear programming notation, consider the following mathematical model for a maximization problem involving two decision variables: Max s.t.
3x1 +
2x 2
2x1 + 2x 2 … 8 1x1 + 0.5x 2 … 3 x1, x 2 Ú 0 We must first develop a graph that displays the possible solutions (x1 and x2 values) for the problem. The usual convention is to plot values of x1 along the horizontal axis and values of x2 along the vertical axis. Figure 2.21 shows the graphical solution for this two-variable problem. Note that for this problem the optimal solution is x1 2 and x2 2, with an objective function value of 10.
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General Linear Programming Notation
FIGURE 2.21 GRAPHICAL SOLUTION OF A TWO-VARIABLE LINEAR PROGRAM WITH GENERAL NOTATION x2
7
6
5
t2
rain nst
Co
4
Co ns tr
ai
nt 1
3 Optimal Solution x1 = 2, x2 = 2 Optimal Value = 3x1 + 2x2 = 10 2
3x1 + 2x2 = 6 1
1
2
3
4
5
x1
Using general linear programming notation, we can write the standard form of the preceding linear program as follows: Max s.t.
3x1 +
2x 2 + 0s1 + 0s2
2x1 + 2x 2 + 1s1 1x1 + 0.5x 2 + x1, x 2, s1, s2 Ú 0
= 8 1s2 = 3
Thus, at the optimal solution x1 2 and x2 2; the values of the slack variables are s1 s2 0.
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SUMMARY We formulated linear programming models for two problems: the Par, Inc., maximization problem and the M&D Chemicals minimization problem. For both problems we showed a graphical solution procedure and provided a computer solution to the problem in a generic solution table. In formulating a mathematical model of these problems, we developed a general definition of a linear programming model. A linear programming model is a mathematical model with the following characteristics: 1. A linear objective function that is to be maximized or minimized 2. A set of linear constraints 3. Variables that are all restricted to nonnegative values Slack variables may be used to write less-than-or-equal-to constraints in equality form and surplus variables may be used to write greater-than-or-equal-to constraints in equality form. The value of a slack variable can usually be interpreted as the amount of unused resource, whereas the value of a surplus variable indicates the amount over and above some stated minimum requirement. When all constraints have been written as equalities, the linear program has been written in its standard form. If the solution to a linear program is infeasible or unbounded, no optimal solution to the problem can be found. In the case of infeasibility, no feasible solutions are possible, whereas, in the case of an unbounded solution, the objective function can be made infinitely large for a maximization problem and infinitely small for a minimization problem. In the case of alternative optimal solutions, two or more optimal extreme points exist, and all the points on the line segment connecting them are also optimal. This chapter concludes with a section showing how to write a linear program using general linear programming notation. The Management Science in Action, Using Linear Programming for Traffic Control, provides another example of the widespread use of linear programming. In the next two chapters we will see many more applications of linear programming. MANAGEMENT SCIENCE IN ACTION USING LINEAR PROGRAMMING FOR TRAFFIC CONTROL* The Hanshin Expressway was the first urban toll expressway in Osaka, Japan. Although in 1964 its length was only 2.3 kilometers, today it is a largescale urban expressway network of 200 kilometers. The Hanshin Expressway provides service for the Hanshin (Osaka-Kobe) area, the second-most populated area in Japan. An average of 828,000 vehicles use the expressway each day, with daily traffic sometimes exceeding 1 million vehicles. In 1990, the Hanshin Expressway Public Corporation started using an automated traffic control system in order to maximize the number of vehicles flowing into the expressway network. The automated traffic control system relies on two control methods: (1) limiting the number of cars that enter the expressway at each entrance ramp; and (2) providing drivers with up-to-date and accurate
traffic information, including expected travel times and information about accidents. The approach used to limit the number of vehicles depends upon whether the expressway is in a normal or steady state of operation, or whether some type of unusual event, such as an accident or a breakdown, has occurred. In the first phase of the steady-state case, the Hanshin system uses a linear programming model to maximize the total number of vehicles entering the system, while preventing traffic congestion and adverse effects on surrounding road networks. The data that drive the linear programming model are collected from detectors installed every 500 meters along the expressway and at all entrance and exit ramps. Every five minutes the real-time data collected from the detectors are used to update the model coefficients, and a new linear program
Glossary
computes the maximum number of vehicles the expressway can accommodate. The automated traffic control system has been successful. According to surveys, traffic control decreased the length of congested portions of the expressway by 30% and the duration by 20%. It
65
proved to be extremely cost effective, and drivers consider it an indispensable service. *Based on T. Yoshino, T. Sasaki, and T. Hasegawa, “The Traffic-Control System on the Hanshin Expressway,” Interfaces (January/February 1995): 94–108.
GLOSSARY Constraint An equation or inequality that rules out certain combinations of decision variables as feasible solutions. Problem formulation The process of translating the verbal statement of a problem into a mathematical statement called the mathematical model. Decision variable A controllable input for a linear programming model. Nonnegativity constraints A set of constraints that requires all variables to be nonnegative. Mathematical model A representation of a problem where the objective and all constraint conditions are described by mathematical expressions. Linear programming model A mathematical model with a linear objective function, a set of linear constraints, and nonnegative variables. Linear program Another term for linear programming model. Linear functions Mathematical expressions in which the variables appear in separate terms and are raised to the first power. Feasible solution A solution that satisfies all the constraints. Feasible region The set of all feasible solutions. Slack variable A variable added to the left-hand side of a less-than-or-equal-to constraint to convert the constraint into an equality. The value of this variable can usually be interpreted as the amount of unused resource. Standard form A linear program in which all the constraints are written as equalities. The optimal solution of the standard form of a linear program is the same as the optimal solution of the original formulation of the linear program. Redundant constraint A constraint that does not affect the feasible region. If a constraint is redundant, it can be removed from the problem without affecting the feasible region. Extreme point Graphically speaking, extreme points are the feasible solution points occurring at the vertices or “corners” of the feasible region. With two-variable problems, extreme points are determined by the intersection of the constraint lines. Surplus variable A variable subtracted from the left-hand side of a greater-than-orequal-to constraint to convert the constraint into an equality. The value of this variable can usually be interpreted as the amount over and above some required minimum level. Alternative optimal solutions The case in which more than one solution provides the optimal value for the objective function. Infeasibility The situation in which no solution to the linear programming problem satisfies all the constraints. Unbounded If the value of the solution may be made infinitely large in a maximization linear programming problem or infinitely small in a minimization problem without violating any of the constraints, the problem is said to be unbounded.
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PROBLEMS 1. Which of the following mathematical relationships could be found in a linear programming model, and which could not? For the relationships that are unacceptable for linear programs, state why. a. 1A 2B 70 b. 2A 2B 50 c. 1A 2B2 10 d. 3 2A 2B 15 e. 1A 1B 6 f. 2A 5B 1AB 25 2. Find the solutions that satisfy the following constraints: a. 4A 2B 16 b. 4A 2B 16 c. 4A 2B 16 3. Show a separate graph of the constraint lines and the solutions that satisfy each of the following constraints: a. 3A 2B 18 b. 12A 8B 480 c. 5A 10B 200 4. Show a separate graph of the constraint lines and the solutions that satisfy each of the following constraints: a. 3A 4B 60 b. 6A 5B 60 c. 5A 2B 0 5. Show a separate graph of the constraint lines and the solutions that satisfy each of the following constraints: a. A 0.25 (A B) b. B 0.10 (A B) c. A 0.50 (A B) 6. Three objective functions for linear programming problems are 7A 10B, 6A 4B, and 4A 7B. Show the graph of each for objective function values equal to 420. 7. Identify the feasible region for the following set of constraints: 0.5A + 0.25B Ú 30 1A + 5B Ú 250 0.25A + 0.5B … 50 A, B Ú 0 8. Identify the feasible region for the following set of constraints: 2A - 1B … 0 - 1A + 1.5B … 200 A, B Ú 0 9. Identify the feasible region for the following set of constraints: 3A - 2B Ú 0 2A - 1B … 200 1A … 150 A, B Ú 0
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Problems
10. For the linear program 2A + 3B
Max s.t.
1A + 2B … 6 5A + 3B … 15 A, B Ú 0 find the optimal solution using the graphical solution procedure. What is the value of the objective function at the optimal solution? 11. Solve the following linear program using the graphical solution procedure: Max s.t.
5A + 5B 1A
… 100 1B … 80 2A + 4B … 400 A, B Ú 0 12. Consider the following linear programming problem: Max s.t.
3A + 3B 2A + 4B … 12 6A + 4B … 24 A, B Ú 0
a. Find the optimal solution using the graphical solution procedure. b. If the objective function is changed to 2A 6B, what will the optimal solution be? c. How many extreme points are there? What are the values of A and B at each extreme point? 13. Consider the following linear program: Max s.t.
1A + 2B 1A
… 5 1B … 4 2A + 2B = 12 A, B Ú 0 a. Show the feasible region. b. What are the extreme points of the feasible region? c. Find the optimal solution using the graphical procedure. 14. RMC, Inc., is a small firm that produces a variety of chemical products. In a particular production process, three raw materials are blended (mixed together) to produce two products: a fuel additive and a solvent base. Each ton of fuel additive is a mixture of ²⁄₅ ton of material 1 and ³⁄₅ of material 3. A ton of solvent base is a mixture of ¹⁄₂ ton of material 1, ¹⁄₅ ton of material 2, and ³⁄₁₀ ton of material 3. After deducting relevant costs, the profit contribution is $40 for every ton of fuel additive produced and $30 for every ton of solvent base produced.
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RMC’s production is constrained by a limited availability of the three raw materials. For the current production period, RMC has available the following quantities of each raw material: Raw Material Material 1 Material 2 Material 3
Amount Available for Production 20 tons 5 tons 21 tons
Assuming that RMC is interested in maximizing the total profit contribution, answer the following: a. What is the linear programming model for this problem? b. Find the optimal solution using the graphical solution procedure. How many tons of each product should be produced, and what is the projected total profit contribution? c. Is there any unused material? If so, how much? d. Are any of the constraints redundant? If so, which ones? 15. Refer to the Par, Inc., problem described in Section 2.1. Suppose that Par’s management encounters the following situations: a. The accounting department revises its estimate of the profit contribution for the deluxe bag to $18 per bag. b. A new low-cost material is available for the standard bag, and the profit contribution per standard bag can be increased to $20 per bag. (Assume that the profit contribution of the deluxe bag is the original $9 value.) c. New sewing equipment is available that would increase the sewing operation capacity to 750 hours. (Assume that 10A 9B is the appropriate objective function.) If each of these situations is encountered separately, what is the optimal solution and the total profit contribution? 16. Refer to the feasible region for Par, Inc., problem in Figure 2.13. a. Develop an objective function that will make extreme point 嘷 45 the optimal extreme point. b. What is the optimal solution for the objective function you selected in part (a)? c. What are the values of the slack variables associated with this solution? 17. Write the following linear program in standard form: Max s.t.
5A + 2B 1A - 2B … 420 2A + 3B … 610 6A - 1B … 125 A, B Ú 0
18. For the linear program Max s.t.
4A + 1B 10A + 2B … 30 3A + 2B … 12 2A + 2B … 10 A, B Ú 0
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Problems
a. Write this problem in standard form. b. Solve the problem using the graphical solution procedure. c. What are the values of the three slack variables at the optimal solution? 19. Given the linear program 3A + 4B
Max s.t.
- 1A + 2B … 8 1A + 2B … 12 2A + 1B … 16 A, B Ú 0 a. Write the problem in standard form. b. Solve the problem using the graphical solution procedure. c. What are the values of the three slack variables at the optimal solution? 20. For the linear program Max s.t.
3A + 2B A + B Ú 3A + 4B … A Ú A - B … A, B Ú 0
4 24 2 0
a. Write the problem in standard form. b. Solve the problem. c. What are the values of the slack and surplus variables at the optimal solution? 21. Consider the following linear program: Max s.t.
2A + 3B 5A + 5B … 400 -1A + 1B … 10 1A + 3B Ú 90 A, B Ú 0
Constraint 1 Constraint 2 Constraint 3
Figure 2.22 shows a graph of the constraint lines. a. Place a number (1, 2, or 3) next to each constraint line to identify which constraint it represents. b. Shade in the feasible region on the graph. c. Identify the optimal extreme point. What is the optimal solution? d. Which constraints are binding? Explain. e. How much slack or surplus is associated with the nonbinding constraint? 22. Reiser Sports Products wants to determine the number of All-Pro (A) and College (C) footballs to produce in order to maximize profit over the next four-week planning horizon. Constraints affecting the production quantities are the production capacities in three departments: cutting and dyeing; sewing; and inspection and packaging. For
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FIGURE 2.22 GRAPH OF THE CONSTRAINT LINES FOR EXERCISE 21 B 90 80 70 60 50 40 30 20 10 0
10
20
30
40
50
60
70
80
90
100
A
the four-week planning period, 340 hours of cutting and dyeing time, 420 hours of sewing time, and 200 hours of inspection and packaging time are available. All-Pro footballs provide a profit of $5 per unit and College footballs provide a profit of $4 per unit. The linear programming model with production times expressed in minutes is as follows: Max s.t.
5A + 4C 12A + 6C … 20,400 Cutting and dyeing 9A + 15C … 25,200 Sewing 6A + 6C … 12,000 Inspection and packaging A, C Ú 0
A portion of the graphical solution to the Reiser problem is shown in Figure 2.23. a. Shade the feasible region for this problem. b. Determine the coordinates of each extreme point and the corresponding profit. Which extreme point generates the highest profit? c. Draw the profit line corresponding to a profit of $4000. Move the profit line as far from the origin as you can in order to determine which extreme point will provide the optimal solution. Compare your answer with the approach you used in part (b). d. Which constraints are binding? Explain. e. Suppose that the values of the objective function coefficients are $4 for each All-Pro model produced and $5 for each College model. Use the graphical solution procedure to determine the new optimal solution and the corresponding value of profit.
71
Problems
FIGURE 2.23 PORTION OF THE GRAPHICAL SOLUTION FOR EXERCISE 22 C 3500
Number of College Footballs
3000
2500
2000
1500
1000
500
500
1000
1500
2000
2500
3000
A
Number of All-Pro Footballs
23. Embassy Motorcycles (EM) manufacturers two lightweight motorcycles designed for easy handling and safety. The EZ-Rider model has a new engine and a low profile that make it easy to balance. The Lady-Sport model is slightly larger, uses a more traditional engine, and is specifically designed to appeal to women riders. Embassy produces the engines for both models at its Des Moines, Iowa, plant. Each EZ-Rider engine requires 6 hours of manufacturing time and each Lady-Sport engine requires 3 hours of manufacturing time. The Des Moines plant has 2100 hours of engine manufacturing time available for the next production period. Embassy’s motorcycle frame supplier can supply as many EZ-Rider frames as needed. However, the Lady-Sport frame is more complex and the supplier can only provide up to 280 Lady-Sport frames for the next production period. Final assembly and testing requires 2 hours for each EZ-Rider model and 2.5 hours for each Lady-Sport model. A maximum of 1000 hours of assembly and testing time are available for the next production period. The company’s accounting department projects a profit contribution of $2400 for each EZ-Rider produced and $1800 for each LadySport produced. a. Formulate a linear programming model that can be used to determine the number of units of each model that should be produced in order to maximize the total contribution to profit. b. Solve the problem graphically. What is the optimal solution? c. Which constraints are binding?
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24. Kelson Sporting Equipment, Inc., makes two different types of baseball gloves: a regular model and a catcher’s model. The firm has 900 hours of production time available in its cutting and sewing department, 300 hours available in its finishing department, and 100 hours available in its packaging and shipping department. The production time requirements and the profit contribution per glove are given in the following table: Production Time (hours) Model Regular model Catcher’s model
Cutting and Sewing 1 ³⁄₂
Finishing
Packaging and Shipping
¹⁄₂ ¹⁄₃
¹⁄₈ ¹⁄₄
Profit/Glove $5 $8
Assuming that the company is interested in maximizing the total profit contribution, answer the following: a. What is the linear programming model for this problem? b. Find the optimal solution using the graphical solution procedure. How many gloves of each model should Kelson manufacture? c. What is the total profit contribution Kelson can earn with the given production quantities? d. How many hours of production time will be scheduled in each department? e. What is the slack time in each department? 25. George Johnson recently inherited a large sum of money; he wants to use a portion of this money to set up a trust fund for his two children. The trust fund has two investment options: (1) a bond fund and (2) a stock fund. The projected returns over the life of the investments are 6% for the bond fund and 10% for the stock fund. Whatever portion of the inheritance he finally decides to commit to the trust fund, he wants to invest at least 30% of that amount in the bond fund. In addition, he wants to select a mix that will enable him to obtain a total return of at least 7.5%. a. Formulate a linear programming model that can be used to determine the percentage that should be allocated to each of the possible investment alternatives. b. Solve the problem using the graphical solution procedure. 26. The Sea Wharf Restaurant would like to determine the best way to allocate a monthly advertising budget of $1000 between newspaper advertising and radio advertising. Management decided that at least 25% of the budget must be spent on each type of media, and that the amount of money spent on local newspaper advertising must be at least twice the amount spent on radio advertising. A marketing consultant developed an index that measures audience exposure per dollar of advertising on a scale from 0 to 100, with higher values implying greater audience exposure. If the value of the index for local newspaper advertising is 50 and the value of the index for spot radio advertising is 80, how should the restaurant allocate its advertising budget in order to maximize the value of total audience exposure? a. Formulate a linear programming model that can be used to determine how the restaurant should allocate its advertising budget in order to maximize the value of total audience exposure. b. Solve the problem using the graphical solution procedure. 27. Blair & Rosen, Inc. (B&R), is a brokerage firm that specializes in investment portfolios designed to meet the specific risk tolerances of its clients. A client who contacted B&R this past week has a maximum of $50,000 to invest. B&R’s investment advisor decides to recommend a portfolio consisting of two investment funds: an Internet fund and a Blue
Problems
73
Chip fund. The Internet fund has a projected annual return of 12%, whereas the Blue Chip fund has a projected annual return of 9%. The investment advisor requires that at most $35,000 of the client’s funds should be invested in the Internet fund. B&R services include a risk rating for each investment alternative. The Internet fund, which is the more risky of the two investment alternatives, has a risk rating of 6 per thousand dollars invested. The Blue Chip fund has a risk rating of 4 per thousand dollars invested. For example, if $10,000 is invested in each of the two investment funds, B&R’s risk rating for the portfolio would be 6(10) 4(10) 100. Finally, B&R developed a questionnaire to measure each client’s risk tolerance. Based on the responses, each client is classified as a conservative, moderate, or aggressive investor. Suppose that the questionnaire results classified the current client as a moderate investor. B&R recommends that a client who is a moderate investor limit his or her portfolio to a maximum risk rating of 240. a. What is the recommended investment portfolio for this client? What is the annual return for the portfolio? b. Suppose that a second client with $50,000 to invest has been classified as an aggressive investor. B&R recommends that the maximum portfolio risk rating for an aggressive investor is 320. What is the recommended investment portfolio for this aggressive investor? Discuss what happens to the portfolio under the aggressive investor strategy. c. Suppose that a third client with $50,000 to invest has been classified as a conservative investor. B&R recommends that the maximum portfolio risk rating for a conservative investor is 160. Develop the recommended investment portfolio for the conservative investor. Discuss the interpretation of the slack variable for the total investment fund constraint. 28. Tom’s, Inc., produces various Mexican food products and sells them to Western Foods, a chain of grocery stores located in Texas and New Mexico. Tom’s, Inc., makes two salsa products: Western Foods Salsa and Mexico City Salsa. Essentially, the two products have different blends of whole tomatoes, tomato sauce, and tomato paste. The Western Foods Salsa is a blend of 50% whole tomatoes, 30% tomato sauce, and 20% tomato paste. The Mexico City Salsa, which has a thicker and chunkier consistency, consists of 70% whole tomatoes, 10% tomato sauce, and 20% tomato paste. Each jar of salsa produced weighs 10 ounces. For the current production period, Tom’s, Inc., can purchase up to 280 pounds of whole tomatoes, 130 pounds of tomato sauce, and 100 pounds of tomato paste; the price per pound for these ingredients is $0.96, $0.64, and $0.56, respectively. The cost of the spices and the other ingredients is approximately $0.10 per jar. Tom’s, Inc., buys empty glass jars for $0.02 each, and labeling and filling costs are estimated to be $0.03 for each jar of salsa produced. Tom’s contract with Western Foods results in sales revenue of $1.64 for each jar of Western Foods Salsa and $1.93 for each jar of Mexico City Salsa. a. Develop a linear programming model that will enable Tom’s to determine the mix of salsa products that will maximize the total profit contribution. b. Find the optimal solution. 29. AutoIgnite produces electronic ignition systems for automobiles at a plant in Cleveland, Ohio. Each ignition system is assembled from two components produced at AutoIgnite’s plants in Buffalo, New York, and Dayton, Ohio. The Buffalo plant can produce 2000 units of component 1, 1000 units of component 2, or any combination of the two components each day. For instance, 60% of Buffalo’s production time could be used to produce component 1 and 40% of Buffalo’s production time could be used to produce component 2; in this case, the Buffalo plant would be able to produce 0.6(2000) 1200 units of component 1 each day and 0.4(1000) 400 units of component 2 each day. The Dayton plant can produce 600 units of component 1, 1400 units of component 2, or any combination of the two components each day. At the end of each day, the component production at Buffalo and Dayton is sent to Cleveland for assembly of the ignition systems on the following workday.
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a. Formulate a linear programming model that can be used to develop a daily production schedule for the Buffalo and Dayton plants that will maximize daily production of ignition systems at Cleveland. b. Find the optimal solution. 30. A financial advisor at Diehl Investments identified two companies that are likely candidates for a takeover in the near future. Eastern Cable is a leading manufacturer of flexible cable systems used in the construction industry, and ComSwitch is a new firm specializing in digital switching systems. Eastern Cable is currently trading for $40 per share, and ComSwitch is currently trading for $25 per share. If the takeovers occur, the financial advisor estimates that the price of Eastern Cable will go to $55 per share and ComSwitch will go to $43 per share. At this point in time, the financial advisor has identified ComSwitch as the higher risk alternative. Assume that a client indicated a willingness to invest a maximum of $50,000 in the two companies. The client wants to invest at least $15,000 in Eastern Cable and at least $10,000 in ComSwitch. Because of the higher risk associated with ComSwitch, the financial advisor has recommended that at most $25,000 should be invested in ComSwitch. a. Formulate a linear programming model that can be used to determine the number of shares of Eastern Cable and the number of shares of ComSwitch that will meet the investment constraints and maximize the total return for the investment. b. Graph the feasible region. c. Determine the coordinates of each extreme point. d. Find the optimal solution. 31. Consider the following linear program: Min s.t.
3A + 4B 1A + 3B Ú 6 1A + 1B Ú 4 A, B Ú 0
Identify the feasible region and find the optimal solution using the graphical solution procedure. What is the value of the objective function? 32. Identify the three extreme-point solutions for the M&D Chemicals problem (see Section 2.5). Identify the value of the objective function and the values of the slack and surplus variables at each extreme point. 33. Consider the following linear programming problem: Min s.t.
A +
2B
A + 2A + 3A + -2A + A, B
4B B 1.5B 6B Ú 0
… Ú … Ú
21 7 21 0
a. Find the optimal solution using the graphical solution procedure and the value of the objective function. b. Determine the amount of slack or surplus for each constraint. c. Suppose the objective function is changed to max 5A + 2B. Find the optimal solution and the value of the objective function.
75
Problems
34. Consider the following linear program: Min s.t.
2A + 2B 1A + 3B … 12 3A + 1B Ú 13 1A - 1B = 3 A, B Ú 0
a. Show the feasible region. b. What are the extreme points of the feasible region? c. Find the optimal solution using the graphical solution procedure. 35. For the linear program Min s.t.
6A + 4B 2A + 1B Ú 12 1A + 1B Ú 10 1B … 4 A, B Ú 0
a. Write the problem in standard form. b. Solve the problem using the graphical solution procedure. c. What are the values of the slack and surplus variables? 36. As part of a quality improvement initiative, Consolidated Electronics employees complete a three-day training program on teaming and a two-day training program on problem solving. The manager of quality improvement has requested that at least 8 training programs on teaming and at least 10 training programs on problem solving be offered during the next six months. In addition, senior-level management has specified that at least 25 training programs must be offered during this period. Consolidated Electronics uses a consultant to teach the training programs. During the next quarter, the consultant has 84 days of training time available. Each training program on teaming costs $10,000 and each training program on problem solving costs $8000. a. Formulate a linear programming model that can be used to determine the number of training programs on teaming and the number of training programs on problem solving that should be offered in order to minimize total cost. b. Graph the feasible region. c. Determine the coordinates of each extreme point. d. Solve for the minimum cost solution. 37. The New England Cheese Company produces two cheese spreads by blending mild cheddar cheese with extra sharp cheddar cheese. The cheese spreads are packaged in 12-ounce containers, which are then sold to distributors throughout the Northeast. The Regular blend contains 80% mild cheddar and 20% extra sharp, and the Zesty blend contains 60% mild cheddar and 40% extra sharp. This year, a local dairy cooperative offered to provide up to 8100 pounds of mild cheddar cheese for $1.20 per pound and up to 3000 pounds of extra sharp cheddar cheese for $1.40 per pound. The cost to blend and package the cheese spreads, excluding the cost of the cheese, is $0.20 per container. If each container of Regular is sold for $1.95 and each container of Zesty is sold for $2.20, how many containers of Regular and Zesty should New England Cheese produce?
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38. Applied Technology, Inc. (ATI), produces bicycle frames using two fiberglass materials that improve the strength-to-weight ratio of the frames. The cost of the standard grade material is $7.50 per yard and the cost of the professional grade material is $9.00 per yard. The standard and professional grade materials contain different amounts of fiberglass, carbon fiber, and Kevlar as shown in the following table:
Fiberglass Carbon fiber Kevlar
Standard Grade 84% 10% 6%
Professional Grade 58% 30% 12%
ATI signed a contract with a bicycle manufacturer to produce a new frame with a carbon fiber content of at least 20% and a Kevlar content of not greater than 10%. To meet the required weight specification, a total of 30 yards of material must be used for each frame. a. Formulate a linear program to determine the number of yards of each grade of fiberglass material that ATI should use in each frame in order to minimize total cost. Define the decision variables and indicate the purpose of each constraint. b. Use the graphical solution procedure to determine the feasible region. What are the coordinates of the extreme points? c. Compute the total cost at each extreme point. What is the optimal solution? d. The distributor of the fiberglass material is currently overstocked with the professional grade material. To reduce inventory, the distributor offered ATI the opportunity to purchase the professional grade for $8 per yard. Will the optimal solution change? e. Suppose that the distributor further lowers the price of the professional grade material to $7.40 per yard. Will the optimal solution change? What effect would an even lower price for the professional grade material have on the optimal solution? Explain. 39. Innis Investments manages funds for a number of companies and wealthy clients. The investment strategy is tailored to each client’s needs. For a new client, Innis has been authorized to invest up to $1.2 million in two investment funds: a stock fund and a money market fund. Each unit of the stock fund costs $50 and provides an annual rate of return of 10%; each unit of the money market fund costs $100 and provides an annual rate of return of 4%. The client wants to minimize risk subject to the requirement that the annual income from the investment be at least $60,000. According to Innis’s risk measurement system, each unit invested in the stock fund has a risk index of 8, and each unit invested in the money market fund has a risk index of 3; the higher risk index associated with the stock fund simply indicates that it is the riskier investment. Innis’s client also specified that at least $300,000 be invested in the money market fund. a. Determine how many units of each fund Innis should purchase for the client to minimize the total risk index for the portfolio. b. How much annual income will this investment strategy generate? c. Suppose the client desires to maximize annual return. How should the funds be invested? 40. Photo Chemicals produces two types of photographic developing fluids. Both products cost Photo Chemicals $1 per gallon to produce. Based on an analysis of current inventory levels and outstanding orders for the next month, Photo Chemicals’ management specified that at least 30 gallons of product 1 and at least 20 gallons of product 2 must be produced during the next two weeks. Management also stated that an existing inventory of highly perishable raw material required in the production of both fluids must be used within the
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next two weeks. The current inventory of the perishable raw material is 80 pounds. Although more of this raw material can be ordered if necessary, any of the current inventory that is not used within the next two weeks will spoil—hence, the management requirement that at least 80 pounds be used in the next two weeks. Furthermore, it is known that product 1 requires 1 pound of this perishable raw material per gallon and product 2 requires 2 pounds of the raw material per gallon. Because Photo Chemicals’ objective is to keep its production costs at the minimum possible level, the firm’s management is looking for a minimum cost production plan that uses all the 80 pounds of perishable raw material and provides at least 30 gallons of product 1 and at least 20 gallons of product 2. What is the minimum cost solution? 41. Southern Oil Company produces two grades of gasoline: regular and premium. The profit contributions are $0.30 per gallon for regular gasoline and $0.50 per gallon for premium gasoline. Each gallon of regular gasoline contains 0.3 gallons of grade A crude oil and each gallon of premium gasoline contains 0.6 gallons of grade A crude oil. For the next production period, Southern has 18,000 gallons of grade A crude oil available. The refinery used to produce the gasolines has a production capacity of 50,000 gallons for the next production period. Southern Oil’s distributors have indicated that demand for the premium gasoline for the next production period will be at most 20,000 gallons. a. Formulate a linear programming model that can be used to determine the number of gallons of regular gasoline and the number of gallons of premium gasoline that should be produced in order to maximize total profit contribution. b. What is the optimal solution? c. What are the values and interpretations of the slack variables? d. What are the binding constraints? 42. Does the following linear program involve infeasibility, unbounded, and/or alternative optimal solutions? Explain. 4A + 8B
Max s.t.
2A + 2B … 10 - 1A + 1B Ú 8 A, B Ú 0 43. Does the following linear program involve infeasibility, unbounded, and/or alternative optimal solutions? Explain. Max s.t.
1A + 1B 8A + 6B Ú 24 2B Ú 4 A, B 0
44. Consider the following linear program: Max s.t.
1A + 1B 5A + 3B … 15 3A + 5B … 15 A, B Ú 0
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a. What is the optimal solution for this problem? b. Suppose that the objective function is changed to 1A + 2B. Find the new optimal solution. 45. Consider the following linear program: Max s.t.
1A - 2B -4A + 3B … 3 1A - 1B … 3 A, B Ú 0
a. b. c. d.
Graph the feasible region for the problem. Is the feasible region unbounded? Explain. Find the optimal solution. Does an unbounded feasible region imply that the optimal solution to the linear program will be unbounded?
46. The manager of a small independent grocery store is trying to determine the best use of her shelf space for soft drinks. The store carries national and generic brands and currently has 200 square feet of shelf space available. The manager wants to allocate at least 60% of the space to the national brands and, regardless of the profitability, allocate at least 10% of the space to the generic brands. How many square feet of space should the manager allocate to the national brands and the generic brands under the following circumstances? a. The national brands are more profitable than the generic brands. b. Both brands are equally profitable. c. The generic brand is more profitable than the national brand. 47. Discuss what happens to the M&D Chemicals problem (see Section 2.5) if the cost per gallon for product A is increased to $3.00 per gallon. What would you recommend? Explain. 48. For the M&D Chemicals problem in Section 2.5, discuss the effect of management’s requiring total production of 500 gallons for the two products. List two or three actions M&D should consider to correct the situation you encounter. 49. PharmaPlus operates a chain of 30 pharmacies. The pharmacies are staffed by licensed pharmacists and pharmacy technicians. The company currently employs 85 full-time equivalent pharmacists (combination of full time and part time) and 175 full-time equivalent technicians. Each spring management reviews current staffing levels and makes hiring plans for the year. A recent forecast of the prescription load for the next year shows that at least 250 full-time equivalent employees (pharmacists and technicians) will be required to staff the pharmacies. The personnel department expects 10 pharmacists and 30 technicians to leave over the next year. To accommodate the expected attrition and prepare for future growth, management stated that at least 15 new pharmacists must be hired. In addition, PharmaPlus’s new service quality guidelines specify no more than two technicians per licensed pharmacist. The average salary for licensed pharmacists is $40 per hour and the average salary for technicians is $10 per hour. a. Determine a minimum-cost staffing plan for PharmaPlus. How many pharmacists and technicians are needed? b. Given current staffing levels and expected attrition, how many new hires (if any) must be made to reach the level recommended in part (a)? What will be the impact on the payroll? 50. Expedition Outfitters manufactures a variety of specialty clothing for hiking, skiing, and mountain climbing. Its management decided to begin production on two new parkas designed
Problems
79
for use in extremely cold weather: the Mount Everest Parka and the Rocky Mountain Parka. The manufacturing plant has 120 hours of cutting time and 120 hours of sewing time available for producing these two parkas. Each Mount Everest Parka requires 30 minutes of cutting time and 45 minutes of sewing time, and each Rocky Mountain Parka requires 20 minutes of cutting time and 15 minutes of sewing time. The labor and material cost is $150 for each Mount Everest Parka and $50 for each Rocky Mountain Parka, and the retail prices through the firm’s mail order catalog are $250 for the Mount Everest Parka and $200 for the Rocky Mountain Parka. Because management believes that the Mount Everest Parka is a unique coat that will enhance the image of the firm, they specified that at least 20% of the total production must consist of this model. Assuming that Expedition Outfitters can sell as many coats of each type as it can produce, how many units of each model should it manufacture to maximize the total profit contribution? 51. English Motors, Ltd. (EML), developed a new all-wheel-drive sports utility vehicle. As part of the marketing campaign, EML produced a video tape sales presentation to send to both owners of current EML four-wheel-drive vehicles as well as to owners of four-wheeldrive sports utility vehicles offered by competitors; EML refers to these two target markets as the current customer market and the new customer market. Individuals who receive the new promotion video will also receive a coupon for a test drive of the new EML model for one weekend. A key factor in the success of the new promotion is the response rate, the percentage of individuals who receive the new promotion and test drive the new model. EML estimates that the response rate for the current customer market is 25% and the response rate for the new customer market is 20%. For the customers who test drive the new model, the sales rate is the percentage of individuals that make a purchase. Marketing research studies indicate that the sales rate is 12% for the current customer market and 20% for the new customer market. The cost for each promotion, excluding the test drive costs, is $4 for each promotion sent to the current customer market and $6 for each promotion sent to the new customer market. Management also specified that a minimum of 30,000 current customers should test drive the new model and a minimum of 10,000 new customers should test drive the new model. In addition, the number of current customers who test drive the new vehicle must be at least twice the number of new customers who test drive the new vehicle. If the marketing budget, excluding test drive costs, is $1.2 million, how many promotions should be sent to each group of customers in order to maximize total sales? 52. Creative Sports Design (CSD) manufactures a standard-size racket and an oversize racket. The firm’s rackets are extremely light due to the use of a magnesium-graphite alloy that was invented by the firm’s founder. Each standard-size racket uses 0.125 kilograms of the alloy and each oversize racket uses 0.4 kilograms; over the next two-week production period only 80 kilograms of the alloy are available. Each standard-size racket uses 10 minutes of manufacturing time and each oversize racket uses 12 minutes. The profit contributions are $10 for each standard-size racket and $15 for each oversize racket, and 40 hours of manufacturing time are available each week. Management specified that at least 20% of the total production must be the standard-size racket. How many rackets of each type should CSD manufacture over the next two weeks to maximize the total profit contribution? Assume that because of the unique nature of their products, CSD can sell as many rackets as they can produce. 53. Management of High Tech Services (HTS) would like to develop a model that will help allocate their technicians’ time between service calls to regular contract customers and new customers. A maximum of 80 hours of technician time is available over the two-week planning period. To satisfy cash flow requirements, at least $800 in revenue (per technician) must be generated during the two-week period. Technician time for regular customers generates $25 per hour. However, technician time for new customers only
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generates an average of $8 per hour because in many cases a new customer contact does not provide billable services. To ensure that new customer contacts are being maintained, the technician time spent on new customer contacts must be at least 60% of the time spent on regular customer contacts. Given these revenue and policy requirements, HTS would like to determine how to allocate technician time between regular customers and new customers so that the total number of customers contacted during the two-week period will be maximized. Technicians require an average of 50 minutes for each regular customer contact and 1 hour for each new customer contact. a. Develop a linear programming model that will enable HTS to allocate technician time between regular customers and new customers. b. Find the optimal solution. 54. Jackson Hole Manufacturing is a small manufacturer of plastic products used in the automotive and computer industries. One of its major contracts is with a large computer company and involves the production of plastic printer cases for the computer company’s portable printers. The printer cases are produced on two injection molding machines. The M-100 machine has a production capacity of 25 printer cases per hour, and the M-200 machine has a production capacity of 40 cases per hour. Both machines use the same chemical material to produce the printer cases; the M-100 uses 40 pounds of the raw material per hour and the M-200 uses 50 pounds per hour. The computer company asked Jackson Hole to produce as many of the cases during the upcoming week as possible; it will pay $18 for each case Jackson Hole can deliver. However, next week is a regularly scheduled vacation period for most of Jackson Hole’s production employees; during this time, annual maintenance is performed for all equipment in the plant. Because of the downtime for maintenance, the M-100 will be available for no more than 15 hours, and the M-200 will be available for no more than 10 hours. However, because of the high setup cost involved with both machines, management requires that, each machine must be operated for at least 5 hours. The supplier of the chemical material used in the production process informed Jackson Hole that a maximum of 1000 pounds of the chemical material will be available for next week’s production; the cost for this raw material is $6 per pound. In addition to the raw material cost, Jackson Hole estimates that the hourly cost of operating the M-100 and the M-200 are $50 and $75, respectively. a. Formulate a linear programming model that can be used to maximize the contribution to profit. b. Find the optimal solution. 55. The Kartick Company is trying to determine how much of each of two products to produce over the coming planning period. There are three departments, A, B and C, with limited labor hours available in each department. Each product must be processed by each department and the per-unit requirements for each product, labor hours available, and per-unit profit are as shown below.
Labor required in each department Department A B C Profit Contribution
Product (hrs./unit) Product 1 Product 2 1.00 0.30 0.30 0.12 0.15 0.56 $33.00
$24.00
Labor Hours Available 100 36 50
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Problems
A linear program for this situation is as follows:
x1 the amount of product 1 to produce x2 the amount of product 2 to produce
Let
Maximize s.t.
33 x1 24 x2 1.0 x1 .30 x2 100 .30 x1 .12 x2 36 .15 x1 .56 x2 50 x1, x2 0
Department A Department B Department C
Mr. Kartick (the owner) used trial and error with a spreadsheet model to arrive at a solution. His proposed solution is x1 75 and x2 60, as shown below in Figure 2.24. He said he felt his proposed solution is optimal. Is his solution optimal? Without solving the problem, explain why you believe this solution is optimal or not optimal.
FIGURE 2.24 MR. KARTICK’S TRIAL-AND-ERROR MODEL
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56. Assume you are given a minimization linear program that has an optimal solution. The problem is then modified by changing an equality constraint in the problem to a less-thanor-equal-to constraint. Is it possible that the modified problem is infeasible? Answer yes or no and justify. 57. Assume you are given a minimization linear program that has an optimal solution. The problem is then modified by changing a greater-than-or-equal-to constraint in the problem to a less-than-or-equal-to constraint. Is it possible that the modified problem is infeasible? Answer yes or no and justify. 58. A consultant was hired to build an optimization model for a large marketing research company. The model is based on a consumer survey that was taken in which each person was asked to rank 30 new products in descending order based on their likelihood of purchasing the product. The consultant was assigned the task of building a model that selects the minimum number of products (which would then be introduced into the marketplace) such that the first, second, and third choice of every subject in the survey is included in the list of selected products. While building a model to figure out which products to introduce, the consultant’s boss walked up to her and said: “Look, if the model tells us we need to introduce more than 15 products, then add a constraint which limits the number of new products to 15 or less. It’s too expensive to introduce more than 15 new products.” Evaluate this statement in terms of what you have learned so far about constrained optimization models.
Case Problem 1
WORKLOAD BALANCING
Digital Imaging (DI) produces photo printers for both the professional and consumer markets. The DI consumer division recently introduced two photo printers that provide color prints rivaling those produced by a professional processing lab. The DI-910 model can produce a 4" 6" borderless print in approximately 37 seconds. The more sophisticated and faster DI-950 can even produce a 13" 19" borderless print. Financial projections show profit contributions of $42 for each DI-910 and $87 for each DI-950. The printers are assembled, tested, and packaged at DI’s plant located in New Bern, North Carolina. This plant is highly automated and uses two manufacturing lines to produce the printers. Line 1 performs the assembly operation with times of 3 minutes per DI-910 printer and 6 minutes per DI-950 printer. Line 2 performs both the testing and packaging operations. Times are 4 minutes per DI-910 printer and 2 minutes per DI-950 printer. The shorter time for the DI-950 printer is a result of its faster print speed. Both manufacturing lines are in operation one 8-hour shift per day.
Managerial Report Perform an analysis for Digital Imaging in order to determine how many units of each printer to produce. Prepare a report to DI’s president presenting your findings and recommendations. Include (but do not limit your discussion to) a consideration of the following: 1. The recommended number of units of each printer to produce to maximize the total contribution to profit for an 8-hour shift. What reasons might management have for not implementing your recommendation? 2. Suppose that management also states that the number of DI-910 printers produced must be at least as great as the number of DI-950 units produced. Assuming that the objective is to maximize the total contribution to profit for an 8-hour shift, how many units of each printer should be produced?
Case Problem 2
Production Strategy
83
3. Does the solution you developed in part (2) balance the total time spent on line 1 and the total time spent on line 2? Why might this balance or lack of it be a concern to management? 4. Management requested an expansion of the model in part (2) that would provide a better balance between the total time on line 1 and the total time on line 2. Management wants to limit the difference between the total time on line 1 and the total time on line 2 to 30 minutes or less. If the objective is still to maximize the total contribution to profit, how many units of each printer should be produced? What effect does this workload balancing have on total profit in part (2)? 5. Suppose that in part (1) management specified the objective of maximizing the total number of printers produced each shift rather than total profit contribution. With this objective, how many units of each printer should be produced per shift? What effect does this objective have on total profit and workload balancing? For each solution that you develop, include a copy of your linear programming model and graphical solution in the appendix to your report.
Case Problem 2
PRODUCTION STRATEGY
Better Fitness, Inc. (BFI), manufactures exercise equipment at its plant in Freeport, Long Island. It recently designed two universal weight machines for the home exercise market. Both machines use BFI-patented technology that provides the user with an extremely wide range of motion capability for each type of exercise performed. Until now, such capabilities have been available only on expensive weight machines used primarily by physical therapists. At a recent trade show, demonstrations of the machines resulted in significant dealer interest. In fact, the number of orders that BFI received at the trade show far exceeded its manufacturing capabilities for the current production period. As a result, management decided to begin production of the two machines. The two machines, which BFI named the BodyPlus 100 and the BodyPlus 200, require different amounts of resources to produce. The BodyPlus 100 consists of a frame unit, a press station, and a pec-dec station. Each frame produced uses 4 hours of machining and welding time and 2 hours of painting and finishing time. Each press station requires 2 hours of machining and welding time and 1 hour of painting and finishing time, and each pec-dec station uses 2 hours of machining and welding time and 2 hours of painting and finishing time. In addition, 2 hours are spent assembling, testing, and packaging each BodyPlus 100. The raw material costs are $450 for each frame, $300 for each press station, and $250 for each pec-dec station; packaging costs are estimated to be $50 per unit. The BodyPlus 200 consists of a frame unit, a press station, a pec-dec station, and a legpress station. Each frame produced uses 5 hours of machining and welding time and 4 hours of painting and finishing time. Each press station requires 3 hours machining and welding time and 2 hours of painting and finishing time, each pec-dec station uses 2 hours of machining and welding time and 2 hours of painting and finishing time, and each legpress station requires 2 hours of machining and welding time and 2 hours of painting and finishing time. In addition, 2 hours are spent assembling, testing, and packaging each Body-Plus 200. The raw material costs are $650 for each frame, $400 for each press station, $250 for each pec-dec station, and $200 for each leg-press station; packaging costs are estimated to be $75 per unit. For the next production period, management estimates that 600 hours of machining and welding time, 450 hours of painting and finishing time, and 140 hours of assembly, testing,
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and packaging time will be available. Current labor costs are $20 per hour for machining and welding time, $15 per hour for painting and finishing time, and $12 per hour for assembly, testing, and packaging time. The market in which the two machines must compete suggests a retail price of $2400 for the BodyPlus 100 and $3500 for the BodyPlus 200, although some flexibility may be available to BFI because of the unique capabilities of the new machines. Authorized BFI dealers can purchase machines for 70% of the suggested retail price. BFI’s president believes that the unique capabilities of the BodyPlus 200 can help position BFI as one of the leaders in high-end exercise equipment. Consequently, he has stated that the number of units of the BodyPlus 200 produced must be at least 25% of the total production.
Managerial Report Analyze the production problem at Better Fitness, Inc., and prepare a report for BFI’s president presenting your findings and recommendations. Include (but do not limit your discussion to) a consideration of the following items: 1. What is the recommended number of BodyPlus 100 and BodyPlus 200 machines to produce? 2. How does the requirement that the number of units of the BodyPlus 200 produced be at least 25% of the total production affect profits? 3. Where should efforts be expended in order to increase profits? Include a copy of your linear programming model and graphical solution in an appendix to your report.
Case Problem 3
HART VENTURE CAPITAL
Hart Venture Capital (HVC) specializes in providing venture capital for software development and Internet applications. Currently HVC has two investment opportunities: (1) Security Systems, a firm that needs additional capital to develop an Internet security software package, and (2) Market Analysis, a market research company that needs additional capital to develop a software package for conducting customer satisfaction surveys. In exchange for Security Systems stock, the firm has asked HVC to provide $600,000 in year 1, $600,000 in year 2, and $250,000 in year 3 over the coming three-year period. In exchange for their stock, Market Analysis has asked HVC to provide $500,000 in year 1, $350,000 in year 2, and $400,000 in year 3 over the same three-year period. HVC believes that both investment opportunities are worth pursuing. However, because of other investments, they are willing to commit at most $800,000 for both projects in the first year, at most $700,000 in the second year, and $500,000 in the third year. HVC’s financial analysis team reviewed both projects and recommended that the company’s objective should be to maximize the net present value of the total investment in Security Systems and Market Analysis. The net present value takes into account the estimated value of the stock at the end of the three-year period as well as the capital outflows that are necessary during each of the three years. Using an 8% rate of return, HVC’s financial analysis team estimates that 100% funding of the Security Systems project has a net present value of $1,800,000, and 100% funding of the Market Analysis project has a net present value of $1,600,000. HVC has the option to fund any percentage of the Security Systems and Market Analysis projects. For example, if HVC decides to fund 40% of the Security Systems
Appendix 2.1
Solving Linear Programs with LINGO
85
project, investments of 0.40($600,000) $240,000 would be required in year 1, 0.40($600,000) $240,000 would be required in year 2, and 0.40($250,000) $100,000 would be required in year 3. In this case, the net present value of the Security Systems project would be 0.40($1,800,000) $720,000. The investment amounts and the net present value for partial funding of the Market Analysis project would be computed in the same manner.
Managerial Report Perform an analysis of HVC’s investment problem and prepare a report that presents your findings and recommendations. Include (but do not limit your discussion to) a consideration of the following items: 1. What is the recommended percentage of each project that HVC should fund and the net present value of the total investment? 2. What capital allocation plan for Security Systems and Market Analysis for the coming three-year period and the total HVC investment each year would you recommend? 3. What effect, if any, would HVC’s willingness to commit an additional $100,000 during the first year have on the recommended percentage of each project that HVC should fund? 4. What would the capital allocation plan look like if an additional $100,000 is made available? 5. What is your recommendation as to whether HVC should commit the additional $100,000 in the first year? Provide model details and relevant computer output in a report appendix.
Appendix 2.1 LINGO is a product of LINDO Systems. It was developed by Linus E. Schrage and Kevin Cunningham at the University of Chicago.
SOLVING LINEAR PROGRAMS WITH LINGO
In this appendix we describe how to use LINGO to solve the Par, Inc., problem. When you start LINGO, two windows are immediately displayed. The outer or main frame window contains all the command menus and the command toolbar. The smaller window is the model window; this window is used to enter and edit the linear programming model you want to solve. The first item we enter into the model window is the objective function. Recall that the objective function for the Par, Inc., problem is Max 10S 9D. Thus, in the first line of the LINGO model window, we enter the following expression: MAX = 10*S + 9*D; Note that in LINGO the symbol * is used to denote multiplication and that the objective function line ends with a semicolon. In general, each mathematical expression (objective function and constraints) in LINGO is terminated with a semicolon. Next, we press the enter key to move to a new line. The first constraint in the Par, Inc., problem is 0.7S 1D 630. Thus, in the second line of the LINGO model window we enter the following expression: 0.7*S + 1*D 6 = 630 Note that LINGO interprets the symbol as . Alternatively, we could enter instead of . As was the case when entering the objective function, a semicolon is required at the
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end of the first constraint. Pressing the enter key moves us to a new line as we continue the process by entering the remaining constraints as shown here: 0.5*S ⁵⁄₆*D 600 1*S ²⁄₃*D 708 0.1*S 0.25*D 135 The model window will now appear as follows: MAX 10*S 9*D 0.7*S 1*D 630 0.5*S ⁵⁄₆*D 600 1*S ²⁄₃*D 708 0.1*S 0.25*D 135 When entering a fraction into LINGO it is not necessary to convert the fraction into an equivalent or rounded decimal number. For example, simply enter the fraction ²⁄₃ into LINGO as ²⁄₃ and do not worry about converting to a decimal or how many decimal places to use. Enter ⁷⁄₁₀ either as ⁷⁄₁₀ or .7. Let LINGO act as a calculator for you. LINGO is very flexible about the format of an equation and it is not necessary to have the variables on the left hand side of an equation and the constant term on the right. For example, 0.7*S 1*D 630 could also be entered as 0.7*S 630 1*D This feature will be very useful later when writing models in a clear and understandable form. Finally, note that although we have expressly included a coefficient of 1 on the variable D above, this is not necessary. In LINGO, 1*D and D are equivalent. If you make an error in entering the model, you can correct it at any time by simply positioning the cursor where you made the error and entering the necessary correction. To solve the model, select the Solve command from the LINGO menu or press the Solve button on the toolbar at the top of the main frame window. LINGO will begin the solution process by determining whether the model conforms to all syntax requirements. If the LINGO model doesn’t pass these tests, you will be informed by an error message. If LINGO does not find any errors in the model input, it will begin to solve the model. As part of the solution process, LINGO displays a Solver Status window that allows you to monitor the progress of the solver. LINGO displays the solution in a new window titled “Solution Report.” The output that appears in the Solution Report window for the Par, Inc., problem is shown in Figure 2.25. The first part of the output shown in Figure 2.25 indicates that an optimal solution has been found and that the value of the objective function is 7668. We see that the optimal solution is S 540 and D 252, and that the slack variables for the four constraints (rows 2–5) are 0, 120, 0, and 18. We will discuss the use of the information in the Reduced Cost column and the Dual Price column in Chapter 3 when we study the topic of sensitivity analysis.
Appendix 2.2
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FIGURE 2.25 PAR, INC., SOLUTION REPORT USING LINGO Global optimal solution found. Objective value: Total solver iterations:
7668.000 2
Variable -------------S D
Value --------------540.0000 252.0000
Reduced Cost ----------------0.000000 0.000000
Row -------------1 2 3 4 5
Slack or Surplus ---------------7668.000 0.000000 120.0000 0.000000 18.00000
Dual Price ----------------1.000000 4.375000 0.000000 6.937500 0.000000
Appendix 2.2
SOLVING LINEAR PROGRAMS WITH EXCEL
In this appendix we will use an Excel worksheet to solve the Par, Inc., linear programming problem. We will enter the problem data for the Par problem in the top part of the worksheet and develop the linear programming model in the bottom part of the worksheet.
Formulation Whenever we formulate a worksheet model of a linear program, we perform the following steps: Step 1. Step 2. Step 3. Step 4.
Enter the problem data in the top part of the worksheet. Specify cell locations for the decision variables. Select a cell and enter a formula for computing the value of the objective function. Select a cell and enter a formula for computing the left-hand side of each constraint. Step 5. Select a cell and enter a formula for computing the right-hand side of each constraint. The formula worksheet that we developed for the Par, Inc., problem using these five steps is shown in Figure 2.26. Note that the worksheet consists of two sections: a data section and a model section. The four components of the model are screened, and the cells reserved for the decision variables are enclosed in a boldface box. Figure 2.26 is called a formula worksheet because it displays the formulas that we have entered and not the values computed from those formulas. In a moment we will see how Excel’s Solver is used to find the optimal solution to the Par, Inc., problem. But first, let’s review each of the preceding steps as they apply to the Par, Inc., problem. Step 1. Enter the problem data in the top part of the worksheet. Cells B5:C8 show the production requirements per unit for each product. Note that in cells C6 and C7, we have entered the exact fractions. That is, in cell C6 we have entered ⁵⁄₆ and in cell C7 we have entered ²⁄₃.
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FIGURE 2.26 FORMULA WORKSHEET FOR THE PAR, INC., PROBLEM A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
B
C
D
Par, Inc.
Operation Cutting and Dyeing Sewing Finishing Inspection and Packaging Profit Per Bag
Production Time Standard Deluxe 0.7 1 0.5 0.83333 1 0.66667 0.1 0.25 10 9
Time Available 630 600 708 135
Model Decision Variables Standard Deluxe Bags Produced Maximize Total Profit
=B9*B16+C9*C16
Constraints Cutting and Dyeing Sewing Finishing Inspection and Packaging
Hours Used (LHS) =B5*B16+C5*C16 =B6*B16+C6*C16 =B7*B16+C7*C16 =B8*B16+C8*C16
Step 2.
Step 3. Step 4.
Step 5.
(s 2T ) and PSN (Z ) is the probability of an observation of Z or less for a normal distribution with mean 0 and variance 1. The purpose of this exercise is to price a Procter & Gamble call option offered on August 25, 2006. The option expires September 15, 2006, which includes 21 days between the market close on August 25, 2006, and the expiration of the option on September 15, 2006. Use the yield on three-month Treasury bills as the risk-free interest rate. As of August 25, 2006, this yield was 0.0494. The strike price on the option is $60 and at the market close on August 25, 2006, the stock was trading at $60.87. In order to use the
401
Problems
Black-Scholes formula, the yearly standard deviation, s is required. One way to obtain this number is to estimate the weekly variance of Procter & Gamble, multiply the weekly variance by 52, and then take the square root to get the annual standard deviation. For this problem, use a weekly variance of 0.000479376. Use these data to calculate the option price using the Black-Scholes formula. For Friday, August 25, 2006, the actual bid on this option was $1.35 and actual ask was $1.45. 19. The port of Lajitas has three loading docks. The distance (in meters) between the loading docks is given in the following table:
1 2 3
1 0 100 150
2 100 0 50
3 150 50 0
Three tankers currently at sea are coming into Lajitas. It is necessary to assign a dock for each tanker. Also, only one tanker can anchor in a given dock. Currently, ships 2 and 3 are empty and have no cargo. However, ship 1 has cargo that must be loaded onto the other two ships. The number of tons that must be transferred are as follows: To From
1
1 0
2 60
3 80
Formulate and solve with Excel Solver or LINGO an optimization problem with binary decision variables (where 1 means an assignment and 0 means no assignment) that will assign ships to docks so that the product of tonnage moved times distance is minimized. (Hints: This problem is an extension of the assignment problem introduced in Chapter 6. Also, be careful with the objective function. Only include the nonzero terms. Each of the 12 nonzero terms in the objective function is a quadratic term, or the product of two variables.) There are 12 nonzero terms in the objective function. This problem formulation is an example of a quadratic assignment problem. The quadratic assignment problem is a powerful model. It is used in a number of facility location problems and components on circuit boards. It is also used to assign jets to gates at airports to minimize product of passengers and distance walked. 20. Andalus Furniture Company has two manufacturing plants, one at Aynor and another at Spartanburg. The cost of producing Q1 kitchen chairs at Aynor is: 75Q1 5Q12 100 and the cost of producing Q2 kitchen chairs at Spartanburg is 25Q2 2.5Q22 150 Andalus needs to manufacture a total of 40 kitchen chairs to meet an order just received. How many chairs should be made at Aynor and how many should be made at Spartanburg in order to minimize total production cost? 21. The weekly box office revenues (in $ millions) for Terminator 3 are given here. Use these data in the Bass forecasting model given by equations (8.21) through (8.23) to estimate the
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parameters p, q, and m. Solve the model using Solver and see whether you can duplicate the results in Table 8.8.
Week 1 2 3 4 5 6 7 8 9 10 11 12
Terminator 3 72.39 37.93 17.58 9.57 5.39 3.13 1.62 0.87 0.61 0.26 0.19 0.35
The Bass forecasting model is a good example of a “hard” nonlinear program and the answer you get may be a local optimum that is not nearly as good as the result given in Table 8.8. If you find your results do not match those in Table 8.8, use the Multistart option as described in Appendix 8.2. Use a lower bound of 1 and an upper bound of 1 on both p and q. Use a lower bound of 100 and an upper bound of 1000 on m.
Case Problem 1 PORTFOLIO OPTIMIZATION WITH TRANSACTION COSTS5 Hauck Financial Services has a number of passive, buy-and-hold clients. For these clients, Hauck offers an investment account whereby clients agree to put their money into a portfolio of mutual funds that is rebalanced once a year. When the rebalancing occurs, Hauck determines the mix of mutual funds in each investor’s portfolio by solving an extension of the Markowitz portfolio model that incorporates transaction costs. Investors are charged a small transaction cost for the annual rebalancing of their portfolio. For simplicity, assume the following: • • • •
5
At the beginning of the time period (in this case one year), the portfolio is rebalanced by buying and selling Hauck mutual funds. The transaction costs associated with buying and selling mutual funds are paid at the beginning of the period when the portfolio is rebalanced, which, in effect, reduces the amount of money available to reinvest. No further transactions are made until the end of the time period, at which point the new value of the portfolio is observed. The transaction cost is a linear function of the dollar amount of mutual funds bought or sold.
The authors appreciate helpful input from Linus Schrage on this case.
Case Problem 1
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Portfolio Optimization with Transaction Costs
Jean Delgado is one of Hauck’s buy-and-hold clients. We briefly describe the model as it is used by Hauck for rebalancing her portfolio. The mix of mutual funds that are being considered for her portfolio are a foreign stock fund (FS), an intermediate-term bond fund (IB), a large-cap growth fund (LG), a large-cap value fund (LV), a small-cap growth fund (SG), and a small-cap value fund (SV). In the traditional Markowitz model, the variables are usually interpreted as the proportion of the portfolio invested in the asset represented by the variable. For example, FS is the proportion of the portfolio invested in the foreign stock fund. However, it is equally correct to interpret FS as the dollar amount invested in the foreign stock fund. Then FS 25,000 implies $25,000 is invested in the foreign stock fund. Based on these assumptions, the initial portfolio value must equal the amount of money spent on transaction costs plus the amount invested in all the assets after rebalancing. That is, Initial portfolio value Amount invested in all assets after rebalancing Transaction costs The extension of the Markowitz model that Hauck uses for rebalancing portfolios requires a balance constraint for each mutual fund. This balance constraint is Amount invested in fund i Initial holding of fund i Amount of fund i purchased Amount of fund i sold Using this balance constraint requires three additional variables for each fund: one for the amount invested prior to rebalancing, one for the amount sold, and one for the amount purchased. For instance, the balance constraint for the foreign stock fund is FS FS_START FS_BUY FS_SELL Jean Delgado has $100,000 in her account prior to the annual rebalancing, and she has specified a minimum acceptable return of 10%. Hauck plans to use the following model to rebalance Ms. Delgado’s portfolio. The complete model with transaction costs is 5
Min ¹⁄₅ a (Rs - R)2 s=1
s.t. 0.1006FS 0.1312FS 0.1347FS 0.4542FS -0.2193FS
+ + + +
0.1764IB 3.25IB 0.0751IB 0.0133IB 0.0736IB
+ + + + -
0.3241LG 0.1871LG 0.3328LG 0.4146LG 0.2326LG
+ + + + -
0.3236LV 0.2061LV 0.1293LV 0.0706LV 0.0537LV
+ + + + -
0.3344SG 0.1940SG 0.385SG 0.5868SG 0.0902SG
+ 0.2456SV + 0.2532SV - 0.0670SV + 0.0543SV + 0.1731SV
= = = = =
R1 R2 R3 R4 R5
5
¹⁄₅ a Rs = R s=1
R FS + IB + LG + LV + SG + SV + TRANS–COST FS–START + FS–BUY - FS–SELL IB–START + IB–BUY - IB–SELL LG–START + LG–BUY - LG–SELL LV–START + LV–BUY - LV–SELL SG–START + SG–BUY - SG–SELL SV–START + SV–BUY - SV–SELL
Ú = = = = = = =
10,000 100,000 FS IB LG LV SG SV
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TRANS–FEE * (FS–BUY + FS–SELL + IB–BUY + IB–SELL + LG–BUY + LG–SELL + LV–BUY + LV–SELL + SG–BUY + SG–SELL + SV–BUY + SV–SELL) FS–START = IB–START = LG–START = LV–START = SG–START = SV–START = TRANS–FEE FS, IB, LG, LV, SG, SV
= TRANS–COST 10,000 10,000 10,000 40,000 10,000 20,000 = 0.01 Ú 0
Notice that the transaction fee is set at 1% in the model (the last constraint) and that the transaction cost for buying and selling shares of the mutual funds is a linear function of the amount bought and sold. With this model, the transactions costs are deducted from the client’s account at the time of rebalancing and thus reduce the amount of money invested. The LINGO solution for Ms. Delgado’s rebalancing problem is shown in Figure 8.16.
Managerial Report Assume you are a newly employed quantitative analyst hired by Hauck Financial Services. One of your first tasks is to review the portfolio rebalancing model in order to help resolve a dispute with Jean Delgado. Ms. Delgado has had one of the Hauck passively managed portfolios for the last five years and has complained that she is not getting the rate of return of 10% that she specified. After a review of her annual statements for the last five years, she feels that she is actually getting less than 10% on average. 1. According to the model solution in Figure 8.16, IB_BUY $41,268.51. How much transaction cost did Ms. Delgado pay for purchasing additional shares of the intermediate-term bond fund? 2. Based on the model solution given in Figure 8.16, what is the total transaction cost associated with rebalancing Ms. Delgado’s portfolio? 3. After paying transactions costs, how much did Ms. Delgado have invested in mutual funds after her portfolio was rebalanced? 4. According to the model solution in Figure 8.16, IB $51,268.51. How much can Ms. Delgado expect to have in the intermediate-term bond fund at the end of the year? 5. According to the model solution in Figure 8.16, the expected return of the portfolio is $10,000. What is the expected dollar amount in Ms. Delgado’s portfolio at the end of the year? Can she expect to earn 10% on the $100,000 she had at the beginning of the year? 6. It is now time to prepare a report to management to explain why Ms. Delgado did not earn 10% each year on her investment. Make a recommendation in terms of a revised portfolio model that can be used so that Jean Delgado can have an expected portfolio balance of $110,000 at the end of next year. Prepare a report that includes a modified optimization model that will give an expected return of 10% on the amount of money available at the beginning of the year before paying the transaction costs. Explain why the current model does not do this. 7. Solve the formulation in part (6) for Jean Delgado. How does the portfolio composition differ from that shown in Figure 8.16?
Case Problem 2
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CAFE Compliance in the Auto Industry
FIGURE 8.16 SOLUTION TO HAUCK MINIMUM VARIANCE PORTFOLIO WITH TRANSACTION COSTS Optimal Objective Value = 27219457.35644 Variable --------------
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HauckCase
R1 RBAR R2 R3 R4 R5 FS IB LG LV SG SV TRANS_COST FS_START FS_BUY FS_SELL IB_START IB_BUY IB_SELL LG_START LG_BUY LG_SELL LV_START LV_BUY LV_SELL SG_START SG_BUY SG_SELL SV_START SV_BUY SV_SELL TRANS_FEE
Case Problem 2
Value -----------------
18953.28 10000.00 11569.21 5663.961 9693.921 4119.631 15026.86 51268.51 4939.312 0.000000 0.000000 27675.00 1090.311 10000.00 5026.863 0.000000 10000.00 41268.51 0.000000 10000.00 0.000000 5060.688 40000.00 0.000000 40000.00 10000.00 0.000000 10000.00 20000.00 7675.004 0.000000 0.010000
Reduced Cost ------------------
0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 418.5587 149.1254 0.000000 0.000000 0.000000 0.000000 1.516067 0.000000 0.000000 1.516067 0.000000 1.516067 0.000000 0.000000 1.516067 0.000000 0.000000 1.516067 0.000000 0.000000 0.000000 1.516067 0.000000
CAFE COMPLIANCE IN THE AUTO INDUSTRY
This case is based on the Management Science in Action, Pricing for Environmental Compliance in the Auto Industry. In this case we build a model similar to the one built for General Motors. The CAFE requirement on fleet miles per gallon is based on an average. The harmonic average is used to calculate the CAFE requirement on average miles per gallon. In order to understand the harmonic average, assume that there is a passenger car and a light truck. The passenger car gets 30 miles per gallon (MPG) and the light truck gets 20 miles per gallon (MPG). Assume each vehicle is driven exactly one mile. Then the
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passenger car consumes ¹⁄₃₀ gallon of gasoline in driving one mile and the light truck consumes ¹⁄₂₀ gallon of gasoline in driving one mile. The amount of gasoline consumed in total is Gas consumption (¹⁄₃₀ ) (¹⁄₂₀ ) (₅⁄₆₀ ) (¹⁄₁₂) gallon The average MPG of the two vehicles calculated the “normal way” is (30 20)兾2 25 MPG. If both vehicles are “average,” and each vehicle is driven exactly one mile, then the total gasoline consumption is Gas consumption (¹⁄₂₅) (¹⁄₂₅) (₂⁄₂₅) gallon Because (₂⁄₂₅) is not equal to (₅⁄₆₀ ), the total gas consumption of two “average vehicles” driving exactly one mile is not equal to the total gas consumption of each of the original vehicles driving exactly one mile. This is unfortunate. In order to make it easy for the government to impose and enforce MPG constraints on the auto companies, it would be nice to have a single target value MPG that every company in the auto industry must meet. As just illustrated, there is a problem with requiring an average MPG on the industry because it will incorrectly estimate the gas mileage consumption of the fleet. Fortunately, there is a statistic called the harmonic average so that total gas consumption by harmonic average vehicles is equal to gas consumption of the actual vehicles. For simplicity, first assume that there are two types of vehicles in the fleet, passenger cars and light trucks. If there is one passenger car getting 30 miles per gallon and there is one light trucks getting 20 miles per gallon, the harmonic average of these two vehicles is 2 1 1 + 30 20
=
2 120 = = 24 5 5 60
If each vehicle were to drive exactly one mile, each vehicle would consume ₁⁄₂₄ gallon of gasoline for a total of ₂⁄₂₄ ₁⁄₁₂ gallon of gasoline. In this case each “average” vehicle driving exactly one mile results in total gas consumption equal to the total gas consumption of each vehicle with a different MPG rating driving exactly one mile. If there are three passenger vehicles and two light trucks, the harmonic average is given by 5 3 2 + 30 20
=
5 5 = = 25 0.1 + 0.1 0.2
In general, when calculating the harmonic average, the numerator is the total number of vehicles. The denominator is the sum of two terms. Each term is the ratio of the number of vehicles in that class to the MPG of cars in that class. For example, the first ratio in the denominator is ₃⁄₃₀ because there are 3 cars (the numerator) each getting 30 MPG (the denominator). These calculations are illustrated in Figure 8.17. Based on Figure 8.17, if each of the 5 cars is average and drives exactly one mile, (₅⁄₂₅) (₁⁄₅) gallon of gas is consumed. If three cars getting 30 MPG drive exactly one mile each and two cars getting 20 MPG drive exactly one mile, then (₃⁄₃₀) (₂⁄₂₀) (₂⁄₁₀) (₁⁄₅) gallon is consumed. Thus, the average cars exactly duplicate the gas consumption of the fleet with varying MPG.
Case Problem 2
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CAFE Compliance in the Auto Industry
FIGURE 8.17 AN EXCEL SPREADSHEET WITH A CAFÉ CALCULATION
A 1 2 3 Passenger Cars 4 Light Trucks 5 6 7 Café Average
B
C Number of Vehicles 3 3 5
MPG 30 20
D Café Weight 0.1000 0.1000 0.2000
25
Now assume that the demand function for passenger cars is
Demand 750 PC
(8.24)
where PC is the price of a passenger car. Similarly, the demand function for light trucks is
Demand 830 PT
(8.25)
where PT is the price of a light truck.
Managerial Report 1. Using the formulas given in (8.24) and (8.25), develop an expression for the total profit contribution as a function of the price of cars and the price of light trucks. 2. Using Excel Solver or LINGO, find the price for each car so that the total profit contribution is maximized. 3. Given the prices determined in Question 2, calculate the number of passenger cars sold and the number of light trucks sold. 4. Duplicate the spreadsheet in Figure 8.17. Your spreadsheet should have formulas in cells D3:D5 and B7 and be able to calculate the harmonic (CAFE) average for any MPG rating and any number of vehicles in each category. 5. Again, assume that passenger cars get 30 MPG and light trucks get 20 MPG; calculate the CAFE average for the fleet size from part (3). 6. If you do the calculation in part (5) correctly, the CAFE average of the fleet is 23.57. Add a constraint that the fleet average must be 25 MPG and resolve the model to get the maximum total profit contribution subject to meeting the CAFE constraint.
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Appendix 8.1 Appendix 2.1 shows how to use LINGO to solve linear programs.
Nonlinear Optimization Models
SOLVING NONLINEAR PROBLEMS WITH LINGO
Solving a nonlinear optimization problem in LINGO is no different from solving a linear optimization problem in LINGO. Simply type in the formulation, select the LINGO menu and choose the Solve option. Just remember that LINGO uses the ^ sign for exponentiation and the / sign for division. Also note that an asterisk (*) must be used to indicate multiplication. We show how the unconstrained Par, Inc., problem from Section 8.1 is solved using LINGO. After starting LINGO, we type in the problem formulation in the model window as follows: MAX 80*S (1兾15)*S^2 150*D (1兾5)*D^2; The solution obtained is shown in Figure 8.18. To solve the problem, select the Solve command from the LINGO menu or press the Solve button on the toolbar. Note that the value of the objective function is 52125.00, S 600, and D 375. Now solve the constrained Par, Inc., problem from Section 8.1 using LINGO. The only difference from the constrained problem is that four lines must be added to the formulation to account for the production constraints. After starting LINGO, we type in the problem formulation in the model window as follows. MAX 80*S (1兾15)*S^2 150*D (1兾5)*D^2; (7兾10)*S D 630; (1兾2)*S (5兾6)*D 600; S (2兾3)*D 708; (1兾10)*S (1兾4)*D 135; Note that at the end of the objective function and each constraint a semicolon is used. After selecting the Solve command from the LINGO menu, the solution shown in Figure 8.2 is obtained. In the Par, Inc., problem, all the variables are constrained to be nonnegative. If some of the variables may assume negative values, extra lines must be added to the LINGO formulation and the @FREE command must be used. For instance, the Hauck index fund model
FIGURE 8.18 THE LINGO OPTIMAL SOLUTION FOR THE UNCONSTRAINED PAR, INC., PROBLEM Local optimal solution found. Objective value: Extended solver steps: Total solver iterations:
52125.00 5 40
Variable -------------S D
Value --------------600.0000 375.0000
Reduced Cost ----------------0.000000 0.000000
Row -------------1
Slack or Surplus ---------------52125.00
Dual Price ----------------1.000000
Appendix 8.2
Solving Nonlinear Problems with Excel Solver
409
shown in Section 8.2 did not contain nonnegativity constraints for variables R1, R2, R3, R4, and R5 because these variables are allowed to assume negative values. Thus, after entering the objective function and constraints, the following five lines must be added to the LINGO model to produce the solution shown in Figure 8.8. @FREE(R1); @FREE(R2); @FREE(R3); @FREE(R4); @FREE(R5);
The demo LINGO provided on the website accompanying this text allows only five variables for problems that use the global solver.
LINGO also provides the user with a wide variety of nonlinear functions that are useful in finance, inventory management, statistics, and other applications. To get a list of these functions, use the online LINGO User’s Manual that is available under the Help menu. In the User’s Manual you will find a chapter entitled “LINGO’s Operators and Functions.” This chapter contains a list of the available functions. When using a LINGO function you must precede the function name with the @ sign. For example, if you wanted to take the natural logarithm of X you would write @LOG(X). We have discussed the concept of global versus local optimum. By default, LINGO finds a local optimum and the global solver is turned off. In order to turn on the global solver, select Options from the LINGO menu. When the Options dialog box appears, select the Global Solver tab and check the Use Global Solver box. When using LINGO one must exercise care in how the minus sign is used. When used in an expression such as y – x2, the minus sign is a binary operator because it connects two terms y and x2. By convention, exponentiation has higher “precedence” than the minus; so if y 2 and x –1, the expression y – x2 evaluates to y – x2 2 – (–1)2 2 – 1 1 However, in the expression –x2 y, the minus sign is a unary operator because it does not combine terms. LINGO, by default, assigns the unary minus sign higher precedence than exponentiation. Thus, if y 2 and x –1 the expression –x2 y evaluates to –x2 y (–x)2 y 12 2 3 This is a potential source of confusion. In this text we, like many authors, expect –x2 to be interpreted as (x2), not (–x)2. Excel also treats the unary minus sign in this fashion.
Appendix 8.2 SOLVING NONLINEAR PROBLEMS WITH EXCEL SOLVER Excel Solver can be used for nonlinear optimization. The Excel formulation of the nonlinear version of the Par, Inc., problem developed in Section 8.1 is shown in Figure 8.19. A worksheet model is constructed just as in the linear case. The formula in cell B18 is the objective function. The formulas in cells B21:B24 are the left-hand sides of constraint inequalities. And the formulas in cells D21:D24 provide the right-hand sides for the constraint inequalities. Note how the nonlinearity comes into the model. The formula in cell B18, the objective function cell, is B27*B16 B28*C16 – B9*B16 – C9*C16
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FIGURE 8.19 THE MODIFIED PAR, INC., PROBLEM IN EXCEL SOLVER A
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ParNonlinear
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
B
C
D
Par, Inc.
Operation Cutting and Dyeing Sewing Finishing Inspection and Packaging Marginal Cost
Production Time Standard Deluxe 0.7 1 0.5 0.83333 1 0.66667 0.1 0.25 70 150
Time Available 630 600 708 135
Model Decision Variables Standard Deluxe Bags Produced Maximize Total Profit
19 20 Constraints Cutting and Dyeing Sewing Finishing Inspection and Packaging
=B27*B16+B28*C16B9*B16-C9*C16 Hours Used (LHS) =B5*B16+C5*C16 =B6*B16+C6*C16 =B7*B16+C7*C16 =B8*B16+C8*C16
21 22 23 24 25 26 27 Standard Bag Price Function =150-(1/15)*SB$16 28 Deluxe Bag Price Function =300-(1/15)*SC$16
60,000)(1.08)
= 3387
The total annual cost using equation (10.15) and Q* 3387 is $2073. Other relevant data include a five-day lead time to schedule and set up a production run and 250 working days per year. Thus, the lead-time demand of (26,000兾250)(5) 520 cases is the reorder point. The cycle time is the time between production runs. Using equation (10.7), the cycle time is T 250Q*兾D [(250)(3387)]兾26,000, or 33 working days. Thus, we should plan a production run of 3387 units every 33 working days.
INVENTORY MODEL WITH PLANNED SHORTAGES A shortage, or stockout, is a demand that cannot be supplied. In many situations, shortages are undesirable and should be avoided if at all possible. However, in other cases it may be desirable—from an economic point of view—to plan for and allow shortages. In practice, these types of situations are most commonly found where the value of the inventory per unit is high and hence the holding cost is high. An example of this type of situation is
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The assumptions of the EOQ model in Table 10.3 apply to this inventory model, with the exception that shortages, referred to as backorders, are now permitted.
Inventory Models
a new car dealer’s inventory. Often a specific car that a customer wants is not in stock. However, if the customer is willing to wait a few weeks, the dealer is usually able to order the car. The model developed in this section takes into account a type of shortage known as a backorder. In a backorder situation, we assume that when a customer places an order and discovers that the supplier is out of stock, the customer waits until the new shipment arrives, and then the order is filled. Frequently, the waiting period in backorder situations is relatively short. Thus, by promising the customer top priority and immediate delivery when the goods become available, companies may be able to convince the customer to wait until the order arrives. In these cases, the backorder assumption is valid. The backorder model that we develop is an extension of the EOQ model presented in Section 10.1. We use the EOQ model in which all goods arrive in inventory at one time and are subject to a constant demand rate. If we let S indicate the number of backorders that are accumulated when a new shipment of size Q is received, then the inventory system for the backorder case has the following characteristics: • •
If S backorders exist when a new shipment of size Q arrives, then S backorders are shipped to the appropriate customers, and the remaining Q S units are placed in inventory. Therefore, Q S is the maximum inventory. The inventory cycle of T days is divided into two distinct phases: t1 days when inventory is on hand and orders are filled as they occur, and t2 days when stockouts occur and all new orders are placed on backorder.
The inventory pattern for the inventory model with backorders, where negative inventory represents the number of backorders, is shown in Figure 10.6. With the inventory pattern now defined, we can proceed with the basic step of all inventory models—namely, the development of a total cost model. For the inventory model with backorders, we encounter the usual holding costs and ordering costs. We also incur a backorder cost in terms of the labor and special delivery costs directly associated with the handling of the backorders. Another portion of the backorder cost accounts for the loss of goodwill because some customers will have to wait for their orders. Because the goodwill cost depends on how long a customer has to wait, it is customary to adopt the convention of expressing backorder cost in terms of the cost of having a unit on backorder for a stated period of time. This method of costing backorders on a time basis is similar to the method FIGURE 10.6 INVENTORY PATTERN FOR AN INVENTORY MODEL WITH BACKORDERS
Maximum Inventory
Inventory
Q–S
Time
0 –S t1
t2 T
10.3
469
Inventory Model with Planned Shortages
used to compute the inventory holding cost, and we can use it to compute a total annual cost of backorders once the average backorder level and the backorder cost per unit per period are known. Let us begin the development of a total cost model by calculating the average inventory for a hypothetical problem. If we have an average inventory of two units for three days and no inventory on the fourth day, what is the average inventory over the four-day period? It is 2 units (3 days) + 0 units (1 day) 6 = = 1.5 units 4 days 4 Refer to Figure 10.6. You can see that this situation is what happens in the backorder model. With a maximum inventory of Q S units, the t1 days we have inventory on hand will have an average inventory of (Q S)兾2. No inventory is carried for the t2 days in which we experience backorders. Thus, over the total cycle time of T t1 t2 days, we can compute the average inventory as follows: >2(Q - S)t1 + 0t2
1
Average inventory =
t1 + t2
>2(Q - S)t1
1
=
T
(10.17)
Can we find other ways of expressing t1 and T? Because we know that the maximum inventory is Q S and that d represents the constant daily demand, we have
t1 =
Q - S days d
(10.18)
That is, the maximum inventory of Q S units will be used up in (Q S)/d days. Because Q units are ordered each cycle, we know the length of a cycle must be
T =
Q days d
(10.19)
Combining equations (10.18) and (10.19) with equation (10.17), we can compute the average inventory as follows: >2(Q - S)[(Q - S)>d]
1
Average inventory =
Q>d
(Q - S)2 =
2Q
(10.20)
Thus, the average inventory is expressed in terms of two inventory decisions: how much we will order (Q) and the maximum number of backorders (S).
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The formula for the annual number of orders placed using this model is identical to that for the EOQ model. With D representing the annual demand, we have
Annual number of orders =
D Q
(10.21)
The next step is to develop an expression for the average backorder level. Because we know the maximum for backorders is S, we can use the same logic we used to establish average inventory in finding the average number of backorders. We have an average number of backorders during the period t2 of ¹⁄₂ the maximum number of backorders, or ¹⁄₂S. We do not have any backorders during the t1 days we have inventory; therefore, we can calculate the average backorders in a manner similar to equation (10.17). Using this approach, we have
Average backorders =
0t1 + (S>2)t2 T
(S>2)t2 =
T
(10.22)
When we let the maximum number of backorders reach an amount S at a daily rate of d, the length of the backorder portion of the inventory cycle is
t2 =
S d
(10.23)
Using equations (10.23) and (10.19) in equation (10.22), we have
Average backorders =
(S>2)(S>d ) Q>d
=
S2 2Q
(10.24)
Let Ch = cost to maintain one unit in inventory for one year Co = cost per order Cb = cost to maintain one unit on backorder for one year The total annual cost (TC) for the inventory model with backorders becomes
TC =
(Q - S)2 2Q
Ch +
D S2 Co + C Q 2Q b
(10.25)
10.3
471
Inventory Model with Planned Shortages
Given Ch, Co, and Cb and the annual demand D, differential calculus can be used to show that the minimum cost values for the order quantity Q* and the planned backorders S* are as follows:
2DCo Ch + Cb a b Cb B Ch Ch S* Q* a b Ch + Cb
Q* =
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An Example Suppose that the Higley Radio Components Company has a product for which the assumptions of the inventory model with backorders are valid. Information obtained by the company is as follows:
Shortage
An inventory situation that incorporates backorder costs is considered in Problem 15.
The backorder cost Cb is one of the most difficult costs to estimate in inventory models. The reason is that it attempts to measure the cost associated with the loss of goodwill when a customer must wait for an order. Expressing this cost on an annual basis adds to the difficulty. If backorders can be tolerated, the total cost including the backorder cost will be less than the total cost of the EOQ model. Some people think the model with backorders will have a greater cost because it includes a backorder cost in addition to the usual inventory holding and ordering costs. You can point out the fallacy in this thinking by noting that the backorder model leads to lower inventory and hence lower inventory holding costs.
D I C Ch Co
= = = = =
2000 units per year 20% $50 per unit IC = (0.20)($50) = $10 per unit per year $25 per order
The company is considering the possibility of allowing some backorders to occur for the product. The annual backorder cost is estimated to be $30 per unit per year. Using equations (10.26) and (10.27), we have Q* =
2(2000)(25) 10 + 30 a b = 115.47 10 20 B
and S* = 115a
10 b = 28.87 10 + 30
If this solution is implemented, the system will operate with the following properties: Maximum inventory = Q - S = 115.47 - 28.87 = 86.6 Q 115.47 Cycle time = T = (250) = (250) = 14.43 working days D 2000 The total annual cost is (86.6)2
(10) 2(115.47) 2000 Ordering cost = (25) 115.47 (28.87)2 Backorder cost = (30) 2(115.47) Total cost Holding cost =
= $325 = $433 = $108 = $866
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If the company chooses to prohibit backorders and adopts the regular EOQ model, the recommended inventory decision would be Q* =
2(2000)(25)
B
10
= 210,000 = 100
This order quantity would result in a holding cost and an ordering cost of $500 each, or a total annual cost of $1000. Thus, in this problem, allowing backorders is projecting a $1000 $866 $134 or 13.4% savings in cost from the no-stockout EOQ model. The preceding comparison and conclusion are based on the assumption that the backorder model with an annual cost per backordered unit of $30 is a valid model for the actual inventory situation. If the company is concerned that stockouts might lead to lost sales, then the savings might not be enough to warrant switching to an inventory policy that allowed for planned shortages. NOTES AND COMMENTS Equation (10.27) shows that the optimal number of planned backorders S* is proportional to the ratio Ch兾(Ch Cb), where Ch is the annual holding cost per unit and Cb is the annual backorder cost per unit. Whenever Ch increases, this ratio becomes larger, and the number of planned backorders increases. This relationship explains why items that have a high per-unit cost and a correspondingly high annual holding cost are more economically
10.4 In the quantity discount model, assumption 4 of the EOQ model in Table 10.3 is altered. The cost per unit varies depending on the quantity ordered.
handled on a backorder basis. On the other hand, whenever the backorder cost Cb increases, the ratio becomes smaller, and the number of planned backorders decreases. Thus, the model provides the intuitive result that items with high backorder costs will be handled with few backorders. In fact, with high backorder costs, the backorder model and the EOQ model with no backordering allowed provide similar inventory policies.
QUANTITY DISCOUNTS FOR THE EOQ MODEL Quantity discounts occur in numerous situations in which suppliers provide an incentive for large order quantities by offering a lower purchase cost when items are ordered in larger quantities. In this section we show how the EOQ model can be used when quantity discounts are available. Assume that we have a product in which the basic EOQ model (see Table 10.3) is applicable. Instead of a fixed unit cost, the supplier quotes the following discount schedule: Discount Category 1 2 3
Order Size 0 to 999 1000 to 2499 2500 and over
Discount (%) 0 3 5
Unit Cost $5.00 4.85 4.75
The 5% discount for the 2500-unit minimum order quantity looks tempting. However, realizing that higher order quantities result in higher inventory holding costs, we should prepare a thorough cost analysis before making a final ordering and inventory policy recommendation.
10.4
Quantity Discounts for the EOQ Model
473
Suppose that the data and cost analyses show an annual holding cost rate of 20%, an ordering cost of $49 per order, and an annual demand of 5000 units; what order quantity should we select? The following three-step procedure shows the calculations necessary to make this decision. In the preliminary calculations, we use Q1 to indicate the order quantity for discount category 1, Q2 for discount category 2, and Q3 for discount category 3. Step 1. For each discount category, compute a Q* using the EOQ formula based on the unit cost associated with the discount category.
Recall that the EOQ model provides Q* = 22DCo>Ch , where Ch IC (0.20)C. With three discount categories providing three different unit costs C, we obtain
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Q* 1 =
2(5000)49
= 700 B (0.20)(5.00) 2(5000)49 Q*2 = = 711 B (0.20)(4.85) 2(5000)49 Q*3 = = 718 B (0.20)(4.75)
file
Discount
Because the only differences in the EOQ formulas come from slight differences in the holding cost, the economic order quantities resulting from this step will be approximately the same. However, these order quantities will usually not all be of the size necessary to qualify for the discount price assumed. In the preceding case, both Q*2 and Q*3 are insufficient order quantities to obtain their assumed discounted costs of $4.85 and $4.75, respectively. For those order quantities for which the assumed price cannot be obtained, the following procedure must be used: Step 2. For the Q* that is too small to qualify for the assumed discount price, adjust the order quantity upward to the nearest order quantity that will allow the product to be purchased at the assumed price. In our example, this adjustment causes us to set Q*2 = 1000 and Q*3 = 2500 Problem 23 at the end of the chapter asks you to show that this property is true. In the EOQ model with quantity discounts, the annual purchase cost must be included because purchase cost depends on the order quantity. Thus, it is a relevant cost.
If a calculated Q* for a given discount price is large enough to qualify for a bigger discount, that value of Q* cannot lead to an optimal solution. Although the reason may not be obvious, it does turn out to be a property of the EOQ quantity discount model. In the previous inventory models considered, the annual purchase cost of the item was not included because it was constant and never affected by the inventory order policy decision. However, in the quantity discount model, the annual purchase cost depends on the order quantity and the associated unit cost. Thus, annual purchase cost (annual demand D unit cost C) is included in the equation for total cost, as shown here:
TC =
Q D C + C + DC 2 h Q o
(10.28)
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TABLE 10.4 TOTAL ANNUAL COST CALCULATIONS FOR THE EOQ MODEL WITH QUANTITY DISCOUNTS Discount Category 1 2 3
Unit Cost $5.00 4.85 4.75
Order Quantity 700 1000 2500
Holding $ 350 $ 485 $1188
Annual Cost Ordering Purchase $350 $25,000 $245 $24,250 $ 98 $23,750
Total $25,700 $24,980 $25,036
Using this total cost equation, we can determine the optimal order quantity for the EOQ discount model in step 3. Step 3. For each order quantity resulting from steps 1 and 2, compute the total annual cost using the unit price from the appropriate discount category and equation (10.28). The order quantity yielding the minimum total annual cost is the optimal order quantity. Problem 21 will give you practice in applying the EOQ model to situations with quantity discounts.
10.5 This inventory model is the first in the chapter that explicitly treats probabilistic demand. Unlike the EOQ model, it is for a single period with unused inventory not carried over to future periods.
The step 3 calculations for the example problem are summarized in Table 10.4. As you can see, a decision to order 1000 units at the 3% discount rate yields the minimum cost solution. Even though the 2500-unit order quantity would result in a 5% discount, its excessive holding cost makes it the second-best solution. Figure 10.7 shows the total cost curve for each of the three discount categories. Note that Q* 1000 provides the minimum cost order quantity.
SINGLE-PERIOD INVENTORY MODEL WITH PROBABILISTIC DEMAND The inventory models discussed thus far were based on the assumption that the demand rate is constant and deterministic throughout the year. We developed minimum cost order quantity and reorder point policies based on this assumption. In situations in which the demand rate is not deterministic, other models treat demand as probabilistic and best described by a probability distribution. In this section we consider a single-period inventory model with probabilistic demand. The single-period inventory model refers to inventory situations in which one order is placed for the product; at the end of the period, the product has either sold out or a surplus of unsold items will be sold for a salvage value. The single-period inventory model is applicable in situations involving seasonal or perishable items that cannot be carried in inventory and sold in future periods. Seasonal clothing (such as bathing suits and winter coats) is typically handled in a single-period manner. In these situations, a buyer places one preseason order for each item and then experiences a stockout or holds a clearance sale on the surplus stock at the end of the season. No items are carried in inventory and sold the following year. Newspapers are another example of a product that is ordered one time and is either sold or not sold during the single period. Although newspapers are ordered daily, they cannot be carried in inventory and sold in later periods. Thus, newspaper orders may be treated as a sequence of single-period models; that is, each day or period is separate, and a single-period inventory decision must be made each period (day). Because we order only once for the period, the only inventory decision we must make is how much of the product to order at the start of the period.
10.5
475
Single-Period Inventory Model with Probabilistic Demand
FIGURE 10.7 TOTAL COST CURVES FOR THE THREE DISCOUNT CATEGORIES
27,000
26,000 Total Cost ($)
D
nt is c o u
C at
ego
$25,700 ou Di s c
25,000
$24,980 D is c
24,000
nt C
tC
2 ory
ory ateg
e urv
Cu
3C
rve
e urv
$25,036
Discount Category 2 1000 ≤ Q ≤ 2499
Discount Category 1 Q ≤ 999
500
oun
ateg
C ry 1
1000
1500
2000
Discount Category 3 Q ≥ 2500
2500
3000
Order Quantity Q The overall minimum cost of $24,980 occurs at Q* = 1000.
Obviously, if the demand were known for a single-period inventory situation, the solution would be easy; we would simply order the amount we knew would be demanded. However, in most single-period models, the exact demand is not known. In fact, forecasts may show that demand can have a wide variety of values. If we are going to analyze this type of inventory problem in a quantitative manner, we need information about the probabilities associated with the various demand values. Thus, the single-period model presented in this section is based on probabilistic demand.
Johnson Shoe Company Let us consider a single-period inventory model that could be used to make a how-muchto-order decision for the Johnson Shoe Company. The buyer for the Johnson Shoe Company decided to order a men’s shoe shown at a buyers’ meeting in New York City. The shoe
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FIGURE 10.8 UNIFORM PROBABILITY DISTRIBUTION OF DEMAND FOR THE JOHNSON SHOE COMPANY PROBLEM Expected Demand = 500
350
500 Demand
650
will be part of the company’s spring–summer promotion and will be sold through nine retail stores in the Chicago area. Because the shoe is designed for spring and summer months, it cannot be expected to sell in the fall. Johnson plans to hold a special August clearance sale in an attempt to sell all shoes not sold by July 31. The shoes cost $40 a pair and retail for $60 a pair. At the sale price of $30 a pair, all surplus shoes can be expected to sell during the August sale. If you were the buyer for the Johnson Shoe Company, how many pairs of the shoes would you order? An obvious question at this time is, What are the possible values of demand for the shoe? We need this information to answer the question of how much to order. Let us suppose that the uniform probability distribution shown in Figure 10.8 can be used to describe the demand for the size 10D shoes. In particular, note that the range of demand is from 350 to 650 pairs of shoes, with an average, or expected, demand of 500 pairs of shoes. Incremental analysis is a method that can be used to determine the optimal order quantity for a single-period inventory model. Incremental analysis addresses the howmuch-to-order question by comparing the cost or loss of ordering one additional unit with the cost or loss of not ordering one additional unit. The costs involved are defined as follows: co cost per unit of overestimating demand. This cost represents the loss of ordering one additional unit and finding that it cannot be sold. cu cost per unit of underestimating demand. This cost represents the opportunity loss of not ordering one additional unit and finding that it could have been sold. The cost of underestimating demand is usually harder to determine than the cost of overestimating demand. The reason is that the cost of underestimating demand includes a lost profit and may include a customer goodwill cost because the customer is unable to purchase the item when desired.
In the Johnson Shoe Company problem, the company will incur the cost of overestimating demand whenever it orders too much and has to sell the extra shoes during the August sale. Thus, the cost per unit of overestimating demand is equal to the purchase cost per unit minus the August sales price per unit; that is, co $40 $30 $10. Therefore, Johnson will lose $10 for each pair of shoes that it orders over the quantity demanded. The cost of underestimating demand is the lost profit because a pair of shoes that could have been sold was not available in inventory. Thus, the per-unit cost of underestimating demand is the difference between the regular selling price per unit and the purchase cost per unit; that is, cu $60 $40 $20. Because the exact level of demand for the size 10D shoes is unknown, we have to consider the probability of demand and thus the probability of obtaining the associated costs or losses. For example, let us assume that Johnson Shoe Company management wishes to
10.5
477
Single-Period Inventory Model with Probabilistic Demand
consider an order quantity equal to the average or expected demand for 500 pairs of shoes. In incremental analysis, we consider the possible losses associated with an order quantity of 501 (ordering one additional unit) and an order quantity of 500 (not ordering one additional unit). The order quantity alternatives and the possible losses are summarized here: Order Quantity Alternatives Q 501 Q 500
Loss Occurs If Demand overestimated; the additional unit cannot be sold Demand underestimated; an additional unit could have been sold
Possible Loss co $10
Probability Loss Occurs P(demand 500)
cu $20
P(demand 500)
By looking at the demand probability distribution in Figure 10.8, we see that P(demand 500) 0.50 and that P(demand 500) 0.50. By multiplying the possible losses, co $10 and cu $20, by the probability of obtaining the loss, we can compute the expected value of the loss, or simply the expected loss (EL), associated with the order quantity alternatives. Thus, EL(Q 501) coP(demand 500) $10(0.50) $5 EL(Q 500) cuP(demand 500) $20(0.50) $10 Based on these expected losses, do you prefer an order quantity of 501 or 500 pairs of shoes? Because the expected loss is greater for Q 500 and because we want to avoid this higher cost or loss, we should make Q 501 the preferred decision. We could now consider incrementing the order quantity one additional unit to Q 502 and repeating the expected loss calculations. Although we could continue this unit-by-unit analysis, it would be time-consuming and cumbersome. We would have to evaluate Q 502, Q 503, Q 504, and so on, until we found the value of Q where the expected loss of ordering one incremental unit is equal to the expected loss of not ordering one incremental unit; that is, the optimal order quantity Q* occurs when the incremental analysis shows that
EL(Q* + 1) = EL(Q*)
(10.29)
When this relationship holds, increasing the order quantity by one additional unit has no economic advantage. Using the logic with which we computed the expected losses for the order quantities of 501 and 500, the general expressions for EL(Q* 1) and EL(Q*) can be written
EL(Q* + 1) = co P(demand … Q*) EL(Q*) = cu P(demand 7 Q*)
(10.30) (10.31)
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Because we know from basic probability that P(demand … Q*) + P(demand 7 Q*) = 1
(10.32)
P(demand 7 Q*) = 1 - P(demand … Q*)
(10.33)
we can write
Using this expression, equation (10.31) can be rewritten as EL(Q*) = cu31 - P(demand … Q*)4
(10.34)
Equations (10.30) and (10.34) can be used to show that EL(Q* 1) EL(Q*) whenever co P(demand … Q*) = cu31 - P(demand … Q*)4
(10.35)
Solving for P(demand Q*), we have
P(demand … Q*) =
cu cu + co
(10.36)
This expression provides the general condition for the optimal order quantity Q* in the single-period inventory model. In the Johnson Shoe Company problem co $10 and cu $20. Thus, equation (10.36) shows that the optimal order size for Johnson shoes must satisfy the following condition: P(demand … Q*) =
cu 20 20 2 = = = cu + co 20 + 10 30 3
We can find the optimal order quantity Q* by referring to the probability distribution shown in Figure 10.8 and finding the value of Q that will provide P(demand Q*) ²⁄₃. To find this solution, we note that in the uniform distribution the probability is evenly distributed over the entire range of 350 to 650 pairs of shoes. Thus, we can satisfy the expression for Q* by moving two-thirds of the way from 350 to 650. Because this range is 650 350 300, we move 200 units from 350 toward 650. Doing so provides the optimal order quantity of 550 pairs of shoes. In summary, the key to establishing an optimal order quantity for single-period inventory models is to identify the probability distribution that describes the demand for the item and the costs of overestimation and underestimation. Then, using the information for the costs of overestimation and underestimation, equation (10.36) can be used to find the location of Q* in the probability distribution.
10.5
Single-Period Inventory Model with Probabilistic Demand
479
Nationwide Car Rental As another example of a single-period inventory model with probabilistic demand, consider the situation faced by Nationwide Car Rental. Nationwide must decide how many automobiles to have available at each car rental location at specific points in time throughout the year. Using the Myrtle Beach, South Carolina, location as an example, management would like to know the number of full-sized automobiles to have available for the Labor Day weekend. Based on previous experience, customer demand for full-sized automobiles for the Labor Day weekend has a normal distribution with a mean of 150 automobiles and a standard deviation of 14 automobiles. The Nationwide Car Rental situation can benefit from use of a single-period inventory model. The company must establish the number of full-sized automobiles to have available prior to the weekend. Customer demand over the weekend will then result in either a stockout or a surplus. Let us denote the number of full-sized automobiles available by Q. If Q is greater than customer demand, Nationwide will have a surplus of cars. The cost of a surplus is the cost of overestimating demand. This cost is set at $80 per car, which reflects, in part, the opportunity cost of not having the car available for rent elsewhere. If Q is less than customer demand, Nationwide will rent all available cars and experience a stockout, or shortage. A shortage results in an underestimation cost of $200 per car. This figure reflects the cost due to lost profit and the lost goodwill of not having a car available for a customer. Given this information, how many full-sized automobiles should Nationwide make available for the Labor Day weekend? Using the cost of underestimation, cu $200, and the cost of overestimation, co $80, equation (10.36) indicates that the optimal order quantity must satisfy the following condition:
P(demand … Q*) =
cu 200 = = 0.7143 (cu + co) 200 + 80
We can use the normal probability distribution for demand, as shown in Figure 10.9, to find the order quantity that satisfies the condition that P(demand Q*) 0.7143. Using the cumulative probabilities for the normal distribution (see Appendix B), the cumulative
FIGURE 10.9 PROBABILITY DISTRIBUTION OF DEMAND FOR THE NATIONWIDE CAR RENTAL PROBLEM SHOWING THE LOCATION OF Q*
P (demand ≤ Q*) = 0.7143 σ = 14
150 Q* = 158
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probability closest to 0.7143 occurs at z 0.57. Thus, the optimal order quantity occurs at 0.57 standard deviations above the mean. With a mean demand of m = 150 automobiles and a standard deviation of s = 14 automobiles, we have
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file
Q* = m + 0.57s = 150 + 0.57(14) = 158
Single-Period
An example of a singleperiod inventory model with probabilistic demand described by a normal probability distribution is considered in Problem 25.
Thus, Nationwide Car Rental should plan to have 158 full-sized automobiles available in Myrtle Beach for the Labor Day weekend. Note that in this case the cost of overestimation is less than the cost of underestimation. Thus, Nationwide is willing to risk a higher probability of overestimating demand and hence a higher probability of a surplus. In fact, Nationwide’s optimal order quantity has a 0.7143 probability of a surplus and a 1 0.7143 0.2857 probability of a stockout. As a result, the probability is 0.2857 that all 158 full-sized automobiles will be rented during the Labor Day weekend.
NOTES AND COMMENTS 1. In any probabilistic inventory model, the assumption about the probability distribution for demand is critical and can affect the recommended inventory decision. In the problems presented in this section, we used the uniform and the normal probability distributions to describe demand. In some situations, other probability distributions may be more appropriate. In using probabilistic inventory models, we must exercise care in selecting the probability distribution that most realistically describes demand. 2. In the single-period inventory model, the value of cu兾(cu co) plays a critical role in selecting the order quantity the ratio [see equation (10.36)]. Whenever cu co, the ratio (cu兾(cu co)) 0.50;
10.6
The inventory model in this section is based on the assumptions of the EOQ model shown in Table 10.3, with the exception that demand is probabilistic rather than deterministic. With probabilistic demand, occasional shortages may occur.
in this case, we should select an order quantity corresponding to the median demand. With this choice, a stockout is just as likely as a surplus because the two costs are equal. However, whenever cu co, a smaller order quantity will be recommended. In this case, the smaller order quantity will provide a higher probability of a stockout; however, the more expensive cost of overestimating demand and having a surplus will tend to be avoided. Finally, whenever cu co, a larger order quantity will be recommended. In this case, the larger order quantity provides a lower probability of a stockout in an attempt to avoid the more expensive cost of underestimating demand and experiencing a stockout.
ORDER-QUANTITY, REORDER POINT MODEL WITH PROBABILISTIC DEMAND In the previous section we considered a single-period inventory model with probabilistic demand. In this section we extend our discussion to a multiperiod order-quantity, reorder point inventory model with probabilistic demand. In the multiperiod model, the inventory system operates continuously with many repeating periods or cycles; inventory can be carried from one period to the next. Whenever the inventory position reaches the reorder point, an order for Q units is placed. Because demand is probabilistic, the time the reorder point will be reached, the time between orders, and the time the order of Q units will arrive in inventory cannot be determined in advance. The inventory pattern for the order-quantity, reorder point model with probabilistic demand will have the general appearance shown in Figure 10.10. Note that the increases or jumps in the inventory occur whenever an order of Q units arrives. The inventory decreases at a nonconstant rate based on the probabilistic demand. A new order is placed whenever the reorder point is reached. At times, the order quantity of Q units will arrive before
10.6
481
Order-Quantity, Reorder Point Model with Probabilistic Demand
FIGURE 10.10
INVENTORY PATTERN FOR AN ORDER-QUANTITY, REORDER POINT MODEL WITH PROBABILISTIC DEMAND
Order Quantity of Size Q Arrives
Probabilistic Demand Reduces Inventory
Inventory
Q Q
Order Placed
Order Placed
Order Placed
Stockout
Reorder Point
Time
inventory reaches zero. However, at other times, higher demand will cause a stockout before a new order is received. As with other order-quantity, reorder point models, the manager must determine the order quantity Q and the reorder point r for the inventory system. The exact mathematical formulation of an order-quantity, reorder point inventory model with probabilistic demand is beyond the scope of this text. However, we present a procedure that can be used to obtain good, workable order quantity and reorder point inventory policies. The solution procedure can be expected to provide only an approximation of the optimal solution, but it can yield good solutions in many practical situations. Let us consider the inventory problem of Dabco Industrial Lighting Distributors. Dabco purchases a special high-intensity lightbulb for industrial lighting systems from a well-known lightbulb manufacturer. Dabco would like a recommendation on how much to order and when to order so that a low-cost inventory policy can be maintained. Pertinent facts are that the ordering cost is $12 per order, one bulb costs $6, and Dabco uses a 20% annual holding cost rate for its inventory (Ch IC 0.20 $6 $1.20). Dabco, which has more than 1000 customers, experiences a probabilistic demand; in fact, the number of units demanded varies considerably from day to day and from week to week. The lead time for a new order of lightbulbs is one week. Historical sales data indicate that demand during a one-week lead time can be described by a normal probability distribution with a mean of 154 lightbulbs and a standard deviation of 25 lightbulbs. The normal distribution of demand during the lead time is shown in Figure 10.11. Because the mean demand during one week is 154 units, Dabco can anticipate a mean or expected annual demand of 154 units per week 52 weeks per year 8008 units per year.
The How-Much-to-Order Decision
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file
Q Prob
Although we are in a probabilistic demand situation, we have an estimate of the expected annual demand of 8008 units. We can apply the EOQ model from Section 10.1 as an approximation of the best order quantity, with the expected annual demand used for D. In Dabco’s case Q* =
2(8008)(12) 2DCo = = 400 units B (1.20) B Ch
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FIGURE 10.11
Inventory Models
LEAD-TIME DEMAND PROBABILITY DISTRIBUTION FOR DABCO LIGHTBULBS
Standard Deviation σ = 25 Mean μ = 154
79
104 129 154 179 204 229 Lead-Time Demand
When we studied the sensitivity of the EOQ model, we learned that the total cost of operating an inventory system was relatively insensitive to order quantities that were in the neighborhood of Q*. Using this knowledge, we expect 400 units per order to be a good approximation of the optimal order quantity. Even if annual demand were as low as 7000 units or as high as 9000 units, an order quantity of 400 units should be a relatively good low-cost order size. Thus, given our best estimate of annual demand at 8008 units, we will use Q* 400. We have established the 400-unit order quantity by ignoring the fact that demand is probabilistic. Using Q* 400, Dabco can anticipate placing approximately D兾Q* 8008兾400 20 orders per year with an average of approximately 250兾20 12.5 working days between orders.
The When-to-Order Decision
The probability of a stockout during any one inventory cycle is easiest to estimate by first determining the number of orders that are expected during the year. The inventory manager can usually state a willingness to allow perhaps one, two, or three stockouts during the year. The allowable stockouts per year divided by the number of orders per year will provide the desired probability of a stockout.
We now want to establish a when-to-order decision rule or reorder point that will trigger the ordering process. With a mean lead-time demand of 154 units, you might first suggest a 154-unit reorder point. However, considering the probability of demand now becomes extremely important. If 154 is the mean lead-time demand, and if demand is symmetrically distributed about 154, then the lead-time demand will be more than 154 units roughly 50% of the time. When the demand during the one-week lead time exceeds 154 units, Dabco will experience a shortage, or stockout. Thus, using a reorder point of 154 units, approximately 50% of the time (10 of the 20 orders a year) Dabco will be short of bulbs before the new supply arrives. This shortage rate would most likely be viewed as unacceptable. Refer to the lead-time demand distribution shown in Figure 10.11. Given this distribution, we can now determine how the reorder point r affects the probability of a stockout. Because stockouts occur whenever the demand during the lead time exceeds the reorder point, we can find the probability of a stockout by using the lead-time demand distribution to compute the probability that demand will exceed r. We could now approach the when-to-order problem by defining a cost per stockout and then attempting to include this cost in a total cost equation. Alternatively, we can ask management to specify the average number of stockouts that can be tolerated per year. If demand for a product is probabilistic, a manager who will never tolerate a stockout is being somewhat unrealistic because attempting to avoid stockouts completely will require high reorder points, high inventory, and an associated high holding cost.
10.6
FIGURE 10.12
483
Order-Quantity, Reorder Point Model with Probabilistic Demand
REORDER POINT r THAT ALLOWS A 5% CHANCE OF A STOCKOUT FOR DABCO LIGHTBULBS
r No Stockout (demand ≤ r) 95%
79
104
Stockout (demand > r) 5%
129 154 179 204 Lead-Time Demand
229
Suppose in this case that Dabco management is willing to tolerate an average of one stockout per year. Because Dabco places 20 orders per year, this decision implies that management is willing to allow demand during lead time to exceed the reorder point one time in 20, or 5% of the time. The reorder point r can be found by using the lead-time demand distribution to find the value of r, with a 5% chance of having a lead-time demand that will exceed it. This situation is shown graphically in Figure 10.12. We can now use the cumulative probabilities for the standard normal distribution (see Appendix B) to determine the reorder point r. In Figure 10.12, the 5% chance of a stockout occurs with the cumulative probability of no stockout being 1.00 0.05 0.95. From Appendix B, we see that the cumulative probability of 0.95 occurs at z 1.645 standard deviations above the mean. Therefore, for the assumed normal distribution for lead-time demand with m = 154 and s = 25, the reorder point r is r = 154 + 1.645(25) = 195 If a normal distribution is used for lead-time demand, the general equation for r is r = m + zs
(10.37)
where z is the number of standard deviations necessary to obtain the acceptable stockout probability. Thus, the recommended inventory decision is to order 400 units whenever the inventory reaches the reorder point of 195. Because the mean or expected demand during the lead time is 154 units, the 195 154 41 units serve as a safety stock, which absorbs higher than usual demand during the lead time. Roughly 95% of the time, the 195 units will be able to satisfy demand during the lead time. The anticipated annual cost for this system is as follows: Holding cost, normal inventory (Q> 2)Ch = (400> 2)(1.20) = Holding cost, safety stock (41)Ch = 41(1.20) = Ordering cost (D>Q)Co = (8008>400)12 = Total
$240 $ 49 $240 $529
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Try Problem 29 as an example of an orderquantity, reorder point model with probabilistic demand.
If Dabco could assume that a known, constant demand rate of 8008 units per year existed for the lightbulbs, then Q* 400, r 154, and a total annual cost of $240 $240 $480 would be optimal. When demand is uncertain and can only be expressed in probabilistic terms, a larger total cost can be expected. The larger cost occurs in the form of larger holding costs because more inventory must be maintained to limit the number of stockouts. For Dabco, this additional inventory or safety stock was 41 units, with an additional annual holding cost of $49. The Management Science in Action, Lowering Inventory Cost at Dutch Companies, describes how a warehouser in the Netherlands implemented an order-quantity, reorder point system with probabilistic demand.
Inventory Models
MANAGEMENT SCIENCE IN ACTION LOWERING INVENTORY COST AT DUTCH COMPANIES* In the Netherlands, companies such as Philips, Rank Xerox, and Fokker have followed the trend of developing closer relations between the firm and its suppliers. As teamwork, coordination, and information sharing improve, opportunities are available for better cost control in the operation of inventory systems. One Dutch public warehouser has a contract with its supplier under which the supplier routinely provides information regarding the status and schedule of upcoming production runs. The warehouser’s inventory system operates as an orderquantity, reorder point system with probabilistic demand. When the order quantity Q has been determined, the warehouser selects the desired reorder point for the product. The distribution of the leadtime demand is essential in determining the reorder point. Usually, the lead-time demand distribution is
approximated directly, taking into account both the probabilistic demand and the probabilistic length of the lead-time period. The supplier’s information concerning scheduled production runs provides the warehouser with a better understanding of the lead time involved for a product and the resulting lead-time demand distribution. With this information, the warehouse can modify the reorder point accordingly. Information sharing by the supplier thus enables the orderquantity, reorder point system to operate with a lower inventory holding cost. *Based on F. A. van der Duyn Schouten, M. J. G. van Eijs, and R. M. J. Heuts, “The Value of Supplier Information to Improve Management of a Retailer’s Inventory,” Decision Sciences 25, no. 1 (January/ February 1994): 1–14.
NOTES AND COMMENTS The Dabco reorder point was based on a 5% probability of a stockout during the lead-time period. Thus, on 95% of all order cycles Dabco will be able to satisfy customer demand without experiencing a stockout. Defining service level as the percentage of all order cycles that do not experience a stockout, we would say that Dabco has a 95%
10.7
service level. However, other definitions of service level may include the percentage of all customer demand that can be satisfied from inventory. Thus, when an inventory manager expresses a desired service level, it is a good idea to clarify exactly what the manager means by the term service level.
PERIODIC REVIEW MODEL WITH PROBABILISTIC DEMAND The order-quantity, reorder point inventory models previously discussed require a continuous review inventory system. In a continuous review inventory system, the inventory position is monitored continuously so that an order can be placed whenever the reorder point is reached. Computerized inventory systems can easily provide the continuous review required by the order-quantity, reorder point models.
10.7 Up to this point, we have assumed that the inventory position is reviewed continuously so that an order can be placed as soon as the inventory position reaches the reorder point. The inventory model in this section assumes probabilistic demand and a periodic review of the inventory position.
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An alternative to the continuous review system is the periodic review inventory system. With a periodic review system, the inventory is checked and reordering is done only at specified points in time. For example, inventory may be checked and orders placed on a weekly, biweekly, monthly, or some other periodic basis. When a firm or business handles multiple products, the periodic review system offers the advantage of requiring that orders for several items be placed at the same preset periodic review time. With this type of inventory system, the shipping and receiving of orders for multiple products are easily coordinated. Under the previously discussed order-quantity, reorder point systems, the reorder points for various products can be encountered at substantially different points in time, making the coordination of orders for multiple products more difficult. To illustrate this system, let us consider Dollar Discounts, a firm with several retail stores that carry a wide variety of products for household use. The company operates its inventory system with a two-week periodic review. Under this system, a retail store manager may order any number of units of any product from the Dollar Discounts central warehouse every two weeks. Orders for all products going to a particular store are combined into one shipment. When making the order quantity decision for each product at a given review period, the store manager knows that a reorder for the product cannot be made until the next review period. Assuming that the lead time is less than the length of the review period, an order placed at a review period will be received prior to the next review period. In this case, the howmuch-to-order decision at any review period is determined using the following:
Q = M - H
(10.38)
where Q order quantity M replenishment level H inventory on hand at the review period Because the demand is probabilistic, the inventory on hand at the review period, H, will vary. Thus, the order quantity that must be sufficient to bring the inventory position back to its maximum or replenishment level M can be expected to vary each period. For example, if the replenishment level for a particular product is 50 units, and the inventory on hand at the review period is H 12 units, an order of Q M H 50 12 38 units should be made. Thus, under the periodic review model, enough units are ordered each review period to bring the inventory position back up to the replenishment level. A typical inventory pattern for a periodic review system with probabilistic demand is shown in Figure 10.13. Note that the time between periodic reviews is predetermined and fixed. The order quantity Q at each review period can vary and is shown to be the difference between the replenishment level and the inventory on hand. Finally, as with other probabilistic models, an unusually high demand can result in an occasional stockout. The decision variable in the periodic review model is the replenishment level M. To determine M, we could begin by developing a total cost model, including holding, ordering, and stockout costs. Instead, we describe an approach that is often used in practice. In this approach, the objective is to determine a replenishment level that will meet a desired performance level, such as a reasonably low probability of stockout or a reasonably low number of stockouts per year.
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FIGURE 10.13
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INVENTORY PATTERN FOR PERIODIC REVIEW MODEL WITH PROBABILISTIC DEMAND
Replenishment Level
M
Q Q Q
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Lead Time Review Period
Review Period Time
Stockout
In the Dollar Discounts problem, we assume that management’s objective is to determine the replenishment level with only a 0.01 probability of a stockout. In the periodic review model, the order quantity at each review period must be sufficient to cover demand for the review period plus the demand for the following lead time. That is, the order quantity that brings the inventory position up to the replenishment level M must last until the order made at the next review period is received in inventory. The length of this time is equal to the review period plus the lead time. Figure 10.14 shows the normal probability distribution of demand during the review period plus the lead-time period for one of the Dollar Discounts products. The mean demand is 250 units, and the standard deviation of demand is 45 units. Given this situation, the logic used to establish M is similar to the logic used to FIGURE 10.14
PROBABILITY DISTRIBUTION OF DEMAND DURING THE REVIEW PERIOD AND LEAD TIME FOR THE DOLLAR DISCOUNTS PROBLEM
Standard Deviation σ = 45
Mean μ = 250
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250 295 Demand
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FIGURE 10.15
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REPLENISHMENT LEVEL M THAT ALLOWS A 1% CHANCE OF A STOCKOUT FOR THE DOLLAR DISCOUNTS PROBLEM
Stock-Out (demand > M) 1%
No Stock-Out (demand ≤ M) 99% M 115
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Problem 33 gives you practice in computing the replenishment level for a periodic review model with probabilistic demand.
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250 295 Demand
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establish the reorder point in Section 10.6. Figure 10.15 shows the replenishment level M with a 0.01 probability of a stockout due to demand exceeding the replenishment level. This means that there will be a 0.99 probability of no stockout. Using the cumulative probability 0.99 and the cumulative probability table for the standard normal distribution (Appendix B), we see that the value of M must be z 2.33 standard deviations above the mean. Thus, for the given probability distribution, the replenishment level that allows a 0.01 probability of stockout is M 250 2.33(45) 355 Although other probability distributions can be used to express the demand during the review period plus the lead-time period, if the normal probability distribution is used, the general expression for M is M = m + zs
Periodic review systems provide advantages of coordinated orders for multiple items. However, periodic review systems require larger safety stock levels than corresponding continuous review systems.
385
(10.39)
where z is the number of standard deviations necessary to obtain the acceptable stockout probability. If demand had been deterministic rather than probabilistic, the replenishment level would have been the demand during the review period plus the demand during the lead-time period. In this case, the replenishment level would have been 250 units, and no stockout would have occurred. However, with the probabilistic demand, we have seen that higher inventory is necessary to allow for uncertain demand and to control the probability of a stockout. In the Dollar Discounts problem, 355 250 105 is the safety stock that is necessary to absorb any higher than usual demand during the review period plus the demand during the lead-time period. This safety stock limits the probability of a stockout to 1%.
More Complex Periodic Review Models The periodic review model just discussed is one approach to determining a replenishment level for the periodic review inventory system with probabilistic demand. More complex versions of the periodic review model incorporate a reorder point as another decision variable;
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that is, instead of ordering at every periodic review, a reorder point is established. If the inventory on hand at the periodic review is at or below the reorder point, a decision is made to order up to the replenishment level. However, if the inventory on hand at the periodic review is greater than the reorder level, such an order is not placed, and the system continues until the next periodic review. In this case, the cost of ordering is a relevant cost and can be included in a cost model along with holding and stockout costs. Optimal policies can be reached based on minimizing the expected total cost. Situations with lead times longer than the review period add to the complexity of the model. The mathematical level required to treat these more extensive periodic review models is beyond the scope of this text.
NOTES AND COMMENTS 1. The periodic review model presented in this section is based on the assumption that the lead time for an order is less than the periodic review period. Most periodic review systems operate under this condition. However, the case in which the lead time is longer than the review period can be handled by defining H in equation (10.38) as the inventory position, where H includes the inventory on hand plus the inventory on order. In this case, the order quantity at any review period is the amount needed for the inventory on hand plus all outstanding orders needed to reach the replenishment level. 2. In the order-quantity, reorder point model discussed in Section 10.6, a continuous review was
used to initiate an order whenever the reorder point was reached. The safety stock for this model was based on the probabilistic demand during the lead time. The periodic review model presented in this section also determined a recommended safety stock. However, because the inventory review was only periodic, the safety stock was based on the probabilistic demand during the review period plus the lead-time period. This longer period for the safety stock computation means that periodic review systems tend to require a larger safety stock than do continuous review systems.
SUMMARY In this chapter we presented some of the approaches management scientists use to assist managers in establishing low-cost inventory policies. We first considered cases in which the demand rate for the product is constant. In analyzing these inventory systems, total cost models were developed, which included ordering costs, holding costs, and, in some cases, backorder costs. Then minimum cost formulas for the order quantity Q were presented. A reorder point r can be established by considering the lead-time demand. In addition, we discussed inventory models in which a deterministic and constant rate could not be assumed, and thus demand was described by a probability distribution. A critical issue with these probabilistic inventory models is obtaining a probability distribution that most realistically approximates the demand distribution. We first described a singleperiod model where only one order is placed for the product and, at the end of the period, either the product has sold out or a surplus remains of unsold products that will be sold for a salvage value. Solution procedures were then presented for multiperiod models based on either an order-quantity, reorder point, continuous review system or a replenishment-level, periodic review system. In closing this chapter we reemphasize that inventory and inventory systems can be an expensive phase of a firm’s operation. It is important for managers to be aware of the
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cost of inventory systems and to make the best possible operating policy decisions for the inventory system. Inventory models, as presented in this chapter, can help managers to develop good inventory policies. The Management Science in Action, Multistage Inventory Planning at Deere & Company, provides another example of how computerbased inventory models can be used to provide optimal inventory policies and cost reductions.
MANAGEMENT SCIENCE IN ACTION MULTISTAGE INVENTORY PLANNING AT DEERE & COMPANY* Deere & Company’s Commercial & Consumer Equipment (C&CE) Division, located in Raleigh, North Carolina, produces seasonal products such as lawn mowers and snow blowers. The seasonal aspect of demand requires the products to be built in advance. Because many of the products involve impulse purchases, the products must be available at dealerships when the customers walk in. Historically, high inventory levels resulted in high inventory costs and an unacceptable return on assets. As a result, management concluded that C&CE needed an inventory planning system that would reduce the average finished goods inventory levels in company warehouses and dealer locations, and at the same time would ensure that stockouts would not cause a negative impact on sales. In order to optimize inventory levels, Deere moved from an aggregate inventory planning model to a series of individual product inventory models. This approach enabled Deere to determine optimal inventory levels for each product at each dealer, as
well as optimal levels for each product at each plant and warehouse. The computerized system developed, known as SmartOps Multistage Inventory Planning and Optimization (MIPO), manages inventory for four C&CE Division plants, 21 dealers, and 150 products. Easily updated, MIPO provides target inventory levels for each product on a weekly basis. In addition, the system provides information about how optimal inventory levels are affected by lead times, forecast errors, and target service levels. The inventory optimization system enabled the C&CE Division to meet its inventory reduction goals. C&CE management estimates that the company will continue to achieve annual cost savings from lower inventory carrying costs. Meanwhile, the dealers also benefit from lower warehouse expenses, as well as lower interest and insurance costs. *Based on “Deere’s New Software Achieves Inventory Reduction Goals,” Inventory Management Report (March 2003): 2.
GLOSSARY Economic order quantity (EOQ) The order quantity that minimizes the annual holding cost plus the annual ordering cost. Constant demand rate An assumption of many inventory models that states that the same number of units are taken from inventory each period of time. Holding cost The cost associated with maintaining an inventory investment, including the cost of the capital investment in the inventory, insurance, taxes, warehouse overhead, and so on. This cost may be stated as a percentage of the inventory investment or as a cost per unit. Cost of capital The cost a firm incurs to obtain capital for investment. It may be stated as an annual percentage rate, and it is part of the holding cost associated with maintaining inventory.
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Ordering cost The fixed cost (salaries, paper, transportation, etc.) associated with placing an order for an item. Inventory position Reorder point
The inventory on hand plus the inventory on order.
The inventory position at which a new order should be placed.
Lead time The time between the placing of an order and its receipt in the inventory system. Lead-time demand The number of units demanded during the lead-time period. Cycle time The length of time between the placing of two consecutive orders. Constant supply rate over a period of time.
A situation in which the inventory is built up at a constant rate
Lot size The order quantity in the production inventory model. Setup cost The fixed cost (labor, materials, lost production) associated with preparing for a new production run. Shortage, or stockout Demand that cannot be supplied from inventory. Backorder The receipt of an order for a product when no units are in inventory. These backorders become shortages, which are eventually satisfied when a new supply of the product becomes available. Goodwill cost A cost associated with a backorder, a lost sale, or any form of stockout or unsatisfied demand. This cost may be used to reflect the loss of future profits because a customer experienced an unsatisfied demand. Quantity discounts Discounts or lower unit costs offered by the manufacturer when a customer purchases larger quantities of the product. Deterministic inventory model A model where demand is considered known and not subject to uncertainty. Probabilistic inventory model A model where demand is not known exactly; probabilities must be associated with the possible values for demand. Single-period inventory model An inventory model in which only one order is placed for the product, and at the end of the period either the item has sold out, or a surplus of unsold items will be sold for a salvage value. Incremental analysis A method used to determine an optimal order quantity by comparing the cost of ordering an additional unit with the cost of not ordering an additional unit. Lead-time demand distribution The distribution of demand that occurs during the leadtime period. Safety stock Inventory maintained in order to reduce the number of stockouts resulting from higher than expected demand. Continuous review inventory system A system in which the inventory position is monitored or reviewed on a continuous basis so that a new order can be placed as soon as the reorder point is reached. Periodic review inventory system A system in which the inventory position is checked or reviewed at predetermined periodic points in time. Reorders are placed only at periodic review points.
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PROBLEMS 1. Suppose that the R&B Beverage Company has a soft drink product that shows a constant annual demand rate of 3600 cases. A case of the soft drink costs R&B $3. Ordering costs are $20 per order and holding costs are 25% of the value of the inventory. R&B has 250 working days per year, and the lead time is 5 days. Identify the following aspects of the inventory policy: a. Economic order quantity b. Reorder point c. Cycle time d. Total annual cost 2. A general property of the EOQ inventory model is that total inventory holding and total ordering costs are equal at the optimal solution. Use the data in Problem 1 to show that this result is true. Use equations (10.2), (10.3), and (10.5) to show that, in general, total holding costs and total ordering costs are equal whenever Q* is used. 3. The reorder point [see equation (10.6)] is defined as the lead-time demand for an item. In cases of long lead times, the lead-time demand and thus the reorder point may exceed the economic order quantity Q*. In such cases, the inventory position will not equal the inventory on hand when an order is placed, and the reorder point may be expressed in terms of either the inventory position or the inventory on hand. Consider the economic order quantity model with D 5000, Co $32, Ch $2, and 250 working days per year. Identify the reorder point in terms of the inventory position and in terms of the inventory on hand for each of the following lead times: a. 5 days b. 15 days c. 25 days d. 45 days 4. Westside Auto purchases a component used in the manufacture of automobile generators directly from the supplier. Westside’s generator production operation, which is operated at a constant rate, will require 1000 components per month throughout the year (12,000 units annually). Assume that the ordering costs are $25 per order, the unit cost is $2.50 per component, and annual holding costs are 20% of the value of the inventory. Westside has 250 working days per year and a lead time of 5 days. Answer the following inventory policy questions: a. What is the EOQ for this component? b. What is the reorder point? c. What is the cycle time? d. What are the total annual holding and ordering costs associated with your recommended EOQ? 5. Suppose that Westside’s management in Problem 4 likes the operational efficiency of ordering once each month and in quantities of 1000 units. How much more expensive would this policy be than your EOQ recommendation? Would you recommend in favor of the 1000-unit order quantity? Explain. What would the reorder point be if the 1000-unit quantity were acceptable? 6. Tele-Reco is a new specialty store that sells television sets, videotape recorders, video games, and other television-related products. A new Japanese-manufactured videotape recorder costs Tele-Reco $600 per unit. Tele-Reco’s annual holding cost rate is 22%. Ordering costs are estimated to be $70 per order. a. If demand for the new videotape recorder is expected to be constant with a rate of 20 units per month, what is the recommended order quantity for the videotape recorder?
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b. What are the estimated annual inventory holding and ordering costs associated with this product? c. How many orders will be placed per year? d. With 250 working days per year, what is the cycle time for this product? 7. A large distributor of oil-well drilling equipment operated over the past two years with EOQ policies based on an annual holding cost rate of 22%. Under the EOQ policy, a particular product has been ordered with a Q* 80. A recent evaluation of holding costs shows that because of an increase in the interest rate associated with bank loans, the annual holding cost rate should be 27%. a. What is the new economic order quantity for the product? b. Develop a general expression showing how the economic order quantity changes when the annual holding cost rate is changed from I to I . 8. Nation-Wide Bus Lines is proud of its six-week bus driver training program that it conducts for all new Nation-Wide drivers. As long as the class size remains less than or equal to 35, a six-week training program costs Nation-Wide $22,000 for instructors, equipment, and so on. The Nation-Wide training program must provide the company with approximately five new drivers per month. After completing the training program, new drivers are paid $1600 per month but do not work until a full-time driver position is open. NationWide views the $1600 per month paid to each idle new driver as a holding cost necessary to maintain a supply of newly trained drivers available for immediate service. Viewing new drivers as inventory-type units, how large should the training classes be to minimize Nation-Wide’s total annual training and new driver idle-time costs? How many training classes should the company hold each year? What is the total annual cost associated with your recommendation? 9. Cress Electronic Products manufactures components used in the automotive industry. Cress purchases parts for use in its manufacturing operation from a variety of different suppliers. One particular supplier provides a part where the assumptions of the EOQ model are realistic. The annual demand is 5000 units, the ordering cost is $80 per order, and the annual holding cost rate is 25%. a. If the cost of the part is $20 per unit, what is the economic order quantity? b. Assume 250 days of operation per year. If the lead time for an order is 12 days, what is the reorder point? c. If the lead time for the part is seven weeks (35 days), what is the reorder point? d. What is the reorder point for part (c) if the reorder point is expressed in terms of the inventory on hand rather than the inventory position? 10. All-Star Bat Manufacturing, Inc., supplies baseball bats to major and minor league baseball teams. After an initial order in January, demand over the six-month baseball season is approximately constant at 1000 bats per month. Assuming that the bat production process can handle up to 4000 bats per month, the bat production setup costs are $150 per setup, the production cost is $10 per bat, and the holding costs have a monthly rate of 2%, what production lot size would you recommend to meet the demand during the baseball season? If All-Star operates 20 days per month, how often will the production process operate, and what is the length of a production run? 11. Assume that a production line operates such that the production lot size model of Section 10.2 is applicable. Given D 6400 units per year, Co $100, and Ch $2 per unit per year, compute the minimum cost production lot size for each of the following production rates: a. 8000 units per year b. 10,000 units per year c. 32,000 units per year d. 100,000 units per year
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Compute the EOQ recommended lot size using equation (10.5). What two observations can you make about the relationship between the EOQ model and the production lot size model? 12. Assume that you are reviewing the production lot size decision associated with a production operation where P 8000 units per year, D 2000 units per year, Co $300, and Ch $1.60 per unit per year. Also assume that current practice calls for production runs of 500 units every three months. Would you recommend changing the current production lot size? Why or why not? How much could be saved by converting to your production lot size recommendation? 13. Wilson Publishing Company produces books for the retail market. Demand for a current book is expected to occur at a constant annual rate of 7200 copies. The cost of one copy of the book is $14.50. The holding cost is based on an 18% annual rate, and production setup costs are $150 per setup. The equipment on which the book is produced has an annual production volume of 25,000 copies. Wilson has 250 working days per year, and the lead time for a production run is 15 days. Use the production lot size model to compute the following values: a. Minimum cost production lot size b. Number of production runs per year c. Cycle time d. Length of a production run e. Maximum inventory f. Total annual cost g. Reorder point 14. A well-known manufacturer of several brands of toothpaste uses the production lot size model to determine production quantities for its various products. The product known as Extra White is currently being produced in production lot sizes of 5000 units. The length of the production run for this quantity is 10 days. Because of a recent shortage of a particular raw material, the supplier of the material announced that a cost increase will be passed along to the manufacturer of Extra White. Current estimates are that the new raw material cost will increase the manufacturing cost of the toothpaste products by 23% per unit. What will be the effect of this price increase on the production lot sizes for Extra White? 15. Suppose that Westside Auto of Problem 4, with D 12,000 units per year, Ch (2.50)(0.20) $0.50, and Co $25, decided to operate with a backorder inventory policy. Backorder costs are estimated to be $5 per unit per year. Identify the following: a. Minimum cost order quantity b. Maximum number of backorders c. Maximum inventory d. Cycle time e. Total annual cost 16. Assuming 250 days of operation per year and a lead time of 5 days, what is the reorder point for Westside Auto in Problem 15? Show the general formula for the reorder point for the EOQ model with backorders. In general, is the reorder point when backorders are allowed greater than or less than the reorder point when backorders are not allowed? Explain. 17. A manager of an inventory system believes that inventory models are important decisionmaking aids. Even though often using an EOQ policy, the manager never considered a backorder model because of the assumption that backorders were “bad” and should be avoided. However, with upper management’s continued pressure for cost reduction, you have been asked to analyze the economics of a backorder policy for some products that can possibly be backordered. For a specific product with D 800 units per year,
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Co $150, Ch $3, and Cb $20, what is the difference in total annual cost between the EOQ model and the planned shortage or backorder model? If the manager adds constraints that no more than 25% of the units can be backordered and that no customer will have to wait more than 15 days for an order, should the backorder inventory policy be adopted? Assume 250 working days per year. 18. If the lead time for new orders is 20 days for the inventory system discussed in Problem 17, find the reorder point for both the EOQ and the backorder models. 19. The A&M Hobby Shop carries a line of radio-controlled model racing cars. Demand for the cars is assumed to be constant at a rate of 40 cars per month. The cars cost $60 each, and ordering costs are approximately $15 per order, regardless of the order size. The annual holding cost rate is 20%. a. Determine the economic order quantity and total annual cost under the assumption that no backorders are permitted. b. Using a $45 per-unit per-year backorder cost, determine the minimum cost inventory policy and total annual cost for the model racing cars. c. What is the maximum number of days a customer would have to wait for a backorder under the policy in part (b)? Assume that the Hobby Shop is open for business 300 days per year. d. Would you recommend a no-backorder or a backorder inventory policy for this product? Explain. e. If the lead time is six days, what is the reorder point for both the no-backorder and backorder inventory policies? 20. Assume that the following quantity discount schedule is appropriate. If annual demand is 120 units, ordering costs are $20 per order, and the annual holding cost rate is 25%, what order quantity would you recommend? Order Size 0 to 49 50 to 99 100 or more
Discount (%) 0 5 10
Unit Cost $30.00 $28.50 $27.00
21. Apply the EOQ model to the following quantity discount situation in which D 500 units per year, Co $40, and the annual holding cost rate is 20%. What order quantity do you recommend?
Discount Category 1 2
Order Size 0 to 99 100 or more
Discount (%) 0 3
Unit Cost $10.00 $ 9.70
22. Keith Shoe Stores carries a basic black men’s dress shoe that sells at an approximate constant rate of 500 pairs of shoes every three months. Keith’s current buying policy is to order 500 pairs each time an order is placed. It costs Keith $30 to place an order. The annual holding cost rate is 20%. With the order quantity of 500, Keith obtains the shoes at the lowest possible unit cost of $28 per pair. Other quantity discounts offered by the manufacturer are as follows. What is the minimum cost order quantity for the shoes? What are the annual savings of your inventory policy over the policy currently being used by Keith?
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Order Quantity 0–99 100–199 200–299 300 or more
Price per Pair $36 $32 $30 $28
23. In the EOQ model with quantity discounts, we stated that if the Q* for a price category is larger than necessary to qualify for the category price, the category cannot be optimal. Use the two discount categories in Problem 21 to show that this statement is true. That is, plot total cost curves for the two categories and show that if the category 2 minimum cost Q is an acceptable solution, we do not have to consider category 1. 24. The J&B Card Shop sells calendars depicting a different Colonial scene each month. The once-a-year order for each year’s calendar arrives in September. From past experience, the September-to-July demand for the calendars can be approximated by a normal probability distribution with µ 500 and s 120. The calendars cost $1.50 each, and J&B sells them for $3 each. a. If J&B throws out all unsold calendars at the end of July (i.e., salvage value is zero), how many calendars should be ordered? b. If J&B reduces the calendar price to $1 at the end of July and can sell all surplus calendars at this price, how many calendars should be ordered? 25. The Gilbert Air-Conditioning Company is considering the purchase of a special shipment of portable air conditioners manufactured in Japan. Each unit will cost Gilbert $80, and it will be sold for $125. Gilbert does not want to carry surplus air conditioners over until the following year. Thus, all surplus air conditioners will be sold to a wholesaler for $50 per unit. Assume that the air conditioner demand follows a normal probability distribution with µ 20 and s 8. a. What is the recommended order quantity? b. What is the probability that Gilbert will sell all units it orders? 26. The Bridgeport city manager and the chief of police agreed on the size of the police force necessary for normal daily operations. However, they need assistance in determining the number of additional police officers needed to cover daily absences due to injuries, sickness, vacations, and personal leave. Records over the past three years show that the daily demand for additional police officers is normally distributed with a mean of 50 officers and a standard deviation of 10 officers. The cost of an additional police officer is based on the average pay rate of $150 per day. If the daily demand for additional police officers exceeds the number of additional officers available, the excess demand will be covered by overtime at the pay rate of $240 per day for each overtime officer. a. If the number of additional police officers available is greater than demand, the city will have to pay for more additional police officers than needed. What is the cost of overestimating demand? b. If the number of additional police officers available is less than demand, the city will have to use overtime to meet the demand. What is the cost of underestimating demand? c. What is the optimal number of additional police officers that should be included in the police force? d. On a typical day, what is the probability that overtime will be necessary? 27. A perishable dairy product is ordered daily at a particular supermarket. The product, which costs $1.19 per unit, sells for $1.65 per unit. If units are unsold at the end of the day,
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the supplier takes them back at a rebate of $1 per unit. Assume that daily demand is approximately normally distributed with m 150 and σ 30. a. What is your recommended daily order quantity for the supermarket? b. What is the probability that the supermarket will sell all the units it orders? c. In problems such as these, why would the supplier offer a rebate as high as $1? For example, why not offer a nominal rebate of, say, 25¢ per unit? What happens to the supermarket order quantity as the rebate is reduced? 28. A retail outlet sells a seasonal product for $10 per unit. The cost of the product is $8 per unit. All units not sold during the regular season are sold for half the retail price in an endof-season clearance sale. Assume that demand for the product is uniformly distributed between 200 and 800. a. What is the recommended order quantity? b. What is the probability that at least some customers will ask to purchase the product after the outlet is sold out? That is, what is the probability of a stockout using your order quantity in part (a)? c. To keep customers happy and returning to the store later, the owner feels that stockouts should be avoided if at all possible. What is your recommended order quantity if the owner is willing to tolerate a 0.15 probability of a stockout? d. Using your answer to part (c), what is the goodwill cost you are assigning to a stockout? 29. Floyd Distributors, Inc., provides a variety of auto parts to small local garages. Floyd purchases parts from manufacturers according to the EOQ model and then ships the parts from a regional warehouse direct to its customers. For a particular type of muffler, Floyd’s EOQ analysis recommends orders with Q* 25 to satisfy an annual demand of 200 mufflers. Floyd’s has 250 working days per year, and the lead time averages 15 days. a. What is the reorder point if Floyd assumes a constant demand rate? b. Suppose that an analysis of Floyd’s muffler demand shows that the lead-time demand follows a normal probability distribution with µ 12 and σ 2.5. If Floyd’s management can tolerate one stockout per year, what is the revised reorder point? c. What is the safety stock for part (b)? If Ch $5/unit/year, what is the extra cost due to the uncertainty of demand? 30. For Floyd Distributors in Problem 29, we were given Q* 25, D 200, Ch $5, and a normal lead-time demand distribution with µ 12 and σ 2.5. a. What is Floyd’s reorder point if the firm is willing to tolerate two stockouts during the year? b. What is Floyd’s reorder point if the firm wants to restrict the probability of a stockout on any one cycle to at most 1%? c. What are the safety stock levels and the annual safety stock costs for the reorder points found in parts (a) and (b)? 31. A product with an annual demand of 1000 units has Co $25.50 and Ch $8. The demand exhibits some variability such that the lead-time demand follows a normal probability distribution with m 25 and s 5. a. What is the recommended order quantity? b. What are the reorder point and safety stock if the firm desires at most a 2% probability of stockout on any given order cycle? c. If a manager sets the reorder point at 30, what is the probability of a stockout on any given order cycle? How many times would you expect a stockout during the year if this reorder point were used? 32. The B&S Novelty and Craft Shop in Bennington, Vermont, sells a variety of quality handmade items to tourists. B&S will sell 300 hand-carved miniature replicas of a Colonial
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soldier each year, but the demand pattern during the year is uncertain. The replicas sell for $20 each, and B&S uses a 15% annual inventory holding cost rate. Ordering costs are $5 per order, and demand during the lead time follows a normal probability distribution with µ 15 and s 6. a. What is the recommended order quantity? b. If B&S is willing to accept a stockout roughly twice a year, what reorder point would you recommend? What is the probability that B&S will have a stockout in any one order cycle? c. What are the safety stock and annual safety stock costs for this product? 33. A firm uses a one-week periodic review inventory system. A two-day lead time is needed for any order, and the firm is willing to tolerate an average of one stockout per year. a. Using the firm’s service guideline, what is the probability of a stockout associated with each replenishment decision? b. What is the replenishment level if demand during the review period plus lead-time period is normally distributed with a mean of 60 units and a standard deviation of 12 units? c. What is the replenishment level if demand during the review period plus lead-time period is uniformly distributed between 35 and 85 units? 34. Foster Drugs, Inc., handles a variety of health and beauty aid products. A particular hair conditioner product costs Foster Drugs $2.95 per unit. The annual holding cost rate is 20%. An order-quantity, reorder point inventory model recommends an order quantity of 300 units per order. a. Lead time is one week and the lead-time demand is normally distributed with a mean of 150 units and a standard deviation of 40 units. What is the reorder point if the firm is willing to tolerate a 1% chance of stockout on any one cycle? b. What safety stock and annual safety stock costs are associated with your recommendation in part (a)? c. The order-quantity, reorder point model requires a continuous review system. Management is considering making a transition to a periodic review system in an attempt to coordinate ordering for many of its products. The demand during the proposed twoweek review period and the one-week lead-time period is normally distributed with a mean of 450 units and a standard deviation of 70 units. What is the recommended replenishment level for this periodic review system if the firm is willing to tolerate the same 1% chance of stockout associated with any replenishment decision? d. What safety stock and annual safety stock costs are associated with your recommendation in part (c)? e. Compare your answers to parts (b) and (d). The company is seriously considering the periodic review system. Would you support this decision? Explain. f. Would you tend to favor the continuous review system for more expensive items? For example, assume that the product in the preceding example sold for $295 per unit. Explain. 35. Statewide Auto Parts uses a four-week periodic review system to reorder parts for its inventory stock. A one-week lead time is required to fill the order. Demand for one particular part during the five-week replenishment period is normally distributed with a mean of 18 units and a standard deviation of 6 units. a. At a particular periodic review, 8 units are in inventory. The parts manager places an order for 16 units. What is the probability that this part will have a stockout before an order that is placed at the next four-week review period arrives? b. Assume that the company is willing to tolerate a 2.5% chance of a stockout associated with a replenishment decision. How many parts should the manager have ordered in part (a)? What is the replenishment level for the four-week periodic review system?
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36. Rose Office Supplies, Inc., which is open six days a week, uses a two-week periodic review for its store inventory. On alternating Monday mornings, the store manager fills out an order sheet requiring a shipment of various items from the company’s warehouse. A particular three-ring notebook sells at an average rate of 16 notebooks per week. The standard deviation in sales is 5 notebooks per week. The lead time for a new shipment is three days. The mean lead-time demand is 8 notebooks with a standard deviation of 3.5. a. What is the mean or expected demand during the review period plus the lead-time period? b. Under the assumption of independent demand from week to week, the variances in demands are additive. Thus, the variance of the demand during the review period plus the lead-time period is equal to the variance of demand during the first week plus the variance of demand during the second week plus the variance of demand during the lead-time period. What is the variance of demand during the review period plus the lead-time period? What is the standard deviation of demand during the review period plus the lead-time period? c. Assuming that demand has a normal probability distribution, what is the replenishment level that will provide an expected stockout rate of one per year? d. On Monday, March 22, 18 notebooks remain in inventory at the store. How many notebooks should the store manager order?
Case Problem 1
WAGNER FABRICATING COMPANY
Managers at Wagner Fabricating Company are reviewing the economic feasibility of manufacturing a part that it currently purchases from a supplier. Forecasted annual demand for the part is 3200 units. Wagner operates 250 days per year. Wagner’s financial analysts established a cost of capital of 14% for the use of funds for investments within the company. In addition, over the past year $600,000 was the average investment in the company’s inventory. Accounting information shows that a total of $24,000 was spent on taxes and insurance related to the company’s inventory. In addition, an estimated $9000 was lost due to inventory shrinkage, which included damaged goods as well as pilferage. A remaining $15,000 was spent on warehouse overhead, including utility expenses for heating and lighting. An analysis of the purchasing operation shows that approximately two hours are required to process and coordinate an order for the part regardless of the quantity ordered. Purchasing salaries average $28 per hour, including employee benefits. In addition, a detailed analysis of 125 orders showed that $2375 was spent on telephone, paper, and postage directly related to the ordering process. A one-week lead time is required to obtain the part from the supplier. An analysis of demand during the lead time shows it is approximately normally distributed with a mean of 64 units and a standard deviation of 10 units. Service level guidelines indicate that one stockout per year is acceptable. Currently, the company has a contract to purchase the part from a supplier at a cost of $18 per unit. However, over the past few months, the company’s production capacity has been expanded. As a result, excess capacity is now available in certain production departments, and the company is considering the alternative of producing the parts itself. Forecasted utilization of equipment shows that production capacity will be available for the part being considered. The production capacity is available at the rate of 1000 units per month, with up to five months of production time available. Management believes that with a two-week lead time, schedules can be arranged so that the part can be produced whenever needed. The demand during the two-week lead time is approximately normally
Case Problem 2
River City Fire Department
499
distributed, with a mean of 128 units and a standard deviation of 20 units. Production costs are expected to be $17 per part. A concern of management is that setup costs will be significant. The total cost of labor and lost production time is estimated to be $50 per hour, and a full eight-hour shift will be needed to set up the equipment for producing the part.
Managerial Report Develop a report for management of Wagner Fabricating that will address the question of whether the company should continue to purchase the part from the supplier or begin to produce the part itself. Include the following factors in your report: 1. An analysis of the holding costs, including the appropriate annual holding cost rate 2. An analysis of ordering costs, including the appropriate cost per order from the supplier 3. An analysis of setup costs for the production operation 4. A development of the inventory policy for the following two alternatives: a. Ordering a fixed quantity Q from the supplier b. Ordering a fixed quantity Q from in-plant production 5. Include the following in the policies of parts 4(a) and 4(b): a. Optimal quantity Q* b. Number of order or production runs per year c. Cycle time d. Reorder point e. Amount of safety stock f. Expected maximum inventory g. Average inventory h. Annual holding cost i. Annual ordering cost j. Annual cost of the units purchased or manufactured k. Total annual cost of the purchase policy and the total annual cost of the production policy 6. Make a recommendation as to whether the company should purchase or manufacture the part. What savings are associated with your recommendation as compared with the other alternative?
Case Problem 2
RIVER CITY FIRE DEPARTMENT
The River City Fire Department (RCFD) fights fires and provides a variety of rescue operations in the River City metropolitan area. The RCFD staffs 13 ladder companies, 26 pumper companies, and several rescue units and ambulances. Normal staffing requires 186 firefighters to be on duty every day. RCFD is organized with three firefighting units. Each unit works a full 24-hour day and then has two days (48 hours) off. For example, Unit 1 covers Monday, Unit 2 covers Tuesday, and Unit 3 covers Wednesday. Then Unit 1 returns on Thursday, and so on. Over a three-week (21-day) scheduling period, each unit will be scheduled for seven days. On a rotational basis, firefighters within each unit are given one of the seven regularly scheduled days off. This day off is referred to as a Kelley day. Thus, over a three-week scheduling period, each firefighter in a unit works six of the seven scheduled unit days and gets one Kelley day off.
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Determining the number of firefighters to be assigned to each unit includes the 186 firefighters who must be on duty plus the number of firefighters in the unit who are off for a Kelley day. Furthermore, each unit needs additional staffing to cover firefighter absences due to injury, sick leave, vacations, or personal time. This additional staffing involves finding the best mix of adding full-time firefighters to each unit and the selective use of overtime. If the number of absences on a particular day brings the number of available firefighters below the required 186, firefighters who are currently off (e.g., on a Kelley day) must be scheduled to work overtime. Overtime is compensated at 1.55 times the regular pay rate. Analysis of the records maintained over the last several years concerning the number of daily absences shows a normal probability distribution. A mean of 20 and a standard deviation of 5 provide a good approximation of the probability distribution for the number of daily absences.
Managerial Report Develop a report that will enable Fire Chief O. E. Smith to determine the necessary numbers for the Fire Department. Include, at a minimum, the following items in your report: 1. Assuming no daily absences and taking into account the need to staff Kelley days, determine the base number of firefighters needed by each unit. 2. Using a minimum cost criterion, how many additional firefighters should be added to each unit in order to cover the daily absences? These extra daily needs will be filled by the additional firefighters and, when necessary, the more expensive use of overtime by off-duty firefighters. 3. On a given day, what is the probability that Kelley-day firefighters will be called in to work overtime? 4. Based on the three-unit organization, how many firefighters should be assigned to each unit? What is the total number of full-time firefighters required for the River City Fire Department?
Appendix 10.1 DEVELOPMENT OF THE OPTIMAL ORDER QUANTITY (Q*) FORMULA FOR THE EOQ MODEL Given equation (10.4) as the total annual cost for the EOQ model,
TC =
1 D QCh + C 2 Q o
(10.4)
we can find the order quantity Q that minimizes the total cost by setting the derivative, dTC/dQ, equal to zero and solving for Q*. d TC dQ 1 C = 2 h
1 D Ch 2 Co 0 2 Q D Co Q2
Ch Q 2 = 2DCo Q2 =
2DCo Ch
Appendix 10.2
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Development of the Optimal Lot Size Formula
Hence,
Q* =
2DCo B Ch
(10.5)
The second derivative is 2D d 2TC = 3 Co 2 dQ Q Because the value of the second derivative is greater than zero, Q* from equation (10.5) is the minimum cost solution.
Appendix 10.2 DEVELOPMENT OF THE OPTIMAL LOT SIZE (Q*) FORMULA FOR THE PRODUCTION LOT SIZE MODEL Given equation (10.15) as the total annual cost for the production lot size model,
TC =
1 D D a1 - bQCh + Co 2 P Q
(10.15)
we can find the order quantity Q that minimizes the total cost by setting the derivative, dTC兾dQ, equal to zero and solving for Q*. d TC 1 D D = a1 - b Ch - 2 Co = 0 dQ 2 P Q Solving for Q*, we have 1 D D a1 - bCh = 2 Co 2 P Q D a1 - bCh Q 2 = 2DCo P 2DCo Q2 = (1 - D>P)Ch Hence,
Q* =
2DCo B (1 - D>P)Ch
(10.16)
The second derivative is 2DCo d 2TC = 2 dQ Q3 Because the value of the second derivative is greater than zero, Q* from equation (10.16) is a minimum cost solution.
CHAPTER
11
Waiting Line Models CONTENTS 11.1 STRUCTURE OF A WAITING LINE SYSTEM Single-Channel Waiting Line Distribution of Arrivals Distribution of Service Times Queue Discipline Steady-State Operation 11.2 SINGLE-CHANNEL WAITING LINE MODEL WITH POISSON ARRIVALS AND EXPONENTIAL SERVICE TIMES Operating Characteristics Operating Characteristics for the Burger Dome Problem Managers’ Use of Waiting Line Models Improving the Waiting Line Operation Excel Solution of Waiting Line Model 11.3 MULTIPLE-CHANNEL WAITING LINE MODEL WITH POISSON ARRIVALS AND EXPONENTIAL SERVICE TIMES Operating Characteristics Operating Characteristics for the Burger Dome Problem
11.4 SOME GENERAL RELATIONSHIPS FOR WAITING LINE MODELS 11.5 ECONOMIC ANALYSIS OF WAITING LINES 11.6 OTHER WAITING LINE MODELS 11.7 SINGLE-CHANNEL WAITING LINE MODEL WITH POISSON ARRIVALS AND ARBITRARY SERVICE TIMES Operating Characteristics for the M/G/1 Model Constant Service Times 11.8 MULTIPLE-CHANNEL MODEL WITH POISSON ARRIVALS, ARBITRARY SERVICE TIMES, AND NO WAITING LINE Operating Characteristics for the M/G/k Model with Blocked Customers Cleared 11.9 WAITING LINE MODELS WITH FINITE CALLING POPULATIONS Operating Characteristics for the M/M/1 Model with a Finite Calling Population
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503
Recall the last time that you had to wait at a supermarket checkout counter, for a teller at your local bank, or to be served at a fast-food restaurant. In these and many other waiting line situations, the time spent waiting is undesirable. Adding more checkout clerks, bank tellers, or servers is not always the most economical strategy for improving service, so businesses need to identify other ways to keep waiting times within tolerable limits. Models have been developed to help managers understand and make better decisions concerning the operation of waiting lines. In management science terminology, a waiting line is also known as a queue, and the body of knowledge dealing with waiting lines is known as queueing theory. In the early 1900s, A. K. Erlang, a Danish telephone engineer, began a study of the congestion and waiting times occurring in the completion of telephone calls. Since then, queueing theory has grown far more sophisticated, with applications in a wide variety of waiting line situations. Waiting line models consist of mathematical formulas and relationships that can be used to determine the operating characteristics (performance measures) for a waiting line. Operating characteristics of interest include the following: 1. The probability that no units are in the system 2. The average number of units in the waiting line 3. The average number of units in the system (the number of units in the waiting line plus the number of units being served) 4. The average time a unit spends in the waiting line 5. The average time a unit spends in the system (the waiting time plus the service time) 6. The probability that an arriving unit has to wait for service Managers who have such information are better able to make decisions that balance desirable service levels against the cost of providing the service. The Management Science in Action, ATM Waiting Times at Citibank, describes how a waiting line model was used to help determine the number of automatic teller machines (ATMs) to place at New York City banking centers. A waiting line model prompted the creation of a new kind of line and a chief line director to implement first-come, first-served queue discipline at Whole Foods Market in the Chelsea neighborhood of New York City. In addition, a waiting line model helped the New Haven, Connecticut, fire department develop policies to improve response time for both fire and medical emergencies. MANAGEMENT SCIENCE IN ACTION ATM WAITING TIMES AT CITIBANK*
The waiting line model used at Citibank is discussed in Section 11.3.
The New York City franchise of U.S. Citibanking operates more than 250 banking centers. Each center provides one or more automatic teller machines (ATMs) capable of performing a variety of banking transactions. At each center, a waiting line is formed by randomly arriving customers who seek service at one of the ATMs. In order to make decisions on the number of ATMs to have at selected banking center locations, management needed information about potential waiting times and general customer service. Waiting line operating characteristics such as average
number of customers in the waiting line, average time a customer spends waiting, and the probability that an arriving customer has to wait would help management determine the number of ATMs to recommend at each banking center. For example, one busy midtown Manhattan center had a peak arrival rate of 172 customers per hour. A multiple-channel waiting line model with six ATMs showed that 88% of the customers would have to wait, with an average wait time (continued)
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between six and seven minutes. This level of service was judged unacceptable. Expansion to seven ATMs was recommended for this location based on the waiting line model’s projection of acceptable waiting times. Use of the waiting line model
11.1
provided guidelines for making incremental ATM decisions at each banking center location. *Based on information provided by Stacey Karter of Citibank.
STRUCTURE OF A WAITING LINE SYSTEM To illustrate the basic features of a waiting line model, we consider the waiting line at the Burger Dome fast-food restaurant. Burger Dome sells hamburgers, cheeseburgers, french fries, soft drinks, and milk shakes, as well as a limited number of specialty items and dessert selections. Although Burger Dome would like to serve each customer immediately, at times more customers arrive than can be handled by the Burger Dome food service staff. Thus, customers wait in line to place and receive their orders. Burger Dome is concerned that the methods currently used to serve customers are resulting in excessive waiting times. Management wants to conduct a waiting line study to help determine the best approach to reduce waiting times and improve service.
Single-Channel Waiting Line In the current Burger Dome operation, a server takes a customer’s order, determines the total cost of the order, takes the money from the customer, and then fills the order. Once the first customer’s order is filled, the server takes the order of the next customer waiting for service. This operation is an example of a single-channel waiting line. Each customer entering the Burger Dome restaurant must pass through the one channel—one order-taking and order-filling station—to place an order, pay the bill, and receive the food. When more customers arrive than can be served immediately, they form a waiting line and wait for the order-taking and order-filling station to become available. A diagram of the Burger Dome single-channel waiting line is shown in Figure 11.1.
Distribution of Arrivals Defining the arrival process for a waiting line involves determining the probability distribution for the number of arrivals in a given period of time. For many waiting line situations, the arrivals occur randomly and independently of other arrivals, and we cannot predict FIGURE 11.1 THE BURGER DOME SINGLE-CHANNEL WAITING LINE System
Server Customer Arrivals Waiting Line
Order Taking and Order Filling
Customer Leaves after Order Is Filled
11.1
505
Structure of a Waiting Line System
when an arrival will occur. In such cases, quantitative analysts have found that the Poisson probability distribution provides a good description of the arrival pattern. The Poisson probability function provides the probability of x arrivals in a specific time period. The probability function is as follows:1
P(x) =
lxe-l x!
for x = 0, 1, 2, . . .
(11.1)
where x = the number of arrivals in the time period l = the mean number of arrivals per time period e = 2.71828 The mean number of arrivals per time period, l, is called the arrival rate. Values of e⫺l can be found with a calculator or by using Appendix C. Suppose that Burger Dome analyzed data on customer arrivals and concluded that the arrival rate is 45 customers per hour. For a one-minute period, the arrival rate would be l ⫽ 45 customers兾60 minutes ⫽ 0.75 customers per minute. Thus, we can use the following Poisson probability function to compute the probability of x customer arrivals during a one-minute period:
P(x) =
lxe-l 0.75xe-0.75 = x! x!
(11.2)
Thus, the probabilities of 0, 1, and 2 customer arrivals during a one-minute period are P(0) = P(1) = P(2) =
(0.75)0e-0.75 0! (0.75)1e-0.75 1! (0.75)2e-0.75 2!
= e-0.75 = 0.4724 = 0.75e-0.75 = 0.75(0.4724) = 0.3543 (0.75)2e-0.75 =
2!
(0.5625)(0.4724) =
2
= 0.1329
The probability of no customers in a one-minute period is 0.4724, the probability of one customer in a one-minute period is 0.3543, and the probability of two customers in a oneminute period is 0.1329. Table 11.1 shows the Poisson probabilities for customer arrivals during a one-minute period. The waiting line models that will be presented in Sections 11.2 and 11.3 use the Poisson probability distribution to describe the customer arrivals at Burger Dome. In practice, you should record the actual number of arrivals per time period for several days or weeks and compare the frequency distribution of the observed number of arrivals to the Poisson probability distribution to determine whether the Poisson probability distribution provides a reasonable approximation of the arrival distribution. 1
The term x!, x factorial, is defined as x! ⫽ x(x ⫺ 1)(x ⫺ 2) . . . (2)(1). For example, 4! ⫽ (4)(3)(2)(1) ⫽ 24. For the special case of x ⫽ 0, 0! ⫽ 1 by definition.
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TABLE 11.1 POISSON PROBABILITIES FOR THE NUMBER OF CUSTOMER ARRIVALS AT A BURGER DOME RESTAURANT DURING A ONE-MINUTE PERIOD (l ⫽ 0.75) Number of Arrivals 0 1 2 3 4 5 or more
Probability 0.4724 0.3543 0.1329 0.0332 0.0062 0.0010
Distribution of Service Times The service time is the time a customer spends at the service facility once the service has started. At Burger Dome, the service time starts when a customer begins to place the order with the food server and continues until the customer receives the order. Service times are rarely constant. At Burger Dome, the number of items ordered and the mix of items ordered vary considerably from one customer to the next. Small orders can be handled in a matter of seconds, but large orders may require more than two minutes. Quantitative analysts have found that if the probability distribution for the service time can be assumed to follow an exponential probability distribution, formulas are available for providing useful information about the operation of the waiting line. Using an exponential probability distribution, the probability that the service time will be less than or equal to a time of length t is P(service time … t) = 1 - e-mt
(11.3)
where m = the mean number of units that can be served per time period e = 2.71828
A property of the exponential probability distribution is that there is a 0.6321 probability that the random variable takes on a value less than its mean. In waiting line applications, the exponential probability distribution indicates that approximately 63 percent of the service times are less than the mean service time and approximately 37 percent of the service times are greater than the mean service time.
The mean number of units that can be served per time period, , is called the service rate. Suppose that Burger Dome studied the order-taking and order-filling process and found that the single food server can process an average of 60 customer orders per hour. On a oneminute basis, the service rate would be ⫽ 60 customers兾60 minutes ⫽ 1 customer per minute. For example, with m ⫽ 1, we can use equation (11.3) to compute probabilities such as the probability an order can be processed in ¹⁄₂ minute or less, 1 minute or less, and 2 minutes or less. These computations are P(service time … 0.5 min.) = 1 - e-1(0.5) = 1 - 0.6065 = 0.3935 P(service time … 1.0 min.) = 1 - e-1(1.0) = 1 - 0.3679 = 0.6321 P(service time … 2.0 min.) = 1 - e-1(2.0) = 1 - 0.1353 = 0.8647 Thus, we would conclude that there is a 0.3935 probability that an order can be processed in ¹⁄₂ minute or less, a 0.6321 probability that it can be processed in 1 minute or less, and a 0.8647 probability that it can be processed in 2 minutes or less.
11.1
Structure of a Waiting Line System
507
In several waiting line models presented in this chapter, we assume that the probability distribution for the service time follows an exponential probability distribution. In practice, you should collect data on actual service times to determine whether the exponential probability distribution is a reasonable approximation of the service times for your application.
Queue Discipline In describing a waiting line system, we must define the manner in which the waiting units are arranged for service. For the Burger Dome waiting line, and in general for most customer-oriented waiting lines, the units waiting for service are arranged on a first-come, first-served basis; this approach is referred to as an FCFS queue discipline. However, some situations call for different queue disciplines. For example, when people wait for an elevator, the last one on the elevator is often the first one to complete service (i.e., the first to leave the elevator). Other types of queue disciplines assign priorities to the waiting units and then serve the unit with the highest priority first. In this chapter we consider only waiting lines based on a first-come, first-served queue discipline. The Management Science in Action, The Serpentine Line and an FCFS Queue Discipline at Whole Foods Market, describes how an FCFS queue discipline is used at a supermarket. MANAGEMENT SCIENCE IN ACTION THE SERPENTINE LINE AND AN FCFS QUEUE DISCIPLINE AT WHOLE FOODS MARKET* The Whole Foods Market in the Chelsea neighborhood of New York City employs a chief line director to implement a first-come, first-served (FCFS) queue discipline. Companies such as Wendy’s, American Airlines, and Chemical Bank were among the first to employ serpentine lines to implement an FCFS queue discipline. Such lines are commonplace today. We see them at banks, amusement parks, and fastfood outlets. The line is called serpentine because of the way it winds around. When a customer gets to the front of the line, the customer then goes to the first available server. People like serpentine lines because they prevent people who join the line later from being served ahead of an earlier arrival. As popular as serpentine lines have become, supermarkets have not employed them because of a lack of space. At the typical supermarket, a separate line forms at each checkout counter. When ready to check out, a person picks one of the checkout counters and stays in that line until receiving service. Sometimes a person joining another checkout line later will receive service first,
which tends to upset people. Manhattan’s Whole Foods Market solved this problem by creating a new kind of line and employing a chief line director to direct the first person in line to the next available checkout counter. The waiting line at the Whole Foods Market is actually three parallel lines. Customers join the shortest line and follow a rotation when they reach the front of the line. For instance, if the first customer in line 1 is sent to a checkout counter, the next customer sent to a checkout counter is the first person in line 2, then the first person in line 3, and so on. This way an FCFS queue discipline is implemented without a long, winding serpentine line. The Whole Foods Market’s customers seem to really like the system, and the line director, Bill Jones, has become something of a celebrity. Children point to him on the street and customers invite him over for dinner. *Based on Ian Parker, “Mr. Next,” The New Yorker (January 13, 2003).
Steady-State Operation When the Burger Dome restaurant opens in the morning, no customers are in the restaurant. Gradually, activity builds up to a normal or steady state. The beginning or start-up period is referred to as the transient period. The transient period ends when the system reaches
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the normal or steady-state operation. Waiting line models describe the steady-state operating characteristics of a waiting line.
11.2 Waiting line models are often based on assumptions such as Poisson arrivals and exponential service times. When applying any waiting line model, data should be collected on the actual system to ensure that the assumptions of the model are reasonable.
SINGLE-CHANNEL WAITING LINE MODEL WITH POISSON ARRIVALS AND EXPONENTIAL SERVICE TIMES In this section we present formulas that can be used to determine the steady-state operating characteristics for a single-channel waiting line. The formulas are applicable if the arrivals follow a Poisson probability distribution and the service times follow an exponential probability distribution. As these assumptions apply to the Burger Dome waiting line problem introduced in Section 11.1, we show how formulas can be used to determine Burger Dome’s operating characteristics and thus provide management with helpful decisionmaking information. The mathematical methodology used to derive the formulas for the operating characteristics of waiting lines is rather complex. However, our purpose in this chapter is not to provide the theoretical development of waiting line models, but rather to show how the formulas that have been developed can provide information about operating characteristics of the waiting line. Readers interested in the mathematical development of the formulas can consult the specialized texts listed in Appendix D at the end of the text.
Operating Characteristics The following formulas can be used to compute the steady-state operating characteristics for a single-channel waiting line with Poisson arrivals and exponential service times, where l = the mean number of arrivals per time period (the arrival rate) m = the mean number of services per time period (the service rate) 1. The probability that no units are in the system: Equations (11.4) through (11.10) do not provide formulas for optimal conditions. Rather, these equations provide information about the steady-state operating characteristics of a waiting line.
P0 = 1 -
l m
(11.4)
2. The average number of units in the waiting line:
Lq =
l2 m(m - l)
(11.5)
3. The average number of units in the system:
L = Lq +
l m
(11.6)
4. The average time a unit spends in the waiting line:
Wq =
Lq l
(11.7)
11.2
Single-Channel Waiting Line Model with Poisson Arrivals and Exponential Service Times
509
5. The average time a unit spends in the system:
W = Wq +
1 m
(11.8)
6. The probability that an arriving unit has to wait for service:
Pw =
l m
(11.9)
7. The probability of n units in the system: l n Pn = a b P0 m
(11.10)
The values of the arrival rate l and the service rate µ are clearly important components in determining the operating characteristics. Equation (11.9) shows that the ratio of the arrival rate to the service rate, l兾m, provides the probability that an arriving unit has to wait because the service facility is in use. Hence, l兾m is referred to as the utilization factor for the service facility. The operating characteristics presented in equations (11.4) through (11.10) are applicable only when the service rate m is greater than the arrival rate l—in other words, when l兾m ⬍ 1. If this condition does not exist, the waiting line will continue to grow without limit because the service facility does not have sufficient capacity to handle the arriving units. Thus, in using equations (11.4) through (11.10), we must have m ⬎ l.
Operating Characteristics for the Burger Dome Problem Recall that for the Burger Dome problem we had an arrival rate of l ⫽ 0.75 customers per minute and a service rate of m ⫽ 1 customer per minute. Thus, with m ⬎ l, equations (11.4) through (11.10) can be used to provide operating characteristics for the Burger Dome single-channel waiting line: l 0.75 = 1 = 0.25 m 1 l2 0.752 = = 2.25 customers m(m - l) 1(1 - 0.75) l 0.75 Lq + = 3 customers = 2.25 + m 1 Lq 2.25 = = 3 minutes l 0.75 1 1 = 3 + = 4 minutes Wq + m 1 l 0.75 = = 0.75 m 1
P0 = 1 Lq = L = Wq = W = Pw =
510
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TABLE 11.2 THE PROBABILITY OF n CUSTOMERS IN THE SYSTEM FOR THE BURGER DOME WAITING LINE PROBLEM Number of Customers 0 1 2 3 4 5 6 7 or more
Problem 5 asks you to compute the operating characteristics for a singlechannel waiting line application.
Probability 0.2500 0.1875 0.1406 0.1055 0.0791 0.0593 0.0445 0.1335
Equation (11.10) can be used to determine the probability of any number of customers in the system. Applying it provides the probability information in Table 11.2.
Managers’ Use of Waiting Line Models The results of the single-channel waiting line for Burger Dome show several important things about the operation of the waiting line. In particular, customers wait an average of three minutes before beginning to place an order, which appears somewhat long for a business based on fast service. In addition, the facts that the average number of customers waiting in line is 2.25 and that 75% of the arriving customers have to wait for service are indicators that something should be done to improve the waiting line operation. Table 11.2 shows a 0.1335 probability that seven or more customers are in the Burger Dome system at one time. This condition indicates a fairly high probability that Burger Dome will experience some long waiting lines if it continues to use the single-channel operation. If the operating characteristics are unsatisfactory in terms of meeting company standards for service, Burger Dome’s management should consider alternative designs or plans for improving the waiting line operation.
Improving the Waiting Line Operation Waiting line models often indicate when improvements in operating characteristics are desirable. However, the decision of how to modify the waiting line configuration to improve the operating characteristics must be based on the insights and creativity of the analyst. After reviewing the operating characteristics provided by the waiting line model, Burger Dome’s management concluded that improvements designed to reduce waiting times are desirable. To make improvements in the waiting line operation, analysts often focus on ways to improve the service rate. Generally, service rate improvements are obtained by making either or both of the following changes: 1. Increase the service rate by making a creative design change or by using new technology. 2. Add one or more service channels so that more customers can be served simultaneously. Assume that in considering alternative 1, Burger Dome’s management decides to employ an order filler who will assist the order taker at the cash register. The customer begins the service process by placing the order with the order taker. As the order is placed, the order taker announces the order over an intercom system, and the order filler begins filling the
11.2
Single-Channel Waiting Line Model with Poisson Arrivals and Exponential Service Times
511
TABLE 11.3 OPERATING CHARACTERISTICS FOR THE BURGER DOME SYSTEM WITH THE SERVICE RATE INCREASED TO μ ⫽ 1.25 CUSTOMERS PER MINUTE Probability of no customers in the system Average number of customers in the waiting line Average number of customers in the system Average time in the waiting line Average time in the system Probability that an arriving customer has to wait Probability that seven or more customers are in the system
Problem 11 asks you to determine whether a change in the service rate will meet the company’s service guideline for its customers.
0.400 0.900 1.500 1.200 minutes 2.000 minutes 0.600 0.028
order. When the order is completed, the order taker handles the money, while the order filler continues to fill the order. With this design, Burger Dome’s management estimates the service rate can be increased from the current 60 customers per hour to 75 customers per hour. Thus, the service rate for the revised system is m ⫽ 75 customers兾60 minutes ⫽ 1.25 customers per minute. For l ⫽ 0.75 customers per minute and m ⫽ 1.25 customers per minute, equations (11.4) through (11.10) can be used to provide the new operating characteristics for the Burger Dome waiting line. These operating characteristics are summarized in Table 11.3. The information in Table 11.3 indicates that all operating characteristics have improved because of the increased service rate. In particular, the average time a customer spends in the waiting line has been reduced from 3 to 1.2 minutes and the average time a customer spends in the system has been reduced from 4 to 2 minutes. Are any other alternatives available that Burger Dome can use to increase the service rate? If so, and if the mean service rate m can be identified for each alternative, equations (11.4) through (11.10) can be used to determine the revised operating characteristics and any improvements in the waiting line system. The added cost of any proposed change can be compared to the corresponding service improvements to help the manager determine whether the proposed service improvements are worthwhile. As mentioned previously, another option often available is to add one or more service channels so that more customers can be served simultaneously. The extension of the singlechannel waiting line model to the multiple-channel waiting line model is the topic of the next section.
Excel Solution of Waiting Line Model Waiting line models are easily implemented with the aid of worksheets. The Excel worksheet for the Burger Dome single-channel waiting line is shown in Figure 11.2. The formula worksheet is in the background; the value worksheet is in the foreground. The arrival rate and the service rate are entered in cells B7 and B8. The formulas for the waiting line’s operating characteristics are placed in cells C13 to C18. The worksheet shows the same values for the operating characteristics that we obtained earlier. Modifications in the waiting line design can be evaluated by entering different arrival rates and/or service rates into cells B7 and B8. The new operating characteristics of the waiting line will be shown immediately. The Excel worksheet in Figure 11.2 is a template that can be used with any singlechannel waiting line model with Poisson arrivals and exponential service times. This worksheet and similar Excel worksheets for the other waiting line models presented in this chapter are available at the website that accompanies this text.
512
Chapter 11
Waiting Line Models
FIGURE 11.2 WORKSHEET FOR THE BURGER DOME SINGLE-CHANNEL WAITING LINE A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
B
C
D
Single-Channel Waiting Line Model Assumptions Poisson Arrivals Exponential Service Times Arrival Rate Service Rate
0.75 1
A
Operating Characteristics Probability that no customers are in the system, Po Average number of customers in the waiting line, Lq Average number of customers in the system, L Average time a customer spends in the waiting line, Wq Average time a customer spends in the system, W Probability an arriving customer has to wait, Pw
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Single
⫽1-B7/B8 ⫽B7^2/(B8*(B8-B7)) ⫽C14⫹B7/B8 ⫽C14/B7 ⫽C16⫹1/B8 ⫽B7/B8
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
B
C
Single-Channel Waiting Line Model Assumptions Poisson Arrivals Exponential Service Times Arrival Rate Service Rate
0.75 1
Operating Characteristics Probability that no customers are in the system, Po Average number of customers in the waiting line, Lq Average number of customers in the system, L Average time a customer spends in the waiting line, Wq Average time a customer spends in the system, W Probability an arriving customer has to wait, Pw
0.2500 2.2500 3.0000 3.0000 4.0000 0.7500
NOTES AND COMMENTS 1. The assumption that arrivals follow a Poisson probability distribution is equivalent to the assumption that the time between arrivals has an exponential probability distribution. For example, if the arrivals for a waiting line follow a Poisson probability distribution with a mean of 20 arrivals per hour, the time between arrivals will follow an exponential probability distribution, with a mean time between arrivals of ¹⁄₂₀, or 0.05, hour. 2. Many individuals believe that whenever the service rate is greater than the arrival rate l, the
11.3 You may be familiar with multiple-channel systems that also have multiple waiting lines. The waiting line model in this section has multiple channels but only a single waiting line. Operating characteristics for a multiplechannel system are better when a single waiting line, rather than multiple waiting lines, is used.
system should be able to handle or serve all arrivals. However, as the Burger Dome example shows, the variability of arrival times and service times may result in long waiting times even when the service rate exceeds the arrival rate. A contribution of waiting line models is that they can point out undesirable waiting line operating characteristics even when the ⬎ l condition appears satisfactory.
MULTIPLE-CHANNEL WAITING LINE MODEL WITH POISSON ARRIVALS AND EXPONENTIAL SERVICE TIMES A multiple-channel waiting line consists of two or more service channels that are assumed to be identical in terms of service capability. In the multiple-channel system, arriving units wait in a single waiting line and then move to the first available channel to be served. The single-channel Burger Dome operation can be expanded to a two-channel system by opening a second service channel. Figure 11.3 shows a diagram of the Burger Dome two-channel waiting line. In this section we present formulas that can be used to determine the steady-state operating characteristics for a multiple-channel waiting line. These formulas are applicable if the following conditions exist: 1. The arrivals follow a Poisson probability distribution. 2. The service time for each channel follows an exponential probability distribution.
11.3
Multiple-Channel Waiting Line Model with Poisson Arrivals and Exponential Service Times
513
FIGURE 11.3 THE BURGER DOME TWO-CHANNEL WAITING LINE System Channel 1
Server A Customer Goes to Next Open Channel
Customer Arrivals Waiting Line
Customer Leaves after Order Is Filled
Channel 2
Server B
3. The service rate is the same for each channel. 4. The arrivals wait in a single waiting line and then move to the first open channel for service.
Operating Characteristics The following formulas can be used to compute the steady-state operating characteristics for multiple-channel waiting lines, where l = the arrival rate for the system m = the service rate for each channel k = the number of channels 1. The probability that no units are in the system:
P0 =
1 n
(l>m) k
k-1 (l>m)
a
n=0
n!
+
k!
km a b km - l
(11.11)
2. The average number of units in the waiting line:
Lq =
(l>m) klm (k - 1)!(km - l)2
P0
(11.12)
514
Chapter 11
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3. The average number of units in the system:
l m
L = Lq +
(11.13)
4. The average time a unit spends in the waiting line:
Wq =
Lq (11.14)
l
5. The average time a unit spends in the system:
W = Wq +
1 m
(11.15)
6. The probability that an arriving unit has to wait for service:
Pw =
km 1 l k a b a bP k! m km - l 0
(11.16)
7. The probability of n units in the system:
Pn = Pn =
(l>m)n n! (l>m)n
P0
k!k(n-k)
P0
for n … k
(11.17)
for n 7 k
(11.18)
Because m is the service rate for each channel, km is the service rate for the multiplechannel system. As was true for the single-channel waiting line model, the formulas for the operating characteristics of multiple-channel waiting lines can be applied only in situations where the service rate for the system is greater than the arrival rate for the system; in other words, the formulas are applicable only if km is greater than l. Some expressions for the operating characteristics of multiple-channel waiting lines are more complex than their single-channel counterparts. However, equations (11.11) through (11.18) provide the same information as provided by the single-channel model. To help simplify the use of the multiple-channel equations, Table 11.4 contains values of P0 for selected values of l兾m and k. The values provided in the table correspond to cases where km ⬎ l, and hence the service rate is sufficient to process all arrivals.
11.3
Multiple-Channel Waiting Line Model with Poisson Arrivals and Exponential Service Times
515
TABLE 11.4 VALUES OF P0 FOR MULTIPLE-CHANNEL WAITING LINES WITH POISSON ARRIVALS AND EXPONENTIAL SERVICE TIMES
Ratio l/μ 0.15 0.20 0.25 0.30 0.35 0.40 0.45 0.50 0.55 0.60 0.65 0.70 0.75 0.80 0.85 0.90 0.95 1.00 1.20 1.40 1.60 1.80 2.00 2.20 2.40 2.60 2.80 3.00 3.20 3.40 3.60 3.80 4.00 4.20 4.40 4.60 4.80
2 0.8605 0.8182 0.7778 0.7391 0.7021 0.6667 0.6327 0.6000 0.5686 0.5385 0.5094 0.4815 0.4545 0.4286 0.4035 0.3793 0.3559 0.3333 0.2500 0.1765 0.1111 0.0526
Number of Channels (k) 3 4 0.8607 0.8607 0.8187 0.8187 0.7788 0.7788 0.7407 0.7408 0.7046 0.7047 0.6701 0.6703 0.6373 0.6376 0.6061 0.6065 0.5763 0.5769 0.5479 0.5487 0.5209 0.5219 0.4952 0.4965 0.4706 0.4722 0.4472 0.4491 0.4248 0.4271 0.4035 0.4062 0.3831 0.3863 0.3636 0.3673 0.2941 0.3002 0.2360 0.2449 0.1872 0.1993 0.1460 0.1616 0.1111 0.1304 0.0815 0.1046 0.0562 0.0831 0.0345 0.0651 0.0160 0.0521 0.0377 0.0273 0.0186 0.0113 0.0051
5 0.8607 0.8187 0.7788 0.7408 0.7047 0.6703 0.6376 0.6065 0.5769 0.5488 0.5220 0.4966 0.4724 0.4493 0.4274 0.4065 0.3867 0.3678 0.3011 0.2463 0.2014 0.1646 0.1343 0.1094 0.0889 0.0721 0.0581 0.0466 0.0372 0.0293 0.0228 0.0174 0.0130 0.0093 0.0063 0.0038 0.0017
Operating Characteristics for the Burger Dome Problem To illustrate the multiple-channel waiting line model, we return to the Burger Dome fastfood restaurant waiting line problem. Suppose that management wants to evaluate the desirability of opening a second order-processing station so that two customers can be served simultaneously. Assume a single waiting line with the first customer in line moving to the first available server. Let us evaluate the operating characteristics for this twochannel system.
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Chapter 11
Waiting Line Models
We use equations (11.12) through (11.18) for the k ⫽ 2 channel system. For an arrival rate of l ⫽ 0.75 customers per minute and a service rate of m ⫽ 1 customer per minute for each channel, we obtain the operating characteristics:
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Multiple
P0 = 0.4545 Lq =
(0.75>1)2(0.75)(1)
(0.4545) = 0.1227 customer (2 - 1)!32(1) - 0.754 2 l 0.75 L = Lq + = 0.1227 + = 0.8727 customer m 1 Lq 0.1227 Wq = = = 0.1636 minute l 0.75 1 1 W = Wq + = 0.1636 + = 1.1636 minutes m 2 Pw =
Try Problem 18 for practice in determining the operating characteristics for a twochannel waiting line.
(from Table 11.4 with l>m = 0.75)
2(1) 1 0.75 2 a b c d(0.4545) = 0.2045 2! 1 2(1) - 0.75
Using equations (11.17) and (11.18), we can compute the probabilities of n customers in the system. The results from these computations are summarized in Table 11.5. We can now compare the steady-state operating characteristics of the two-channel system to the operating characteristics of the original single-channel system discussed in Section 11.2. 1. The average time a customer spends in the system (waiting time plus service time) is reduced from W ⫽ 4 minutes to W ⫽ 1.1636 minutes. 2. The average number of customers in the waiting line is reduced from Lq ⫽ 2.25 customers to Lq ⫽ 0.1227 customer. 3. The average time a customer spends in the waiting line is reduced from Wq ⫽ 3 minutes to Wq ⫽ 0.1636 minute. 4. The probability that a customer has to wait for service is reduced from Pw ⫽ 0.75 to Pw ⫽ 0.2045. Clearly the two-channel system will significantly improve the operating characteristics of the waiting line. However, adding an order filler at each service station would further increase the service rate and improve the operating characteristics. The final decision regarding the staffing policy at Burger Dome rests with the Burger Dome management. The waiting line study simply provides the operating characteristics that can be anticipated
TABLE 11.5 THE PROBABILITY OF n CUSTOMERS IN THE SYSTEM FOR THE BURGER DOME TWO-CHANNEL WAITING LINE Number of Customers 0 1 2 3 4 5 or more
Probability 0.4545 0.3409 0.1278 0.0479 0.0180 0.0109
11.4
Some General Relationships for Waiting Line Models
517
under three configurations: a single-channel system with one employee, a single-channel system with two employees, and a two-channel system with an employee for each channel. After considering these results, what action would you recommend? In this case, Burger Dome adopted the following policy statement: For periods when customer arrivals are expected to average 45 customers per hour, Burger Dome will open two order-processing channels with one employee assigned to each. By changing the arrival rate l to reflect arrival rates at different times of the day, and then computing the operating characteristics, Burger Dome’s management can establish guidelines and policies that tell the store managers when to schedule service operations with a single channel, two channels, or perhaps even three or more channels. NOTES AND COMMENTS The multiple-channel waiting line model is based on a single waiting line. You may have also encountered situations where each of the k channels has its own waiting line. Analysts have shown that the operating characteristics of multiple-channel systems are better if a single waiting line is used.
11.4
People like them better also; no one who comes in after you can be served ahead of you. Thus, when possible, banks, airline reservation counters, foodservice establishments, and other businesses use a single waiting line for a multiple-channel system.
SOME GENERAL RELATIONSHIPS FOR WAITING LINE MODELS In Sections 11.2 and 11.3 we presented formulas for computing the operating characteristics for single-channel and multiple-channel waiting lines with Poisson arrivals and exponential service times. The operating characteristics of interest included Lq L Wq W
= = = =
the average number of units in the waiting line the average number of units in the system the average time a unit spends in the waiting line the average time a unit spends in the system
John D. C. Little showed that several relationships exist among these four characteristics and that these relationships apply to a variety of different waiting line systems. Two of the relationships, referred to as Little’s flow equations, are L = lW Lq = lWq
(11.19) (11.20)
Equation (11.19) shows that the average number of units in the system, L, can be found by multiplying the arrival rate, l, by the average time a unit spends in the system, W. Equation (11.20) shows that the same relationship holds between the average number of units in the waiting line, Lq, and the average time a unit spends in the waiting line, Wq. Using equation (11.20) and solving for Wq, we obtain
Wq ⫽
Lq λ
(11.21)
518
Chapter 11
Waiting Line Models
Equation (11.21) follows directly from Little’s second flow equation. We used it for the single-channel waiting line model in Section 11.2 and the multiple-channel waiting line model in Section 11.3 [see equations (11.7) and (11.14)]. Once Lq is computed for either of these models, equation (11.21) can then be used to compute Wq. Another general expression that applies to waiting line models is that the average time in the system, W, is equal to the average time in the waiting line, Wq, plus the average service time. For a system with a service rate m, the mean service time is 1兾m. Thus, we have the general relationship
W = Wq +
The advantage of Little’s flow equations is that they show how operating characteristics L, Lq, W, and Wq are related in any waiting line system. Arrivals and service times do not have to follow specific probability distributions for the flow equations to be applicable.
1 m
(11.22)
Recall that we used equation (11.22) to provide the average time in the system for both the single- and multiple-channel waiting line models [see equations (11.8) and (11.15)]. The importance of Little’s flow equations is that they apply to any waiting line model regardless of whether arrivals follow the Poisson probability distribution and regardless of whether service times follow the exponential probability distribution. For example, in a study of the grocery checkout counters at Murphy’s Foodliner, an analyst concluded that arrivals follow the Poisson probability distribution with an arrival rate of 24 customers per hour or l ⫽ 24兾60 ⫽ 0.40 customers per minute. However, the analyst found that service times follow a normal probability distribution rather than an exponential probability distribution. The service rate was found to be 30 customers per hour, or m ⫽ 30兾60 ⫽ 0.50 customers per minute. A time study of actual customer waiting times showed that, on average, a customer spends 4.5 minutes in the system (waiting time plus checkout time); that is, W ⫽ 4.5. Using the waiting line relationships discussed in this section, we can now compute other operating characteristics for this waiting line. First, using equation (11.22) and solving for Wq, we have Wq = W -
1 1 = 4.5 = 2.5 minutes m 0.50
With both W and Wq known, we can use Little’s flow equations, (11.19) and (11.20), to compute L = lW = 0.40(4.5) = 1.8 customers Lq = lWq = 0.40(2.5) = 1 customer The application of Little’s flow equations is demonstrated in Problem 25.
The manager of Murphy’s Foodliner can now review these operating characteristics to see whether action should be taken to improve the service and to reduce the waiting time and the length of the waiting line.
NOTES AND COMMENTS In waiting line systems where the length of the waiting line is limited (e.g., a small waiting area), some arriving units will be blocked from joining the waiting line and will be lost. In this case, the blocked or lost arrivals will make the mean number
of units entering the system something less than the arrival rate. By defining l as the mean number of units joining the system, rather than the arrival rate, the relationships discussed in this section can be used to determine W, L, Wq, and Lq.
11.5
11.5
Economic Analysis of Waiting Lines
519
ECONOMIC ANALYSIS OF WAITING LINES Frequently, decisions involving the design of waiting lines will be based on a subjective evaluation of the operating characteristics of the waiting line. For example, a manager may decide that an average waiting time of one minute or less and an average of two customers or fewer in the system are reasonable goals. The waiting line models presented in the preceding sections can be used to determine the number of channels that will meet the manager’s waiting line performance goals. On the other hand, a manager may want to identify the cost of operating the waiting line system and then base the decision regarding system design on a minimum hourly or daily operating cost. Before an economic analysis of a waiting line can be conducted, a total cost model, which includes the cost of waiting and the cost of service, must be developed. To develop a total cost model for a waiting line, we begin by defining the notation to be used:
Waiting cost is based on average number of units in the system. It includes the time spent waiting in line plus the time spent being served.
cw L cs k TC
= = = = =
the waiting cost per time period for each unit the average number of units in the system the service cost per time period for each channel the number of channels the total cost per time period
The total cost is the sum of the waiting cost and the service cost; that is, TC = cw L + cs k Adding more channels always improves the operating characteristics of the waiting line and reduces the waiting cost. However, additional channels increase the service cost. An economic analysis of waiting lines attempts to find the number of channels that will minimize total cost by balancing the waiting cost and the service cost.
(11.23)
To conduct an economic analysis of a waiting line, we must obtain reasonable estimates of the waiting cost and the service cost. Of these two costs, the waiting cost is usually the more difficult to evaluate. In the Burger Dome restaurant problem, the waiting cost would be the cost per minute for a customer waiting for service. This cost is not a direct cost to Burger Dome. However, if Burger Dome ignores this cost and allows long waiting lines, customers ultimately will take their business elsewhere. Thus, Burger Dome will experience lost sales and, in effect, incur a cost. The service cost is generally easier to determine. This cost is the relevant cost associated with operating each service channel. In the Burger Dome problem, this cost would include the server’s wages, benefits, and any other direct costs associated with operating the service channel. At Burger Dome, this cost is estimated to be $7 per hour. To demonstrate the use of equation (11.23), we assume that Burger Dome is willing to assign a cost of $10 per hour for customer waiting time. We use the average number of units in the system, L, as computed in Sections 11.2 and 11.3 to obtain the total hourly cost for the single-channel and two-channel systems. Single-channel system (L ⫽ 3 customers) TC = cw L + cs k = 10(3) + 7(1) = $37.00 per hour Two-channel system (L ⫽ 0.8727 customer) TC = cw L + cs k = 10(0.8727) + 7(2) = $22.73 per hour Thus, based on the cost data provided by Burger Dome, the two-channel system provides the most economical operation.
520
Chapter 11
Waiting Line Models
Total Cost per Hour
FIGURE 11.4 THE GENERAL SHAPE OF WAITING COST, SERVICE COST, AND TOTAL COST CURVES IN WAITING LINE MODELS
Total Cost Service Cost
Waiting Cost
Number of Channels (k)
Problem 21 tests your ability to conduct an economic analysis of proposed single-channel and two-channel waiting line systems.
Figure 11.4 shows the general shape of the cost curves in the economic analysis of waiting lines. The service cost increases as the number of channels is increased. However, with more channels, the service is better. As a result, waiting time and cost decrease as the number of channels is increased. The number of channels that will provide a good approximation of the minimum total cost design can be found by evaluating the total cost for several design alternatives.
NOTES AND COMMENTS 1. In dealing with government agencies and utility companies, customers may not be able to take their business elsewhere. In these situations, no lost business occurs when long waiting times are encountered. This condition is one reason that service in such organizations may be poor and that customers in such situations may experience long waiting times. 2. In some instances, the organization providing the service also employs the units waiting for the service. For example, consider the case of a com-
11.6
pany that owns and operates the trucks used to deliver goods to and from its manufacturing plant. In addition to the costs associated with the trucks waiting to be loaded or unloaded, the firm also pays the wages of the truck loaders and unloaders who operate the service channel. In this case, the cost of having the trucks wait and the cost of operating the service channel are direct expenses to the firm. An economic analysis of the waiting line system is highly recommended for these types of situations.
OTHER WAITING LINE MODELS D. G. Kendall suggested a notation that is helpful in classifying the wide variety of different waiting line models that have been developed. The three-symbol Kendall notation is as follows: A>B>k
11.7
Single-Channel Waiting Line Model with Poisson Arrivals and Arbitrary Service Times
521
where A B k
denotes the probability distribution for the arrivals denotes the probability distribution for the service time denotes the number of channels
Depending on the letter appearing in the A or B position, a variety of waiting line systems can be described. The letters that are commonly used are as follows: M D G
designates a Poisson probability distribution for the arrivals or an exponential probability distribution for service time designates that the arrivals or the service time is deterministic or constant designates that the arrivals or the service time has a general probability distribution with a known mean and variance
Using the Kendall notation, the single-channel waiting line model with Poisson arrivals and exponential service times is classified as an M/M/1 model. The two-channel waiting line model with Poisson arrivals and exponential service times presented in Section 11.3 would be classified as an M/M/2 model. NOTES AND COMMENTS In some cases, the Kendall notation is extended to five symbols. The fourth symbol indicates the largest number of units that can be in the system, and the fifth symbol indicates the size of the population. The fourth symbol is used in situations where the waiting line can hold a finite or maxi-
11.7 When providing input to the M/G/1 model, be consistent in terms of the time period. For example, if l and m are expressed in terms of the number of units per hour, the standard deviation of the service time should be expressed in hours. The example that follows uses minutes as the time period for the arrival and service data.
mum number of units, and the fifth symbol is necessary when the population of arriving units or customers is finite. When the fourth and fifth symbols of the Kendall notation are omitted, the waiting line system is assumed to have infinite capacity, and the population is assumed to be infinite.
SINGLE-CHANNEL WAITING LINE MODEL WITH POISSON ARRIVALS AND ARBITRARY SERVICE TIMES Let us return to the single-channel waiting line model where arrivals are described by a Poisson probability distribution. However, we now assume that the probability distribution for the service times is not an exponential probability distribution. Thus, using the Kendall notation, the waiting line model that is appropriate is an M/G/1 model, where G denotes a general or unspecified probability distribution.
Operating Characteristics for the M/G/1 Model The notation used to describe the operating characteristics for the M/G/1 model is l = the arrival rate m = the service rate s = the standard deviation of the service time
522
Chapter 11
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Some of the steady-state operating characteristics of the M/G/1 waiting line model are as follows: 1. The probability that no units are in the system:
P0 = 1 -
l m
(11.24)
2. The average number of units in the waiting line:
Lq =
l2s2 + (l>m)2 2(1 - l>m)
(11.25)
3. The average number of units in the system:
L = Lq +
l m
(11.26)
4. The average time a unit spends in the waiting line:
Wq =
Lq (11.27)
l
5. The average time a unit spends in the system:
W = Wq +
1 m
(11.28)
6. The probability that an arriving unit has to wait for service:
Pw =
l m
(11.29)
Note that the relationships for L, Wq, and W are the same as the relationships used for the waiting line models in Sections 11.2 and 11.3. They are given by Little’s flow equations. Problem 27 provides another application of a single-channel waiting line with Poisson arrivals and arbitrary service times.
An Example Retail sales at Hartlage’s Seafood Supply are handled by one clerk. Customer arrivals are random, and the arrival rate is 21 customers per hour, or l ⫽ 21兾60 ⫽ 0.35 customers per minute. A study of the service process shows that the service time is 2 minutes per customer, with a standard deviation of s ⫽ 1.2 minutes. The mean time of
11.7
Single-Channel Waiting Line Model with Poisson Arrivals and Arbitrary Service Times
523
2 minutes per customer shows that the clerk has a service rate of m ⫽ ¹⁄₂ ⫽ 0.50 customers per minute. The operating characteristics of this M/G/1 waiting line system are l 0.35 = 1 = 0.30 m 0.50 (0.35)2(1.2)2 + (0.35>0.50)2
P0 = 1 -
WEB
file
Lq =
Single-Arbitrary
L = Wq = W = Pw =
= 1.1107 customers 2(1 - 0.35>0.50) l 0.35 Lq + = 1.1107 + = 1.8107 customers m 0.50 Lq 1.1107 = = 3.1733 minutes l 0.35 1 1 Wq + = 3.1733 + = 5.1733 minutes m 0.50 l 0.35 = = 0.70 m 0.50
Hartlage’s manager can review these operating characteristics to determine whether scheduling a second clerk appears to be worthwhile.
Constant Service Times We want to comment briefly on the single-channel waiting line model that assumes random arrivals but constant service times. Such a waiting line can occur in production and manufacturing environments where machine-controlled service times are constant. This waiting line is described by the M/D/1 model, with the D referring to the deterministic service times. With the M/D/1 model, the average number of units in the waiting line, Lq, can be found by using equation (11.25) with the condition that the standard deviation of the constant service time is s ⫽ 0. Thus, the expression for the average number of units in the waiting line for the M/D/1 waiting line becomes
Lq =
(l>m)2 2(1 - l>m)
(11.30)
The other expressions presented earlier in this section can be used to determine additional operating characteristics of the M/D/1 system. NOTES AND COMMENTS Whenever the operating characteristics of a waiting line are unacceptable, managers often try to improve service by increasing the service rate m. This approach is good, but equation (11.25) shows that the variation in the service times also affects the operating characteristics of the waiting line. Because the standard deviation of service times, s, appears in the numerator of equation (11.25), a larger variation in service times results in a larger
average number of units in the waiting line. Hence, another alternative for improving the service capabilities of a waiting line is to reduce the variation in the service times. Thus, even when the service rate of the service facility cannot be increased, a reduction in s will reduce the average number of units in the waiting line and improve the operating characteristics of the system.
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Waiting Line Models
MULTIPLE-CHANNEL MODEL WITH POISSON ARRIVALS, ARBITRARY SERVICE TIMES, AND NO WAITING LINE An interesting variation of the waiting line models discussed so far involves a system in which no waiting is allowed. Arriving units or customers seek service from one of several service channels. If all channels are busy, arriving units are denied access to the system. In waiting line terminology, arrivals occurring when the system is full are blocked and are cleared from the system. Such customers may be lost or may attempt a return to the system later. The specific model considered in this section is based on the following assumptions: 1. 2. 3. 4. 5.
The system has k channels. The arrivals follow a Poisson probability distribution, with arrival rate l. The service times for each channel may have any probability distribution. The service rate m is the same for each channel. An arrival enters the system only if at least one channel is available. An arrival occurring when all channels are busy is blocked—that is, denied service and not allowed to enter the system.
With G denoting a general or unspecified probability distribution for service times, the appropriate model for this situation is referred to as an M/G/k model with “blocked customers cleared.” The question addressed in this type of situation is, How many channels or servers should be used? A primary application of this model involves the design of telephone and other communication systems where the arrivals are the calls and the channels are the number of telephone or communication lines available. In such a system, the calls are made to one telephone number, with each call automatically switched to an open channel if possible. When all channels are busy, additional calls receive a busy signal and are denied access to the system.
Operating Characteristics for the M/G/k Model with Blocked Customers Cleared We approach the problem of selecting the best number of channels by computing the steady-state probabilities that j of the k channels will be busy. These probabilities are
Pj =
(l>m) j>j!
k
a (l>m) >i!
(11.31)
i
i=0
With no waiting allowed, operating characteristics Lq and Wq considered in previous waiting line models are automatically zero regardless of the number of service channels. In this situation, the more important design consideration involves determining how the percentage of blocked customers is affected by the number of service channels
where l m k Pj
= = = =
the arrival rate the service rate for each channel the number of channels the probability that j of the k channels are busy for j = 0, 1, 2, . . . , k
The most important probability value is Pk, which is the probability that all k channels are busy. On a percentage basis, Pk indicates the percentage of arrivals that are blocked and denied access to the system.
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Multiple-Channel Model with Poisson Arrivals, Arbitrary Service Times, and No Waiting Line
525
Another operating characteristic of interest is the average number of units in the system; note that this number is equivalent to the average number of channels in use. Letting L denote the average number of units in the system, we have
L =
l (1 - Pk ) m
(11.32)
An Example Microdata Software, Inc., uses a telephone ordering system for its computer software products. Callers place orders with Microdata by using the company’s 800 telephone number. Assume that calls to this telephone number arrive at a rate of l ⫽ 12 calls per hour. The time required to process a telephone order varies considerably from order to order. However, each Microdata sales representative can be expected to handle m ⫽ 6 calls per hour. Currently, the Microdata 800 telephone number has three internal lines, or channels, each operated by a separate sales representative. Calls received on the 800 number are automatically transferred to an open line, or channel, if available. Whenever all three lines are busy, callers receive a busy signal. In the past, Microdata’s management assumed that callers receiving a busy signal would call back later. However, recent research on telephone ordering showed that a substantial number of callers who are denied access do not call back later. These lost calls represent lost revenues for the firm, so Microdata’s management requested an analysis of the telephone ordering system. Specifically, management wanted to know the percentage of callers who get busy signals and are blocked from the system. If management’s goal is to provide sufficient capacity to handle 90% of the callers, how many telephone lines and sales representatives should Microdata use? We can demonstrate the use of equation (11.31) by computing P3, the probability that all three of the currently available telephone lines will be in use and additional callers will be blocked:
WEB file No Waiting
P3 ⫽
1
With P3 ⫽ 0.2105, approximately 21% of the calls, or slightly more than one in five calls, are being blocked. Only 79% of the calls are being handled immediately by the three-line system. Let us assume that Microdata expands to a four-line system. Then, the probability that all four channels will be in use and that callers will be blocked is P4 ⫽
Problem 30 provides practice in calculating probabilities for multiplechannel systems with no waiting line.
(¹²₆)3兾3! 1.3333 ⫽ ⫽ 0.2105 (¹²₆) 兾0! ⫹ (¹²₆) 兾1! ⫹ (¹²₆)2兾2! ⫹ (¹²₆)3兾3! 6.3333 0
(¹²₆)4兾4! 0.667 ⫽ ⫽ 0.0952 (¹²₆) 兾0! ⫹ (¹²₆) 兾1! ⫹ (¹²₆)2兾2! ⫹ (¹²₆)3兾3! ⫹ (¹²₆)4兾4! 7 0
1
With only 9.52% of the callers blocked, 90.48% of the callers will reach the Microdata sales representatives. Thus, Microdata should expand its order-processing operation to four lines to meet management’s goal of providing sufficient capacity to handle at least 90% of the callers. The average number of calls in the four-line system and thus the average number of lines and sales representatives that will be busy is L =
12 l (1 - P4 ) = (1 - 0.0952) = 1.8095 m 6
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TABLE 11.6 PROBABILITIES OF BUSY LINES FOR THE MICRODATA FOUR-LINE SYSTEM Number of Busy Lines 0 1 2 3 4
Probability 0.1429 0.2857 0.2857 0.1905 0.0952
Although an average of fewer than two lines will be busy, the four-line system is necessary to provide the capacity to handle at least 90% of the callers. We used equation (11.31) to calculate the probability that 0, 1, 2, 3, or 4 lines will be busy. These probabilities are summarized in Table 11.6. As we discussed in Section 11.5, an economic analysis of waiting lines can be used to guide system design decisions. In the Microdata system, the cost of the additional line and additional sales representative should be relatively easy to establish. This cost can be balanced against the cost of the blocked calls. With 9.52% of the calls blocked and l ⫽ 12 calls per hour, an eight-hour day will have an average of 8(12)(0.0952) ⫽ 9.1 blocked calls. If Microdata can estimate the cost of possible lost sales, the cost of these blocked calls can be established. The economic analysis based on the service cost and the blocked-call cost can assist in determining the optimal number of lines for the system.
NOTES AND COMMENTS Many of the operating characteristics considered in previous sections are not relevant for the M/G/k model with blocked customers cleared. In particular, the average time in the waiting line, Wq, and the
11.9 In previous waiting line models, the arrival rate was constant and independent of the number of units in the system. With a finite calling population, the arrival rate decreases as the number of units in the system increases because, with more units in the system, fewer units are available for arrivals.
average number of units in the waiting line, Lq, are no longer considered because waiting is not permitted in this type of system.
WAITING LINE MODELS WITH FINITE CALLING POPULATIONS For the waiting line models introduced so far, the population of units or customers arriving for service has been considered to be unlimited. In technical terms, when no limit is placed on how many units may seek service, the model is said to have an infinite calling population. Under this assumption, the arrival rate l remains constant regardless of how many units are in the waiting line system. This assumption of an infinite calling population is made in most waiting line models. In other cases, the maximum number of units or customers that may seek service is assumed to be finite. In this situation, the arrival rate for the system changes, depending on the number of units in the waiting line, and the waiting line model is said to have a finite calling population. The formulas for the operating characteristics of the previous waiting line models must be modified to account for the effect of the finite calling population.
11.9
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Waiting Line Models with Finite Calling Populations
The finite calling population model discussed in this section is based on the following assumptions: 1. The arrivals for each unit follow a Poisson probability distribution, with arrival rate l. 2. The service times follow an exponential probability distribution, with service rate m. 3. The population of units that may seek service is finite. The arrival rate l is defined differently for the finite calling population model. Specifically, l is defined in terms of the arrival rate for each unit.
With a single channel, the waiting line model is referred to as an M/M/1 model with a finite calling population. The arrival rate for the M/M/1 model with a finite calling population is defined in terms of how often each unit arrives or seeks service. This situation differs from that for previous waiting line models in which l denoted the arrival rate for the system. With a finite calling population, the arrival rate for the system varies, depending on the number of units in the system. Instead of adjusting for the changing system arrival rate, in the finite calling population model l indicates the arrival rate for each unit.
Operating Characteristics for the M/M/1 Model with a Finite Calling Population The following formulas are used to determine the steady-state operating characteristics for an M/M/1 model with a finite calling population, where l = the arrival rate for each unit m = the service rate N = the size of the population 1. The probability that no units are in the system:
P0 =
1 N
N! l n a b a n = 0 (N - n)! m
(11.33)
2. The average number of units in the waiting line:
Lq = N -
l + m (1 - P0) l
(11.34)
3. The average number of units in the system: L = Lq + (1 - P0)
(11.35)
4. The average time a unit spends in the waiting line:
Wq =
Lq (N - L)l
(11.36)
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5. The average time a unit spends in the system: W = Wq +
1 m
(11.37)
6. The probability an arriving unit has to wait for service: Pw = 1 - P0
(11.38)
7. The probability of n units in the system:
Pn =
N! l n a b P0 (N - n)! m
for n = 0, 1, . . . , N
(11.39)
One of the primary applications of the M/M/1 model with a finite calling population is referred to as the machine repair problem. In this problem, a group of machines is considered to be the finite population of “customers” that may request repair service. Whenever a machine breaks down, an arrival occurs in the sense that a new repair request is initiated. If another machine breaks down before the repair work has been completed on the first machine, the second machine begins to form a “waiting line” for repair service. Additional breakdowns by other machines will add to the length of the waiting line. The assumption of first-come, first-served indicates that machines are repaired in the order they break down. The M/M/1 model shows that one person or one channel is available to perform the repair service. To return the machine to operation, each machine with a breakdown must be repaired by the single-channel operation. An Example The Kolkmeyer Manufacturing Company uses a group of six identical machines; each machine operates an average of 20 hours between breakdowns. Thus, the arrival rate or request for repair service for each machine is l ⫽ ¹⁄₂₀ ⫽ 0.05 per hour. With randomly occurring breakdowns, the Poisson probability distribution is used to describe the machine breakdown arrival process. One person from the maintenance department provides the single-channel repair service for the six machines. The exponentially distributed service times have a mean of two hours per machine or a service rate of m ⫽ ¹⁄₂ ⫽ 0.50 machines per hour. With l ⫽ 0.05 and m ⫽ 0.50, we use equations (11.33) through (11.38) to compute the operating characteristics for this system. Note that the use of equation (11.33) makes the computations involved somewhat cumbersome. Confirm for yourself that equation (11.33) provides the value of P0 ⫽ 0.4845. The computations for the other operating characteristics are Lq = 6 - a L = Wq = W = Pw =
0.05 + 0.50 b(1 - 0.4845) = 0.3297 machine 0.05 0.3295 + (1 - 0.4845) = 0.8451 machine 0.3295 = 1.279 hours (6 - 0.845)0.50 1 1.279 + = 3.279 hours 0.50 1 - P0 = 1 - 0.4845 = 0.5155
529
Summary Operating characteristics of an M/M/1 waiting line with a finite calling population are considered in Problem 34.
An Excel worksheet template at the course website may be used to analyze the multiplechannel finite calling population model.
Finally, equation (11.39) can be used to compute the probabilities of any number of machines being in the repair system. As with other waiting line models, the operating characteristics provide the manager with information about the operation of the waiting line. In this case, the fact that a machine breakdown waits an average of Wq ⫽ 1.279 hours before maintenance begins and the fact that more than 50% of the machine breakdowns must wait for service, Pw ⫽ 0.5155, indicates a two-channel system may be needed to improve the machine repair service. Computations of the operating characteristics of a multiple-channel finite calling population waiting line are more complex than those for the single-channel model. A computer solution is virtually mandatory in this case. The Excel worksheet for the Kolkmeyer twochannel machine repair system is shown in Figure 11.5. With two repair personnel, the average machine breakdown waiting time is reduced to Wq ⫽ 0.0834 hours, or 5 minutes, and only 10%, Pw ⫽ 0.1036, of the machine breakdowns wait for service. Thus, the two-channel system significantly improves the machine repair service operation. Ultimately, by considering the cost of machine downtime and the cost of the repair personnel, management can determine whether the improved service of the two-channel system is cost-effective.
FIGURE 11.5 WORKSHEET FOR THE KOLKMEYER TWO-CHANNEL MACHINE REPAIR PROBLEM A
WEB
file
Finite
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21
B
C
D
Waiting Line Model with a Finite Calling Population Assumptions Poisson Arrivals Exponential Service Times Finite Calling Population Number of Channels Arrival Rate for Each Unit Service Rate for Each Channel Population Size
2 0.05 0.5 6
Operating Characteristics Probability that no machines are in the system, Po Average number of machines in the waiting line, Lq Average number of machines in the system, L Average time a machine spends in the waiting line, Wq Average time a machine spends in the system, W Probability an arriving machine has to wait, Pw
0.5602 0.0227 0.5661 0.0834 2.0834 0.1036
SUMMARY In this chapter we presented a variety of waiting line models that have been developed to help managers make better decisions concerning the operation of waiting lines. For each model, we presented formulas that could be used to develop operating characteristics or
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performance measures for the system being studied. The operating characteristics presented include the following: 1. 2. 3. 4. 5. 6.
Probability that no units are in the system Average number of units in the waiting line Average number of units in the system Average time a unit spends in the waiting line Average time a unit spends in the system Probability that arriving units will have to wait for service
We also showed how an economic analysis of the waiting line could be conducted by developing a total cost model that includes the cost associated with units waiting for service and the cost required to operate the service facility. As many of the examples in this chapter show, the most obvious applications of waiting line models are situations in which customers arrive for service such as at a grocery checkout counter, bank, or restaurant. However, with a little creativity, waiting line models can be applied to many different situations such as telephone calls waiting for connections, mail orders waiting for processing, machines waiting for repairs, manufacturing jobs waiting to be processed, and money waiting to be spent or invested. The Management Science in Action, Improving Productivity at the New Haven Fire Department, describes an application in which a waiting line model helped improve emergency medical response time and also provided a significant savings in operating costs. The complexity and diversity of waiting line systems found in practice often prevent an analyst from finding an existing waiting line model that fits the specific application being studied. Simulation, the topic discussed in Chapter 12, provides an approach to determining the operating characteristics of such waiting line systems.
MANAGEMENT SCIENCE IN ACTION IMPROVING PRODUCTIVITY AT THE NEW HAVEN FIRE DEPARTMENT* The New Haven, Connecticut, Fire Department implemented a reorganization plan with cross-trained fire and medical personnel responding to both fire and medical emergencies. A waiting line model provided the basis for the reorganization by demonstrating that substantial improvements in emergency medical response time could be achieved with only a small reduction in fire protection. Annual savings were reported to be $1.4 million. The model was based on Poisson arrivals and exponential service times for both fire and medical emergencies. It was used to estimate the average time that a person placing a call would have to wait for the appropriate emergency unit to arrive at the location. Waiting times were estimated by the model’s prediction of the average travel time to reach each of the city’s 28 census tracts.
The model was first applied to the original system of 16 fire units and 4 emergency medical units that operated independently. It was then applied to the proposed reorganization plan that involved cross-trained department personnel qualified to respond to both fire and medical emergencies. Results from the model demonstrated that average travel times could be reduced under the reorganization plan. Various facility location alternatives also were evaluated. When implemented, the reorganization plan reduced operating cost and improved public safety services. *Based on A. J. Swersey, L. Goldring, and E. D. Geyer, “Improving Fire Department Productivity: Merging Fire and Emergency Medical Units in New Haven,” Interfaces 23, no. 1 (January/February 1993): 109–129.
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GLOSSARY Queue A waiting line. Queueing theory The body of knowledge dealing with waiting lines. Operating characteristics The performance measures for a waiting line including the probability that no units are in the system, the average number of units in the waiting line, the average waiting time, and so on. Single-channel waiting line A waiting line with only one service facility. Poisson probability distribution A probability distribution used to describe the arrival pattern for some waiting line models. Arrival rate
The mean number of customers or units arriving in a given period of time.
Exponential probability distribution A probability distribution used to describe the service time for some waiting line models. Service rate The mean number of customers or units that can be served by one service facility in a given period of time. First-come, first-served (FCFS) The queue discipline that serves waiting units on a first-come, first-served basis. Transient period The start-up period for a waiting line, occurring before the waiting line reaches a normal or steady-state operation. Steady-state operation The normal operation of the waiting line after it has gone through a start-up or transient period. The operating characteristics of waiting lines are computed for steady-state conditions. Multiple-channel waiting line A waiting line with two or more parallel service facilities. Blocked When arriving units cannot enter the waiting line because the system is full. Blocked units can occur when waiting lines are not allowed or when waiting lines have a finite capacity. Infinite calling population The population of customers or units that may seek service has no specified upper limit. Finite calling population The population of customers or units that may seek service has a fixed and finite value.
PROBLEMS 1. Willow Brook National Bank operates a drive-up teller window that allows customers to complete bank transactions without getting out of their cars. On weekday mornings, arrivals to the drive-up teller window occur at random, with an arrival rate of 24 customers per hour or 0.4 customer per minute. a. What is the mean or expected number of customers that will arrive in a five-minute period? b. Assume that the Poisson probability distribution can be used to describe the arrival process. Use the arrival rate in part (a) and compute the probabilities that exactly 0, 1, 2, and 3 customers will arrive during a five-minute period. c. Delays are expected if more than three customers arrive during any five-minute period. What is the probability that delays will occur?
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2. In the Willow Brook National Bank waiting line system (see Problem 1), assume that the service times for the drive-up teller follow an exponential probability distribution with a service rate of 36 customers per hour, or 0.6 customer per minute. Use the exponential probability distribution to answer the following questions: a. What is the probability the service time is one minute or less? b. What is the probability the service time is two minutes or less? c. What is the probability the service time is more than two minutes? 3. Use the single-channel drive-up bank teller operation referred to in Problems 1 and 2 to determine the following operating characteristics for the system: a. The probability that no customers are in the system b. The average number of customers waiting c. The average number of customers in the system d. The average time a customer spends waiting e. The average time a customer spends in the system f. The probability that arriving customers will have to wait for service 4. Use the single-channel drive-up bank teller operation referred to in Problems 1–3 to determine the probabilities of 0, 1, 2, and 3 customers in the system. What is the probability that more than three customers will be in the drive-up teller system at the same time? 5. The reference desk of a university library receives requests for assistance. Assume that a Poisson probability distribution with an arrival rate of 10 requests per hour can be used to describe the arrival pattern and that service times follow an exponential probability distribution with a service rate of 12 requests per hour. a. What is the probability that no requests for assistance are in the system? b. What is the average number of requests that will be waiting for service? c. What is the average waiting time in minutes before service begins? d. What is the average time at the reference desk in minutes (waiting time plus service time)? e. What is the probability that a new arrival has to wait for service? 6. Movies Tonight is a typical video and DVD movie rental outlet for home viewing customers. During the weeknight evenings, customers arrive at Movies Tonight with an arrival rate of 1.25 customers per minute. The checkout clerk has a service rate of 2 customers per minute. Assume Poisson arrivals and exponential service times. a. What is the probability that no customers are in the system? b. What is the average number of customers waiting for service? c. What is the average time a customer waits for service to begin? d. What is the probability that an arriving customer will have to wait for service? e. Do the operating characteristics indicate that the one-clerk checkout system provides an acceptable level of service? 7. Speedy Oil provides a single-channel automobile oil change and lubrication service. Customers provide an arrival rate of 2.5 cars per hour. The service rate is 5 cars per hour. Assume that arrivals follow a Poisson probability distribution and that service times follow an exponential probability distribution. a. What is the average number of cars in the system? b. What is the average time that a car waits for the oil and lubrication service to begin? c. What is the average time a car spends in the system? d. What is the probability that an arrival has to wait for service? 8. For the Burger Dome single-channel waiting line in Section 11.2, assume that the arrival rate is increased to 1 customer per minute and that the service rate is increased to 1.25 customers per minute. Compute the following operating characteristics for the new system: P0, Lq, L, Wq, W, and Pw. Does this system provide better or poorer service compared to the original system? Discuss any differences and the reason for these differences.
Problems
533
9. Marty’s Barber Shop has one barber. Customers have an arrival rate of 2.2 customers per hour, and haircuts are given with a service rate of 5 per hour. Use the Poisson arrivals and exponential service times model to answer the following questions: a. What is the probability that no units are in the system? b. What is the probability that one customer is receiving a haircut and no one is waiting? c. What is the probability that one customer is receiving a haircut and one customer is waiting? d. What is the probability that one customer is receiving a haircut and two customers are waiting? e. What is the probability that more than two customers are waiting? f. What is the average time a customer waits for service? 10. Trosper Tire Company decided to hire a new mechanic to handle all tire changes for customers ordering a new set of tires. Two mechanics applied for the job. One mechanic has limited experience, can be hired for $14 per hour, and can service an average of three customers per hour. The other mechanic has several years of experience, can service an average of four customers per hour, but must be paid $20 per hour. Assume that customers arrive at the Trosper garage at the rate of two customers per hour. a. What are the waiting line operating characteristics using each mechanic, assuming Poisson arrivals and exponential service times? b. If the company assigns a customer waiting cost of $30 per hour, which mechanic provides the lower operating cost? 11. Agan Interior Design provides home and office decorating assistance to its customers. In normal operation, an average of 2.5 customers arrive each hour. One design consultant is available to answer customer questions and make product recommendations. The consultant averages 10 minutes with each customer. a. Compute the operating characteristics of the customer waiting line, assuming Poisson arrivals and exponential service times. b. Service goals dictate that an arriving customer should not wait for service more than an average of 5 minutes. Is this goal being met? If not, what action do you recommend? c. If the consultant can reduce the average time spent per customer to 8 minutes, what is the mean service rate? Will the service goal be met? 12. Pete’s Market is a small local grocery store with only one checkout counter. Assume that shoppers arrive at the checkout lane according to a Poisson probability distribution, with an arrival rate of 15 customers per hour. The checkout service times follow an exponential probability distribution, with a service rate of 20 customers per hour. a. Compute the operating characteristics for this waiting line. b. If the manager’s service goal is to limit the waiting time prior to beginning the checkout process to no more than five minutes, what recommendations would you provide regarding the current checkout system? 13. After reviewing the waiting line analysis of Problem 12, the manager of Pete’s Market wants to consider one of the following alternatives for improving service. What alternative would you recommend? Justify your recommendation. a. Hire a second person to bag the groceries while the cash register operator is entering the cost data and collecting money from the customer. With this improved singlechannel operation, the service rate could be increased to 30 customers per hour. b. Hire a second person to operate a second checkout counter. The two-channel operation would have a service rate of 20 customers per hour for each channel. 14. Ocala Software Systems operates a technical support center for its software customers. If customers have installation or use problems with Ocala software products, they may telephone the technical support center and obtain free consultation. Currently, Ocala operates
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its support center with one consultant. If the consultant is busy when a new customer call arrives, the customer hears a recorded message stating that all consultants are currently busy with other customers. The customer is then asked to hold and a consultant will provide assistance as soon as possible. The customer calls follow a Poisson probability distribution with an arrival rate of five calls per hour. On average, it takes 7.5 minutes for a consultant to answer a customer’s questions. The service time follows an exponential probability distribution. a. What is the service rate in terms of customers per hour? b. What is the probability that no customers are in the system and the consultant is idle? c. What is the average number of customers waiting for a consultant? d. What is the average time a customer waits for a consultant? e. What is the probability that a customer will have to wait for a consultant? f. Ocala’s customer service department recently received several letters from customers complaining about the difficulty in obtaining technical support. If Ocala’s customer service guidelines state that no more than 35% of all customers should have to wait for technical support and that the average waiting time should be two minutes or less, does your waiting line analysis indicate that Ocala is or is not meeting its customer service guidelines? What action, if any, would you recommend? 15. To improve customer service, Ocala Software Systems (see Problem 14) wants to investigate the effect of using a second consultant at its technical support center. What effect would the additional consultant have on customer service? Would two technical consultants enable Ocala to meet its service guidelines with no more than 35% of all customers having to wait for technical support and an average customer waiting time of two minutes or less? Discuss. 16. The new Fore and Aft Marina is to be located on the Ohio River near Madison, Indiana. Assume that Fore and Aft decides to build a docking facility where one boat at a time can stop for gas and servicing. Assume that arrivals follow a Poisson probability distribution, with an arrival rate of 5 boats per hour, and that service times follow an exponential probability distribution, with a service rate of 10 boats per hour. Answer the following questions: a. What is the probability that no boats are in the system? b. What is the average number of boats that will be waiting for service? c. What is the average time a boat will spend waiting for service? d. What is the average time a boat will spend at the dock? e. If you were the manager of Fore and Aft Marina, would you be satisfied with the service level your system will be providing? Why or why not? 17. The manager of the Fore and Aft Marina in Problem 16 wants to investigate the possibility of enlarging the docking facility so that two boats can stop for gas and servicing simultaneously. Assume that the arrival rate is 5 boats per hour and that the service rate for each channel is 10 boats per hour. a. What is the probability that the boat dock will be idle? b. What is the average number of boats that will be waiting for service? c. What is the average time a boat will spend waiting for service? d. What is the average time a boat will spend at the dock? e. If you were the manager of Fore and Aft Marina, would you be satisfied with the service level your system will be providing? Why or why not? 18. All airplane passengers at the Lake City Regional Airport must pass through a security screening area before proceeding to the boarding area. The airport has three screening stations available, and the facility manager must decide how many to have open at any particular time. The service rate for processing passengers at each screening station is 3 passengers per minute. On Monday morning the arrival rate is 5.4 passengers per minute.
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Assume that processing times at each screening station follow an exponential distribution and that arrivals follow a Poisson distribution. a. Suppose two of the three screening stations are open on Monday morning. Compute the operating characteristics for the screening facility. b. Because of space considerations, the facility manager’s goal is to limit the average number of passengers waiting in line to 10 or fewer. Will the two-screening-station system be able to meet the manager’s goal? c. What is the average time required for a passenger to pass through security screening? 19. Refer again to the Lake City Regional Airport described in Problem 18. When the security level is raised to high, the service rate for processing passengers is reduced to 2 passengers per minute at each screening station. Suppose the security level is raised to high on Monday morning. The arrival rate is 5.4 passengers per minute. a. The facility manager’s goal is to limit the average number of passengers waiting in line to 10 or fewer. How many screening stations must be open in order to satisfy the manager’s goal? b. What is the average time required for a passenger to pass through security screening? 20. A Florida coastal community experiences a population increase during the winter months with seasonal residents arriving from northern states and Canada. Staffing at a local post office is often in a state of change due to the relatively low volume of customers in the summer months and the relatively high volume of customers in the winter months. The service rate of a postal clerk is 0.75 customer per minute. The post office counter has a maximum of three work stations. The target maximum time a customer waits in the system is five minutes. a. For a particular Monday morning in November, the anticipated arrival rate is 1.2 customers per minute. What is the recommended staffing for this Monday morning? Show the operating characteristics of the waiting line. b. A new population growth study suggests that over the next two years the arrival rate at the post office during the busy winter months can be expected to be 2.1 customers per minute. Use a waiting line analysis to make a recommendation to the post office manager. 21. Refer to the Agan Interior Design situation in Problem 11. Agan’s management would like to evaluate two alternatives: • Use one consultant with an average service time of 8 minutes per customer. • Expand to two consultants, each of whom has an average service time of 10 minutes per customer. If the consultants are paid $16 per hour and the customer waiting time is valued at $25 per hour for waiting time prior to service, should Agan expand to the two-consultant system? Explain. 22. A fast-food franchise is considering operating a drive-up window food-service operation. Assume that customer arrivals follow a Poisson probability distribution, with an arrival rate of 24 cars per hour, and that service times follow an exponential probability distribution. Arriving customers place orders at an intercom station at the back of the parking lot and then drive to the service window to pay for and receive their orders. The following three service alternatives are being considered: • A single-channel operation in which one employee fills the order and takes the money from the customer. The average service time for this alternative is 2 minutes. • A single-channel operation in which one employee fills the order while a second employee takes the money from the customer. The average service time for this alternative is 1.25 minutes. • A two-channel operation with two service windows and two employees. The employee stationed at each window fills the order and takes the money from customers arriving at the window. The average service time for this alternative is 2 minutes for each channel.
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Answer the following questions and recommend an alternative design for the fast-food franchise: a. What is the probability that no cars are in the system? b. What is the average number of cars waiting for service? c. What is the average number of cars in the system? d. What is the average time a car waits for service? e. What is the average time in the system? f. What is the probability that an arriving car will have to wait for service? 23. The following cost information is available for the fast-food franchise in Problem 22: • Customer waiting time is valued at $25 per hour to reflect the fact that waiting time is costly to the fast-food business. • The cost of each employee is $6.50 per hour. • To account for equipment and space, an additional cost of $20 per hour is attributable to each channel. What is the lowest-cost design for the fast-food business? 24. Patients arrive at a dentist’s office with an arrival rate of 2.8 patients per hour. The dentist can treat patients at a service rate of 3 patients per hour. A study of patient waiting times shows that a patient waits an average of 30 minutes before seeing the dentist. a. What are the arrival and service rates in terms of patients per minute? b. What is the average number of patients in the waiting room? c. If a patient arrives at 10:10 A.M., at what time is the patient expected to leave the office? 25. A study of the multiple-channel food-service operation at the Red Birds baseball park shows that the average time between the arrival of a customer at the food-service counter and his or her departure with a filled order is 10 minutes. During the game, customers arrive at the rate of four per minute. The food-service operation requires an average of 2 minutes per customer order. a. What is the service rate per channel in terms of customers per minute? b. What is the average waiting time in the line prior to placing an order? c. On average, how many customers are in the food-service system? 26. Manning Autos operates an automotive service counter. While completing the repair work, Manning mechanics arrive at the company’s parts department counter with an arrival rate of four per hour. The parts coordinator spends an average of 6 minutes with each mechanic, discussing the parts the mechanic needs and retrieving the parts from inventory. a. Currently, Manning has one parts coordinator. On average, each mechanic waits 4 minutes before the parts coordinator is available to answer questions or retrieve parts from inventory. Find Lq, W, and L for this single-channel parts operation. b. A trial period with a second parts coordinator showed that, on average, each mechanic waited only 1 minute before a parts coordinator was available. Find Lq, W, and L for this two-channel parts operation. c. If the cost of each mechanic is $20 per hour and the cost of each parts coordinator is $12 per hour, is the one-channel or the two-channel system more economical? 27. Gubser Welding, Inc., operates a welding service for construction and automotive repair jobs. Assume that the arrival of jobs at the company’s office can be described by a Poisson probability distribution with an arrival rate of two jobs per 8-hour day. The time required to complete the jobs follows a normal probability distribution with a mean time of 3.2 hours and a standard deviation of 2 hours. Answer the following questions, assuming that Gubser uses one welder to complete all jobs: a. What is the mean arrival rate in jobs per hour? b. What is the mean service rate in jobs per hour? c. What is the average number of jobs waiting for service?
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d. What is the average time a job waits before the welder can begin working on it? e. What is the average number of hours between when a job is received and when it is completed? f. What percentage of the time is Gubser’s welder busy? 28. Jobs arrive randomly at a particular assembly plant; assume that the arrival rate is five jobs per hour. Service times (in minutes per job) do not follow the exponential probability distribution. Two proposed designs for the plant’s assembly operation are shown: Service Time Design A B
Mean 6.0 6.25
Standard Deviation 3.0 0.6
a. What is the service rate in jobs per hour for each design? b. For the service rates in part (a), what design appears to provide the best or fastest service rate? c. What are the standard deviations of the service times in hours? d. Use the M/G/1 model to compute the operating characteristics for each design. e. Which design provides the best operating characteristics? Why? 29. The Robotics Manufacturing Company operates an equipment repair business where emergency jobs arrive randomly at the rate of three jobs per 8-hour day. The company’s repair facility is a single-channel system operated by a repair technician. The service time varies, with a mean repair time of 2 hours and a standard deviation of 1.5 hours. The company’s cost of the repair operation is $28 per hour. In the economic analysis of the waiting line system, Robotics uses $35 per hour cost for customers waiting during the repair process. a. What are the arrival rate and service rate in jobs per hour? b. Show the operating characteristics including the total cost per hour. c. The company is considering purchasing a computer-based equipment repair system that would enable a constant repair time of 2 hours. For practical purposes, the standard deviation is 0. Because of the computer-based system, the company’s cost of the new operation would be $32 per hour. The firm’s director of operations said no to the request for the new system because the hourly cost is $4 higher and the mean repair time is the same. Do you agree? What effect will the new system have on the waiting line characteristics of the repair service? d. Does paying for the computer-based system to reduce the variation in service time make economic sense? How much will the new system save the company during a 40-hour work week? 30. A large insurance company maintains a central computing system that contains a variety of information about customer accounts. Insurance agents in a six-state area use telephone lines to access the customer information database. Currently, the company’s central computer system allows three users to access the central computer simultaneously. Agents who attempt to use the system when it is full are denied access; no waiting is allowed. Management realizes that with its expanding business, more requests will be made to the central information system. Being denied access to the system is inefficient as well as annoying for agents. Access requests follow a Poisson probability distribution, with a mean of 42 calls per hour. The service rate per line is 20 calls per hour. a. What is the probability that 0, 1, 2, and 3 access lines will be in use? b. What is the probability that an agent will be denied access to the system? c. What is the average number of access lines in use?
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d. In planning for the future, management wants to be able to handle l ⫽ 50 calls per hour; in addition, the probability that an agent will be denied access to the system should be no greater than the value computed in part (b). How many access lines should this system have? 31. Mid-West Publishing Company publishes college textbooks. The company operates an 800 telephone number whereby potential adopters can ask questions about forthcoming texts, request examination copies of texts, and place orders. Currently, two extension lines are used, with two representatives handling the telephone inquiries. Calls occurring when both extension lines are being used receive a busy signal; no waiting is allowed. Each representative can accommodate an average of 12 calls per hour. The arrival rate is 20 calls per hour. a. How many extension lines should be used if the company wants to handle 90% of the calls immediately? b. What is the average number of extension lines that will be busy if your recommendation in part (a) is used? c. What percentage of calls receive a busy signal for the current telephone system with two extension lines? 32. City Cab, Inc., uses two dispatchers to handle requests for service and to dispatch the cabs. The telephone calls that are made to City Cab use a common telephone number. When both dispatchers are busy, the caller hears a busy signal; no waiting is allowed. Callers who receive a busy signal can call back later or call another cab service. Assume that the arrival of calls follows a Poisson probability distribution, with a mean of 40 calls per hour, and that each dispatcher can handle a mean of 30 calls per hour. a. What percentage of time are both dispatchers idle? b. What percentage of time are both dispatchers busy? c. What is the probability callers will receive a busy signal if two, three, or four dispatchers are used? d. If management wants no more than 12% of the callers to receive a busy signal, how many dispatchers should be used? 33. Kolkmeyer Manufacturing Company (see Section 11.9) is considering adding two machines to its manufacturing operation. This addition will bring the number of machines to eight. The president of Kolkmeyer asked for a study of the need to add a second employee to the repair operation. The arrival rate is 0.05 machine per hour for each machine, and the service rate for each individual assigned to the repair operation is 0.50 machine per hour. a. Compute the operating characteristics if the company retains the single-employee repair operation. b. Compute the operating characteristics if a second employee is added to the machine repair operation. c. Each employee is paid $20 per hour. Machine downtime is valued at $80 per hour. From an economic point of view, should one or two employees handle the machine repair operation? Explain. 34. Five administrative assistants use an office copier. The average time between arrivals for each assistant is 40 minutes, which is equivalent to an arrival rate of 1兾40 ⫽ 0.025 arrival per minute. The mean time each assistant spends at the copier is 5 minutes, which is equivalent to a service rate of ¹⁄₂ ⫽ 0.20 per minute. Use the M/M/1 model with a finite calling population to determine the following: a. The probability that the copier is idle b. The average number of administrative assistants in the waiting line c. The average number of administrative assistants at the copier d. The average time an assistant spends waiting for the copier e. The average time an assistant spends at the copier
Case Problem 1
Regional Airlines
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f.
During an 8-hour day, how many minutes does an assistant spend at the copier? How much of this time is waiting time? g. Should management consider purchasing a second copier? Explain. 35. Schips Department Store operates a fleet of 10 trucks. The trucks arrive at random times throughout the day at the store’s truck dock to be loaded with new deliveries or to have incoming shipments from the regional warehouse unloaded. Each truck returns to the truck dock for service two times per 8-hour day. Thus, the arrival rate per truck is 0.25 trucks per hour. The service rate is 4 trucks per hour. Using the Poisson arrivals and exponential service times model with a finite calling population of 10 trucks, determine the following operating characteristics: a. The probability no trucks are at the truck dock b. The average number of trucks waiting for loading/unloading c. The average number of trucks in the truck dock area d. The average waiting time before loading/unloading begins e. The average waiting time in the system f. What is the hourly cost of operation if the cost is $50 per hour for each truck and $30 per hour for the truck dock? g. Consider a two-channel truck dock operation where the second channel could be operated for an additional $30 per hour. How much would the average number of trucks waiting for loading/unloading have to be reduced to make the two-channel truck dock economically feasible? h. Should the company consider expanding to the two-channel truck dock? Explain.
Case Problem 1 REGIONAL AIRLINES Regional Airlines is establishing a new telephone system for handling flight reservations. During the 10:00 A.M. to 11:00 A.M. time period, calls to the reservation agent occur randomly at an average of one call every 3.75 minutes. Historical service time data show that a reservation agent spends an average of 3 minutes with each customer. The waiting line model assumptions of Poisson arrivals and exponential service times appear reasonable for the telephone reservation system. Regional Airlines’ management believes that offering an efficient telephone reservation system is an important part of establishing an image as a service-oriented airline. If the system is properly implemented, Regional Airlines will establish good customer relations, which in the long run will increase business. However, if the telephone reservation system is frequently overloaded and customers have difficulty contacting an agent, a negative customer reaction may lead to an eventual loss of business. The cost of a ticket reservation agent is $20 per hour. Thus, management wants to provide good service, but it does not want to incur the cost of overstaffing the telephone reservation operation by using more agents than necessary. At a planning meeting, Regional’s management team agreed that an acceptable customer service goal is to answer at least 85% of the incoming calls immediately. During the planning meeting, Regional’s vice president of administration pointed out that the data show that the average service rate for an agent is faster than the average arrival rate of the telephone calls. The vice president’s conclusion was that personnel costs could be minimized by using one agent and that the single agent should be able to handle the telephone reservations and still have some idle time. The vice president of marketing restated the importance of customer service and expressed support for at least two reservation agents.
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The current telephone reservation system design does not allow callers to wait. Callers who attempt to reach a reservation agent when all agents are occupied receive a busy signal and are blocked from the system. A representative from the telephone company suggested that Regional Airlines consider an expanded system that accommodates waiting. In the expanded system, when a customer calls and all agents are busy, a recorded message tells the customer that the call is being held in the order received and that an agent will be available shortly. The customer can stay on the line and listen to background music while waiting for an agent. Regional’s management will need more information before switching to the expanded system.
Managerial Report Prepare a managerial report for Regional Airlines analyzing the telephone reservation system. Evaluate both the system that does not allow waiting and the expanded system that allows waiting. Include the following information in your report: 1. An analysis of the current reservation system that does not allow callers to wait. How many reservation agents are needed to meet the service goal? 2. An analysis of the expanded system proposed by the telephone company. How many agents are needed to meet the service goal? 3. Make a recommendation concerning which system to use and how many agents to hire. Provide supporting rationale for your recommendation. 4. The telephone arrival data presented are for the 10:00 A.M. to 11:00 A.M. time period; however, the arrival rate of incoming calls is expected to change from hour to hour. Describe how your waiting line analysis could be used to develop a ticket agent staffing plan that would enable the company to provide different levels of staffing for the ticket reservation system at different times during the day. Indicate the information that you would need to develop this staffing plan.
Case Problem 2 OFFICE EQUIPMENT, INC. Office Equipment, Inc. (OEI), leases automatic mailing machines to business customers in Fort Wayne, Indiana. The company built its success on a reputation for providing timely maintenance and repair service. Each OEI service contract states that a service technician will arrive at a customer’s business site within an average of three hours from the time that the customer notifies OEI of an equipment problem. Currently, OEI has 10 customers with service contracts. One service technician is responsible for handling all service calls. A statistical analysis of historical service records indicates that a customer requests a service call at an average rate of one call per 50 hours of operation. If the service technician is available when a customer calls for service, it takes the technician an average of 1 hour of travel time to reach the customer’s office and an average of 1.5 hours to complete the repair service. However, if the service technician is busy with another customer when a new customer calls for service, the technician completes the current service call and any other waiting service calls before responding to the new service call. In such cases, once the technician is free from all existing service commitments, the technician takes an average of 1 hour of travel time to reach the new customer’s office and an average of 1.5 hours to complete the repair service. The cost of the service technician is $80 per hour. The downtime cost (wait time and service time) for customers is $100 per hour.
Case Problem 2
Office Equipment, Inc.
541
OEI is planning to expand its business. Within one year, OEI projects that it will have 20 customers, and within two years, OEI projects that it will have 30 customers. Although OEI is satisfied that one service technician can handle the 10 existing customers, management is concerned about the ability of one technician to meet the average three-hour service call guarantee when the OEI customer base expands. In a recent planning meeting, the marketing manager made a proposal to add a second service technician when OEI reaches 20 customers and to add a third service technician when OEI reaches 30 customers. Before making a final decision, management would like an analysis of OEI service capabilities. OEI is particularly interested in meeting the average three-hour waiting time guarantee at the lowest possible total cost.
Managerial Report Develop a managerial report summarizing your analysis of the OEI service capabilities. Make recommendations regarding the number of technicians to be used when OEI reaches 20 customers and when OEI reaches 30 customers. Include a discussion of the following in your report: 1. What is the arrival rate for each customer per hour? 2. What is the service rate in terms of the number of customers per hour? Note that the average travel time of 1 hour becomes part of the service time because the time that the service technician is busy handling a service call includes the travel time plus the time required to complete the repair. 3. Waiting line models generally assume that the arriving customers are in the same location as the service facility. Discuss the OEI situation in light of the fact that a service technician travels an average of 1 hour to reach each customer. How should the travel time and the waiting time predicted by the waiting line model be combined to determine the total customer waiting time? 4. OEI is satisfied that one service technician can handle the 10 existing customers. Use a waiting line model to determine the following information: • Probability that no customers are in the system • Average number of customers in the waiting line • Average number of customers in the system • Average time a customer waits until the service technician arrives • Average time a customer waits until the machine is back in operation • Probability that a customer will have to wait more than one hour for the service technician to arrive • The number of hours a week the technician is not making service calls • The total cost per hour for the service operation Do you agree with OEI management that one technician can meet the average three-hour service call guarantee? Explain. 5. What is your recommendation for the number of service technicians to hire when OEI expands to 20 customers? Use the information that you developed in part (4) to justify your answer. 6. What is your recommendation for the number of service technicians to hire when OEI expands to 30 customers? Use the information that you developed in part (4) to justify your answer. 7. What are the annual savings of your recommendation in part (6) compared to the planning committee’s proposal that 30 customers will require three service technicians? Assume 250 days of operation per year.
CHAPTER
12
Simulation CONTENTS 12.1 RISK ANALYSIS PortaCom Project What-If Analysis Simulation Simulation of the PortaCom Project 12.2 INVENTORY SIMULATION Butler Inventory Simulation 12.3 WAITING LINE SIMULATION Hammondsport Savings Bank ATM Waiting Line Customer Arrival Times
Customer Service Times Simulation Model Hammondsport Savings Bank ATM Simulation Simulation with Two ATMs Simulation Results with Two ATMs 12.4 OTHER SIMULATION ISSUES Computer Implementation Verification and Validation Advantages and Disadvantages of Using Simulation
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Simulation
Simulation is one of the most widely used quantitative approaches to decision making. It is a method for learning about a real system by experimenting with a model that represents the system. The simulation model contains the mathematical expressions and logical relationships that describe how to compute the value of the outputs given the values of the inputs. Any simulation model has two inputs: controllable inputs and probabilistic inputs. Figure 12.1 shows a conceptual diagram of a simulation model. In conducting a simulation experiment, an analyst selects the value, or values, for the controllable inputs. Then values for the probabilistic inputs are randomly generated. The simulation model uses the values of the controllable inputs and the values of the probabilistic inputs to compute the value, or values, of the output. By conducting a series of experiments using a variety of values for the controllable inputs, the analyst learns how values of the controllable inputs affect or change the output of the simulation model. After reviewing the simulation results, the analyst is often able to make decision recommendations for the controllable inputs that will provide the desired output for the real system. Simulation has been successfully applied in a variety of applications. The following examples are typical: 1. New product development. The objective of this simulation is to determine the probability that a new product will be profitable. A model is developed relating profit (the output measure) to various probabilistic inputs such as demand, parts cost, and labor cost. The only controllable input is whether to introduce the product. A variety of possible values will be generated for the probabilistic inputs, and the resulting profit will be computed. We develop a simulation model for this type of application in Section 12.1. 2. Airline overbooking. The objective of this simulation is to determine the number of reservations an airline should accept for a particular flight. A simulation model is developed relating profit for the flight to a probabilistic input, the number of passengers with a reservation who show up and use their reservation, and a controllable input, the number of reservations accepted for the flight. For each selected value for the controllable input, a variety of possible values will be generated for the number of passengers who show up, and the resulting profit can be computed. Similar simulation models are applicable for hotel and car rental reservation systems. 3. Inventory policy. The objective of this simulation is to choose an inventory policy that will provide good customer service at a reasonable cost. A model is developed relating two output measures, total inventory cost and the service level, to probabilistic inputs, such as product demand and delivery lead time from vendors, and controllable inputs, such as the order quantity and the reorder point. For each setting of the controllable inputs, a variety of possible values would be generated for the probabilistic inputs, and the resulting cost and service levels would be computed. FIGURE 12.1 DIAGRAM OF A SIMULATION MODEL Probabilistic Inputs
Controllable Inputs
Model
Output
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4. Traffic flow. The objective of this simulation is to determine the effect of installing a left turn signal on the flow of traffic through a busy intersection. A model is developed relating waiting time for vehicles to get through the intersection to probabilistic inputs such as the number of vehicle arrivals and the fraction that want to make a left turn, and controllable inputs such as the length of time the left turn signal is on. For each setting of the controllable inputs, values would be generated for the probabilistic inputs, and the resulting vehicle waiting times would be computed. 5. Waiting lines. The objective of this simulation is to determine the waiting times for customers at a bank’s automated teller machine (ATM). A model is developed relating customer waiting times to probabilistic inputs such as customer arrivals and service times, and a controllable input, the number of ATM machines installed. For each value of the controllable input (the number of ATM machines), a variety of values would be generated for the probabilistic inputs, and the customer waiting times would be computed. The Management Science in Action, Call Center Design, describes how simulation of a waiting line system at a call center helped the company balance the service to its customers with the cost of agents providing the service. Simulation is not an optimization technique. It is a method that can be used to describe or predict how a system will operate given certain choices for the controllable inputs and randomly generated values for the probabilistic inputs. Management scientists often use simulation to determine values for the controllable inputs that are likely to lead to desirable system outputs. In this sense, simulation can be an effective tool in designing a system to provide good performance. MANAGEMENT SCIENCE IN ACTION CALL CENTER DESIGN* A call center is a place where large volumes of calls are made to or received from current or potential customers. More than 60,000 call centers operate in the United States. Saltzman and Mehrotra describe how a simulation model helped make a strategic change in the design of the technical support call center for a major software company. The application used a waiting line simulation model to balance the service to customers calling for assistance with the cost of agents providing the service. Historically, the software company provided free phone-in technical support, but over time service requests grew to the point where 80% of the callers were waiting between 5 and 10 minutes and abandonment rates were too high. On some days 40% of the callers hung up before receiving service. This service level was unacceptable. As a result, management considered instituting a Rapid Program in which customers would pay a fee for service, but would be guaranteed to receive service within one minute, or the service would be free. Nonpaying customers would continue receiving service but without a guarantee of short service times. A simulation model was developed to help understand the impact of this new program on the
waiting line characteristics of the call center. Data available were used to develop the arrival distribution, the service time distribution, and the probability distribution for abandonment. The key design variables considered were the number of agents (channels) and the percentage of callers subscribing to the Rapid Program. The model was developed using the Arena simulation package. The simulation results helped the company decide to go ahead with the Rapid Program. Under most of the scenarios considered, the simulation model showed that 95% of the callers in the Rapid Program would receive service within one minute and that free service to the remaining customers could be maintained within acceptable limits. Within nine months, 10% of the software company’s customers subscribed to the Rapid Program, generating $2 million in incremental revenue. The company viewed the simulation model as a vehicle for mitigating risk. The model helped evaluate the likely impact of the Rapid Program without experimenting with actual customers. *Based on Robert M. Saltzman and Vijay Mehrotra, “A Call Center Uses Simulation to Drive Strategic Change,” Interfaces (May/June 2001): 87–101.
12.1
545
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In this chapter we begin by showing how simulation can be used to study the financial risks associated with the development of a new product. We continue with illustrations showing how simulation can be used to establish an effective inventory policy and how simulation can be used to design waiting line systems. Other issues, such as verifying the simulation program, validating the model, and selecting a simulation software package, are discussed in Section 12.4.
12.1
RISK ANALYSIS Risk analysis is the process of predicting the outcome of a decision in the face of uncertainty. In this section, we describe a problem that involves considerable uncertainty: the development of a new product. We first show how risk analysis can be conducted without using simulation; then we show how a more comprehensive risk analysis can be conducted with the aid of simulation.
PortaCom Project PortaCom manufactures personal computers and related equipment. PortaCom’s product design group developed a prototype for a new high-quality portable printer. The new printer features an innovative design and has the potential to capture a significant share of the portable printer market. Preliminary marketing and financial analyses provided the following selling price, first-year administrative cost, and first-year advertising cost: Selling price $249 per unit Administrative cost $400,000 Advertising cost $600,000 In the simulation model for the PortaCom project, the preceding values are constants and are referred to as parameters of the model. The cost of direct labor, the cost of parts, and the first-year demand for the printer are not known with certainty and are considered probabilistic inputs. At this stage of the planning process, PortaCom’s best estimates of these inputs are $45 per unit for the direct labor cost, $90 per unit for the parts cost, and 15,000 units for the first-year demand. PortaCom would like an analysis of the first-year profit potential for the printer. Because of PortaCom’s tight cash flow situation, management is particularly concerned about the potential for a loss.
What-If Analysis One approach to risk analysis is called what-if analysis. A what-if analysis involves generating values for the probabilistic inputs (direct labor cost, parts cost, and first-year demand) and computing the resulting value for the output (profit). With a selling price of $249 per unit and administrative plus advertising costs equal to $400,000 $600,000 $1,000,000, the PortaCom profit model is Profit ($249 – Direct labor cost per unit – Parts cost per unit) (Demand) – $1,000,000 Letting c1 direct labor cost per unit c2 parts cost per unit x first-year demand
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the profit model for the first year can be written as follows: Profit = (249 - c1 - c2)x - 1,000,000
(12.1)
The PortaCom profit model can be depicted as shown in Figure 12.2. Recall that PortaCom’s best estimates of the direct labor cost per unit, the parts cost per unit, and first-year demand are $45, $90, and 15,000 units, respectively. These values constitute the base-case scenario for PortaCom. Substituting these values into equation (12.1) yields the following profit projection: Profit = (249 - 45 - 90)(15,000) - 1,000,000 = 710,000 Thus, the base-case scenario leads to an anticipated profit of $710,000. In risk analysis we are concerned with both the probability of a loss and the magnitude of a loss. Although the base-case scenario looks appealing, PortaCom might be interested in what happens if the estimates of the direct labor cost per unit, parts cost per unit, and first-year demand do not turn out to be as expected under the base-case scenario. For instance, suppose that PortaCom believes that direct labor costs could range from $43 to $47 per unit, parts cost could range from $80 to $100 per unit, and first-year demand could range from 1500 to 28,500 units. Using these ranges, what-if analysis can be used to evaluate a worst-case scenario and a best-case scenario. The worst-case value for the direct labor cost is $47 (the highest value), the worst-case value for the parts cost is $100 (the highest value), and the worst-case value for demand is 1500 units (the lowest value). Thus, in the worst-case scenario, c1 47, c2 100, and x 1500. Substituting these values into equation (12.1) leads to the following profit projection: Profit = (249 - 47 - 100)(1500) - 1,000,000 = - 847,000 The worst-case scenario leads to a projected loss of $847,000. The best-case value for the direct labor cost is $43 (the lowest value), the best-case value for the parts cost is $80 (the lowest value), and the best-case value for demand is 28,500 units (the highest value). Substituting these values into equation (12.1) leads to the following profit projection: Problem 2 will give you practice using what-if analysis.
Profit (249 43 80)(28,500) 1,000,000 2,591,000 The best-case scenario leads to a projected profit of $2,591,000.
FIGURE 12.2 PORTACOM PROFIT MODEL Probabilistic Inputs Direct FirstLabor Parts Year Cost Cost Demand c1 c2 x
Introduce Product
(249 − c1 − c2) x − 1,000,000
Profit
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Risk Analysis
At this point the what-if analysis provides the conclusion that profits can range from a loss of $847,000 to a profit of $2,591,000 with a base-case profit of $710,000. Although the base-case profit of $710,000 is possible, the what-if analysis indicates that either a substantial loss or a substantial profit is possible. Other scenarios that PortaCom might want to consider can also be evaluated. However, the difficulty with what-if analysis is that it does not indicate the likelihood of the various profit or loss values. In particular, we do not know anything about the probability of a loss.
Simulation Using simulation to perform risk analysis for the PortaCom project is like playing out many what-if scenarios by randomly generating values for the probabilistic inputs. The advantage of simulation is that it allows us to assess the probability of a profit and the probability of a loss. Using the what-if approach to risk analysis, we selected values for the probabilistic inputs [direct labor cost per unit (c1), parts cost per unit (c2), and first-year demand (x)], and then computed the resulting profit. Applying simulation to the PortaCom project requires generating values for the probabilistic inputs that are representative of what we might observe in practice. To generate such values, we must know the probability distribution for each probabilistic input. Further analysis by PortaCom led to the following probability distributions for the direct labor cost per unit, the parts cost per unit, and first-year demand: One advantage of simulation is the ability to use probability distributions that are unique to the system being studied.
Direct Labor Cost PortaCom believes that the direct labor cost will range from $43 to $47 per unit and is described by the discrete probability distribution shown in Table 12.1. Thus, we see a 0.1 probability that the direct labor cost will be $43 per unit, a 0.2 probability that the direct labor cost will be $44 per unit, and so on. The highest probability of 0.4 is associated with a direct labor cost of $45 per unit. Parts Cost This cost depends upon the general economy, the overall demand for parts, and the pricing policy of PortaCom’s parts suppliers. PortaCom believes that the parts cost will range from $80 to $100 per unit and is described by the uniform probability distribution shown in Figure 12.3. Costs per unit between $80 and $100 are equally likely. First-Year Demand PortaCom believes that first-year demand is described by the normal probability distribution shown in Figure 12.4. The mean or expected value of first-year demand is 15,000 units. The standard deviation of 4500 units describes the variability in the first-year demand. To simulate the PortaCom project, we must generate values for the three probabilistic inputs and compute the resulting profit. Then we generate another set of values for the
TABLE 12.1 PROBABILITY DISTRIBUTION FOR DIRECT LABOR COST PER UNIT Direct Labor Cost per Unit $43 $44 $45 $46 $47
Probability 0.1 0.2 0.4 0.2 0.1
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FIGURE 12.3 UNIFORM PROBABILITY DISTRIBUTION FOR THE PARTS COST PER UNIT
1 20
80
90
100
Parts Cost per Unit
A flowchart provides a graphical representation that helps describe the logic of the simulation model.
probabilistic inputs, compute a second value for profit, and so on. We continue this process until we are satisfied that enough trials have been conducted to describe the probability distribution for profit. This process of generating probabilistic inputs and computing the value of the output is called simulation. The sequence of logical and mathematical operations required to conduct a simulation can be depicted with a flowchart. A flowchart for the PortaCom simulation is shown in Figure 12.5. Following the logic described by the flowchart, we see that the model parameters— selling price, administrative cost, and advertising cost—are $249, $400,000, and $600,000, respectively. These values will remain fixed throughout the simulation. The next three blocks depict the generation of values for the probabilistic inputs. First, a value for the direct labor cost (c1) is generated. Then a value for the parts cost (c2) is generated, followed by a value for the first-year demand (x). These probabilistic input values are combined using the profit model given by equation (12.1). Profit (249 – c1 – c2)x – 1,000,000 The computation of profit completes one trial of the simulation. We then return to the block where we generated the direct labor cost and begin another trial. This process is repeated until a satisfactory number of trials has been generated.
FIGURE 12.4 NORMAL PROBABILITY DISTRIBUTION OF FIRST-YEAR DEMAND
Standard Deviation σ = 4500 units
15,000 Number of Units Sold
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FIGURE 12.5 FLOWCHART FOR THE PORTACOM SIMULATION Model Parameters Selling Price per Unit = $249 Administrative Cost = $400,000 Advertising Cost = $600,000 Generate Direct Labor Cost, c 1
Next Trial
Generate Parts Cost, c 2
Generate First-Year Demand, x
Compute Profit Profit = (249 c 1c 2) x 1,000,000
At the end of the simulation, output measures of interest can be developed. For example, we will be interested in computing the average profit and the probability of a loss. For the output measures to be meaningful, the values of the probabilistic inputs must be representative of what is likely to happen when the PortaCom printer is introduced into the market. An essential part of the simulation procedure is the ability to generate representative values for the probabilistic inputs. We now discuss how to generate these values.
Because random numbers are equally likely, management scientists can assign ranges of random numbers to corresponding values of probabilistic inputs so that the probability of any input value to the simulation model is identical to the probability of its occurrence in the real system.
Random Numbers and Generating Probabilistic Input Values In the PortaCom simulation, representative values must be generated for the direct labor cost per unit (c1), the parts cost per unit (c2), and the first-year demand (x). Random numbers and the probability distributions associated with each probabilistic input are used to generate representative values. To illustrate how to generate these values, we need to introduce the concept of computer-generated random numbers. Computer-generated random numbers1 are randomly selected decimal numbers from 0 up to, but not including, 1. The computer-generated random numbers are equally likely and are uniformly distributed over the interval from 0 to 1. Computer-generated random numbers can be obtained using built-in functions available in computer simulation packages and spreadsheets. For instance, placing RAND() in a cell of an Excel worksheet will result in a random number between 0 and 1 being placed into that cell. Table 12.2 contains 500 random numbers generated using Excel. These numbers can be viewed as a random sample of 500 values from a uniform probability distribution over the interval from 0 to 1. Let us show how random numbers can be used to generate values for the PortaCom probability distributions. We begin by showing how to generate a value for the direct labor cost per unit. The approach described is applicable for generating values from any discrete probability distribution. 1
Computer-generated random numbers are called pseudorandom numbers. Because they are generated through the use of mathematical formulas, they are not technically random. The difference between random numbers and pseudorandom numbers is primarily philosophical, and we use the term random numbers regardless of whether they are generated by a computer.
550
TABLE 12.2 0.6953 0.0082 0.6799 0.8898 0.6515 0.3976 0.0642 0.0377 0.5739 0.5827 0.0508 0.4757 0.6805 0.2603 0.8143 0.5681 0.1501 0.8806 0.4582 0.0785 0.1158 0.2762 0.9382 0.5102 0.2354 0.9082 0.6936 0.4042 0.9410 0.0917 0.8532 0.8980 0.8412 0.5688 0.5006 0.5748 0.1100 0.5802 0.1019 0.9909 0.6292 0.9430 0.9938 0.4690 0.2028 0.6141 0.2757 0.0561 0.1419 0.3125
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500 COMPUTER-GENERATED RANDOM NUMBERS 0.5247 0.9925 0.1241 0.1514 0.5027 0.7790 0.4086 0.5250 0.5181 0.0341 0.7905 0.1399 0.9931 0.7507 0.7625 0.7854 0.9363 0.7989 0.7590 0.1467 0.6635 0.7018 0.6411 0.7021 0.7410 0.7906 0.0702 0.8158 0.2201 0.2504 0.4869 0.0455 0.8792 0.8633 0.1215 0.4164 0.0873 0.7747 0.6628 0.8991 0.4923 0.2579 0.7098 0.1395 0.3774 0.4131 0.8479 0.0126 0.4308 0.0053
0.1368 0.6874 0.3056 0.1826 0.9290 0.0035 0.6078 0.7774 0.0234 0.7482 0.2932 0.5668 0.4166 0.6414 0.1708 0.5016 0.3858 0.7484 0.4393 0.3880 0.4992 0.6782 0.7984 0.4353 0.7089 0.7589 0.9716 0.3623 0.6348 0.2878 0.2685 0.8314 0.2025 0.5818 0.8102 0.3427 0.9407 0.1285 0.8998 0.2298 0.0276 0.7933 0.7964 0.0930 0.0485 0.2006 0.7880 0.6531 0.8073 0.9209
0.9850 0.2122 0.5590 0.0004 0.5177 0.0064 0.2044 0.2390 0.7305 0.6351 0.4971 0.9569 0.1091 0.9907 0.1900 0.9403 0.3545 0.8083 0.4704 0.5274 0.9070 0.4013 0.0608 0.3398 0.2579 0.8870 0.0374 0.6614 0.0367 0.1735 0.6349 0.8189 0.9320 0.0692 0.1026 0.2809 0.8747 0.0074 0.1334 0.2603 0.6734 0.0945 0.7952 0.3189 0.7718 0.2329 0.8492 0.0378 0.4681 0.9768
0.7467 0.6885 0.0423 0.5259 0.3134 0.0441 0.0484 0.9121 0.0376 0.9146 0.0225 0.7255 0.7730 0.2699 0.2781 0.1078 0.5448 0.2701 0.6903 0.8723 0.2975 0.2224 0.5945 0.8038 0.1358 0.1189 0.0683 0.7954 0.0311 0.3872 0.9364 0.6783 0.7656 0.2543 0.9251 0.8064 0.0496 0.6252 0.2798 0.6921 0.6562 0.3192 0.8947 0.6972 0.9656 0.6182 0.6859 0.4975 0.0481 0.3584
0.3813 0.2159 0.6515 0.2425 0.9177 0.3437 0.4691 0.5345 0.5169 0.4700 0.4466 0.4650 0.0691 0.4571 0.2830 0.5255 0.0643 0.5039 0.3732 0.7517 0.5686 0.4672 0.3977 0.2260 0.8446 0.7125 0.2397 0.7516 0.0688 0.6816 0.3451 0.8086 0.3815 0.5453 0.6851 0.5855 0.4380 0.7747 0.7351 0.5573 0.4231 0.3195 0.1214 0.7291 0.2444 0.5151 0.8947 0.1133 0.2918 0.0390
0.5827 0.4299 0.2750 0.8421 0.2605 0.1248 0.7058 0.8178 0.5679 0.7869 0.5118 0.4084 0.9411 0.9254 0.6877 0.8727 0.3167 0.9439 0.6587 0.9905 0.8495 0.5753 0.4570 0.1250 0.1648 0.6324 0.7753 0.6518 0.2346 0.2731 0.4998 0.1386 0.5302 0.9955 0.1559 0.2229 0.5847 0.0112 0.7330 0.8191 0.1980 0.7772 0.8454 0.8513 0.0304 0.6300 0.6246 0.3572 0.2975 0.2161
0.7893 0.3467 0.8156 0.9248 0.6668 0.5442 0.8552 0.8443 0.5495 0.1337 0.1200 0.3701 0.3468 0.2371 0.0488 0.3815 0.6732 0.1027 0.8675 0.8904 0.1652 0.6219 0.9924 0.1884 0.3889 0.1096 0.2029 0.3638 0.3927 0.3846 0.2842 0.4442 0.8744 0.1237 0.1214 0.2805 0.4183 0.3958 0.6723 0.0384 0.6551 0.4672 0.8294 0.9256 0.1395 0.9311 0.1574 0.0071 0.0685 0.6333
0.7169 0.2186 0.2871 0.9155 0.1167 0.9800 0.5029 0.4154 0.7872 0.0702 0.0200 0.9446 0.0014 0.8664 0.8635 0.5541 0.6283 0.9677 0.2905 0.8177 0.2039 0.6871 0.8398 0.3432 0.5620 0.5155 0.1464 0.3107 0.7327 0.6621 0.0643 0.9941 0.4584 0.7535 0.2628 0.9139 0.5929 0.3285 0.6924 0.2954 0.3716 0.7070 0.5394 0.7478 0.1577 0.3837 0.4936 0.4555 0.6384 0.4391
0.8166 0.1033 0.4680 0.9518 0.7870 0.1857 0.3288 0.2526 0.5321 0.4219 0.5445 0.8064 0.7379 0.9553 0.3155 0.9833 0.2631 0.4597 0.3058 0.6660 0.2553 0.9255 0.8361 0.1192 0.6555 0.3449 0.8000 0.2718 0.9994 0.8983 0.6656 0.6812 0.3585 0.5993 0.9374 0.9013 0.4863 0.5389 0.3963 0.0636 0.0507 0.5925 0.9413 0.8124 0.8625 0.7828 0.8077 0.7563 0.0812 0.6991
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TABLE 12.3 RANDOM NUMBER INTERVALS FOR GENERATING VALUES OF DIRECT LABOR COST PER UNIT Direct Labor Cost per Unit $43 $44 $45 $46 $47
Try Problem 5 for an opportunity to establish intervals of random numbers and simulate demand from a discrete probability distribution.
Probability 0.1 0.2 0.4 0.2 0.1
Interval of Random Numbers 0.0 but less than 0.1 0.1 but less than 0.3 0.3 but less than 0.7 0.7 but less than 0.9 0.9 but less than 1.0
An interval of random numbers is assigned to each possible value of the direct labor cost in such a fashion that the probability of generating a random number in the interval is equal to the probability of the corresponding direct labor cost. Table 12.3 shows how this process is done. The interval of random numbers greater than or equal to 0.0 but less than 0.1 is associated with a direct labor cost of $43, the interval of random numbers greater than or equal to 0.1 but less than 0.3 is associated with a direct labor cost of $44, and so on. With this assignment of random number intervals to the possible values of the direct labor cost, the probability of generating a random number in any interval is equal to the probability of obtaining the corresponding value for the direct labor cost. Thus, to select a value for the direct labor cost, we generate a random number between 0 and 1. If the random number is greater than or equal to 0.0 but less than 0.1, we set the direct labor cost equal to $43. If the random number is greater than or equal to 0.1 but less than 0.3, we set the direct labor cost equal to $44, and so on. Each trial of the simulation requires a value for the direct labor cost. Suppose that on the first trial the random number is 0.9109. From Table 12.3, the simulated value for the direct labor cost is $47 per unit. Suppose that on the second trial the random number is 0.2841. From Table 12.3, the simulated value for the direct labor cost is $44 per unit. Table 12.4 shows the results obtained for the first 10 simulation trials. Each trial in the simulation requires a value of the direct labor cost, parts cost, and firstyear demand. Let us now turn to the issue of generating values for the parts cost. The probability distribution for the parts cost per unit is the uniform distribution shown in Figure 12.3. Because this random variable has a different probability distribution than direct labor cost, we use random numbers in a slightly different way to generate values for parts cost. With a
TABLE 12.4 RANDOM GENERATION OF 10 VALUES FOR THE DIRECT LABOR COST PER UNIT Trial 1 2 3 4 5 6 7 8 9 10
Random Number 0.9109 0.2841 0.6531 0.0367 0.3451 0.2757 0.6859 0.6246 0.4936 0.8077
Direct Labor Cost ($) 47 44 45 43 45 44 45 45 45 46
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uniform probability distribution, the following relationship between the random number and the associated value of the parts cost is used: Parts cost = a + r (b - a)
(12.2)
where r = random number between 0 and 1 a = smallest value for parts cost b = largest value for parts cost For PortaCom, the smallest value for the parts cost is $80, and the largest value is $100. Applying equation (12.2) with a 80 and b 100 leads to the following formula for generating the parts cost given a random number, r: Parts cost = 80 + r(100 - 80) = 80 + r20
(12.3)
Equation (12.3) generates a value for the parts cost. Suppose that a random number of 0.2680 is obtained. The value for the parts cost is Parts cost = 80 + 0.2680(20) = 85.36 per unit Spreadsheet packages such as Excel have built-in functions that make simulations based on probability distributions such as the normal probability distribution relatively easy.
Suppose that a random number of 0.5842 is generated on the next trial. The value for the parts cost is Parts cost 80 0.5842(20) 91.68 per unit With appropriate choices of a and b, equation (12.2) can be used to generate values for any uniform probability distribution. Table 12.5 shows the generation of 10 values for the parts cost per unit. Finally, we need a random number procedure for generating the first-year demand. Because first-year demand is normally distributed with a mean of 15,000 units and a standard deviation of 4500 units (see Figure 12.4), we need a procedure for generating random
TABLE 12.5
RANDOM GENERATION OF 10 VALUES FOR THE PARTS COST PER UNIT Trial 1 2 3 4 5 6 7 8 9 10
Random Number 0.2680 0.5842 0.6675 0.9280 0.4180 0.7342 0.4325 0.1186 0.6944 0.7869
Parts Cost ($) 85.36 91.68 93.35 98.56 88.36 94.68 88.65 82.37 93.89 95.74
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values from a normal probability distribution. Because of the mathematical complexity, a detailed discussion of the procedure for generating random values from a normal probability distribution is omitted. However, computer simulation packages and spreadsheets include a built-in function that provides randomly generated values from a normal probability distribution. In most cases the user only needs to provide the mean and standard deviation of the normal distribution. For example, using Excel the following formula can be placed into a cell to obtain a value for a probabilistic input that is normally distributed: = NORMINV(RAND(),Mean,Standard Deviation) Because the mean for the first-year demand in the PortaCom problem is 15,000 and the standard deviation is 4500, the Excel statement = NORMINV(RAND(),15000,4500)
(12.4)
will provide a normally distributed value for first-year demand. For example, if Excel’s RAND() function generates the random number 0.7005, the Excel function shown in equation (12.4) will provide a first-year demand of 17,366 units. If RAND() generates the random number 0.3204, equation (12.4) will provide a first-year demand of 12,900. Table 12.6 shows the results for the first 10 randomly generated values for demand. Note that random numbers less than 0.5 generate first-year demand values below the mean and that random numbers greater than 0.5 generate first-year demand values greater than the mean. Running the Simulation Model Running the simulation model means implementing the sequence of logical and mathematical operations described in the flowchart in Figure 12.5. The model parameters are $249 per unit for the selling price, $400,000 for the administrative cost, and $600,000 for the advertising cost. Each trial in the simulation involves randomly generating values for the probabilistic inputs (direct labor cost, parts cost, and first-year demand) and computing profit. The simulation is complete when a satisfactory number of trials have been conducted. Let us compute the profit for the first trial assuming the following probabilistic inputs: Direct labor cost: Parts cost: First-year demand:
C1 = 47 C2 = 85.36 x = 17,366
TABLE 12.6 RANDOM GENERATION OF 10 VALUES FOR FIRST-YEAR DEMAND Trial 1 2 3 4 5 6 7 8 9 10
Random Number 0.7005 0.3204 0.8968 0.1804 0.4346 0.9605 0.5646 0.7334 0.0216 0.3218
Demand 17,366 12,900 20,686 10,888 14,259 22,904 15,732 17,804 5,902 12,918
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TABLE 12.7 PORTACOM SIMULATION RESULTS FOR 10 TRIALS Direct Labor Cost per Unit ($) 47 44 45 43 45 44 45 45 45 46
Trial 1 2 3 4 5 6 7 8 9 10
Parts Cost per Unit ($) 85.36 91.68 93.35 98.56 88.36 94.68 88.65 82.37 93.89 95.74
Units Sold 17,366 12,900 20,686 10,888 14,259 22,904 15,732 17,804 5,902 12,918
Profit ($) 1,025,570 461,828 1,288,906 169,807 648,911 1,526,769 814,686 1,165,501 350,131 385,585
Total
449
912.64
151,359
7,137,432
Average
$44.90
$91.26
15,136
$713,743
Referring to the flowchart in Figure 12.5, we see that the profit obtained is Profit = (249 - c1 - c2)x - 1,000,000 = (249 - 47 - 85.36)17,366 - 1,000,000 = 1,025,570 The first row of Table 12.7 shows the result of this trial of the PortaCom simulation. The simulated profit for the PortaCom printer if the direct labor cost is $47 per unit, the parts cost is $85.36 per unit, and first-year demand is 17,366 units is $1,025,570. Of course, one simulation trial does not provide a complete understanding of the possible profit and loss. Because other values are possible for the probabilistic inputs, we can benefit from additional simulation trials. Suppose that on a second simulation trial, random numbers of 0.2841, 0.5842, and 0.3204 are generated for the direct labor cost, the parts cost, and first-year demand, respectively. These random numbers will provide the probabilistic inputs of $44 for the direct labor cost, $91.68 for the parts cost, and 12,900 for first-year demand. These values provide a simulated profit of $461,828 on the second simulation trial (see the second row of Table 12.7). Repetition of the simulation process with different values for the probabilistic inputs is an essential part of any simulation. Through the repeated trials, management will begin to understand what might happen when the product is introduced into the real world. We have shown the results of 10 simulation trials in Table 12.7. For these 10 cases, we find a profit as high as $1,526,769 for the 6th trial and a loss of $350,131 for the 9th trial. Thus, we see both the possibility of a profit and of a loss. Averages for the 10 trials are presented at the bottom of the table. We see that the average profit for the 10 trials is $713,743. The probability of a loss is 0.10, because one of the 10 trials (the 9th) resulted in a loss. We note also that the average values for labor cost, parts cost, and first-year demand are fairly close to their means of $45, $90, and 15,000, respectively.
Simulation of the PortaCom Project Using an Excel worksheet, we simulated the PortaCom project 500 times. The worksheet used to carry out the simulation is shown in Figure 12.6. Note that the simulation results for trials 6 through 495 have been hidden so that the results can be shown in a reasonably sized
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FIGURE 12.6 EXCEL WORKSHEET SIMULATION FOR THE PORTACOM PROJECT A
WEB
file
PortaCom
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 516 517 518 519 520 521 522 523 524 525 526 527 528
Excel worksheets for all simulations presented in this chapter are available on the website that accompanies this text.
B
C
D
E
F
PortaCom Risk Analysis Selling Price per Unit Administrative Cost Advertising Cost Direct Labor Cost Lower Upper Random No. Random No. 0.0 0.1 0.1 0.3 0.3 0.7 0.7 0.9 0.9 1.0
$249 $400,000 $600,000
Cost per Unit $43 $44 $45 $46 $47
Parts Cost (Uniform Distribution) Smallest Value $80 Largest Value $100
Demand (Normal Distribution) Mean 15000 Std Deviation 4500
Simulation Trials
Trial 1 2 3 4 5 496 497 498 499 500
Direct Labor Cost per Unit 47 44 45 43 45 44 45 44 43 46
Parts Cost per Unit $85.36 $91.68 $93.35 $98.56 $88.36 $98.67 $94.38 $90.85 $90.37 $92.50
First-Year Demand 17,366 12,900 20,686 10,888 14,259 8,730 19,257 14,920 13,471 18,614
Summary Statistics Mean Profit Standard Deviation Minimum Profit Maximum Profit Number of Losses Probability of Loss
Profit $1,025,570 $461,828 $1,288,906 $169,807 $648,911 ($71,739) $1,110,952 $703,118 $557,652 $1,056,847
$698,457 $520,485 ($785,234) $2,367,058 51 0.1020
figure. If desired, the rows for these trials can be shown and the simulation results displayed for all 500 trials. The details of the Excel worksheet that provided the PortaCom simulation are described in Appendix 12.1. The simulation summary statistics in Figure 12.6 provide information about the risk associated with PortaCom’s new printer. The worst result obtained in a simulation of 500 trials is a loss of $785,234, and the best result is a profit of $2,367,058. The mean profit is
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Simulation studies enable an objective estimate of the probability of a loss, which is an important aspect of risk analysis.
For practice working through a simulation problem, try Problems 9 and 14.
Simulation
$698,457. Fifty-one of the trials resulted in a loss; thus, the estimated probability of a loss is 51/500 0.1020. A histogram of simulated profit values is shown in Figure 12.7. We note that the distribution of profit values is fairly symmetric with a large number of values in the range of $250,000 to $1,250,000. The probability of a large loss or a large gain is small. Only three trials resulted in a loss of more than $500,000, and only three trials resulted in a profit greater than $2,000,000. However, the probability of a loss is significant. Forty-eight of the 500 trials resulted in a loss in the $0 to $500,000 range—almost 10%. The modal category, the one with the largest number of values, is the range of profits between $750,000 and $1,000,000. In comparing the simulation approach to risk analysis to the what-if approach, we see that much more information is obtained by using simulation. With the what-if analysis, we learned that the base-case scenario projected a profit of $710,000. The worst-case scenario projected a loss of $847,000, and the best-case scenario projected a profit of $2,591,000. From the 500 trials of the simulation run, we see that the worst- and best-case scenarios, although possible, are unlikely. None of the 500 trials provided a loss as low as the worstcase or a profit as high as the best-case. Indeed, the advantage of simulation for risk analysis is the information it provides on the likely values of the output. We now know the probability of a loss, how the profit values are distributed over their range, and what profit values are most likely. The simulation results help PortaCom’s management better understand the profit/loss potential of the PortaCom portable printer. The 0.1020 probability of a loss may be acceptable to management given a probability of almost 0.80 (see Figure 12.7) that profit will exceed $250,000. On the other hand, PortaCom might want to conduct further market research before deciding whether to introduce the product. In any case, the simulation results should be helpful in reaching an appropriate decision. The Management Science in Action, Meeting Demand Levels at Pfizer, describes how a simulation model helped find ways to meet increasing demand for a product.
FIGURE 12.7 HISTOGRAM OF SIMULATED PROFIT FOR 500 TRIALS OF THE PORTACOM SIMULATION 120
Frequency
100 80 60
51 of 500 Simulation Trials Show a Loss
40 20 0
−1000
−500
500 1000 Profit ($000s)
1500
2000
2500
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MANAGEMENT SCIENCE IN ACTION MEETING DEMAND LEVELS AT PFIZER* Pharmacia & Upjohn’s merger with Pfizer created one of the world’s largest pharmaceutical firms. Demand for one of Pharmacia & Upjohn’s longstanding products remained stable for several years at a level easily satisfied by the company’s manufacturing facility. However, changes in market conditions caused an increase in demand to a level beyond the current capacity. A simulation model of the production process was developed to explore ways to increase production to meet the new level of demand in a cost-effective manner. Simulation results were used to help answer the following questions: • • •
What is the maximum throughput of the existing facility? How can the existing production process be modified to increase throughput? How much equipment must be added to the existing facility to meet the increased demand?
•
What is the desired size and configuration of the new production process?
The simulation model was able to demonstrate that the existing facilities, with some operating policy improvements, were large enough to satisfy the increased demand for the next several years. Expansion to a new production facility was not necessary. The simulation model also helped determine the number of operators required as the production level increased in the future. This result helped ensure that the proper number of operators would be trained by the time they were needed. The simulation model also provided a way reprocessed material could be used to replace fresh raw materials, resulting in a savings of approximately $3 million per year. *Based on information provided by David B. Magerlein, James M. Magerlein, and Michael J. Goodrich.
NOTES AND COMMENTS
Appendix 12.2 shows how to perform a simulation of the PortaCom project using Crystal Ball.
1. The PortaCom simulation model is based on independent trials in which the results for one trial do not affect what happens in subsequent trials. Historically, this type of simulation study was referred to as a Monte Carlo simulation. The term Monte Carlo simulation was used because early practitioners of simulation saw similarities between the models they were developing and the gambling games played in the casinos of Monte Carlo. Today, many individuals interpret the term Monte Carlo simulation more broadly to mean any simulation that involves randomly generating values for the probabilistic inputs. 2. The probability distribution used to generate values for probabilistic inputs in a simulation model is often developed using historical data. For instance, suppose that an analysis of daily sales at a new car dealership for the past 50 days showed that on 2 days no cars were sold, on 5 days one car was sold, on 9 days two cars were sold, on 24 days three cars were sold, on 7 days four cars were sold, and on 3 days five cars were
sold. We can estimate the probability distribution of daily demand using the relative frequencies for the observed data. An estimate of the probability that no cars are sold on a given day is 2/50 0.04, an estimate of the probability that one car is sold is 5/50 0.10, and so on. The estimated probability distribution of daily demand is shown in the table below. 3. Spreadsheet add-in packages such as @RISK® and Crystal Ball® have been developed to make spreadsheet simulation easier. For instance, using Crystal Ball we could simulate the PortaCom new product introduction by first entering the formulas showing the relationships between the probabilistic inputs and the output measure, profit. Then, a probability distribution type is selected for each probabilistic input from among a number of available choices. Crystal Ball will generate random values for each probabilistic input, compute the profit, and repeat the simulation for as many trials as specified. Graphical displays and a variety of descriptive statistics can be easily obtained.
Daily Sales
1
2
3
4
5
Probability
0.04
0.10
0.18
0.48
0.14
0.06
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12.2
Simulation
INVENTORY SIMULATION In this section we describe how simulation can be used to establish an inventory policy for a product that has an uncertain demand. The product is a home ventilation fan distributed by the Butler Electrical Supply Company. Each fan costs Butler $75 and sells for $125. Thus Butler realizes a gross profit of $125 $75 $50 for each fan sold. Monthly demand for the fan is described by a normal probability distribution with a mean of 100 units and a standard deviation of 20 units. Butler receives monthly deliveries from its supplier and replenishes its inventory to a level of Q at the beginning of each month. This beginning inventory level is referred to as the replenishment level. If monthly demand is less than the replenishment level, an inventory holding cost of $15 is charged for each unit that is not sold. However, if monthly demand is greater than the replenishment level, a stockout occurs and a shortage cost is incurred. Because Butler assigns a goodwill cost of $30 for each customer turned away, a shortage cost of $30 is charged for each unit of demand that cannot be satisfied. Management would like to use a simulation model to determine the average monthly net profit resulting from using a particular replenishment level. Management would also like information on the percentage of total demand that will be satisfied. This percentage is referred to as the service level. The controllable input to the Butler simulation model is the replenishment level, Q. The probabilistic input is the monthly demand, D. The two output measures are the average monthly net profit and the service level. Computation of the service level requires that we keep track of the number of fans sold each month and the total demand for fans for each month. The service level will be computed at the end of the simulation run as the ratio of total units sold to total demand. A diagram of the relationship between the inputs and the outputs is shown in Figure 12.8. When demand is less than or equal to the replenishment level (D Q), D units are sold, and an inventory holding cost of $15 is incurred for each of the Q D units that remain in inventory. Net profit for this case is computed as follows: Case 1: D ≤ Q Gross profit = $50D (12.5) Holding cost = $15(Q - D) Net profit = Gross profit - Holding cost = $50D - $15(Q - D) When demand is greater than the replenishment level (D Q), Q fans are sold, and a shortage cost of $30 is imposed for each of the D Q units of demand not satisfied. Net profit for this case is computed as follows: Case 2: D > Q Gross profit = $50Q Shortage cost = $30(D - Q) (12.6) Net profit = Gross profit - Shortage cost = $50Q - $30(D - Q)
Figure 12.9 shows a flowchart that defines the sequence of logical and mathematical operations required to simulate the Butler inventory system. Each trial in the simulation
12.2
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Inventory Simulation
FIGURE 12.8 BUTLER INVENTORY SIMULATION MODEL Demand D
Replenishment Q Level
Average Net Profit Service Level
Model
FIGURE 12.9 FLOWCHART FOR THE BUTLER INVENTORY SIMULATION Set Model Parameters Gross Profit = $50 per unit Holding Cost = $15 per unit Shortage Cost = $30 per unit Select a Replenishment Level, Q Generate Monthly Demand, D
Yes
Next Month
No
Is D ≤ Q ?
Sales = D
Sales = Q
Gross Profit = $50D
Gross Profit = $50Q
Holding Cost = $15(Q – D)
Shortage Cost = $30(D – Q)
Net Profit = Gross Profit Holding Cost
Net Profit = Gross Profit Shortage Cost
Record Monthly Results
No
Is Month = 300 ? Yes Compute Average Net Profit Service Level
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represents one month of operation. The simulation is run for 300 months using a given replenishment level, Q. Then the average profit and service level output measures are computed. Let us describe the steps involved in the simulation by illustrating the results for the first two months of a simulation run using a replenishment level of Q 100. The first block of the flowchart in Figure 12.9 sets the values of the model parameters: gross profit $50 per unit, holding cost $15 per unit, and shortage cost $30 per unit. The next block shows that a replenishment level of Q is selected; in our illustration, Q 100. Then a value for monthly demand is generated. Because monthly demand is normally distributed with a mean of 100 units and a standard deviation of 20 units, we can use the Excel function NORMINV(RAND(),100,20), as described in Section 12.1, to generate a value for monthly demand. Suppose that a value of D 79 is generated on the first trial. This value of demand is then compared with the replenishment level, Q. With the replenishment level set at Q 100, demand is less than the replenishment level, and the left branch of the flowchart is followed. Sales are set equal to demand (79), and gross profit, holding cost, and net profit are computed as follows: Gross profit = 50D = 50(79) = 3950 Holding cost = 15(Q - D) = 15(100 - 79) = 315 Net profit = Gross profit - Holding cost = 3950 - 315 = 3635 The values of demand, sales, gross profit, holding cost, and net profit are recorded for the first month. The first row of Table 12.8 summarizes the information for this first trial. For the second month, suppose that a value of 111 is generated for monthly demand. Because demand is greater than the replenishment level, the right branch of the flowchart is followed. Sales are set equal to the replenishment level (100), and gross profit, shortage cost, and net profit are computed as follows: Gross profit = 50Q = 50(100) = 5000 Shortage cost = 30(D - Q) = 30(111 - 100) = 330 Net profit = Gross profit - Shortage cost = 5000 - 330 = 4670 The values of demand, sales, gross profit, holding cost, shortage cost, and net profit are recorded for the second month. The second row of Table 12.8 summarizes the information generated in the second trial. Results for the first five months of the simulation are shown in Table 12.8. The totals show an accumulated total net profit of $22,310, which is an average monthly net profit of TABLE 12.8 BUTLER INVENTORY SIMULATION RESULTS FOR FIVE TRIALS WITH Q 100
Month 1 2 3 4 5
Demand 79 111 93 100 118
Sales 79 100 93 100 100
Gross Profit ($) 3,950 5,000 4,650 5,000 5,000
Holding Cost ($) 315 0 105 0 0
Shortage Cost ($) 0 330 0 0 540
Net Profit ($) 3,635 4,670 4,545 5,000 4,460
Totals Average
501 100
472 94
23,600 $4,720
420 $ 84
870 $174
22,310 $4,462
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Inventory Simulation
$22,310/5 $4462. Total unit sales are 472, and total demand is 501. Thus, the service level is 472/501 0.942, indicating Butler has been able to satisfy 94.2% of demand during the five-month period.
Butler Inventory Simulation Using Excel, we simulated the Butler inventory operation for 300 months. The worksheet used to carry out the simulation is shown in Figure 12.10. Note that the simulation results for months 6 through 295 have been hidden so that the results can be shown in a reasonably sized figure. If desired, the rows for these months can be shown and the simulation results displayed for all 300 months.
FIGURE 12.10 A
WEB
file
Butler
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 312 313 314 315 316 317 318 319 320 321 322 323
EXCEL WORKSHEET FOR THE BUTLER INVENTORY SIMULATION B
C
D
E
F
G
Butler Inventory Gross Profit per Unit Holding Cost per Unit Shortage Cost per Unit
$50 $15 $30
Replenishment Level
100
Demand (Normal Distribution) Mean 100 Std Deviation 20
Simulation Month 1 2 3 4 5 296 297 298 299 300 Totals
Demand 79 111 93 100 118 89 91 122 93 126
Sales 79 100 93 100 100 89 91 100 93 100
30,181
27,917
Gross Profit Holding Cost Shortage Cost Net Profit $3,950 $315 $0 $3,635 $5,000 $0 $330 $4,670 $4,650 $105 $0 $4,545 $5,000 $0 $0 $5,000 $5,000 $0 $540 $4,460 $4,450 $165 $0 $4,285 $4,550 $135 $0 $4,415 $5,000 $0 $660 $4,340 $4,650 $105 $0 $4,545 $5,000 $0 $780 $4,220 Summary Statistics Mean Profit Standard Deviation Minimum Profit Maximum Profit Service Level
$4,293 $658 ($206) $5,000 92.5%
H
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TABLE 12.9 BUTLER INVENTORY SIMULATION RESULTS FOR 300 TRIALS Replenishment Level 100 110 120 130 140 Simulation allows the user to consider different operating policies and changes to model parameters and then to observe the impact of the changes on output measures such as profit or service level.
Problem 18 gives you a chance to develop a different simulation model.
Average Net Profit ($) 4293 4524 4575 4519 4399
Service Level (%) 92.5 96.5 98.6 99.6 99.9
The summary statistics in Figure 12.10 show what can be anticipated over 300 months if Butler operates its inventory system using a replenishment level of 100. The average net profit is $4293 per month. Because 27,917 units of the total demand of 30,181 units were satisfied, the service level is 27,917/30,181 92.5%. We are now ready to use the simulation model to consider other replenishment levels that may improve the net profit and the service level. At this point, we conducted a series of simulation experiments by repeating the Butler inventory simulation with replenishment levels of 110, 120, 130, and 140 units. The average monthly net profits and the service levels are shown in Table 12.9. The highest monthly net profit of $4575 occurs with a replenishment level of Q 120. The associated service level is 98.6%. On the basis of these results, Butler selected a replenishment level of Q 120. Experimental simulation studies, such as this one for Butler’s inventory policy, can help identify good operating policies and decisions. Butler’s management used simulation to choose a replenishment level of 120 for its home ventilation fan. With the simulation model in place, management can also explore the sensitivity of this decision to some of the model parameters. For instance, we assigned a shortage cost of $30 for any customer demand not met. With this shortage cost, the replenishment level was Q 120 and the service level was 98.6%. If management felt a more appropriate shortage cost was $10 per unit, running the simulation again using $10 as the shortage cost would be a simple matter. We mentioned earlier that simulation is not an optimization technique. Even though we used simulation to choose a replenishment level, it does not guarantee that this choice is optimal. All possible replenishment levels were not tested. Perhaps a manager would like to consider additional simulation runs with replenishment levels of Q 115 and Q 125 to search for an even better inventory policy. Also, we have no guarantee that with another set of 300 randomly generated demand values the replenishment level with the highest profit would not change. However, with a large number of simulation trials, we should find a good and, at least, near optimal solution. The Management Science in Action, Petroleum Distribution in the Gulf of Mexico, describes a simulation application for 15 petroleum companies in the state of Florida.
MANAGEMENT SCIENCE IN ACTION PETROLEUM DISTRIBUTION IN THE GULF OF MEXICO* Domestic suppliers who operate oil refineries along the Gulf Coast are helping to satisfy Florida’s increasing demand for refined petroleum products. Barge fleets, operated either by independent shipping companies or by the petroleum companies themselves, are used to transport more than
20 different petroleum products to 15 Florida petroleum companies. The petroleum products are loaded at refineries in Texas, Louisiana, and Mississippi and are discharged at tank terminals concentrated in Tampa, Port Everglades, and Jacksonville.
12.3
Barges operate under three types of contracts between the fleet operator and the client petroleum company: • •
•
The client assumes total control of a barge and uses it for trips between its own refinery and one or more discharging ports. The client is guaranteed a certain volume will be moved during the contract period. Schedules vary considerably depending upon the customer’s needs and the fleet operator’s capabilities. The client hires a barge for a single trip.
A simulation model was developed to analyze the complex process of operating barge fleets in the Gulf of Mexico. An appropriate probability distribution was used to simulate requests for shipments by the petroleum companies. Additional probability distributions were used to simulate the travel times depending upon the size and type of barge. Using this information, the simulation model was
12.3
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Waiting Line Simulation
used to track barge loading times, barge discharge times, barge utilization, and total cost. Analysts used simulation runs with a variety of what-if scenarios to answer questions about the petroleum distribution system and to make recommendations for improving the efficiency of the operation. Simulation helped determine the following: • • • •
The optimal trade-off between fleet utilization and on-time delivery The recommended fleet size The recommended barge capacities The best service contract structure to balance the trade-off between customer service and delivery cost
Implementation of the simulation-based recommendations demonstrated a significant improvement in the operation and a significant lowering of petroleum distribution costs. *Based on E. D. Chajakis, “Sophisticated Crude Transportation,” OR/MS Today (December 1997): 30–34.
WAITING LINE SIMULATION The simulation models discussed thus far have been based on independent trials in which the results for one trial do not affect what happens in subsequent trials. In this sense, the system being modeled does not change or evolve over time. Simulation models such as these are referred to as static simulation models. In this section we develop a simulation model of a waiting line system where the state of the system, including the number of customers in the waiting line and whether the service facility is busy or idle, changes or evolves over time. To incorporate time into the simulation model, we use a simulation clock to record the time that each customer arrives for service as well as the time that each customer completes service. Simulation models that must take into account how the system changes or evolves over time are referred to as dynamic simulation models. In situations where the arrivals and departures of customers are events that occur at discrete points in time, the simulation model is also referred to as a discrete-event simulation model. In Chapter 11 we presented formulas that could be used to compute the steady-state operating characteristics of a waiting line, including the average waiting time, the average number of units in the waiting line, the probability of waiting, and so on. In most cases, the waiting line formulas were based on specific assumptions about the probability distribution for arrivals, the probability distribution for service times, the queue discipline, and so on. Simulation, as an alternative for studying waiting lines, is more flexible. In applications where the assumptions required by the waiting line formulas are not reasonable, simulation may be the only feasible approach to studying the waiting line system. In this section we discuss the simulation of the waiting line for the Hammondsport Savings Bank automated teller machine (ATM).
Hammondsport Savings Bank ATM Waiting Line Hammondsport Savings Bank will open several new branch banks during the coming year. Each new branch is designed to have one automated teller machine (ATM). A concern is that during busy periods several customers may have to wait to use the ATM. This concern
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Simulation
prompted the bank to undertake a study of the ATM waiting line system. The bank’s vice president wants to determine whether one ATM will be sufficient. The bank established service guidelines for its ATM system stating that the average customer waiting time for an ATM should be one minute or less. Let us show how a simulation model can be used to study the ATM waiting line at a particular branch.
Customer Arrival Times One probabilistic input to the ATM simulation model is the arrival times of customers who use the ATM. In waiting line simulations, arrival times are determined by randomly generating the time between two successive arrivals, referred to as the interarrival time. For the branch bank being studied, the customer interarrival times are assumed to be uniformly distributed between 0 and 5 minutes, as shown in Figure 12.11. With r denoting a random number between 0 and 1, an interarrival time for two successive customers can be simulated by using the formula for generating values from a uniform probability distribution. Interarrival time a r(b a)
(12.7)
where r = random number between 0 and 1 a = minimum interarrival time b = maximum interarrival time A uniform probability distribution of interarrival times is used here to illustrate the simulation computations. Actually, any interarrival time probability distribution can be assumed, and the logic of the waiting line simulation model will not change.
For the Hammondsport ATM system, the minimum interarrival time is a 0 minutes, and the maximum interarrival time is b 5 minutes; therefore, the formula for generating an interarrival time is Interarrival time 0 r(5 0) 5r
(12.8)
Assume that the simulation run begins at time 0. A random number of r 0.2804 generates an interarrival time of 5(0.2804) 1.4 minutes for customer 1. Thus, customer 1 arrives 1.4 minutes after the simulation run begins. A second random number of r 0.2598
FIGURE 12.11
UNIFORM PROBABILITY DISTRIBUTION OF INTERARRIVAL TIMES FOR THE ATM WAITING LINE SYSTEM
2.5 Interarrival Time in Minutes
5
12.3
FIGURE 12.12
565
Waiting Line Simulation
NORMAL PROBABILITY DISTRIBUTION OF SERVICE TIMES FOR THE ATM WAITING LINE SYSTEM
Standard Deviation 0.5 Minutes
2 Service Time in Minutes
generates an interarrival time of 5(0.2598) 1.3 minutes, indicating that customer 2 arrives 1.3 minutes after customer 1. Thus, customer 2 arrives 1.4 1.3 2.7 minutes after the simulation begins. Continuing, a third random number of r 0.9802 indicates that customer 3 arrives 4.9 minutes after customer 2, which is 7.6 minutes after the simulation begins.
Customer Service Times Another probabilistic input in the ATM simulation model is the service time, which is the time a customer spends using the ATM machine. Past data from similar ATMs indicate that a normal probability distribution with a mean of 2 minutes and a standard deviation of 0.5 minutes, as shown in Figure 12.12, can be used to describe service times. As discussed in Sections 12.1 and 12.2, values from a normal probability distribution with mean 2 and standard deviation 0.5 can be generated using the Excel function NORMINV(RAND(),2,0.5). For example, the random number of 0.7257 generates a customer service time of 2.3 minutes.
Simulation Model The probabilistic inputs to the Hammondsport Savings Bank ATM simulation model are the interarrival time and the service time. The controllable input is the number of ATMs used. The output will consist of various operating characteristics such as the probability of waiting, the average waiting time, the maximum waiting time, and so on. We show a diagram of the ATM simulation model in Figure 12.13. FIGURE 12.13
HAMMONDSPORT SAVINGS BANK ATM SIMULATION MODEL Interarrival Time
Number of ATMs
Model
Service Time
Operating Characteristics
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Figure 12.14 shows a flowchart that defines the sequence of logical and mathematical operations required to simulate the Hammondsport ATM system. The flowchart uses the following notation: IAT Arrival time (i ) Start time (i ) Wait time (i ) ST Completion time (i ) System time (i ) FIGURE 12.14
= = = = = = =
interarrival time generated time at which customer i arrives time at which customer I service waiting time for customer i service time generated time at which customer i completes service system time for customer i (completion time - arrival time)
FLOWCHART OF THE HAMMONDSPORT SAVINGS BANK ATM WAITING LINE SIMULATION Initialize Simulation Model i = 0; Arrival Time(0) = 0; Completion Time(0) = 0
New Customer i=i+1
Generate Interarrival Time (IAT )
Next Customer
Arrival Time(i) = Arrival Time(i – 1) + IAT
Is Arrival Time(i) Greater Than Completion Time(i – 1)?
Yes
ATM Idle Customer i can begin service immediately. Start Time(i) = Arrival Time(i )
No
ATM Busy Customer i must wait for preceding customer to complete service. Start Time(i) = Completion Time(i – 1)
Waiting Time(i) = Start Time(i) – Arrival Time(i)
Generate Service Time (ST ) Completion Time(i) = Start Time(i) + ST
System Time(i) = Completion Time(i) – Arrival Time(i)
12.3
The decision rule for deciding whether the ATM is idle or busy is the most difficult aspect of the logic in a waiting line simulation model.
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Waiting Line Simulation
Referring to Figure 12.14, we see that the simulation is initialized in the first block of the flowchart. Then a new customer is created. An interarrival time is generated to determine the time since the preceding customer arrived.2 The arrival time for the new customer is then computed by adding the interarrival time to the arrival time of the preceding customer. The arrival time for the new customer must be compared to the completion time of the preceding customer to determine whether the ATM is idle or busy. If the arrival time of the new customer is greater than the completion time of the preceding customer, the preceding customer will have finished service prior to the arrival of the new customer. In this case, the ATM will be idle, and the new customer can begin service immediately. The service start time for the new customer is equal to the arrival time of the new customer. However, if the arrival time for the new customer is not greater than the completion time of the preceding customer, the new customer arrived before the preceding customer finished service. In this case, the ATM is busy; the new customer must wait to use the ATM until the preceding customer completes service. The service start time for the new customer is equal to the completion time of the preceding customer. Note that the time the new customer has to wait to use the ATM is the difference between the customer’s service start time and the customer’s arrival time. At this point, the customer is ready to use the ATM, and the simulation run continues with the generation of the customer’s service time. The time at which the customer begins service plus the service time generated determine the customer’s completion time. Finally, the total time the customer spends in the system is the difference between the customer’s service completion time and the customer’s arrival time. At this point, the computations are complete for the current customer, and the simulation continues with the next customer. The simulation is continued until a specified number of customers have been served by the ATM. Simulation results for the first 10 customers are shown in Table 12.10. We discuss the computations for the first three customers to illustrate the logic of the simulation model and to show how the information in Table 12.10 was developed.
TABLE 12.10 SIMULATION RESULTS FOR 10 ATM CUSTOMERS
Customer 1 2 3 4 5 6 7 8 9 10
Interarrival Time 1.4 1.3 4.9 3.5 0.7 2.8 2.1 0.6 2.5 1.9
Totals Averages
21.7 2.17
2
Arrival Time 1.4 2.7 7.6 11.1 11.8 14.6 16.7 17.3 19.8 21.7
Service Start Time 1.4 3.7 7.6 11.1 13.6 15.4 17.8 19.9 21.7 23.7
Waiting Time 0.0 1.0 0.0 0.0 1.8 0.8 1.1 2.6 1.9 2.0
Service Time 2.3 1.5 2.2 2.5 1.8 2.4 2.1 1.8 2.0 2.3
11.2 1.12
20.9 2.09
Completion Time 3.7 5.2 9.8 13.6 15.4 17.8 19.9 21.7 23.7 26.0
Time in System 2.3 2.5 2.2 2.5 3.6 3.2 3.2 4.4 3.9 4.3 32.1 3.21
For the first customer, the interarrival time determines the time since the simulation started. Thus, the first interarrival time determines the time the first customer arrives.
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Customer 1 • • • • • • •
An interarrival time of IAT 1.4 minutes is generated. Because the simulation run begins at time 0, the arrival time for customer 1 is 0 1.4 1.4 minutes. Customer 1 may begin service immediately with a start time of 1.4 minutes. The waiting time for customer 1 is the start time minus the arrival time: 1.4 1.4 0 minutes. A service time of ST 2.3 minutes is generated for customer 1. The completion time for customer 1 is the start time plus the service time: 1.4 2.3 3.7 minutes. The time in the system for customer 1 is the completion time minus the arrival time: 3.7 1.4 2.3 minutes.
Customer 2 • • •
•
• • • •
An interarrival time of IAT 1.3 minutes is generated. Because the arrival time of customer 1 is 1.4, the arrival time for customer 2 is 1.4 1.3 2.7 minutes. Because the completion time of customer 1 is 3.7 minutes, the arrival time of customer 2 is not greater than the completion time of customer 1; thus, the ATM is busy when customer 2 arrives. Customer 2 must wait for customer 1 to complete service before beginning service. Customer 1 completes service at 3.7 minutes, which becomes the start time for customer 2. The waiting time for customer 2 is the start time minus the arrival time: 3.7 2.7 1 minute. A service time of ST 1.5 minutes is generated for customer 2. The completion time for customer 2 is the start time plus the service time: 3.7 1.5 5.2 minutes. The time in the system for customer 2 is the completion time minus the arrival time: 5.2 2.7 2.5 minutes.
Customer 3 • • •
• • • • •
An interarrival time of IAT 4.9 minutes is generated. Because the arrival time of customer 2 was 2.7 minutes, the arrival time for customer 3 is 2.7 4.9 7.6 minutes. The completion time of customer 2 is 5.2 minutes, so the arrival time for customer 3 is greater than the completion time of customer 2. Thus, the ATM is idle when customer 3 arrives. Customer 3 begins service immediately with a start time of 7.6 minutes. The waiting time for customer 3 is the start time minus the arrival time: 7.6 7.6 0 minutes. A service time of ST 2.2 minutes is generated for customer 3. The completion time for customer 3 is the start time plus the service time: 7.6 2.2 9.8 minutes. The time in the system for customer 3 is the completion time minus the arrival time: 9.8 7.6 2.2 minutes.
Using the totals in Table 12.10, we can compute an average waiting time for the 10 customers of 11.2/10 1.12 minutes, and an average time in the system of 32.1/10 3.21 minutes. Table 12.10 shows that seven of the 10 customers had to wait. The total time for the
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10-customer simulation is given by the completion time of the 10th customer: 26.0 minutes. However, at this point, we realize that a simulation for 10 customers is much too short a period to draw any firm conclusions about the operation of the waiting line.
Hammondsport Savings Bank ATM Simulation Using an Excel worksheet, we simulated the operation of the Hammondsport ATM waiting line system for 1000 customers. The worksheet used to carry out the simulation is shown in Figure 12.15. Note that the simulation results for customers 6 through 995 have been hidden so that the results can be shown in a reasonably sized figure. If desired, the rows for these customers can be shown and the simulation results displayed for all 1000 customers. FIGURE 12.15
EXCEL WORKSHEET FOR THE HAMMONDSPORT SAVINGS BANK WITH ONE ATM
A
WEB
file
Hammondsport1
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 1011 1012 1013 1014 1015 1016 1017 1018 1019 1020 1021 1022 1023 1024
B
C
D
E
F
G
H
Hammondsport Savings Bank with One ATM Interarrival Times (Uniform Distribution) Smallest Value 0 Largest Value 5 Service Times (Normal Distribution) Mean 2 Std Deviation 0.5
Simulation
Customer 1 2 3 4 5 996 997 998 999 1000
Interarrival Time 1.4 1.3 4.9 3.5 0.7 0.5 0.2 2.7 3.7 4.0
Arrival Service Waiting Service Completion Time Time Start Time Time Time Time in System 1.4 1.4 0.0 2.3 3.7 2.3 2.7 3.7 1.0 1.5 5.2 2.5 7.6 7.6 0.0 2.2 9.8 2.2 11.1 11.1 0.0 2.5 13.6 2.5 11.8 13.6 1.8 1.8 15.4 3.6 2496.8 2498.1 1.3 0.6 2498.7 1.9 2497.0 2498.7 1.7 2.0 2500.7 3.7 2499.7 2500.7 1.0 1.8 2502.5 2.8 2503.4 2503.4 0.0 2.4 2505.8 2.4 2507.4 2507.4 0.0 1.9 2509.3 1.9
Summary Statistics Number Waiting Probability of Waiting Average Waiting Time Maximum Waiting Time Utilization of ATM Number Waiting > 1 Min Probability of Waiting > 1 Min
549 0.6100 1.59 13.5 0.7860 393 0.4367
I
Chapter 12
FIGURE 12.16
Simulation
HISTOGRAM SHOWING THE WAITING TIME FOR 900 ATM CUSTOMERS 507 customers (56.33%) had a waiting time of 1 minute or less.
500 400 Frequency
570
393 customers (43.67%) had a waiting time greater than 1 minute.
300 200
45 customers (5%) had a waiting time greater than 6 minutes.
100
1
2
3 4 5 6 7 Waiting Time in Minutes
Ultimately, summary statistics will be collected in order to describe the results of 1000 customers. Before collecting the summary statistics, let us point out that most simulation studies of dynamic systems focus on the operation of the system during its long-run or steady-state operation. To ensure that the effects of start-up conditions are not included in the steady-state calculations, a dynamic simulation model is usually run for a specified period without collecting any data about the operation of the system. The length of the start-up period can vary depending on the application. For the Hammondsport Savings Bank ATM simulation, we treated the results for the first 100 customers as the start-up period. Thus, the summary statistics shown in Figure 12.15 are for the 900 customers arriving during the steady-state period. The summary statistics show that 549 of the 900 Hammondsport customers had to wait. This result provides a 549/900 0.61 probability that a customer will have to wait for service. In other words, approximately 61% of the customers will have to wait because the ATM is in use. The average waiting time is 1.59 minutes per customer with at least one customer waiting the maximum time of 13.5 minutes. The utilization rate of 0.7860 indicates that the ATM is in use 78.6% of the time. Finally, 393 of the 900 customers had to wait more than 1 minute (43.67% of all customers). A histogram of waiting times for the 900 customers is shown in Figure 12.16. This figure shows that 45 customers (5%) had a waiting time greater than 6 minutes. The simulation supports the conclusion that the branch will have a busy ATM system. With an average customer wait time of 1.59 minutes, the branch does not satisfy the bank’s customer service guideline. This branch is a good candidate for installation of a second ATM.
Simulation with Two ATMs We extended the simulation model to the case of two ATMs. For the second ATM we also assume that the service time is normally distributed with a mean of 2 minutes and a standard deviation of 0.5 minutes. Table 12.11 shows the simulation results for the first 10 customers. In comparing the two-ATM system results in Table 12.11 with the single ATM simulation results shown in Table 12.10, we see that two additional columns are needed. These two columns show when each ATM becomes available for customer service. We assume that, when a new customer arrives, the customer will be served by the ATM that frees up first. When the simulation begins, the first customer is assigned to ATM 1.
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TABLE 12.11 SIMULATION RESULTS FOR 10 CUSTOMERS FOR A TWO-ATM SYSTEM
Customer
Interarrival Arrival Time Time
1 2 3 4 5 6 7 8 9 10
1.7 0.7 2.0 0.1 4.6 1.3 0.6 0.3 3.4 0.1
Totals Averages
1.7 2.4 4.4 4.5 9.1 10.4 11.0 11.3 14.7 14.8
Service Waiting Service Completion Time in Time Available Start Time Time Time Time System ATM 1 ATM 2 1.7 2.4 4.4 4.5 9.1 10.4 11.3 12.0 14.7 14.8
0.0 0.0 0.0 0.0 0.0 0.0 0.3 0.7 0.0 0.0
2.1 2.0 1.4 0.9 2.2 1.6 1.7 2.2 2.9 2.8
3.8 4.4 5.8 5.4 11.3 12.0 13.0 14.2 17.6 17.6
2.1 2.0 1.4 0.9 2.2 1.6 2.0 2.9 2.9 2.8
14.8
1.0
19.8
20.8
1.48
0.1
1.98
2.08
3.8 3.8 5.8 5.8 5.8 12.0 12.0 14.2 14.2 17.6
0.0 4.4 4.4 5.4 11.3 11.3 13.0 13.0 17.6 17.6
Table 12.11 shows that customer 7 is the first customer who has to wait to use an ATM. We describe how customers 6, 7, and 8 are processed to show how the logic of the simulation run for two ATMs differs from that with a single ATM. Customer 6 • •
• •
An interarrival time of 1.3 minutes is generated, and customer 6 arrives 9.1 1.3 10.4 minutes into the simulation. From the customer 5 row, we see that ATM 1 frees up at 5.8 minutes, and ATM 2 will free up at 11.3 minutes into the simulation. Because ATM 1 is free, customer 6 does not wait and begins service on ATM 1 at the arrival time of 10.4 minutes. A service time of 1.6 minutes is generated for customer 6. So customer 6 has a completion time of 10.4 1.6 12.0 minutes. The time ATM 1 will next become available is set at 12.0 minutes; the time available for ATM 2 remains 11.3 minutes.
Customer 7 • •
• •
An interarrival time of 0.6 minute is generated, and customer 7 arrives 10.4 0.6 11.0 minutes into the simulation. From the previous row, we see that ATM 1 will not be available until 12.0 minutes, and ATM 2 will not be available until 11.3 minutes. So customer 7 must wait to use an ATM. Because ATM 2 will free up first, customer 7 begins service on that machine at a start time of 11.3 minutes. With an arrival time of 11.0 and a service start time of 11.3, customer 7 experiences a waiting time of 11.3 11.0 0.3 minute. A service time of 1.7 minutes is generated, leading to a completion time of 11.3 1.7 13.0 minutes. The time available for ATM 2 is updated to 13.0 minutes, and the time available for ATM 1 remains at 12.0 minutes.
Customer 8 • •
An interarrival time of 0.3 minute is generated, and customer 8 arrives 11.0 0.3 11.3 minutes into the simulation. From the previous row, we see that ATM 1 will be the first available. Thus, customer 8 starts service on ATM 1 at 12.0 minutes resulting in a waiting time of 12.0 11.3 0.7 minute.
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A service time of 2.2 minutes is generated, resulting in a completion time of 12.0 2.2 14.2 minutes and a system time of 0.7 2.2 2.9 minutes. The time available for ATM 1 is updated to 14.2 minutes, and the time available for ATM 2 remains at 13.0 minutes.
From the totals in Table 12.11, we see that the average waiting time for these 10 customers is only 1.0/10 0.1 minute. Of course, a much longer simulation will be necessary before any conclusions can be drawn. Worksheets for the Hammondsport one-ATM and two-ATM systems are available on the website that accompanies this text.
Simulation Results with Two ATMs The Excel worksheet that we used to conduct a simulation for 1000 customers using two ATMs is shown in Figure 12.17. Results for the first 100 customers were discarded to account for the start-up period. With two ATMs, the number of customers who had to wait was reduced from 549 to 78. This reduction provides a 78/900 0.0867 probability that a customer will have to wait for service when two ATMs are used. The two-ATM system also reduced the
FIGURE 12.17
A
WEB
file
Hammondsport2
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 1011 1012 1013 1014 1015 1016 1017 1018 1019 1020 1021 1022 1023 1024
EXCEL WORKSHEET FOR THE HAMMONDSPORT SAVINGS BANK WITH TWO ATMs B
C
D
E
F
G
H
I
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Hammondsport Savings Bank with Two ATMs Interarrival Times (Uniform Distribution) Smallest Value 0 Largest Value 5 Service Times (Normal Distribution) Mean 2 Std Deviation 0.5
Simulation
Customer 1 2 3 4 5 996 997 998 999 1000
Interarrival Time 1.7 0.7 2.0 0.1 4.6 3.3 4.5 3.8 0.0 2.6
Arrival Service Waiting Service Completion Time Time Start Time Time Time Time in System 1.7 1.7 0.0 2.1 3.8 2.1 2.4 2.4 0.0 2.0 4.4 2.0 4.4 4.4 0.0 1.4 5.8 1.4 4.5 4.5 0.0 0.9 5.4 0.9 9.1 9.1 0.0 2.2 11.3 2.2 2483.2 2483.2 0.0 2.2 2485.4 2.2 2487.7 2487.7 0.0 1.9 2489.6 1.9 2491.5 2491.5 0.0 3.2 2494.7 3.2 2491.5 2491.5 0.0 2.4 2493.9 2.4 2494.1 2494.1 0.0 2.8 2496.9 2.8
Summary Statistics Number Waiting Probability of Waiting Average Waiting Time Maximum Waiting Time Utilization of ATMs Number Waiting > 1 Min Probability of Waiting > 1 Min
78 0.0867 0.07 2.9 0.4084 23 0.0256
Time Available ATM 1 ATM 2 3.8 0.0 3.8 4.4 5.8 4.4 5.8 5.4 5.8 11.3 2485.4 2482.1 2485.4 2489.6 2494.7 2489.6 2494.7 2493.9 2494.7 2496.9
K
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average waiting time to 0.07 minute (4.2 seconds) per customer. The maximum waiting time was reduced from 13.5 to 2.9 minutes, and each ATM was in use 40.84% of the time. Finally, only 23 of the 900 customers had to wait more than 1 minute for an ATM to become available. Thus, only 2.56% of customers had to wait more than 1 minute. The simulation results provide evidence that Hammondsport Savings Bank needs to expand to the two-ATM system. The simulation models that we developed can now be used to study the ATM operation at other branch banks. In each case, assumptions must be made about the appropriate interarrival time and service time probability distributions. However, once appropriate assumptions have been made, the same simulation models can be used to determine the operating characteristics of the ATM waiting line system. The Management Science in Action, Preboard Screening at Vancouver International Airport, describes another use of simulation for a queueing system.
MANAGEMENT SCIENCE IN ACTION PREBOARD SCREENING AT VANCOUVER INTERNATIONAL AIRPORT* Following the September 11, 2001, terrorist attacks in the United States, long lines at airport security checkpoints became commonplace. In order to reduce passenger waiting time, the Vancouver International Airport Authority teamed up with students and faculty at the University of British Columbia’s Centre for Operations Excellence (COE) to build a simulation model of the airport’s preboard screening security checkpoints. The goal was to use the simulation model to help achieve acceptable service standards. Prior to building the simulation model, students from the COE observed the flow of passengers through the screening process and collected data on the service time at each process step. In addition to service time data, passenger demand data provided input to the simulation model. Two triangular probability distributions were used to simulate passenger arrivals at the preboarding facilities. For flights to Canadian destinations a 90-40-20 triangle was used.
This distribution assumes that, for each flight, the first passenger will arrive at the screening checkpoint 90 minutes before departure, the last passenger will arrive 20 minutes before departure, and the most likely arrival time is 40 minutes before departure. For international flights a 150-80-20 triangle was used. Output statistics from the simulation model provided information concerning resource utilization, waiting line lengths, and the time passengers spend in the system. The simulation model provided information concerning the number of personnel needed to process 90% of the passengers with a waiting time of 10 minutes or less. Ultimately, the airport authority was able to design and staff the preboarding checkpoints in such a fashion that waiting times for 90% of the passengers were a maximum of 10 minutes. *Based on Derek Atkins et al., “Right on Queue,” OR/MS Today (April 2003): 26–29.
NOTES AND COMMENTS 1. The ATM waiting line model was based on uniformly distributed interarrival times and normally distributed service times. One advantage of simulation is its flexibility in accommodating a variety of different probability distributions. For instance, if we believe an exponential distribution is more appropriate for interarrival times, the ATM simulation could be repeated by simply changing the way the interarrival times are generated.
2. At the beginning of this section, we defined discrete-event simulation as involving a dynamic system that evolves over time. The simulation computations focus on the sequence of events as they occur at discrete points in time. In the ATM waiting line example, customer arrivals and the customer service completions were the discrete events. Referring to the arrival times and completion times in Table 12.10, we see (continued)
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that the first five discrete events for the ATM waiting line simulation were as follows: Event Customer 1 arrives Customer 2 arrives Customer 1 finished Customer 2 finished Customer 3 arrives
Time 1.4 2.7 3.7 5.2 7.6
3. We did not keep track of the number of customers in the ATM waiting line as we carried out the ATM simulation computations on a customer-by-customer basis. However, we can determine the average number of customers in the waiting line from other information in the simulation output. The following relationship is valid for any waiting line system:
12.4
Total waiting time Average number = in waiting line Total time of simulation For the system with one ATM, the 100th customer completed service at 247.8 minutes into the simulation. Thus, the total time of the simulation for the next 900 customers was 2509.3 247.8 2261.5 minutes. The average waiting time was 1.59 minutes. During the simulation, the 900 customers had a total waiting time of 900(1.59) 1431 minutes. Therefore, the average number of customers in the waiting line is Average number in waiting line = 1431>2261.5 = 0.63 customer
OTHER SIMULATION ISSUES Because simulation is one of the most widely used quantitative analysis techniques, various software tools have been developed to help analysts implement a simulation model on a computer. In this section we comment on the software available and discuss some issues involved in verifying and validating a simulation model. We close the section with a discussion of some of the advantages and disadvantages of using simulation to study a real system.
Computer Implementation
The computational and record-keeping aspects of simulation models are assisted by special simulation software packages. The packages ease the tasks of developing a computer simulation model.
The use of spreadsheets for simulation has grown rapidly in recent years, and third-party software vendors have developed spreadsheet add-ins that make building simulation models on a spreadsheet much easier. These add-in packages provide an easy facility for generating random values from a variety of probability distributions and provide a rich array of statistics describing the simulation output. Two popular spreadsheet add-ins are Crystal Ball from Oracle Corporation and @RISK from Palisade Corporation. Although spreadsheets can be a valuable tool for some simulation studies, they are generally limited to smaller, less complex systems. With the growth of simulation applications, both users of simulation and software developers began to realize that computer simulations have many common features: model development, generating values from probability distributions, maintaining a record of what happens during the simulation, and recording and summarizing the simulation output. A variety of special-purpose simulation packages are available, including GPSS®, SIMSCRIPT®, SLAM®, and Arena®. These packages have built-in simulation clocks, simplified methods for generating probabilistic inputs, and procedures for collecting and summarizing the simulation output. Special-purpose simulation packages enable quantitative analysts to simplify the process of developing and implementing the simulation model. Indeed, Arena 6.0 was used to develop the simulation model described in the Management Science in Action, Preboard Screening at Vancouver International Airport. Simulation models can also be developed using general-purpose computer programming languages such as BASIC, FORTRAN, PASCAL, C, and C. The disadvantage of using these languages is that special simulation procedures are not built in. One command in a special-purpose simulation package often performs the computations and record-keeping
12.4
Other Simulation Issues
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tasks that would require several BASIC, FORTRAN, PASCAL, C, or C statements to duplicate. The advantage of using a general-purpose programming language is that they offer greater flexibility in terms of being able to model more complex systems. To decide which software to use, an analyst will have to consider the relative merits of a spreadsheet, a special-purpose simulation package, and a general-purpose computer programming language. The goal is to select the method that is easy to use while still providing an adequate representation of the system being studied.
Verification and Validation
Using simulation, we can ask what-if questions and project how the real system will behave. Although simulation does not guarantee optimality, it will usually provide nearoptimal solutions. In addition, simulation models often warn against poor decision strategies by projecting disastrous outcomes such as system failures, large financial losses, and so on.
An important aspect of any simulation study involves confirming that the simulation model accurately describes the real system. Inaccurate simulation models cannot be expected to provide worthwhile information. Thus, before using simulation results to draw conclusions about a real system, one must take steps to verify and validate the simulation model. Verification is the process of determining that the computer procedure that performs the simulation calculations is logically correct. Verification is largely a debugging task to make sure that no errors are in the computer procedure that implements the simulation. In some cases, an analyst may compare computer results for a limited number of events with independent hand calculations. In other cases, tests may be performed to verify that the probabilistic inputs are being generated correctly and that the output from the simulation model seems reasonable. The verification step is not complete until the user develops a high degree of confidence that the computer procedure is error free. Validation is the process of ensuring that the simulation model provides an accurate representation of a real system. Validation requires an agreement among analysts and managers that the logic and the assumptions used in the design of the simulation model accurately reflect how the real system operates. The first phase of the validation process is done prior to, or in conjunction with, the development of the computer procedure for the simulation process. Validation continues after the computer program has been developed, with the analyst reviewing the simulation output to see whether the simulation results closely approximate the performance of the real system. If possible, the output of the simulation model is compared to the output of an existing real system to make sure that the simulation output closely approximates the performance of the real system. If this form of validation is not possible, an analyst can experiment with the simulation model and have one or more individuals experienced with the operation of the real system review the simulation output to determine whether it is a reasonable approximation of what would be obtained with the real system under similar conditions. Verification and validation are not tasks to be taken lightly. They are key steps in any simulation study and are necessary to ensure that decisions and conclusions based on the simulation results are appropriate for the real system.
Advantages and Disadvantages of Using Simulation The primary advantages of simulation are that it is easy to understand and that the methodology can be used to model and learn about the behavior of complex systems that would be difficult, if not impossible, to deal with analytically. Simulation models are flexible; they can be used to describe systems without requiring the assumptions that are often required by mathematical models. In general, the larger the number of probabilistic inputs a system has, the more likely that a simulation model will provide the best approach for studying the system. Another advantage of simulation is that a simulation model provides a convenient experimental laboratory for the real system. Changing assumptions or operating policies in the simulation model and rerunning it can provide results that help predict how such changes will affect the operation of the real system. Experimenting directly with a real system is often not feasible.
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Simulation is not without some disadvantages. For complex systems, the process of developing, verifying, and validating a simulation model can be time-consuming and expensive. In addition, each simulation run provides only a sample of how the real system will operate. As such, the summary of the simulation data provides only estimates or approximations about the real system. Consequently, simulation does not guarantee an optimal solution. Nonetheless, the danger of obtaining poor solutions is slight if the analyst exercises good judgment in developing the simulation model and if the simulation process is run long enough under a wide variety of conditions so that the analyst has sufficient data to predict how the real system will operate.
SUMMARY Simulation is a method for learning about a real system by experimenting with a model that represents the system. Some of the reasons simulation is frequently used are listed here: 1. It can be used for a wide variety of practical problems. 2. The simulation approach is relatively easy to explain and understand. As a result, management confidence is increased, and acceptance of the results is more easily obtained. 3. Spreadsheet packages now provide another alternative for model implementation, and third-party vendors have developed add-ins that expand the capabilities of the spreadsheet packages. 4. Computer software developers have produced simulation packages that make it easier to develop and implement simulation models for more complex problems. We first showed how simulation can be used for risk analysis by analyzing a situation involving the development of a new product: the PortaCom printer. We then showed how simulation can be used to select an inventory replenishment level that would provide both a good profit and a good customer service level. Finally, we developed a simulation model for the Hammondsport Savings Bank ATM waiting line system. This model is an example of a dynamic simulation model in which the state of the system changes or evolves over time. Our approach was to develop a simulation model that contained both controllable inputs and probabilistic inputs. Procedures were developed for randomly generating values for the probabilistic inputs, and a flowchart was developed to show the sequence of logical and mathematical operations that describe the steps of the simulation process. Simulation results obtained by running the simulation for a suitable number of trials or length of time provided the basis for conclusions drawn about the operation of the real system. The Management Science in Action, Netherlands Company Improves Warehouse Order-Picking Efficiency, describes how a simulation model determined the warehouse storage location for 18,000 products and the sequence in which products were retrieved by order-picking personnel. MANAGEMENT SCIENCE IN ACTION NETHERLANDS COMPANY IMPROVES WAREHOUSE ORDER-PICKING EFFICIENCY* As a wholesaler of tools, hardware, and garden equipment, Ankor, based in The Netherlands, warehouses more than 18,000 different products for customers who are primarily retail store chains, do-it-yourself businesses, and garden centers. Warehouse managers store the fastest-moving
products on the ends of the aisles on the ground floor, the medium-moving products in the middle section of the aisles on the ground floor, and the slow-moving products on the mezzanine. When a new order is received, a warehouse order-picker travels to each product location and
Glossary
selects the requested number of units. An average order includes 25 different products, which requires the order-picker to travel to 25 different locations in the warehouse. In order to minimize damage to the products, heavier products are picked first and breakable products are picked last. Order-picking is typically one of the most time-consuming and expensive aspects of operating the warehouse. The company is under continuous pressure to improve the efficiency of this operation. To increase efficiency, researchers developed a simulation model of the warehouse order-picking system. Using a sequence of 1098 orders received for 27,790 products over a seven-week period, the researchers used the model to simulate the required order-picking times. The researchers, with the help of the model, varied the assignment of products to storage locations and the sequence in which products were retrieved from the storage locations. The
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model simulated order-picking times for a variety of product storage location alternatives and four different routing policies that determined the sequence in which products were picked. Analysis of the simulation results provided a new storage assignment policy for the warehouse as well as new routing rules for the sequence in which to retrieve products from storage. Implementation of the new storage and routing procedures reduced the average route length of the order-picking operation by 31%. Due to the increased efficiency of the operation, the number of order pickers was reduced by more than 25%, saving the company an estimated €140,00 per year. *Based on R. Dekker, M. B. M. de Koster, K. J. Roodbergen, and H. van Kalleveen, “Improving OrderPicking Response Time at Ankor’s Warehouse,” Interfaces (July/August 2004): 303–313.
GLOSSARY Simulation A method for learning about a real system by experimenting with a model that represents the system. Simulation experiment The generation of a sample of values for the probabilistic inputs of a simulation model and computing the resulting values of the model outputs. Controllable input Input to a simulation model that is selected by the decision maker. Probabilistic input Input to a simulation model that is subject to uncertainty. A probabilistic input is described by a probability distribution. Risk analysis The process of predicting the outcome of a decision in the face of uncertainty. Parameters Numerical values that appear in the mathematical relationships of a model. Parameters are considered known and remain constant over all trials of a simulation. What-if analysis A trial-and-error approach to learning about the range of possible outputs for a model. Trial values are chosen for the model inputs (these are the what-ifs) and the value of the output(s) is computed. Base-case scenario Determining the output given the most likely values for the probabilistic inputs of a model. Worst-case scenario Determining the output given the worst values that can be expected for the probabilistic inputs of a model. Best-case scenario Determining the output given the best values that can be expected for the probabilistic inputs of a model. Static simulation model A simulation model used in situations where the state of the system at one point in time does not affect the state of the system at future points in time. Each trial of the simulation is independent. Dynamic simulation model A simulation model used in situations where the state of the system affects how the system changes or evolves over time.
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Event An instantaneous occurrence that changes the state of the system in a simulation model. Discrete-event simulation model A simulation model that describes how a system evolves over time by using events that occur at discrete points in time. Verification The process of determining that a computer program implements a simulation model as it is intended. Validation The process of determining that a simulation model provides an accurate representation of a real system.
PROBLEMS Note: Problems 1–12 are designed to give you practice in setting up a simulation model and demonstrating how random numbers can be used to generate values for the probabilistic inputs. These problems, which ask you to provide a small number of simulation trials, can be done with hand calculations. This approach should give you a good understanding of the simulation process, but the simulation results will not be sufficient for you to draw final conclusions or make decisions about the situation. Problems 13–24 are more realistic in that they ask you to generate simulation output(s) for a large number of trials and use the results to draw conclusions about the behavior of the system being studied. These problems require the use of a computer to carry out the simulation computations. The ability to use Excel will be necessary when you attempt Problems 13–24. 1. Consider the PortaCom project discussed in Section 12.1. a. An engineer on the product development team believes that first-year sales for the new printer will be 20,000 units. Using estimates of $45 per unit for the direct labor cost and $90 per unit for the parts cost, what is the first-year profit using the engineer’s sales estimate? b. The financial analyst on the product development team is more conservative, indicating that parts cost may well be $100 per unit. In addition, the analyst suggests that a sales volume of 10,000 units is more realistic. Using the most likely value of $45 per unit for the direct labor cost, what is the first-year profit using the financial analyst’s estimates? c. Why is the simulation approach to risk analysis preferable to generating a variety of what-if scenarios such as those suggested by the engineer and the financial analyst? 2.
The management of Madeira Manufacturing Company is considering the introduction of a new product. The fixed cost to begin the production of the product is $30,000. The variable cost for the product is expected to be between $16 and $24 with a most likely value of $20 per unit. The product will sell for $50 per unit. Demand for the product is expected to range from 300 to 2100 units, with 1200 units the most likely demand. a. Develop the profit model for this product. b. Provide the base-case, worst-case, and best-case analyses. c. Discuss why simulation would be desirable.
3.
Use the random numbers 0.3753, 0.9218, 0.0336, 0.5145, and 0.7000 to generate five simulated values for the PortaCom direct labor cost per unit.
4.
To generate leads for new business, Gustin Investment Services offers free financial planning seminars at major hotels in Southwest Florida. Attendance is limited to 25 individuals per seminar. Each seminar costs Gustin $3500, and the average first-year commission for each new account opened is $5000. Historical data collected over the past four years show that the number of new accounts opened at a seminar varies from no accounts opened to a maximum of six accounts opened according to the following probability distribution:
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Number of New Accounts Opened 0 1 2 3 4 5 6
Probability 0.01 0.04 0.10 0.25 0.40 0.15 0.05
a. Set up intervals of random numbers that can be used to simulate the number of new accounts opened at a seminar. b. Using the first 10 random numbers in column 9 of Table 12.2, simulate the number of new accounts opened for 10 seminars. c. Would you recommend that Gustin continue running the seminars? 5.
The price of a share of a particular stock listed on the New York Stock Exchange is currently $39. The following probability distribution shows how the price per share is expected to change over a three-month period: Stock Price Change ($) 2 1 0 1 2 3 4
Probability 0.05 0.10 0.25 0.20 0.20 0.10 0.10
a. Set up intervals of random numbers that can be used to generate the change in stock price over a three-month period. b. With the current price of $39 per share and the random numbers 0.1091, 0.9407, 0.1941, and 0.8083, simulate the price per share for the next four 3-month periods. What is the ending simulated price per share? 6.
The Statewide Auto Insurance Company developed the following probability distribution for automobile collision claims paid during the past year: Payment($) 0 500 1,000 2,000 5,000 8,000 10,000
Probability 0.83 0.06 0.05 0.02 0.02 0.01 0.01
a. Set up intervals of random numbers that can be used to generate automobile collision claim payments.
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b. Using the first 20 random numbers in column 4 of Table 12.2, simulate the payments for 20 policyholders. How many claims are paid and what is the total amount paid to the policyholders? 7.
A variety of routine maintenance checks are made on commercial airplanes prior to each takeoff. A particular maintenance check of an airplane’s landing gear requires between 10 and 18 minutes of a maintenance engineer’s time. In fact, the exact time required is uniformly distributed over this interval. As part of a larger simulation model designed to determine total on-ground maintenance time for an airplane, we will need to simulate the actual time required to perform this maintenance check on the airplane’s landing gear. Using random numbers of 0.1567, 0.9823, 0.3419, 0.5572, and 0.7758, compute the time required for each of five simulated maintenance checks of the airplane’s landing gear.
8.
Baseball’s World Series is a maximum of seven games, with the winner being the first team to win four games. Assume that the Atlanta Braves are in the World Series and that the first two games are to be played in Atlanta, the next three games at the opponent’s ball park, and the last two games, if necessary, back in Atlanta. Taking into account the projected starting pitchers for each game and the homefield advantage, the probabilities of Atlanta winning each game are as follows: Game Probability of Win
1
2
3
4
5
6
7
0.60
0.55
0.48
0.45
0.48
0.55
0.50
a. Set up random number intervals that can be used to determine the winner of each game. Let the smaller random numbers indicate that Atlanta wins the game. For example, the random number interval “0.00 but less than 0.60” corresponds to Atlanta winning game 1. b. Use the random numbers in column 6 of Table 12.2 beginning with 0.3813 to simulate the playing of the World Series. Do the Atlanta Braves win the series? How many games are played? c. Discuss how repeated simulation trials could be used to estimate the overall probability of Atlanta winning the series as well as the most likely number of games in the series. 9.
A project has four activities (A, B, C, and D) that must be performed sequentially. The probability distributions for the time required to complete each of the activities are as follows: Activity Time (weeks) 5 6 7 8
Probability 0.25 0.35 0.25 0.15
B
3 5 7
0.20 0.55 0.25
C
10 12 14 16 18
0.10 0.25 0.40 0.20 0.05
D
8 10
0.60 0.40
Activity A
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a. Provide the base-case, worst-case, and best-case calculations for the time to complete the project. b. Use the random numbers 0.1778, 0.9617, 0.6849, and 0.4503 to simulate the completion time of the project in weeks. c. Discuss how simulation could be used to estimate the probability the project can be completed in 35 weeks or less. 10. Blackjack, or 21, is a popular casino game that begins with each player and the dealer being dealt two cards. The value of each hand is determined by the point total of the cards in the hand. Face cards and 10s count 10 points; aces can be counted as either 1 or 11 points; and all other cards count at their face value. For instance, the value of a hand consisting of a jack and an 8 is 18; the value of a hand consisting of an ace and a two is either 3 or 13 depending on whether the ace is counted as 1 or 11 points. The goal is to obtain a hand with a value of 21, or as close to it as possible without exceeding 21. After the initial deal, each player and the dealer may draw additional cards (called taking a “hit”) in order to improve their hand. If a player or the dealer takes a hit and the value of their hand exceeds 21, that person “goes broke” and loses. The dealer’s advantage is that each player must decide whether to take a hit before the dealer. If a player takes a hit and goes over 21, the player loses even if the dealer later takes a hit and goes over 21. For this reason, players will often decide not to take a hit when the value of their hand is 12 or greater. The dealer’s hand is dealt with one card up and one card down. The player then decides whether to take a hit based on knowledge of the dealer’s up card. A gambling professional determined that when the dealer’s up card is a 6, the following probabilities describe the ending value of the dealer’s hand: Value of Hand Probability
17
18
19
20
21
Broke
0.1654
0.1063
0.1063
0.1017
0.0972
0.4231
a. Set up intervals of random numbers that can be used to simulate the ending value of the dealer’s hand when the dealer has a 6 as the up card. b. Use the random numbers in column 4 of Table 12.2 to simulate the ending value of the dealer’s hand for 20 plays of the game. c. Suppose you are playing blackjack and your hand has a value of 16 for the two cards initially dealt. If you decide to take a hit, the following cards will improve your hand: ace, 2, 3, 4, and 5. Any card with a point count greater than 5 will result in you going broke. Suppose you have a hand with a value of 16 and decide to take a hit. The following probabilities describe the ending value of your hand: Value of Hand Probability
17
18
19
20
21
Broke
0.0769
0.0769
0.0769
0.0769
0.0769
0.6155
Use the random numbers in column 5 of Table 12.2 to simulate the ending value of your hand after taking a hit for 20 plays of the game. d. Use the results of parts (b) and (c) to simulate the result of 20 blackjack hands when the dealer has a 6 up and the player chooses to take a hit with a hand that has a value of 16. How many hands result in the dealer winning, a push (a tie), and the player winning? e. If the player has a hand with a value of 16 and doesn’t take a hit, the only way the player can win is if the dealer goes broke. How many of the hands in part (b) result in the player winning without taking a hit? On the basis of this result and the results in part (d), would you recommend the player take a hit if the player has a hand with a value of 16 and the dealer has a 6 up?
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11. Over a five-year period, the quarterly change in the price per share of common stock for a major oil company ranged from –8% to 12%. A financial analyst wants to learn what can be expected for price appreciation of this stock over the next two years. Using the five-year history as a basis, the analyst is willing to assume the change in price for each quarter is uniformly distributed between –8% and 12%. Use simulation to provide information about the price per share for the stock over the coming two-year period (eight quarters). a. Use two-digit random numbers from column 2 of Table 12.2, beginning with 0.52, 0.99, and so on, to simulate the quarterly price change for each of the eight quarters. b. If the current price per share is $80, what is the simulated price per share at the end of the two-year period? c. Discuss how risk analysis would be helpful in identifying the risk associated with a two-year investment in this stock. 12. The management of Brinkley Corporation is interested in using simulation to estimate the profit per unit for a new product. Probability distributions for the purchase cost, the labor cost, and the transportation cost are as follows: Purchase Cost ($) 10 11 12
Probability 0.25 0.45 0.30
Labor Cost ($) 20 22 24 25
Probability 0.10 0.25 0.35 0.30
Transportation Cost ($) 3 5
Probability 0.75 0.25
Assume that these are the only costs and that the selling price for the product will be $45 per unit. a. Provide the base-case, worst-case, and best-case calculations for the profit per unit. b. Set up intervals of random numbers that can be used to randomly generate the three cost components. c. Using the random numbers 0.3726, 0.5839, and 0.8275, calculate the profit per unit. d. Using the random numbers 0.1862, 0.7466, and 0.6171, calculate the profit per unit. e. Management believes the project may not be profitable if the profit per unit is less than $5. Explain how simulation can be used to estimate the probability the profit per unit will be less than $5. 13. Using the PortaCom Risk Analysis worksheet in Figure 12.6 and on the website accompanying the text, develop your own worksheet for the PortaCom simulation model. a. Compute the mean profit, the minimum profit, and the maximum profit. b. What is your estimate of the probability of a loss? 14. The management of Madeira Manufacturing Company is considering the introduction of a new product. The fixed cost to begin the production of the product is $30,000. The variable cost for the product is uniformly distributed between $16 and $24 per unit. The product will sell for $50 per unit. Demand for the product is best described by a normal probability distribution with a mean of 1200 units and a standard deviation of 300 units. Develop a spreadsheet simulation similar to Figure 12.6. Use 500 simulation trials to answer the following questions: a. What is the mean profit for the simulation? b. What is the probability the project will result in a loss? c. What is your recommendation concerning the introduction of the product? 15. Use a worksheet to simulate the rolling of dice. Use the VLOOKUP function as described in Appendix 12.1 to select the outcome for each die. Place the number for the first die in column B and the number for the second die in column C. Show the sum in column D.
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Repeat the simulation for 1000 rolls of the dice. What is your simulation estimate of the probability of rolling a 7? 16. Strassel Investors buys real estate, develops it, and resells it for a profit. A new property is available, and Bud Strassel, the president and owner of Strassel Investors, believes it can be sold for $160,000. The current property owner asked for bids and stated that the property will be sold for the highest bid in excess of $100,000. Two competitors will be submitting bids for the property. Strassel does not know what the competitors will bid, but he assumes for planning purposes that the amount bid by each competitor will be uniformly distributed between $100,000 and $150,000. a. Develop a worksheet that can be used to simulate the bids made by the two competitors. Strassel is considering a bid of $130,000 for the property. Using a simulation of 1000 trials, what is the estimate of the probability Strassel will be able to obtain the property using a bid of $130,000? b. How much does Strassel need to bid to be assured of obtaining the property? What is the profit associated with this bid? c. Use the simulation model to compute the profit for each trial of the simulation run. With maximization of profit as Strassel’s objective, use simulation to evaluate Strassel’s bid alternatives of $130,000, $140,000, or $150,000. What is the recommended bid, and what is the expected profit? 17. Grear Tire Company has produced a new tire with an estimated mean lifetime mileage of 36,500 miles. Management also believes that the standard deviation is 5000 miles and that tire mileage is normally distributed. Use a worksheet to simulate the miles obtained for a sample of 500 tires. a. Use the Excel COUNTIF function to determine the number of tires that last longer than 40,000 miles. What is your estimate of the percentage of tires that will exceed 40,000 miles? b. Use COUNTIF to find the number of tires that obtain mileage less than 32,000 miles. Then, find the number with less than 30,000 miles and the number with less than 28,000 miles. c. If management would like to advertise a tire mileage guarantee such that approximately no more than 10% of the tires would obtain mileage low enough to qualify for the guarantee, what tire mileage considered in part (b) would you recommend for the guarantee? 18. A building contractor is preparing a bid on a new construction project. Two other contractors will be submitting bids for the same project. Based on past bidding practices, bids from the other contractors can be described by the following probability distributions: Contractor A B
Probability Distribution of Bid Uniform probability distribution between $600,000 and $800,000 Normal probability distribution with a mean bid of $700,000 and a standard deviation of $50,000
a. If the building contractor submits a bid of $650,000, what is the probability that the contractor submits the lowest bid and wins the contract for the new construction project? Use a worksheet to simulate 1000 trials of the contract bidding process. b. The building contractor is also considering bids of $625,000 and $615,000. If the building contractor would like to bid such that the probability of winning the bid is about 0.80, what bid would you recommend? Repeat the simulation process with bids of $625,000 and $615,000 to justify your recommendation. 19. Develop your own worksheet for the Butler inventory simulation model shown in Figure 12.10. Suppose that management prefers not to charge for loss of goodwill. Run the
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Butler inventory simulation model with replenishment levels of 110, 115, 120, and 125. What is your recommendation? 20. In preparing for the upcoming holiday season, Mandrell Toy Company designated a new doll called Freddy. The fixed cost to produce the doll is $100,000. The variable cost, which includes material, labor, and shipping costs, is $34 per doll. During the holiday selling season, Mandrell will sell the dolls for $42 each. If Mandrell overproduces the dolls, the excess dolls will be sold in January through a distributor who has agreed to pay Mandrell $10 per doll. Demand for new toys during the holiday selling season is extremely uncertain. Forecasts are for expected sales of 60,000 dolls with a standard deviation of 15,000. The normal probability distribution is assumed to be a good description of the demand. a. Create a worksheet similar to the inventory worksheet in Figure 12.10. Include columns showing demand, sales, revenue from sales, amount of surplus, revenue from sales of surplus, total cost, and net profit. Use your worksheet to simulate the sales of the Freddy doll using a production quantity of 60,000 units. Using 500 simulation trials, what is the estimate of the mean profit associated with the production quantity of 60,000 dolls? b. Before making a final decision on the production quantity, management wants an analysis of a more aggressive 70,000 unit production quantity and a more conservative 50,000 unit production quantity. Run your simulation with these two production quantities. What is the mean profit associated with each? What is your recommendation on the production of the Freddy doll? c. Assuming that Mandrell’s management adopts your recommendation, what is the probability of a stockout and a shortage of the Freddy dolls during the holiday season? 21. South Central Airlines operates a commuter flight between Atlanta and Charlotte. The plane holds 30 passengers, and the airline makes a $100 profit on each passenger on the flight. When South Central takes 30 reservations for the flight, experience has shown that on average, two passengers do not show up. As a result, with 30 reservations, South Central is averaging 28 passengers with a profit of 28(100) $2800 per flight. The airline operations office has asked for an evaluation of an overbooking strategy where they would accept 32 reservations even though the airplane holds only 30 passengers. The probability distribution for the number of passengers showing up when 32 reservations are accepted is as follows: Passengers Showing Up 28 29 30 31 32
Probability 0.05 0.25 0.50 0.15 0.05
The airline will receive a profit of $100 for each passenger on the flight up to the capacity of 30 passengers. The airline will incur a cost for any passenger denied seating on the flight. This cost covers added expenses of rescheduling the passenger as well as loss of goodwill, estimated to be $150 per passenger. Develop a worksheet model that will simulate the performance of the overbooking system. Simulate the number of passengers showing up for each of 500 flights by using the VLOOKUP function. Use the results to compute the profit for each flight. a. Does your simulation recommend the overbooking strategy? What is the mean profit per flight if overbooking is implemented? b. Explain how your simulation model could be used to evaluate other overbooking levels such as 31, 33, or 34 and for recommending a best overbooking strategy.
Case Problem 1
Tri-State Corporation
585
22. Develop your own waiting line simulation model for the Hammondsport Savings Bank problem (see Figure 12.14). Assume that a new branch is expected to open with interarrival times uniformly distributed between 0 and 4 minutes. The service times at this branch are anticipated to be normal with a mean of 2 minutes and a standard deviation of 0.5 minute. Simulate the operation of this system for 600 customers using one ATM. What is your assessment of the ability to operate this branch with one ATM? What happens to the average waiting time for customers near the end of the simulation period? 23. The Burger Dome waiting line model in Section 11.2 studies the waiting time of customers at its fast-food restaurant. Burger Dome’s single-channel waiting line system has an arrival rate of 0.75 customers per minute and a service rate of 1 customer per minute. a. Use a worksheet based on Figure 12.15 to simulate the operation of this waiting line. Assuming that customer arrivals follow a Poisson probability distribution, the interarrival times can be simulated with the cell formula –(1/l)*LN(RAND()), where l 0.75. Assuming that the service time follows an exponential probability distribution, the service times can be simulated with the cell formula –m*LN(RAND()), where m 1. Run the Burger Dome simulation for 500 customers. The analytical model in Chapter 11 indicates an average waiting time of 3 minutes per customer. What average waiting time does your simulation model show? b. One advantage of using simulation is that a simulation model can be altered easily to reflect other assumptions about the probabilistic inputs. Assume that the service time is more accurately described by a normal probability distribution with a mean of 1 minute and a standard deviation of 0.2 minute. This distribution has less service time variability than the exponential probability distribution used in part (a). What is the impact of this change on the average waiting time? 24. Telephone calls come into an airline reservations office randomly at the mean rate of 15 calls per hour. The time between calls follows an exponential distribution with a mean of 4 minutes. When the two reservation agents are busy, a telephone message tells the caller that the call is important and to please wait on the line until the next reservation agent becomes available. The service time for each reservation agent is normally distributed with a mean of 4 minutes and a standard deviation of 1 minute. Use a two-channel waiting line simulation model to evaluate this waiting line system. Use the worksheet design shown in Figure 12.17. The cell formula –4*LN(RAND()) can be used to generate the interarrival times. Simulate the operation of the telephone reservation system for 600 customers. Discard the first 100 customers, and collect data over the next 500 customers. a. Compute the mean interarrival time and the mean service time. If your simulation model is operating correctly, both of these should have means of approximately 4 minutes. b. What is the mean customer waiting time for this system? c. Use the COUNTIF function to determine the number of customers who have to wait for a reservation agent. What percentage of the customers have to wait?
Case Problem 1 TRI-STATE CORPORATION What will your portfolio be worth in 10 years? In 20 years? When you stop working? The Human Resources Department at Tri-State Corporation was asked to develop a financial planning model that would help employees address these questions. Tom Gifford was asked to lead this effort and decided to begin by developing a financial plan for himself. Tom has a degree in business and, at the age of 25, is making $34,000 per year. After two years of contributions to his company’s retirement program and the receipt of a small inheritance, Tom has accumulated a portfolio valued at $14,500. Tom plans to work 30 more years and hopes to accumulate a portfolio valued at $1 million. Can he do it?
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Tom began with a few assumptions about his future salary, his new investment contributions, and his portfolio growth rate. He assumed 5% annual salary growth rate as reasonable and wanted to make new investment contributions at 4% of his salary. After some research on historical stock market performance, Tom decided that a 10% annual portfolio growth rate was reasonable. Using these assumptions, Tom developed the Excel worksheet shown in Figure 12.18. Tom’s specific situation and his assumptions are in the top portion of the worksheet (cells D3:D8). The worksheet provides a financial plan for the next five years. In computing the portfolio earnings for a given year, Tom assumed that his new investment contribution would occur evenly throughout the year and thus half of the new investment could be included in the computation of the portfolio earnings for the year. Using Figure 12.18, we see that at age 29, Tom is projected to have a portfolio valued at $32,898. Tom’s plan was to use this worksheet as a template to develop financial plans for the company’s employees. The assumptions in cells D3:D8 would be different for each employee, and rows would be added to the worksheet to reflect the number of years appropriate for each employee. After adding another 25 rows to the worksheet, Tom found that he could expect to have a portfolio of $627,937 after 30 years. Tom then took his results to show his boss, Kate Riegle. Although Kate was pleased with Tom’s progress, she voiced several criticisms. One of the criticisms was the assumption of a constant annual salary growth rate. She noted that most employees experience some variation in the annual salary growth rate from year to year. In addition, she pointed out that the constant annual portfolio growth rate was unrealistic and that the actual growth rate would vary considerably from year to year. She further suggested that a simulation model for the portfolio projection might allow Tom to account for the random variability in the salary growth rate and the portfolio growth rate. After some research, Tom and Kate decided to assume that the annual salary growth rate would vary from 0% to 10% and that a uniform probability distribution would provide a realistic approximation. Tri-State’s accounting firm suggested that the annual portfolio growth rate could be approximated by a normal probability distribution with a mean of 10% and a standard deviation of 5%. With this information, Tom set off to develop a simulation model that could be used by the company’s employees for financial planning. FIGURE 12.18 A
WEB
file
Gifford
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
FINANCIAL PLANNING WORKSHEET FOR TOM GIFFORD B
C
D
E
F
G
Portfolio Earnings 1,518 1,809 2,136 2,504 2,916
Ending Portfolio 17,378 20,615 24,251 28,329 32,898
Financial Analysis - Portfolio Projection Age Current Salary Current Portfolio Annual Salary Growth Rate Annual Investment Rate Annual Portfolio Growth Rate
Year 1 2 3 4 5
Age 25 26 27 28 29
Beginning Portfolio 14,500 17,378 20,615 24,251 28,329
25 $34,000 $14,500 5% 4% 10% New Salary Investment 34,000 1,360 35,700 1,428 37,485 1,499 39,359 1,574 41,327 1,653
H
Case Problem 2
Harbor Dunes Golf Course
587
Managerial Report Play the role of Tom Gifford and develop a simulation model for financial planning. Write a report for Tom’s boss and, at a minimum, include the following: 1. Without considering the random variability in growth rates, extend the worksheet in Figure 12.18 to 30 years. Confirm that by using the constant annual salary growth rate and the constant annual portfolio growth rate, Tom can expect to have a 30-year portfolio of $627,937. What would Tom’s annual investment rate have to increase to in order for his portfolio to reach a 30-year, $1 million goal? 2. Incorporate the random variability of the annual salary growth rate and the annual portfolio growth rate into a simulation model. Assume that Tom is willing to use the annual investment rate that predicted a 30-year, $1 million portfolio in part 1. Show how to simulate Tom’s 30-year financial plan. Use results from the simulation model to comment on the uncertainty associated with Tom reaching the 30-year, $1 million goal. Discuss the advantages of repeating the simulation numerous times. 3. What recommendations do you have for employees with a current profile similar to Tom’s after seeing the impact of the uncertainty in the annual salary growth rate and the annual portfolio growth rate? 4. Assume that Tom is willing to consider working 35 years instead of 30 years. What is your assessment of this strategy if Tom’s goal is to have a portfolio worth $1 million? 5. Discuss how the financial planning model developed for Tom Gifford can be used as a template to develop a financial plan for any of the company’s employees.
Case Problem 2 HARBOR DUNES GOLF COURSE Harbor Dunes Golf Course was recently honored as one of the top public golf courses in South Carolina. The course, situated on land that was once a rice plantation, offers some of the best views of saltwater marshes available in the Carolinas. Harbor Dunes targets the upper end of the golf market and in the peak spring golfing season, charges green fees of $160 per person and golf cart fees of $20 per person. Harbor Dunes takes reservations for tee times for groups of four players (foursome) starting at 7:30 each morning. Foursomes start at the same time on both the front nine and the back nine of the course, with a new group teeing off every nine minutes. The process continues with new foursomes starting play on both the front and back nine at noon. To enable all players to complete 18 holes before darkness, the last two afternoon foursomes start their rounds at 1:21 P.M. Under this plan, Harbor Dunes can sell a maximum of 20 afternoon tee times. Last year Harbor Dunes was able to sell every morning tee time available for every day of the spring golf season. The same result is anticipated for the coming year. Afternoon tee times, however, are generally more difficult to sell. An analysis of the sales data for last year enabled Harbor Dunes to develop the probability distribution of sales for the afternoon tee times as shown in Table 12.12. For the season, Harbor Dunes averaged selling approximately 14 of the 20 available afternoon tee times. The average income from afternoon green fees and cart fees has been $10,240. However, the average of six unused tee times per day resulted in lost revenue. In an effort to increase the sale of afternoon tee times, Harbor Dunes is considering an idea popular at other golf courses. These courses offer foursomes that play in the morning the option to play another round of golf in the afternoon by paying a reduced fee for the afternoon round. Harbor Dunes is considering two replay options: (1) a green fee of $25
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TABLE 12.12 PROBABILITY DISTRIBUTION OF SALES FOR THE AFTERNOON TEE TIMES Number of Tee Times Sold 8 9 10 11 12 13 14 15 16 17 18 19 20
Probability 0.01 0.04 0.06 0.08 0.10 0.11 0.12 0.15 0.10 0.09 0.07 0.05 0.02
per player plus a cart fee of $20 per player; (2) a green fee of $50 per player plus a cart fee of $20 per player. For option 1, each foursome will generate additional revenues of $180; for option 2, each foursome will generate additional revenues of $280. The key in making a decision as to what option is best depends upon the number of groups that find the option attractive enough to take the replay offer. Working with a consultant who has expertise in statistics and the golf industry, Harbor Dunes developed probability distributions for the number of foursomes requesting a replay for each of the two options. These probability distributions are shown in Table 12.13. In offering these replay options, Harbor Dunes’ first priority will be to sell full-price afternoon advance reservations. If the demand for replay tee times exceeds the number of afternoon tee times available, Harbor Dunes will post a notice that the course is full. In this case, any excess replay requests will not be accepted. TABLE 12.13 PROBABILITY DISTRIBUTIONS FOR THE NUMBER OF GROUPS REQUESTING A REPLAY Option 1: $25 per Person ⴙ Cart Fee Number of Foursomes Requesting a Replay Probability 0 0.01 1 0.03 2 0.05 3 0.05 4 0.11 5 0.15 6 0.17 7 0.15 8 0.13 9 0.09 10 0.06
Option 2: $50 per Person ⴙ Cart Fee Number of Foursomes Requesting a Replay Probability 0 0.06 1 0.09 2 0.12 3 0.17 4 0.20 5 0.13 6 0.11 7 0.07 8 0.05
Case Problem 3
589
County Beverage Drive-Thru
Managerial Report Develop simulation models for both replay options using Crystal Ball. Run each simulation for 5000 trials. Prepare a report that will help management of Harbor Dunes Golf Course decide which replay option to implement for the upcoming spring golf season. In preparing your report be sure to include the following: 1. Statistical summaries of the revenue expected under each replay option. 2. Your recommendation as to the best replay option. 3. Assuming a 90-day spring golf season, what is the estimate of the added revenue using your recommendation? 4. Discuss any other recommendations you have that might improve the income for Harbor Dunes.
Case Problem 3 COUNTY BEVERAGE DRIVE-THRU County Beverage Drive-Thru, Inc., operates a chain of beverage supply stores in Northern Illinois. Each store has a single service lane; cars enter at one end of the store and exit at the other end. Customers pick up soft drinks, beer, snacks, and party supplies without getting out of their cars. When a new customer arrives at the store, the customer waits until the preceding customer’s order is complete and then drives into the store for service. Typically, three employees operate each store during peak periods; two clerks take and fill orders, and a third clerk serves as cashier and store supervisor. County Beverage is considering a revised store design in which computerized order-taking and payment are integrated with specialized warehousing equipment. Management hopes that the new design will permit operating each store with one clerk. To determine whether the new design is beneficial, management decided to build a new store using the revised design. County Beverage’s new store will be located near a major shopping center. Based on experience at other locations, management believes that during the peak late afternoon and evening hours, the time between arrivals follows an exponential probability distribution with a mean of six minutes. These peak hours are the most critical time period for the company; most of their profit is generated during these peak hours. An extensive study of times required to fill orders with a single clerk led to the following probability distribution of service times: Service Time (minutes) 2 3 4 5 6 7 8 9
Probability 0.24 0.20 0.15 0.14 0.12 0.08 0.05 0.02 Total 1.00
In case customer waiting times prove too long with just a single clerk, County Beverage’s management is considering two alternatives: add a second clerk to help with bagging, taking orders, and related tasks, or enlarge the drive-thru area so that two cars can be served at once (a two-channel system). With either of these options, two clerks will be needed. With the two-channel option, service times are expected to be the same for each channel.
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With the second clerk helping with a single channel, service times will be reduced. The following probability distribution describes service times given that option: Service Time (minutes) 1 2 3 4 5
Probability 0.20 0.35 0.30 0.10 0.05 Total 1.00
County Beverage’s management would like you to develop a spreadsheet simulation model of the new system and use it to compare the operation of the system using the following three designs: Design A One channel, one clerk B One channel, two clerks C Two channels, each with one clerk Management is especially concerned with how long customers have to wait for service. Research has shown that 30% of the customers will wait no longer than 6 minutes and that 90% will wait no longer than 10 minutes. As a guideline, management requires the average waiting time to be less than 1.5 minutes.
Managerial Report Prepare a report that discusses the general development of the spreadsheet simulation model, and make any recommendations that you have regarding the best store design and staffing plan for County Beverage. One additional consideration is that the design allowing for a two-channel system will cost an additional $10,000 to build. 1. List the information the spreadsheet simulation model should generate so that a decision can be made on the store design and the desired number of clerks. 2. Run the simulation for 1000 customers for each alternative considered. You may want to consider making more than one run with each alternative. [Note: Values from an exponential probability distribution with mean m can be generated in Excel using the following function: –m*LN(RAND()).] 3. Be sure to note the number of customers County Beverage is likely to lose due to long customer waiting times with each design alternative.
Appendix 12.1 SIMULATION WITH EXCEL Excel enables small and moderate-sized simulation models to be implemented relatively easily and quickly. In this appendix we show the Excel worksheets for the three simulation models presented in the chapter.
The PortaCom Simulation Model We simulated the PortaCom problem 500 times. The worksheet used to carry out the simulation is shown again in Figure 12.19. Note that the simulation results for trials 6 through 495
Appendix 12.1
FIGURE 12.19
WORKSHEET FOR THE PORTACOM PROBLEM
A
WEB
file
PortaCom
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 516 517 518 519 520 521 522 523 524 525 526 527 528
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B
C
D
E
F
PortaCom Risk Analysis Selling Price per Unit Administrative Cost Advertising Cost
$249 $400,000 $600,000
Direct Labor Cost Lower Upper Random No. Random No. Cost per Unit 0.0 0.1 $43 0.1 0.3 $44 0.3 0.7 $45 0.7 0.9 $46 0.9 1.0 $47
Parts Cost (Uniform Distribution) Smallest Value $80 Largest Value $100
Demand (Normal Distribution) Mean 15000 Std Deviation 4500
Simulation Trials
Trial 1 2 3 4 5 496 497 498 499 500
Direct Labor Parts Cost per Unit Cost per Unit 47 $85.36 44 $91.68 45 $93.35 43 $98.56 45 $88.36 44 $98.67 45 $94.38 44 $90.85 43 $90.37 46 $92.50
First-Year Demand 17,366 12,900 20,686 10,888 14,259 8,730 19,257 14,920 13,471 18,614
Summary Statistics Mean Profit Standard Deviation Minimum Profit Maximum Profit Number of Losses Probability of Loss
Profit $1,025,570 $461,828 $1,288,906 $169,807 $648,911 ($71,739) $1,110,952 $703,118 $557,652 $1,056,847
$698,457 $520,485 ($785,234) $2,367,058 51 0.1020
have been hidden so that the results can be shown in a reasonably sized figure. If desired, the rows for these trials can be shown and the simulation results displayed for all 500 trials. Let us describe the details of the Excel worksheet that provided the PortaCom simulation. First, the PortaCom data are presented in the first 14 rows of the worksheet. The selling price per unit, administrative cost, and advertising cost parameters are entered directly into cells C3, C4, and C5. The discrete probability distribution for the direct labor cost per unit is shown in a tabular format. Note that the random number intervals are entered first,
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followed by the corresponding cost per unit. For example, 0.0 in cell A10 and 0.1 in cell B10 show that a cost of $43 per unit will be assigned if the random number is in the interval 0.0 but less than 0.1. Thus, approximately 10% of the simulated direct labor costs will be $43 per unit. The uniform probability distribution with a smallest value of $80 in cell E8 and a largest value of $100 in cell E9 describes the parts cost per unit. Finally, a normal probability distribution with a mean of 15,000 units in cell E13 and a standard deviation of 4500 units in cell E14 describes the first-year demand distribution for the product. At this point we are ready to insert the Excel formulas that will carry out each simulation trial. Simulation information for the first trial appears in row 21 of the worksheet. The cell formulas for row 21 are as follows: Cell A21 Cell B21 Cell C21 Cell D21 Cell E21
Enter 1 for the first simulation trial Simulate the direct labor cost per unit* VLOOKUP(RAND(),$A$10:$C$14,3) Simulate the parts cost per unit (uniform distribution) $E$8($E$9–$E$8)*RAND() Simulate the first-year demand (normal distribution) NORMINV(RAND(),$E$13,$E$14) The profit obtained for the first trial ($C$3–B21–C21)*D21–$C$4–$C$5
Cells A21:E21 can be copied to A520:E520 in order to provide the 500 simulation trials. Ultimately, summary statistics will be collected in order to describe the results of the 500 simulated trials. Using the standard Excel functions, the following summary statistics are computed for the 500 simulated profits appearing in cells E21 to E520: Cell E523 Cell E524 Cell E525 Cell E526 Cell E527 Cell E528
The mean profit per trial AVERAGE(E21:E520) The standard deviation of profit STDEV(E21:E520) The minimum profit MIN(E21:E520) The maximum profit MAX(E21:E520) The count of the number of trials where a loss occurred (i.e., profit $0) COUNTIF(E21:E520,“0”) The percentage or probability of a loss based on the 500 trials E527/500
The F9 key can be used to perform another complete simulation of PortaCom. In this case, the entire worksheet will be recalculated and a set of new simulation results will be provided. Any data summaries, measures, or functions that have been built into the worksheet earlier will be updated automatically.
The Butler Inventory Simulation Model We simulated the Butler inventory operation for 300 months. The worksheet used to carry out the simulation is shown again in Figure 12.20. Note that the simulation results for *The VLOOKUP function generates a random number using the RAND() function. Then, using the table defined by the region from cells $A$10 to $C$14, the function identifies the row containing the RAND() random number and assigns the corresponding direct labor cost per unit shown in column C.
Appendix 12.1
FIGURE 12.20 A
WEB
file
Butler
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 312 313 314 315 316 317 318 319 320 321 322 323
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WORKSHEET FOR THE BUTLER INVENTORY PROBLEM B
C
D
E
F
G
H
Butler Inventory Gross Profit per Unit Holding Cost per Unit Shortage Cost per Unit
$50 $15 $30
Replenishment Level
100
Demand (Normal Distribution) Mean 100 Std Deviation 20
Simulation Month 1 2 3 4 5 296 297 298 299 300 Totals
Demand 79 111 93 100 118 89 91 122 93 126
Sales 79 100 93 100 100 89 91 100 93 100
30,181
27,917
Gross Profit Holding Cost Shortage Cost Net Profit $3,950 $315 $0 $3,635 $5,000 $0 $330 $4,670 $4,650 $105 $0 $4,545 $5,000 $0 $0 $5,000 $5,000 $0 $540 $4,460 $4,450 $165 $0 $4,285 $4,550 $135 $0 $4,415 $5,000 $0 $660 $4,340 $4,650 $105 $0 $4,545 $5,000 $0 $780 $4,220 Summary Statistics Mean Profit Standard Deviation Minimum Profit Maximum Profit Service Level
$4,293 $658 ($206) $5,000 92.5%
months 6 through 295 have been hidden so that the results can be shown in a reasonably sized figure. If desired, the rows for these months can be shown and the simulation results displayed for all 300 months. Let us describe the details of the Excel worksheet that provided the Butler inventory simulation. First, the Butler inventory data are presented in the first 11 rows of the worksheet. The gross profit per unit, holding cost per unit, and shortage cost per unit data are entered directly into cells C3, C4, and C5. The replenishment level is entered into cell C7, and the mean and standard deviation of the normal probability distribution for demand are entered into cells B10 and B11. At this point we are ready to insert Excel formulas that will carry out each simulation month or trial.
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Simulation information for the first month or trial appears in row 17 of the worksheet. The cell formulas for row 17 are as follows: Cell A17 Cell B17
Enter 1 for the first simulation month Simulate demand (normal distribution) NORMINV(RAND(),$B$10,$B$11)
Next compute the sales, which is equal to demand (cell B17) if demand is less than or equal to the replenishment level, or is equal to the replenishment level (cell C7) if demand is greater than the replenishment level. Compute sales IF(B17$C$7,B17,$C$7) Calculate gross profit $C$3*C17 Calculate the holding cost if demand is less than or equal to the replenishment level IF(B17$C$7,$C$4*($C$7–B17),0) Cell F17 Calculate the shortage cost if demand is greater than the replenishment level IF(B17$C$7,$C$5*(B17–$C$7),0) Cell G17 Calculate net profit D17–E17–F17 Cells A17:G17 can be copied to cells A316:G316 in order to provide the 300 simulation months. Cell C17 Cell D17 Cell E17
Finally, summary statistics will be collected in order to describe the results of the 300 simulated trials. Using the standard Excel functions, the following totals and summary statistics are computed for the 300 months: Cell B318 Cell C319 Cell G319 Cell G320 Cell G321 Cell G322 Cell G323
Total demand SUM(B17:B316) Total sales SUM(C17:C316) The mean profit per month AVERAGE(G17:G316) The standard deviation of net profit STDEV(G17:G316) The minimum net profit MIN(G17:G316) The maximum net profit MAX(G17:G316) The service level C318/B318
The Hammondsport ATM Simulation Model We simulated the operation of the Hammondsport ATM waiting line system for 1000 customers. The worksheet used to carry out the simulation is shown again in Figure 12.21. Note that the simulation results for customers 6 through 995 have been hidden so that the results can be shown in a reasonably sized figure. If desired, the rows for these customers can be shown and the simulation results displayed for all 1000 customers. Let us describe the details of the Excel worksheet that provided the Hammondsport ATM simulation. The data are presented in the first 9 rows of the worksheet. The interarrival times are described by a uniform distribution with a smallest time of 0 minutes (cell B4) and a largest time of 5 minutes (cell B5). A normal probability distribution with a mean of 2 minutes (cell B8) and a standard deviation of 0.5 minute (cell B9) describes the service time distribution.
Appendix 12.1
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FIGURE 12.21 WORKSHEET FOR THE HAMMONDSPORT SAVINGS BANK WITH ONE ATM A
WEB
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Hammondsport1
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 1011 1012 1013 1014 1015 1016 1017 1018 1019 1020 1021 1022 1023 1024
B
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E
F
G
H
I
Hammondsport Savings Bank with One ATM Interarrival Times (Uniform Distribution) Smallest Value 0 Largest Value 5 Service Times (Normal Distribution) Mean 2 Std Deviation 0.5
Simulation
Customer 1 2 3 4 5 996 997 998 999 1000
Interarrival Time 1.4 1.3 4.9 3.5 0.7 0.5 0.2 2.7 3.7 4.0
Arrival Service Waiting Service Completion Time Time Start Time Time Time Time in System 1.4 1.4 0.0 2.3 3.7 2.3 2.7 3.7 1.0 1.5 5.2 2.5 7.6 7.6 0.0 2.2 9.8 2.2 11.1 11.1 0.0 2.5 13.6 2.5 11.8 13.6 1.8 1.8 15.4 3.6 2496.8 2498.1 1.3 0.6 2498.7 1.9 2497.0 2498.7 1.7 2.0 2500.7 3.7 2499.7 2500.7 1.0 1.8 2502.5 2.8 2503.4 2503.4 0.0 2.4 2505.8 2.4 2507.4 2507.4 0.0 1.9 2509.3 1.9
Summary Statistics Number Waiting Probability of Waiting Average Waiting Time Maximum Waiting Time Utilization of ATM Number Waiting > 1 Min Probability of Waiting > 1 Min
549 0.6100 1.59 13.5 0.7860 393 0.4367
Simulation information for the first customer appears in row 16 of the worksheet. The cell formulas for row 16 are as follows: Cell A16 Cell B16 Cell C16 Cell D16 Cell E16
Enter 1 for the first customer Simulate the interarrival time for customer 1 (uniform distribution) $B$4RAND()*($B$5–$B$4) Compute the arrival time for customer 1 B16 Compute the start time for customer 1 C16 Compute the waiting time for customer 1 D1–C16
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Cell F16 Cell G16 Cell H16
Simulation
Simulate the service time for customer 1 (normal distribution) NORMINV(RAND(),$B$8,$B$9) Compute the completion time for customer 1 D16F16 Compute the time in the system for customer 1 G16–C16
Simulation information for the second customer appears in row 17 of the worksheet. The cell formulas for row 17 are as follows: Cell A17 Cell B17 Cell C17 Cell D17 Cell E17 Cell F17 Cell G17 Cell H17
Enter 2 for the second customer Simulate the interarrival time for customer 2 (uniform distribution) $B$4RAND()*($B$5–$B$4) Compute the arrival time for customer 2 C16B17 Compute the start time for customer 2 IF(C17G16,C17,G16) Compute the waiting time for customer 2 D17–C17 Simulate the service time for customer 2 (normal distribution) NORMINV(RAND(),$B$8,$B$9) Compute the completion time for customer 2 D17F17 Compute the time in the system for customer 2 G17–C17
Cells A17:H17 can be copied to cells A1015:H1015 in order to provide the 1000-customer simulation. Ultimately, summary statistics will be collected in order to describe the results of 1000 customers. Before collecting the summary statistics, let us point out that most simulation studies of dynamic systems focus on the operation of the system during its long-run or steady-state operation. To ensure that the effects of start-up conditions are not included in the steady-state calculations, a dynamic simulation model is usually run for a specified period without collecting any data about the operation of the system. The length of the startup period can vary depending on the application. For the Hammondsport Savings Bank ATM simulation, we treated the results for the first 100 customers as the start-up period. The simulation information for customer 100 appears in row 115 of the spreadsheet. Cell G115 shows that the completion time for the 100th customer is 247.8. Thus the length of the start-up period is 247.8 minutes. Summary statistics are collected for the next 900 customers corresponding to rows 116 to 1015 of the worksheet. The following Excel formulas provided the summary statistics: Cell E1018 Number of customers who had to wait (i.e., waiting time 0) COUNTIF(E116:E1015,“0”) Cell E1019 Probability of waiting E1018/900 Cell E1020 The average waiting time AVERAGE(E116:E1015) Cell E1021 The maximum waiting time MAX(E116:E1015) Cell E1022 The utilization of the ATM* SUM(F116:F1015)/(G1015–G115)
*The proportion of time the ATM is in use is equal to the sum of the 900 customer service times in column F divided by the total elapsed time required for the 900 customers to complete service. This total elapsed time is the difference between the completion time of customer 1000 and the completion time of customer 100.
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Cell E1023 The number of customers who had to wait more than 1 minute COUNTIF(E116:E1015, “1”) Cell E1024 Probability of waiting more than 1 minute E1023/900
Appendix 12.2
SIMULATION USING CRYSTAL BALL
In Section 12.1 we used simulation to perform risk analysis for the PortaCom problem, and in Appendix 12.1 we showed how to construct the Excel worksheet that provided the simulation results. Developing the worksheet simulation for the PortaCom problem using the basic Excel package was relatively easy. The use of add-ins enables larger and more complex simulation problems to be easily analyzed using spreadsheets. In this appendix, we show how Crystal Ball, an add-in package, can be used to perform the PortaCom simulation. We will run the simulation for 1000 trials here. Instructions for installing and starting Crystal Ball are included with the Crystal Ball software.
Formulating a Crystal Ball Model We begin by entering the problem data into the top portion of the worksheet. For the PortaCom problem, we must enter the following data: selling price, administrative cost, advertising cost, probability distribution for the direct labor cost per unit, smallest and largest values for the parts cost per unit (uniform distribution), and the mean and standard deviation for first-year demand (normal distribution). These data with appropriate descriptive labels are shown in cells A1:E13 of Figure 12.22. For the PortaCom problem, the Crystal Ball model contains the following two components: (1) cells for the probabilistic inputs (direct labor cost, parts cost, first-year demand), and (2) a cell containing a formula for computing the value of the simulation model output (profit). In Crystal Ball the cells that contain the values of the probabilistic inputs are called assumption cells, and the cells that contain the formulas for the model outputs are referred to as forecast cells. The PortaCom problem requires only one output (profit), and thus the Crystal Ball model only contains one forecast cell. In more complex simulation problems more than one forecast cell may be necessary. The assumption cells may only contain simple numeric values. In this model-building stage, we entered PortaCom’s best estimates of the direct labor cost ($45), the parts cost ($90), and the first-year demand (15,000) into cells C21:C23, respectively. The forecast cells in a Crystal Ball model contain formulas that refer to one or more of the assumption cells. Because only one forecast cell in the PortaCom problem corresponds to profit, we entered the following formula into cell C27: (C3–C21–C22)*C23–C4–C5 The resulting value of $710,000 is the profit corresponding to the base-case scenario discussed in Section 12.1.
Defining and Entering Assumptions We are now ready to define the probability distributions corresponding to each of the assumption cells. We begin by defining the probability distribution for the direct labor cost. Step 1. Select the Crystal Ball tab Step 2. Select cell C21
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FIGURE 12.22
CRYSTAL BALL WORKSHEET FOR THE PORTACOM PROBLEM
A
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PortaCom Crystal
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27
Simulation
B
C
D
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PortaCom Risk Analysis Selling Price per Unit Administrative Cost Advertising Cost
$249 $400,000 $600,000
Direct Labor Cost per Unit Probability $43 0.1 $44 0.2 $45 0.4 $46 0.2 $47 0.1
Parts Cost (Uniform Distribution) Smallest Value Largest Value Demand (Normal Distribution) Mean Standard Dev
$80 $100
15,000 4,500
Crystal Ball Model Assumption Cells Direct Labor Cost $45 Parts Cost $90 Demand 15,000 Forecast Cell $710,000
Profit
Step 3. Choose Define Assumption from the Define group of the Crystal Ball ribbon. Step 4. When the Distribution Gallery: Cell 21 dialog box appears: Choose Custom* (Use the scroll bar to see all possible distributions.) Click OK Step 5. When the Define Assumption: Cell C21 dialog box appears: If the button is to the right of the Name box, proceed to step 6 If the
button is to the right of the Name box, click the
obtain the button Step 6. Choose Load Data Enter B9:C13 in the Location of data box Click Keep Linked to Spreadsheet Click OK to terminate the data entry process Click OK *You may have to click All and use the scroll bar to see all possible distributions.
button to
Appendix 12.2
Simulation Using Crystal Ball
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The procedure for defining the probability distribution for the parts cost is similar. Step 1. Select cell C22 Step 2. Choose Define Assumption from the Define group of the Crystal Ball ribbon. Step 3. When the Distribution Gallery: Cell C22 dialog box appears: Choose Uniform (Use the scroll bar to see all possible distributions.) Click OK Step 4. When the Define Assumption: Cell C22 dialog box appears: Enter E8 in the Minimum box Enter E9 in the Maximum box Click Enter Click OK Finally, we perform the following steps to define the probability distribution for first-year demand: Step 1. Select cell C23 Step 2. Choose Define Assumption from the Define group of the Crystal Ball ribbon. Step 3. When the Distribution Gallery: Cell 23 dialog box appears: Choose Normal (Use the scroll bar to see all possible distributions.) Click OK Step 4. When the Define Assumption: Cell C23 dialog box appears: Enter E12 in the Mean box Enter E13 in the Std. Dev. box Click Enter Click OK
Defining Forecasts After defining the assumption cells, we are ready to define the forecast cells. The following steps show this process for cell C27, which is the profit forecast cell for the PortaCom project: Step 1. Select cell C27 Step 2. Choose Define Forecast from the Define group of the Crystal Ball ribbon. Step 3. When the Define Forecast: Cell C27 dialog box appears: Profit will appear in the Name box Click OK
Setting Run Preferences We must now make the choices that determine how Crystal Ball runs the simulation. For the PortaCom simulation, we only need to specify the number of trials. Step 1. Choose Run Preferences from the Run group of the Crystal Ball ribbon. Step 2. When the Run Preferences dialog box appears: Make sure the Trials tab has been selected Enter 1000 in the Number of trials to run: box Click OK
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Running the Simulation Crystal Ball repeats three steps on each of the 1000 trials of the PortaCom simulation. 1. Values are generated for the three assumption cells according to the defined probability distributions. 2. A new simulated profit (forecast cell) is computed based on the new values in the three assumption cells. 3. The new simulated profit is recorded. The simulation is started by selecting the Start button . When the run is complete, Crystal Ball displays a Forecast: Profit window, which shows a frequency distribution of the simulated profit values obtained during the simulation run. See Figure 12.23. Other types of charts and output can be displayed. For instance, the following steps describe how to display the descriptive statistics for the simulation run: Step 1. Select the View menu in the Forecast: Profit window Step 2. Choose Statistics
FIGURE 12.23 CRYSTAL BALL FREQUENCY CHART FOR THE PORTACOM SIMULATION
Appendix 12.2
FIGURE 12.24
Simulation Using Crystal Ball
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CRYSTAL BALL STATISTICS FOR THE PORTACOM SIMULATION
Figure 12.24 shows the Forecast: Profit window with descriptive statistics. Note that the worst result obtained in this simulation of 1000 trials is a loss of $1,216,126, and the best result is a profit of $2,415,674. The mean profit is $701,306. These values are similar to the results obtained in Section 12.1. The differences result from the different random numbers used in the two simulations and from the fact that we used 1000 trials with Crystal Ball. If you perform another simulation, your results will differ slightly.
CHAPTER
13
Decision Analysis CONTENTS 13.1 PROBLEM FORMULATION Influence Diagrams Payoff Tables Decision Trees 13.2 DECISION MAKING WITHOUT PROBABILITIES Optimistic Approach Conservative Approach Minimax Regret Approach 13.3 DECISION MAKING WITH PROBABILITIES Expected Value of Perfect Information 13.4 RISK ANALYSIS AND SENSITIVITY ANALYSIS Risk Analysis Sensitivity Analysis
13.5 DECISION ANALYSIS WITH SAMPLE INFORMATION Influence Diagram Decision Tree Decision Strategy Risk Profile Expected Value of Sample Information Efficiency of Sample Information 13.6 COMPUTING BRANCH PROBABILITIES
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Decision Analysis
Decision analysis can be used to develop an optimal strategy when a decision maker is faced with several decision alternatives and an uncertain or risk-filled pattern of future events. For example, Ohio Edison used decision analysis to choose the best type of particulate control equipment for coal-fired generating units when it faced future uncertainties concerning sulfur content requirements, construction costs, and so on. The State of North Carolina used decision analysis in evaluating whether to implement a medical screening test to detect metabolic disorders in newborns. Thus, decision analysis repeatedly proves its value in decision making. The Management Science in Action, Decision Analysis at Eastman Kodak, describes how the use of decision analysis added approximately $1 billion in value. Even when a careful decision analysis has been conducted, uncertain future events make the final consequence uncertain. In some cases, the selected decision alternative may provide good or excellent results. In other cases, a relatively unlikely future event may occur, causing the selected decision alternative to provide only fair or even poor results. The risk associated with any decision alternative is a direct result of the uncertainty associated with the final consequence. A good decision analysis includes risk analysis. Through risk analysis, the decision maker is provided with probability information about favorable as well as unfavorable consequences that may occur.
MANAGEMENT SCIENCE IN ACTION DECISION ANALYSIS AT EASTMAN KODAK* Clemen and Kwit conducted a study to determine the value of decision analysis at the Eastman Kodak Company. The study involved an analysis of 178 decision analysis projects over a 10-year period. The projects involved a variety of applications including strategy development, vendor selection, process analysis, new-product brainstorming, product-portfolio selection, and emissionreduction analysis. These projects required 14,372 hours of analyst time and the involvement of many other individuals at Kodak over the 10-year period. The shortest projects took less than 20 hours, and the longest projects took almost a year to complete. Most decision analysis projects are one-time activities, which makes it difficult to measure the value added to the corporation. Clemen and Kwit used detailed records that were available and some innovative approaches to develop estimates of the incremental dollar value generated by the decision analysis projects. Their conservative estimate of the average value per project was $6.65 million, and their optimistic estimate of the average value per project was $16.35 million. Their analysis led to the conclusion that all projects taken together added more than $1 billion in value to Eastman Kodak. Using these estimates, Clemen and Kwit concluded that decision analysis returned substan-
tial value to the company. Indeed, they concluded that the value added by the projects was at least 185 times the cost of the analysts’ time. In addition to the monetary benefits, the authors point out that decision analysis adds value by facilitating discussion among stakeholders, promoting careful thinking about strategies, providing a common language for discussing the elements of a decision problem, and speeding implementation by helping to build consensus among decision makers. In commenting on the value of decision analysis at Eastman Kodak, Nancy L. S. Sousa said, “As General Manager, New Businesses, VP Health Imaging, Eastman Kodak, I encourage all of the business planners to use the decision and risk principles and processes as part of evaluating new business opportunities. The processes have clearly led to better decisions about entry and exit of businesses.” Although measuring the value of a particular decision analysis project can be difficult, it would be hard to dispute the success that decision analysis had at Kodak. *Based on Robert T. Clemen and Robert C. Kwit, “The Value of Decision Analysis at Eastman Kodak Company,” Interfaces (September/October 2001): 74–92.
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We begin the study of decision analysis by considering problems that involve reasonably few decision alternatives and reasonably few possible future events. Influence diagrams and payoff tables are introduced to provide a structure for the decision problem and to illustrate the fundamentals of decision analysis. We then introduce decision trees to show the sequential nature of decision problems. Decision trees are used to analyze more complex problems and to identify an optimal sequence of decisions, referred to as an optimal decision strategy. Sensitivity analysis shows how changes in various aspects of the problem affect the recommended decision alternative.
13.1
PROBLEM FORMULATION The first step in the decision analysis process is problem formulation. We begin with a verbal statement of the problem. We then identify the decision alternatives, the uncertain future events, referred to as chance events, and the consequences associated with each decision alternative and each chance event outcome. Let us begin by considering a construction project of the Pittsburgh Development Corporation. Pittsburgh Development Corporation (PDC) purchased land that will be the site of a new luxury condominium complex. The location provides a spectacular view of downtown Pittsburgh and the Golden Triangle where the Allegheny and Monongahela Rivers meet to form the Ohio River. PDC plans to price the individual condominium units between $300,000 and $1,400,000. PDC commissioned preliminary architectural drawings for three different projects: one with 30 condominiums, one with 60 condominiums, and one with 90 condominiums. The financial success of the project depends upon the size of the condominium complex and the chance event concerning the demand for the condominiums. The statement of the PDC decision problem is to select the size of the new luxury condominium project that will lead to the largest profit given the uncertainty concerning the demand for the condominiums. Given the statement of the problem, it is clear that the decision is to select the best size for the condominium complex. PDC has the following three decision alternatives: d1 = a small complex with 30 condominiums d2 = a medium complex with 60 condominiums d3 = a large complex with 90 condominiums A factor in selecting the best decision alternative is the uncertainty associated with the chance event concerning the demand for the condominiums. When asked about the possible demand for the condominiums, PDC’s president acknowledged a wide range of possibilities but decided that it would be adequate to consider two possible chance event outcomes: a strong demand and a weak demand. In decision analysis, the possible outcomes for a chance event are referred to as the states of nature. The states of nature are defined so that one, and only one, of the possible states of nature will occur. For the PDC problem, the chance event concerning the demand for the condominiums has two states of nature: s1 = strong demand for the condominiums s2 = weak demand for the condominiums Management must first select a decision alternative (complex size); then a state of nature follows (demand for the condominiums); and finally a consequence will occur. In this case, the consequence is PDC’s profit.
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Influence Diagrams An influence diagram is a graphical device that shows the relationships among the decisions, the chance events, and the consequences for a decision problem. The nodes in an influence diagram represent the decisions, chance events, and consequences. Rectangles or squares depict decision nodes, circles or ovals depict chance nodes, and diamonds depict consequence nodes. The lines connecting the nodes, referred to as arcs, show the direction of influence that the nodes have on one another. Figure 13.1 shows the influence diagram for the PDC problem. The complex size is the decision node, demand is the chance node, and profit is the consequence node. The arcs connecting the nodes show that both the complex size and the demand influence PDC’s profit.
Payoff Tables
Payoffs can be expressed in terms of profit, cost, time, distance, or any other measure appropriate for the decision problem being analyzed.
Given the three decision alternatives and the two states of nature, which complex size should PDC choose? To answer this question, PDC will need to know the consequence associated with each decision alternative and each state of nature. In decision analysis, we refer to the consequence resulting from a specific combination of a decision alternative and a state of nature as a payoff. A table showing payoffs for all combinations of decision alternatives and states of nature is a payoff table. Because PDC wants to select the complex size that provides the largest profit, profit is used as the consequence. The payoff table with profits expressed in millions of dollars is shown in Table 13.1. Note, for example, that if a medium complex is built and demand turns out to be strong, a profit of $14 million will be realized. We will use the notation Vij to denote the payoff associated with decision alternative i and state of nature j. Using Table 13.1, V31 20 indicates a payoff of $20 million occurs if the decision is to build a large complex (d3) and the strong demand state of nature (s1) occurs. Similarly, V32 –9 indicates a loss of $9 million if the decision is to build a large complex (d3) and the weak demand state of nature (s2) occurs.
FIGURE 13.1 INFLUENCE DIAGRAM FOR THE PDC PROJECT
Demand
Complex Size
Decision Alternatives Small complex (d1) Medium complex (d2) Large complex (d3)
States of Nature Strong (s1) Weak (s2 )
Profit
Consequence Profit
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TABLE 13.1 PAYOFF TABLE FOR THE PDC CONDOMINIUM PROJECT (PAYOFFS IN $ MILLIONS)
Decision Alternative Small complex, d1 Medium complex, d2 Large complex, d3
State of Nature Strong Demand s1 Weak Demand s2 8 7 14 5 20 9
Decision Trees A decision tree provides a graphical representation of the decision-making process. Figure 13.2 presents a decision tree for the PDC problem. Note that the decision tree shows the natural or logical progression that will occur over time. First, PDC must make a decision regarding the size of the condominium complex (d1, d2, or d3). Then, after the decision is implemented, either state of nature s1 or s2 will occur. The number at each end point of the tree indicates the payoff associated with a particular sequence. For example, the topmost payoff of 8 indicates that an $8 million profit is anticipated if PDC constructs a small condominium complex (d1) and demand turns out to be strong (s1). The next payoff of 7 indicates an anticipated profit of $7 million if PDC constructs a small condominium complex (d1) and demand turns out to be weak (s2). Thus, the decision tree shows graphically the sequences of decision alternatives and states of nature that provide the six possible payoffs for PDC.
FIGURE 13.2 DECISION TREE FOR THE PDC CONDOMINIUM PROJECT (PAYOFFS IN $ MILLIONS) Strong (s1) Small (d1)
2 Weak (s 2)
Strong (s1) 1
Medium (d 2)
7
14
3 Weak (s 2)
Strong (s1) Large (d 3)
8
5
20
4 Weak (s 2)
–9
13.2 If you have a payoff table, you can develop a decision tree. Try Problem 1(a).
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The decision tree in Figure 13.2 shows four nodes, numbered 1–4. Squares are used to depict decision nodes and circles are used to depict chance nodes. Thus, node 1 is a decision node, and nodes 2, 3, and 4 are chance nodes. The branches connect the nodes; those leaving the decision node correspond to the decision alternatives. The branches leaving each chance node correspond to the states of nature. The payoffs are shown at the end of the states-of-nature branches. We now turn to the question: How can the decision maker use the information in the payoff table or the decision tree to select the best decision alternative? Several approaches may be used.
NOTES AND COMMENTS 1. Experts in problem solving agree that the first step in solving a complex problem is to decompose it into a series of smaller subproblems. Decision trees provide a useful way to show how a problem can be decomposed and the sequential nature of the decision process.
13.2 Many people think of a good decision as one in which the consequence is good. However, in some instances, a good, well-thought-out decision may still lead to a bad or undesirable consequence.
2. People often view the same problem from different perspectives. Thus, the discussion regarding the development of a decision tree may provide additional insight about the problem.
DECISION MAKING WITHOUT PROBABILITIES In this section we consider approaches to decision making that do not require knowledge of the probabilities of the states of nature. These approaches are appropriate in situations in which the decision maker has little confidence in his or her ability to assess the probabilities, or in which a simple best-case and worst-case analysis is desirable. Because different approaches sometimes lead to different decision recommendations, the decision maker should understand the approaches available and then select the specific approach that, according to the decision maker’s judgment, is the most appropriate.
Optimistic Approach
For a maximization problem, the optimistic approach often is referred to as the maximax approach; for a minimization problem, the corresponding terminology is minimin.
The optimistic approach evaluates each decision alternative in terms of the best payoff that can occur. The decision alternative that is recommended is the one that provides the best possible payoff. For a problem in which maximum profit is desired, as in the PDC problem, the optimistic approach would lead the decision maker to choose the alternative corresponding to the largest profit. For problems involving minimization, this approach leads to choosing the alternative with the smallest payoff. To illustrate the optimistic approach, we use it to develop a recommendation for the PDC problem. First, we determine the maximum payoff for each decision alternative; then we select the decision alternative that provides the overall maximum payoff. These steps systematically identify the decision alternative that provides the largest possible profit. Table 13.2 illustrates these steps. Because 20, corresponding to d3, is the largest payoff, the decision to construct the large condominium complex is the recommended decision alternative using the optimistic approach.
Conservative Approach The conservative approach evaluates each decision alternative in terms of the worst payoff that can occur. The decision alternative recommended is the one that provides the best
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TABLE 13.2
Decision Analysis
MAXIMUM PAYOFF FOR EACH PDC DECISION ALTERNATIVE Decision Alternative Small complex, d1 Medium complex, d2 Large complex, d3
For a maximization problem, the conservative approach often is referred to as the maximax approach; for a minimization problem, the corresponding terminology is minimax.
Maximum Payoff 8 14 20
Maximum of the maximum payoff values
of the worst possible payoffs. For a problem in which the output measure is profit, as in the PDC problem, the conservative approach would lead the decision maker to choose the alternative that maximizes the minimum possible profit that could be obtained. For problems involving minimization, this approach identifies the alternative that will minimize the maximum payoff. To illustrate the conservative approach, we use it to develop a recommendation for the PDC problem. First, we identify the minimum payoff for each of the decision alternatives; then we select the decision alternative that maximizes the minimum payoff. Table 13.3 illustrates these steps for the PDC problem. Because 7, corresponding to d1, yields the maximum of the minimum payoffs, the decision alternative of a small condominium complex is recommended. This decision approach is considered conservative because it identifies the worst possible payoffs and then recommends the decision alternative that avoids the possibility of extremely “bad” payoffs. In the conservative approach, PDC is guaranteed a profit of at least $7 million. Although PDC may make more, it cannot make less than $7 million.
Minimax Regret Approach The minimax regret approach to decision making is neither purely optimistic nor purely conservative. Let us illustrate the minimax regret approach by showing how it can be used to select a decision alternative for the PDC problem. Suppose that PDC constructs a small condominium complex (d1) and demand turns out to be strong (s1). Table 13.1 showed that the resulting profit for PDC would be $8 million. However, given that the strong demand state of nature (s1) has occurred, we realize that the decision to construct a large condominium complex (d3), yielding a profit of $20 million, would have been the best decision. The difference between the payoff for the best decision alternative ($20 million) and the payoff for the decision to construct a small condominium complex ($8 million) is the opportunity loss, or regret, associated with decision alternative d1 when state of nature s1 occurs; thus, for this case, the opportunity loss or regret is $20 million $8 million $12 million. Similarly, if PDC makes the decision to construct a medium condominium complex (d2) and the strong demand state of nature (s1) occurs, the opportunity loss, or regret, associated with d2 would be $20 million $14 million $6 million. TABLE 13.3
MINIMUM PAYOFF FOR EACH PDC DECISION ALTERNATIVE Decision Alternative Small complex, d1 Medium complex, d2 Large complex, d3
Minimum Payoff 7 5 9
Maximum of the minimum payoff values
13.2
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Decision Making without Probabilities
In general, the following expression represents the opportunity loss, or regret: Rij = ƒ Vj* - Vij ƒ
(13.1)
where Rij the regret associated with decision alternative di and state of nature sj V*j the payoff value1 corresponding to the best decision for the state of nature sj Vij the payoff corresponding to decision alternative di and state of nature sj
For practice in developing a decision recommendation using the optimistic, conservative, and minimax regret approaches, try Problem 1 (part b).
Note the role of the absolute value in equation (13.1). For minimization problems, the best payoff, V *j, is the smallest entry in column j. Because this value always is less than or equal to Vij, the absolute value of the difference between V *j and Vij ensures that the regret is always the magnitude of the difference. Using equation (4.1) and the payoffs in Table 13.1, we can compute the regret associated with each combination of decision alternative di and state of nature sj. Because the PDC problem is a maximization problem, V *j will be the largest entry in column j of the payoff table. Thus, to compute the regret, we simply subtract each entry in a column from the largest entry in the column. Table 13.4 shows the opportunity loss, or regret, table for the PDC problem. The next step in applying the minimax regret approach is to list the maximum regret for each decision alternative; Table 13.5 shows the results for the PDC problem. Selecting the decision alternative with the minimum of the maximum regret values—hence, the name minimax regret—yields the minimax regret decision. For the PDC problem, the alternative to construct the medium condominium complex, with a corresponding maximum regret of $6 million, is the recommended minimax regret decision. Note that the three approaches discussed in this section provide different recommendations, which in itself isn’t bad. It simply reflects the difference in decision-making philosophies that underlie the various approaches. Ultimately, the decision maker will have to choose the most appropriate approach and then make the final decision accordingly. The main criticism of the approaches discussed in this section is that they do not consider any information about the probabilities of the various states of nature. In the next section we discuss an approach that utilizes probability information in selecting a decision alternative.
TABLE 13.4 OPPORTUNITY LOSS, OR REGRET, TABLE FOR THE PDC CONDOMINIUM PROJECT ($ MILLIONS)
Decision Alternative Small complex, d1 Medium complex, d2 Large complex, d3
1
State of Nature Strong Demand s1 Weak Demand s2 12 0 6 2 0 16
In maximization problems, V*j will be the largest entry in column j of the payoff table. In minimization problems, V*j will be the smallest entry in column j of the payoff table.
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TABLE 13.5
Decision Analysis
MAXIMUM REGRET FOR EACH PDC DECISION ALTERNATIVE Decision Alternative Small complex, d1 Medium complex, d2 Large complex, d3
13.3
Maximum Regret 12 6 16
Minimum of the maximum regret
DECISION MAKING WITH PROBABILITIES In many decision-making situations, we can obtain probability assessments for the states of nature. When such probabilities are available, we can use the expected value approach to identify the best decision alternative. Let us first define the expected value of a decision alternative and then apply it to the PDC problem. Let N = the number of states of nature P(sj) = the probability of state of nature sj Because one and only one of the N states of nature can occur, the probabilities must satisfy two conditions:
P(sj) Ú 0
for all states of nature
(13.2)
N
. . . + P(sN ) = 1 a P(sj) = P(s1) + P(s2) +
(13.3)
j=1
The expected value (EV) of decision alternative di is defined as follows:
N
EV(di) = a P(sj)Vij
(13.4)
j=1
In words, the expected value of a decision alternative is the sum of weighted payoffs for the decision alternative. The weight for a payoff is the probability of the associated state of nature and therefore the probability that the payoff will occur. Let us return to the PDC problem to see how the expected value approach can be applied. PDC is optimistic about the potential for the luxury high-rise condominium complex. Suppose that this optimism leads to an initial subjective probability assessment of 0.8 that demand will be strong (s1) and a corresponding probability of 0.2 that demand will be weak (s2). Thus, P(s1) 0.8 and P(s2) 0.2. Using the payoff values in Table 13.1 and equation
13.3
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(13.4), we compute the expected value for each of the three decision alternatives as follows: EV(d1) = 0.8(8) + 0.2(7) = 7.8 EV(d2) = 0.8(14) + 0.2(5) = 12.2 EV(d3) = 0.8(20) + 0.2( -9) = 14.2
Can you now use the expected value approach to develop a decision recommendation? Try Problem 4.
Computer software packages are available to help in constructing more complex decision trees. See Appendix 13.1.
Thus, using the expected value approach, we find that the large condominium complex, with an expected value of $14.2 million, is the recommended decision. The calculations required to identify the decision alternative with the best expected value can be conveniently carried out on a decision tree. Figure 13.3 shows the decision tree for the PDC problem with state-of-nature branch probabilities. Working backward through the decision tree, we first compute the expected value at each chance node. That is, at each chance node, we weight each possible payoff by its probability of occurrence. By doing so, we obtain the expected values for nodes 2, 3, and 4, as shown in Figure 13.4. Because the decision maker controls the branch leaving decision node 1 and because we are trying to maximize the expected profit, the best decision alternative at node 1 is d3. Thus, the decision tree analysis leads to a recommendation of d3, with an expected value of $14.2 million. Note that this recommendation is also obtained with the expected value approach in conjunction with the payoff table. Other decision problems may be substantially more complex than the PDC problem, but if a reasonable number of decision alternatives and states of nature are present, you can use the decision tree approach outlined here. First, draw a decision tree consisting of decision nodes, chance nodes, and branches that describe the sequential nature of the problem. If you use the expected value approach, the next step is to determine the probabilities for each of the states of nature and compute the expected value at each chance node. Then select the decision branch leading to the chance node with the best expected value. The decision alternative associated with this branch is the recommended decision.
FIGURE 13.3 PDC DECISION TREE WITH STATE-OF-NATURE BRANCH PROBABILITIES Strong (s1) Small (d1)
2
P(s1) = 0.8 Weak (s 2) P(s2) = 0.2 Strong (s1)
1
Medium (d 2 )
3
P(s1) = 0.8 Weak (s2) P(s2) = 0.2 Strong (s1)
Large (d 3)
4
P(s1) = 0.8 Weak (s2) P(s2) = 0.2
8
7
14
5
20
–9
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FIGURE 13.4 APPLYING THE EXPECTED VALUE APPROACH USING A DECISION TREE Small (d 1)
1
Medium (d 2)
Large (d 3)
2
EV(d 1) = 0.8(8) + 0.2(7) = $7.8
3
EV(d 2) = 0.8(14) + 0.2(5) = $12.2
4
EV(d 3) = 0.8(20) + 0.2(–9) = $14.2
The Management Science in Action, Early Detection of High-Risk Worker Disability Claims, describes how the Workers’ Compensation Board of British Columbia used a decision tree and expected cost to help determine whether a short-term disability claim should be considered a high-risk or a low-risk claim.
MANAGEMENT SCIENCE IN ACTION EARLY DETECTION OF HIGH-RISK WORKER DISABILITY CLAIMS* The Workers’ Compensation Board of British Columbia (WCB) helps workers and employers maintain safe workplaces and helps injured workers obtain disability income and return to work safely. The funds used to make the disability compensation payments are obtained from assessments levied on employers. In return, employers receive protection from lawsuits arising from work-related injuries. In recent years, the WCB spent more than $1 billion on worker compensation and rehabilitation. A short-term disability claim occurs when a worker suffers an injury or illness that results in temporary absence from work. Whenever a worker fails to recover completely from a short-term disability, the claim is reclassified as a long-term disability claim and more expensive long-term benefits are paid. The WCB wanted a systematic way to identify short-term disability claims that posed a high financial risk of being converted to the more
expensive long-term disability claims. If a shortterm disability claim could be classified as high risk early in the process, a WCB management team could intervene and monitor the claim and the recovery process more closely. As a result, WCB could improve the management of the high-risk claims and reduce the cost of any subsequent longterm disability claims. The WCB used a decision analysis approach to classify each new short-term disability claim as being either a high-risk claim or a low-risk claim. A decision tree consisting of two decision nodes and two states-of-nature nodes was developed. The two decision alternatives were: (1) Classify the new short-term claim as high-risk and intervene. (2) Classify the new short-term claim as low-risk and do not intervene. The two states of nature were: (1) The short-term claim converts to a longterm claim. (2) The short-term claim does not convert to a long-term claim. The characteristics of each new short-term claim were used to determine
13.3
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the probabilities for the states of nature. The payoffs were the disability claim costs associated with each decision alternative and each state-of-nature outcome. The objective of minimizing the expected cost determined whether a new short-term claim should be classified as high-risk. Implementation of the decision analysis model improved the practice of claim management for the Workers’ Compensation Board. Early intervention
on the high-risk claims saved an estimated $4.7 million per year.
*Based and S. Claims British 15–26.
on E. Urbanovich, E. Young, M. Puterman, Fattedad, “Early Detection of High-Risk at the Workers’ Compensation Board of Columbia,” Interfaces (July/August 2003):
Expected Value of Perfect Information Suppose that PDC has the opportunity to conduct a market research study that would help evaluate buyer interest in the condominium project and provide information that management could use to improve the probability assessments for the states of nature. To determine the potential value of this information, we begin by supposing that the study could provide perfect information regarding the states of nature; that is, we assume for the moment that PDC could determine with certainty, prior to making a decision, which state of nature is going to occur. To make use of this perfect information, we will develop a decision strategy that PDC should follow once it knows which state of nature will occur. A decision strategy is simply a decision rule that specifies the decision alternative to be selected after new information becomes available. To help determine the decision strategy for PDC, we reproduced PDC’s payoff table as Table 13.6. Note that, if PDC knew for sure that state of nature s1 would occur, the best decision alternative would be d3, with a payoff of $20 million. Similarly, if PDC knew for sure that state of nature s2 would occur, the best decision alternative would be d1, with a payoff of $7 million. Thus, we can state PDC’s optimal decision strategy when the perfect information becomes available as follows: If s1, select d3 and receive a payoff of $20 million. If s2, select d1 and receive a payoff of $7 million. What is the expected value for this decision strategy? To compute the expected value with perfect information, we return to the original probabilities for the states of nature: P(s1) 0.8 and P(s2) 0.2. Thus, there is a 0.8 probability that the perfect information will indicate state of nature s1 and the resulting decision alternative d3 will provide a $20 million profit. Similarly, with a 0.2 probability for state of nature s2, the optimal decision alternative d1 will provide a $7 million profit. Thus, from equation (13.4), the expected value of the decision strategy that uses perfect information is 0.8(20) 0.2(7) 17.4 We refer to the expected value of $17.4 million as the expected value with perfect information (EVwPI). Earlier in this section we showed that the recommended decision using the expected value approach is decision alternative d3, with an expected value of $14.2 million. Because this decision recommendation and expected value computation were made without the benefit of perfect information, $14.2 million is referred to as the expected value without perfect information (EVwoPI).
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TABLE 13.6
Decision Analysis
PAYOFF TABLE FOR THE PDC CONDOMINIUM PROJECT ($ MILLIONS)
Decision Alternative Small complex, d1 Medium complex, d2 Large complex, d3
It would be worth $3.2 million for PDC to learn the level of market acceptance before selecting a decision alternative.
State of Nature Strong Demand s1 Weak Demand s2 8 7 14 5 20 9
The expected value with perfect information is $17.4 million, and the expected value without perfect information is $14.2; therefore, the expected value of the perfect information (EVPI) is $17.4 $14.2 $3.2 million. In other words, $3.2 million represents the additional expected value that can be obtained if perfect information were available about the states of nature. Generally speaking, a market research study will not provide “perfect” information; however, if the market research study is a good one, the information gathered might be worth a sizable portion of the $3.2 million. Given the EVPI of $3.2 million, PDC might seriously consider a market survey as a way to obtain more information about the states of nature. In general, the expected value of perfect information (EVPI) is computed as follows: EVPI = ƒ EVwPI - EVwoPI ƒ
(13.5)
where EVPI expected value of perfect information EVwPI expected value with perfect information about the states of nature EVwoPI expected value without perfect information about the states of nature For practice in determining the expected value of perfect information, try Problem 14.
Note the role of the absolute value in equation (13.5). For minimization problems the expected value with perfect information is always less than or equal to the expected value without perfect information. In this case, EVPI is the magnitude of the difference between EVwPI and EVwoPI, or the absolute value of the difference as shown in equation (13.5).
NOTES AND COMMENTS We restate the opportunity loss, or regret, table for the PDC problem (see Table 13.4) as follows. State of Nature
Decision Alternative Small complex, d1 Medium complex, d 2 Large complex, d3
Strong Demand s1 12 6 0
Weak Demand s2 0 2 16
Using P(s1), P(s2), and the opportunity loss values, we can compute the expected opportunity loss (EOL) for each decision alternative. With P(s1) 0.8 and P(s2) 0.2, the expected opportunity loss for each of the three decision alternatives is EOL(d1) 0.8(12) 0.2(0) 9.6 EOL(d2 ) 0.8(6) 0.2(2) 5.2 EOL(d3) 0.8(0) 0.2(16) 3.2 Regardless of whether the decision analysis involves maximization or minimization, the minimum
13.4
expected opportunity loss always provides the best decision alternative. Thus, with EOL(d3) 3.2, d3 is the recommended decision. In addition, the minimum expected opportunity loss always is equal to
13.4
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Risk Analysis and Sensitivity Analysis
the expected value of perfect information. That is, EOL(best decision) EVPI; for the PDC problem, this value is $3.2 million.
RISK ANALYSIS AND SENSITIVITY ANALYSIS Risk analysis helps the decision maker recognize the difference between the expected value of a decision alternative and the payoff that may actually occur. Sensitivity analysis also helps the decision maker by describing how changes in the state-of-nature probabilities and/or changes in the payoffs affect the recommended decision alternative.
Risk Analysis A decision alternative and a state of nature combine to generate the payoff associated with a decision. The risk profile for a decision alternative shows the possible payoffs along with their associated probabilities. Let us demonstrate risk analysis and the construction of a risk profile by returning to the PDC condominium construction project. Using the expected value approach, we identified the large condominium complex (d3) as the best decision alternative. The expected value of $14.2 million for d3 is based on a 0.8 probability of obtaining a $20 million profit and a 0.2 probability of obtaining a $9 million loss. The 0.8 probability for the $20 million payoff and the 0.2 probability for the $9 million payoff provide the risk profile for the large complex decision alternative. This risk profile is shown graphically in Figure 13.5. Sometimes a review of the risk profile associated with an optimal decision alternative may cause the decision maker to choose another decision alternative even though the expected value of the other decision alternative is not as good. For example, the risk profile for the medium complex decision alternative (d2) shows a 0.8 probability for a $14 million
FIGURE 13.5 RISK PROFILE FOR THE LARGE COMPLEX DECISION ALTERNATIVE FOR THE PDC CONDOMINIUM PROJECT
Probability
1.0 .8 .6 .4 .2 –10
0 10 Profit ($ millions)
20
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payoff and a 0.2 probability for a $5 million payoff. Because no probability of a loss is associated with decision alternative d2, the medium complex decision alternative would be judged less risky than the large complex decision alternative. As a result, a decision maker might prefer the less-risky medium complex decision alternative even though it has an expected value of $2 million less than the large complex decision alternative.
Sensitivity Analysis Sensitivity analysis can be used to determine how changes in the probabilities for the states of nature or changes in the payoffs affect the recommended decision alternative. In many cases, the probabilities for the states of nature and the payoffs are based on subjective assessments. Sensitivity analysis helps the decision maker understand which of these inputs are critical to the choice of the best decision alternative. If a small change in the value of one of the inputs causes a change in the recommended decision alternative, the solution to the decision analysis problem is sensitive to that particular input. Extra effort and care should be taken to make sure the input value is as accurate as possible. On the other hand, if a modest to large change in the value of one of the inputs does not cause a change in the recommended decision alternative, the solution to the decision analysis problem is not sensitive to that particular input. No extra time or effort would be needed to refine the estimated input value. One approach to sensitivity analysis is to select different values for the probabilities of the states of nature and the payoffs and then re-solve the decision analysis problem. If the recommended decision alternative changes, we know that the solution is sensitive to the changes made. For example, suppose that in the PDC problem the probability for a strong demand is revised to 0.2 and the probability for a weak demand is revised to 0.8. Would the recommended decision alternative change? Using P(s1) 0.2, P(s2) 0.8, and equation (13.4), the revised expected values for the three decision alternatives are EV(d1) = 0.2(8) + 0.8(7) = 7.2 EV(d2) = 0.2(14) + 0.8(5) = 6.8 EV(d3) = 0.2(20) + 0.8( - 9) = - 3.2
Computer software packages for decision analysis make it easy to calculate these revised scenarios.
With these probability assessments the recommended decision alternative is to construct a small condominium complex (d1), with an expected value of $7.2 million. The probability of strong demand is only 0.2, so constructing the large condominium complex (d3) is the least preferred alternative, with an expected value of $3.2 million (a loss). Thus, when the probability of strong demand is large, PDC should build the large complex; when the probability of strong demand is small, PDC should build the small complex. Obviously, we could continue to modify the probabilities of the states of nature and learn even more about how changes in the probabilities affect the recommended decision alternative. The drawback to this approach is the numerous calculations required to evaluate the effect of several possible changes in the state-of-nature probabilities. For the special case of two states of nature, a graphical procedure can be used to determine how changes for the probabilities of the states of nature affect the recommended decision alternative. To demonstrate this procedure, we let p denote the probability of state of nature s1; that is, P(s1) p. With only two states of nature in the PDC problem, the probability of state of nature s2 is P(s2 ) = 1 - P(s1) = 1 - p
13.4
Risk Analysis and Sensitivity Analysis
617
Using equation (13.4) and the payoff values in Table 13.1, we determine the expected value for decision alternative d1 as follows:
EV(d1) = P(s1)(8) + P(s2 )(7) = p(8) + (1 - p)(7) = 8p + 7 - 7p = p + 7
(13.6)
Repeating the expected value computations for decision alternatives d2 and d3, we obtain expressions for the expected value of each decision alternative as a function of p:
EV(d2) = 9p + 5 EV(d3) = 29p - 9
(13.7) (13.8)
Thus, we have developed three equations that show the expected value of the three decision alternatives as a function of the probability of state of nature s1. We continue by developing a graph with values of p on the horizontal axis and the associated EVs on the vertical axis. Because equations (13.6), (13.7), and (13.8) are linear equations, the graph of each equation is a straight line. For each equation, we can obtain the line by identifying two points that satisfy the equation and drawing a line through the points. For instance, if we let p 0 in equation (13.6), EV(d1) 7. Then, letting p 1, EV(d1) 8. Connecting these two points, (0, 7) and (1, 8), provides the line labeled EV(d1) in Figure 13.6. Similarly, we obtain the lines labeled EV(d2) and EV(d3); these lines are the graphs of equations (13.7) and (13.8), respectively. Figure 13.6 shows how the recommended decision changes as p, the probability of the strong demand state of nature (s1), changes. Note that for small values of p, decision alternative d1 (small complex) provides the largest expected value and is thus the recommended decision. When the value of p increases to a certain point, decision alternative d2 (medium complex) provides the largest expected value and is the recommended decision. Finally, for large values of p, decision alternative d3 (large complex) becomes the recommended decision. The value of p for which the expected values of d1 and d2 are equal is the value of p corresponding to the intersection of the EV(d1) and the EV(d2) lines. To determine this value, we set EV(d1) EV(d2) and solve for the value of p: p + 7 = 9p + 5 8p = 2 2 = 0.25 p = 8 Graphical sensitivity analysis shows how changes in the probabilities for the states of nature affect the recommended decision alternative. Try Problem 8.
Hence, when p 0.25, decision alternatives d1 and d2 provide the same expected value. Repeating this calculation for the value of p corresponding to the intersection of the EV(d2) and EV(d3) lines, we obtain p 0.70. Using Figure 13.6, we can conclude that decision alternative d1 provides the largest expected value for p 0.25, decision alternative d2 provides the largest expected value for
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FIGURE 13.6 EXPECTED VALUE FOR THE PDC DECISION ALTERNATIVES AS A FUNCTION OF p
d3 provides the highest EV
20
)
d2 provides the highest EV
15 Expected Value (EV)
(d 3 EV
) EV(d 2
d1 provides the highest EV 10
EV(d1)
5
0.2
0.4
0.6
0.8
1.0
p
–5
–10
0.25 p 0.70, and decision alternative d3 provides the largest expected value for p 0.70. Because p is the probability of state of nature s1 and (1 p) is the probability of state of nature s2, we now have the sensitivity analysis information that tells us how changes in the state-of-nature probabilities affect the recommended decision alternative. Sensitivity analysis calculations can also be made for the values of the payoffs. In the original PDC problem, the expected values for the three decision alternatives were as follows: EV(d1) 7.8, EV(d2) 12.2, and EV(d3) 14.2. Decision alternative d3 (large complex) was recommended. Note that decision alternative d2 with EV(d2) 12.2 was the second best decision alternative. Decision alternative d3 will remain the optimal decision alternative as long as EV(d3) is greater than or equal to the expected value of the second best decision alternative. Thus, decision alternative d3 will remain the optimal decision alternative as long as EV(d3) Ú 12.2
Let S = the payoff of decision alternative d3 when demand is strong W = the payoff of decision alternative d3 when demand is weak
(13.9)
13.4
Risk Analysis and Sensitivity Analysis
619
Using P(s1) 0.8 and P(s2) 0.2, the general expression for EV(d3) is
EV(d3) = 0.8S + 0.2W
(13.10)
Assuming that the payoff for d3 stays at its original value of $9 million when demand is weak, the large complex decision alternative will remain optimal as long as
EV(d3) = 0.8S + 0.2( -9) Ú 12.2
(13.11)
Solving for S, we have 0.8S - 1.8 Ú 12.2 0.8S Ú 14 S Ú 17.5 Recall that when demand is strong, decision alternative d3 has an estimated payoff of $20 million. The preceding calculation shows that decision alternative d3 will remain optimal as long as the payoff for d3 when demand is strong is at least $17.5 million. Assuming that the payoff for d3 when demand is strong stays at its original value of $20 million, we can make a similar calculation to learn how sensitive the optimal solution is with regard to the payoff for d3 when demand is weak. Returning to the expected value calculation of equation (13.10), we know that the large complex decision alternative will remain optimal as long as
EV(d3) = 0.8(20) + 0.2W Ú 12.2
(13.12)
Solving for W, we have 16 + 0.2W Ú 12.2 0.2W Ú -3.8 W Ú -19 Recall that when demand is weak, decision alternative d3 has an estimated payoff of –$9 million. The preceding calculation shows that decision alternative d3 will remain optimal as long as the payoff for d3 when demand is weak is at least –$19 million. Based on this sensitivity analysis, we conclude that the payoffs for the large complex decision alternative (d3) could vary considerably, and d3 would remain the recommended decision alternative. Thus, we conclude that the optimal solution for the PDC decision problem is not particularly sensitive to the payoffs for the large complex decision alternative. We note, however, that this sensitivity analysis has been conducted based on only one change at a time. That is, only one payoff was changed and the probabilities for the states
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Sensitivity analysis can assist management in deciding whether more time and effort should be spent obtaining better estimates of payoffs and probabilities.
of nature remained P(s1) 0.8 and P(s2) 0.2. Note that similar sensitivity analysis calculations can be made for the payoffs associated with the small complex decision alternative d1 and the medium complex decision alternative d2. However, in these cases, decision alternative d3 remains optimal only if the changes in the payoffs for decision alternatives d1 and d2 meet the requirements that EV(d1) 14.2 and EV(d2) 14.2.
Decision Analysis
NOTES AND COMMENTS 1. Some decision analysis software automatically provides the risk profiles for the optimal decision alternative. These packages also allow the user to obtain the risk profiles for other decision alternatives. After comparing the risk profiles, a decision maker may decide to select a decision alternative with a good risk profile even though the expected value of the decision alternative is not as good as the optimal decision alternative. 2. A tornado diagram, a graphical display, is particularly helpful when several inputs combine
13.5
to determine the value of the optimal solution. By varying each input over its range of values, we obtain information about how each input affects the value of the optimal solution. To display this information, a bar is constructed for the input with the width of the bar showing how the input affects the value of the optimal solution. The widest bar corresponds to the input that is most sensitive. The bars are arranged in a graph with the widest bar at the top, resulting in a graph that has the appearance of a tornado.
DECISION ANALYSIS WITH SAMPLE INFORMATION In applying the expected value approach, we showed how probability information about the states of nature affects the expected value calculations and thus the decision recommendation. Frequently, decision makers have preliminary or prior probability assessments for the states of nature that are the best probability values available at that time. However, to make the best possible decision, the decision maker may want to seek additional information about the states of nature. This new information can be used to revise or update the prior probabilities so that the final decision is based on more accurate probabilities for the states of nature. Most often, additional information is obtained through experiments designed to provide sample information about the states of nature. Raw material sampling, product testing, and market research studies are examples of experiments (or studies) that may enable management to revise or update the state-of-nature probabilities. These revised probabilities are called posterior probabilities. Let us return to the PDC problem and assume that management is considering a sixmonth market research study designed to learn more about potential market acceptance of the PDC condominium project. Management anticipates that the market research study will provide one of the following two results: 1. Favorable report: A significant number of the individuals contacted express interest in purchasing a PDC condominium. 2. Unfavorable report: Very few of the individuals contacted express interest in purchasing a PDC condominium.
Influence Diagram By introducing the possibility of conducting a market research study, the PDC problem becomes more complex. The influence diagram for the expanded PDC problem is shown in Figure 13.7. Note that the two decision nodes correspond to the research study and the
13.5
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FIGURE 13.7 INFLUENCE DIAGRAM FOR THE PDC PROBLEM WITH SAMPLE INFORMATION
Research Study
Research Study Results
Demand
Complex Size
Profit
complex-size decisions. The two chance nodes correspond to the research study results and demand for the condominiums. Finally, the consequence node is the profit. From the arcs of the influence diagram, we see that demand influences both the research study results and profit. Although demand is currently unknown to PDC, some level of demand for the condominiums already exists in the Pittsburgh area. If existing demand is strong, the research study is likely to find a significant number of individuals who express an interest in purchasing a condominium. However, if the existing demand is weak, the research study is more likely to find a significant number of individuals who express little interest in purchasing a condominium. In this sense, existing demand for the condominiums will influence the research study results, and clearly, demand will have an influence upon PDC’s profit. The arc from the research study decision node to the complex-size decision node indicates that the research study decision precedes the complex-size decision. No arc spans from the research study decision node to the research study results node, because the decision to conduct the research study does not actually influence the research study results. The decision to conduct the research study makes the research study results available, but it does not influence the results of the research study. Finally, the complex-size node and the demand node both influence profit. Note that if a stated cost to conduct the research study were given, the decision to conduct the research study would also influence profit. In such a case, we would need to add an arc from the research study decision node to the profit node to show the influence that the research study cost would have on profit.
Decision Tree The decision tree for the PDC problem with sample information shows the logical sequence for the decisions and the chance events in Figure 13.8. First, PDC’s management must decide whether the market research should be conducted. If it is conducted, PDC’s management must be prepared to make a decision about the size of the condominium project if the market research report is favorable and, possibly, a different decision about the size of the condominium project if the market research report is unfavorable. In Figure 13.8, the squares are decision nodes and the circles are chance nodes. At each decision node, the branch of the tree that is taken is based on the decision made. At each chance node, the branch of the tree that is taken is based on probability or chance. For example, decision node 1 shows that PDC must first make the decision
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FIGURE 13.8 THE PDC DECISION TREE INCLUDING THE MARKET RESEARCH STUDY
Small (d1)
6
Strong (s1)
8
Weak (s2)
7
Strong (s1) Favorable Report
3
Medium (d2)
7
Weak (s2) Strong (s1)
Large (d3)
8
Market Research 2 Study
Weak (s2) Strong (s1)
Small (d1)
9
Weak (s2) Strong (s1)
1
Unfavorable Report
4
Medium (d2)
10
Weak (s2) Strong (s1)
Large (d3)
11
Weak (s2) Strong (s1)
Small (d1)
12
Weak (s2) Strong (s1)
No Market Research Study
5
Medium (d2)
13
Weak (s2) Strong (s1)
Large (d3)
14
Weak (s2)
14 5 20 9 8 7 14 5 20 9 8 7 14 5 20 9
of whether to conduct the market research study. If the market research study is undertaken, chance node 2 indicates that both the favorable report branch and the unfavorable report branch are not under PDC’s control and will be determined by chance. Node 3 is a decision node, indicating that PDC must make the decision to construct the small, medium, or large complex if the market research report is favorable. Node 4 is a decision node showing that
13.5
We explain in Section 13.6 how these probabilities can be developed.
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PDC must make the decision to construct the small, medium, or large complex if the market research report is unfavorable. Node 5 is a decision node indicating that PDC must make the decision to construct the small, medium, or large complex if the market research is not undertaken. Nodes 6 to 14 are chance nodes indicating that the strong demand or weak demand state-of-nature branches will be determined by chance. Analysis of the decision tree and the choice of an optimal strategy require that we know the branch probabilities corresponding to all chance nodes. PDC has developed the following branch probabilities: If the market research study is undertaken P(Favorable report) = 0.77 P(Unfavorable report) = 0.23 If the market research report is favorable P(Strong demand given a favorable report) = 0.94 P(Weak demand given a favorable report) = 0.06 If the market research report is unfavorable P(Strong demand given an unfavorable report) = 0.35 P(Weak demand given an unfavorable report) = 0.65 If the market research report is not undertaken, the prior probabilities are applicable. P(Strong demand) = 0.80 P(Weak demand) = 0.20 The branch probabilities are shown on the decision tree in Figure 13.9.
Decision Strategy A decision strategy is a sequence of decisions and chance outcomes where the decisions chosen depend on the yet-to-be-determined outcomes of chance events. The approach used to determine the optimal decision strategy is based on a backward pass through the decision tree using the following steps: 1. At chance nodes, compute the expected value by multiplying the payoff at the end of each branch by the corresponding branch probabilities. 2. At decision nodes, select the decision branch that leads to the best expected value. This expected value becomes the expected value at the decision node. Starting the backward pass calculations by computing the expected values at chance nodes 6 to 14 provides the following results: EV(Node 6) EV(Node 7) EV(Node 8) EV(Node 9) EV(Node 10) EV(Node 11) EV(Node 12) EV(Node 13) EV(Node 14)
0.94(8) 0.94(14) 0.94(20) 0.35(8) 0.35(14) 0.35(20) 0.80(8) 0.80(14) 0.80(20)
0.06(7) 0.06(5) 0.06(–9) 0.65(7) 0.65(5) 0.65(–9) 0.20(7) 0.20(5) 0.20(–9)
7.94 13.46 18.26 7.35 8.15 1.15 7.80 12.20 14.20
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FIGURE 13.9 THE PDC DECISION TREE WITH BRANCH PROBABILITIES Strong (s1) Small (d1)
0.94
6
Weak (s2) 0.06
Strong (s1) Favorable Report 0.77
3
Medium (d2)
0.94
7
Weak (s2) 0.06
Strong (s1) Large (d3)
0.94
8
Weak (s2) 0.06
Market Research 2 Study
Strong (s1) Small (d1)
0.35
9
Weak (s2) 0.65
Strong (s1) 1
Unfavorable Report 0.23
4
Medium (d2)
0.35
10
Weak (s2) 0.65
Strong (s1) Large (d3)
0.35
11
Weak (s2) 0.65
Strong (s1) Small (d1)
0.80
12
Weak (s2) 0.20
Strong (s1) No Market Research Study
5
Medium (d2)
0.80
13
Weak (s2) 0.20
Strong (s1) Large (d3)
0.80
14
Weak (s2) 0.20
8 7 14 5 20 9 8 7 14 5 20 9 8 7 14 5 20 9
Figure 13.10 shows the reduced decision tree after computing expected values at these chance nodes. Next, move to decision nodes 3, 4, and 5. For each of these nodes, we select the decision alternative branch that leads to the best expected value. For example, at node 3 we have the choice of the small complex branch with EV(Node 6) 7.94, the medium complex branch with EV(Node 7) 13.46, and the large complex branch with EV(Node 8) 18.26. Thus,
13.5
FIGURE 13.10
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PDC DECISION TREE AFTER COMPUTING EXPECTED VALUES AT CHANCE NODES 6 TO 14 Small (d1)
Favorable Report 0.77
3
Medium (d2)
Large (d3)
6
EV = 7.94
7
EV = 13.46
8
EV = 18.26
9
EV = 7.35
10
EV = 8.15
11
EV = 1.15
12
EV = 7.80
13
EV = 12.20
14
EV = 14.20
Market Research 2 Study Small (d1)
1
Unfavorable Report 0.23
4
Medium (d2)
Large (d3)
Small (d1)
No Market Research Study
5
Medium (d2)
Large (d3)
we select the large complex decision alternative branch and the expected value at node 3 becomes EV(Node 3) 18.26. For node 4, we select the best expected value from nodes 9, 10, and 11. The best decision alternative is the medium complex branch that provides EV(Node 4) 8.15. For node 5, we select the best expected value from nodes 12, 13, and 14. The best decision alternative is the large complex branch that provides EV(Node 5) 14.20. Figure 13.11 shows the reduced decision tree after choosing the best decisions at nodes 3, 4, and 5.
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FIGURE 13.11
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PDC DECISION TREE AFTER CHOOSING BEST DECISIONS AT NODES 3, 4, AND 5 Favorable Report 0.77
3
EV(d3) = 18.26
Unfavorable Report 0.23
4
EV(d2 ) = 8.15
5
EV(d3) = 14.20
Market Research 2 Study
1
No Market Research Study
The expected value at chance node 2 can now be computed as follows: EV(Node 2) = 0.77EV(Node 3) + 0.23EV(Node 4) = 0.77(18.26) + 0.23(8.15) = 15.93
Problem 16 will test your ability to develop an optimal decision strategy.
This calculation reduces the decision tree to one involving only the two decision branches from node 1 (see Figure 13.12). Finally, the decision can be made at decision node 1 by selecting the best expected values from nodes 2 and 5. This action leads to the decision alternative to conduct the market research study, which provides an overall expected value of 15.93. The optimal decision for PDC is to conduct the market research study and then carry out the following decision strategy: If the market research is favorable, construct the large condominium complex. If the market research is unfavorable, construct the medium condominium complex. The analysis of the PDC decision tree describes the methods that can be used to analyze more complex sequential decision problems. First, draw a decision tree consisting of
13.5
Decision Analysis with Sample Information
FIGURE 13.12
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PDC DECISION TREE REDUCED TO TWO DECISION BRANCHES
Market Research Study
2
EV = 15.93
5
EV = 14.20
1
No Market Research Study
decision and chance nodes and branches that describe the sequential nature of the problem. Determine the probabilities for all chance outcomes. Then, by working backward through the tree, compute expected values at all chance nodes and select the best decision branch at all decision nodes. The sequence of optimal decision branches determines the optimal decision strategy for the problem. The Management Science in Action, New Drug Decision Analysis at Bayer Pharmaceuticals, describes how an extension of the decision analysis principles presented in this section enabled Bayer to make decisions about the development and marketing of a new drug.
Risk Profile Figure 13.13 provides a reduced decision tree showing only the sequence of decision alternatives and chance events for the PDC optimal decision strategy. By implementing the optimal decision strategy, PDC will obtain one of the four payoffs shown at the terminal branches of the decision tree. Recall that a risk profile shows the possible payoffs with their associated probabilities. Thus, in order to construct a risk profile for the optimal decision strategy, we will need to compute the probability for each of the four payoffs. Note that each payoff results from a sequence of branches leading from node 1 to the payoff. For instance, the payoff of $20 million is obtained by following the upper branch from node 1, the upper branch from node 2, the lower branch from node 3, and the upper branch from node 8. The probability of following that sequence of branches can be found by multiplying the probabilities for the branches from the chance nodes in the sequence.
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FIGURE 13.13
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PDC DECISION TREE SHOWING ONLY BRANCHES ASSOCIATED WITH OPTIMAL DECISION STRATEGY Favorable Report 0.77
3
Strong (s1) Large (d3)
0.94
8
Weak (s2) 0.06
Market Research 2 Study
Strong (s1) 1
Unfavorable Report 0.23
4
Medium (d2)
0.35
10
Weak (s2) 0.65
20 9
14 5
Thus, the probability of the $20 million payoff is (0.77)(0.94) 0.72. Similarly, the probabilities for each of the other payoffs are obtained by multiplying the probabilities for the branches from the chance nodes leading to the payoffs. Doing so, we find the probability of the –$9 million payoff is (0.77)(0.06) 0.05; the probability of the $14 million payoff is (0.23)(0.35) 0.08; and the probability of the $5 million payoff is (0.23)(0.65) 0.15. The following table showing the probability distribution for the payoffs for the PDC optimal decision strategy is the tabular representation of the risk profile for the optimal decision strategy.
Payoff ($ millions) 9 5 14 20
Probability 0.05 0.15 0.08 0.72 1.00
Figure 13.14 provides a graphical representation of the risk profile. Comparing Figures 13.5 and 13.14, we see that the PDC risk profile is changed by the strategy to conduct the market research study. In fact, the use of the market research study lowered the probability of the $9 million loss from 0.20 to 0.05. PDC’s management would most likely view that change as a significant reduction in the risk associated with the condominium project.
13.5
FIGURE 13.14
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RISK PROFILE FOR PDC CONDOMINIUM PROJECT WITH SAMPLE INFORMATION SHOWING PAYOFFS ASSOCIATED WITH OPTIMAL DECISION STRATEGY
Probability
0.8
0.6
0.4
0.2
–10
0 10 Profit ($ millions)
20
MANAGEMENT SCIENCE IN ACTION NEW DRUG DECISION ANALYSIS AT BAYER PHARMACEUTICALS* Drug development in the United States requires substantial investment and is very risky. It takes nearly 15 years to research and develop a new drug. The Bayer Biological Products (BP) group used decision analysis to evaluate the potential for a new blood clot–busting drug. An influence diagram was used to describe the complex structure of the decision analysis process. Six key yes-or-no decision nodes were identified: (1) begin preclinical development; (2) begin testing in humans; (3) continue development into phase 3; (4) continue development into phase 4; (5) file a license application with the FDA; and (6) launch the new drug into the marketplace. More than 50 chance nodes appeared in the influence diagram. The chance nodes showed how uncertainties—related to factors such as direct labor costs, process development costs, market share, tax rate, and pricing—affected the outcome. Net present value provided the consequence and the decision-making criterion.
The EVSI $1.73 million suggests PDC should be willing to pay up to $1.73 million to conduct the market research study.
Probability assessments were made concerning both the technical risk and market risk at each stage of the process. The resulting sequential decision tree had 1955 possible paths that led to different net present value outcomes. Cost inputs, judgments of potential outcomes, and the assignment of probabilities helped evaluate the project’s potential contribution. Sensitivity analysis was used to identify key variables that would require special attention by the project team and management during the drug development process. Application of decision analysis principles allowed Bayer to make good decisions about how to develop and market the new drug. *Based on Jeffrey S. Stonebraker, “How Bayer Makes Decisions to Develop New Drugs,” Interfaces, no. 6 (November/December 2002): 77–90.
Expected Value of Sample Information In the PDC problem, the market research study is the sample information used to determine the optimal decision strategy. The expected value associated with the market research study is $15.93. In Section 13.3 we showed that the best expected value if the market research
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study is not undertaken is $14.20. Thus, we can conclude that the difference, $15.93 – $14.20 $1.73, is the expected value of sample information (EVSI). In other words, conducting the market research study adds $1.73 million to the PDC expected value. In general, the expected value of sample information is as follows: EVSI = ƒ EVwSI - EVwoSI ƒ
(13.13)
where EVSI = expected value of sample information EVwSI = expected value with sample information about the states of nature EVwoSI = expected value without sample information about the states of nature Note the role of the absolute value in equation (13.13). For minimization problems the expected value with sample information is always less than or equal to the expected value without sample information. In this case, EVSI is the magnitude of the difference between EVwSI and EVwoSI; thus, by taking the absolute value of the difference as shown in equation (13.13), we can handle both the maximization and minimization cases with one equation.
Efficiency of Sample Information In Section 13.3 we showed that the expected value of perfect information (EVPI) for the PDC problem is $3.2 million. We never anticipated that the market research report would obtain perfect information, but we can use an efficiency measure to express the value of the market research information. With perfect information having an efficiency rating of 100%, the efficiency rating E for sample information is computed as follows:
E
EVSI 100 EVPI
(13.14)
For the PDC problem, E =
1.73 * 100 = 54.1% 3.2
In other words, the information from the market research study is 54.1% as efficient as perfect information. Low efficiency ratings for sample information might lead the decision maker to look for other types of information. However, high efficiency ratings indicate that the sample information is almost as good as perfect information and that additional sources of information would not yield significantly better results.
13.6
COMPUTING BRANCH PROBABILITIES In Section 13.5 the branch probabilities for the PDC decision tree chance nodes were specified in the problem description. No computations were required to determine these probabilities. In this section we show how Bayes’ theorem can be used to compute branch probabilities for decision trees.
13.6
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Computing Branch Probabilities
FIGURE 13.15
THE PDC DECISION TREE
Small (d1)
Favorable Report P(F )
3
Medium (d2)
Large (d3)
6
7
8
Market Research 2 Study Small (d1)
1
Unfavorable Report P(U )
4
Medium (d2)
Large (d3)
Small (d1)
No Market Research Study
5
Medium (d2)
Large (d3)
9
10
11
12
13
14
Strong (s1) 8 P(s1| F) Weak (s2) 7 P(s2| F) Strong (s1) 14 P(s1| F) Weak (s2) 5 P(s2| F) Strong (s1) 20 P(s1| F) Weak (s2) 9 P(s2| F) Strong (s1) 8 P(s1| U) Weak (s2) 7 P(s2| U) Strong (s1) 14 P(s1| U) Weak (s2) 5 P(s2| U) Strong (s1) 20 P(s1| U) Weak (s2) 9 P(s2| U) Strong (s1) P(s1)
8
Weak (s2) P(s2)
7
Strong (s1) P(s1)
14
Weak (s2) P(s2)
5
Strong (s1) P(s1)
20
Weak (s2) P(s2)
9
The PDC decision tree is shown again in Figure 13.15. Let F U s1 s2
= = = =
Favorable market research report Unfavorable market research report Strong demand (state of nature 1) Weak demand (state of nature 2)
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At chance node 2, we need to know the branch probabilities P(F) and P(U). At chance nodes 6, 7, and 8, we need to know the branch probabilities P(s1 兩 F), the probability of state of nature 1 given a favorable market research report, and P(s2 兩 F), the probability of state of nature 2 given a favorable market research report. P(s1 兩 F) and P(s2 兩 F) are referred to as posterior probabilities because they are conditional probabilities based on the outcome of the sample information. At chance nodes 9, 10, and 11, we need to know the branch probabilities P(s1 兩 U) and P(s2 兩 U); note that these are also posterior probabilities, denoting the probabilities of the two states of nature given that the market research report is unfavorable. Finally, at chance nodes 12, 13, and 14, we need the probabilities for the states of nature, P(s1) and P(s2), if the market research study is not undertaken. In making the probability computations, we need to know PDC’s assessment of the probabilities for the two states of nature, P(s1) and P(s2), which are the prior probabilities as discussed earlier. In addition, we must know the conditional probability of the market research outcomes (the sample information) given each state of nature. For example, we need to know the conditional probability of a favorable market research report given that the state of nature is strong demand for the PDC project; note that this conditional probability of F given state of nature s1 is written P(F 兩 s1). To carry out the probability calculations, we will need conditional probabilities for all sample outcomes given all states of nature, that is, P(F 兩 s1), P(F 兩 s2), P(U 兩 s1), and P(U 兩 s2). In the PDC problem we assume that the following assessments are available for these conditional probabilities:
State of Nature Strong demand, s1 Weak demand, s2
Market Research Favorable, F Unfavorable, U P(F 冷 s1) 0.90 P(U 冷 s1) 0.10 P(F 冷 s2) 0.25 P(U 冷 s2) 0.75
Note that the preceding probability assessments provide a reasonable degree of confidence in the market research study. If the true state of nature is s1, the probability of a favorable market research report is 0.90, and the probability of an unfavorable market research report is 0.10. If the true state of nature is s2, the probability of a favorable market research report is 0.25, and the probability of an unfavorable market research report is 0.75. The reason for a 0.25 probability of a potentially misleading favorable market research report for state of nature s2 is that when some potential buyers first hear about the new condominium project, their enthusiasm may lead them to overstate their real interest in it. A potential buyer’s initial favorable response can change quickly to a “no thank you” when later faced with the reality of signing a purchase contract and making a down payment. In the following discussion we present a tabular approach as a convenient method for carrying out the probability computations. The computations for the PDC problem based on a favorable market research report (F) are summarized in Table 13.7. The steps used to develop this table are as follows: Step 1. In column 1 enter the states of nature. In column 2 enter the prior probabilities for the states of nature. In column 3 enter the conditional probabilities of a favorable market research report (F) given each state of nature. Step 2. In column 4 compute the joint probabilities by multiplying the prior probability values in column 2 by the corresponding conditional probability values in column 3.
13.6
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TABLE 13.7 BRANCH PROBABILITIES FOR THE PDC CONDOMINIUM PROJECT BASED ON A FAVORABLE MARKET RESEARCH REPORT States of Nature sj s1 s2
Prior Probabilities P(sj) 0.8 0.2 1.0
Conditional Probabilities P(F | sj) 0.90 0.25
Joint Probabilities P(F > sj) 0.72 0.05 P(F) 0.77
Posterior Probabilities P(sj | F) 0.94 0.06 1.00
Step 3. Sum the joint probabilities in column 4 to obtain the probability of a favorable market research report, P(F). Step 4. Divide each joint probability in column 4 by P(F) 0.77 to obtain the revised or posterior probabilities, P(s1 兩 F) and P(s2 兩 F).
Problem 23 asks you to compute the posterior probabilities.
Table 13.7 shows that the probability of obtaining a favorable market research report is P(F) 0.77. In addition, P(s1 兩 F) 0.94 and P(s2 兩 F) 0.06. In particular, note that a favorable market research report will prompt a revised or posterior probability of 0.94 that the market demand of the condominium will be strong, s1. The tabular probability computation procedure must be repeated for each possible sample information outcome. Thus, Table 13.8 shows the computations of the branch probabilities of the PDC problem based on an unfavorable market research report. Note that the probability of obtaining an unfavorable market research report is P(U) 0.23. If an unfavorable report is obtained, the posterior probability of a strong market demand, s1, is 0.35 and of a weak market demand, s2, is 0.65. The branch probabilities from Tables 13.7 and 13.8 were shown on the PDC decision tree in Figure 13.9. The discussion in this section shows an underlying relationship between the probabilities on the various branches in a decision tree. To assume different prior probabilities, P(s1) and P(s2), without determining how these changes would alter P(F) and P(U), as well as the posterior probabilities P(s1 兩 F), P(s2 兩 F), P(s1 兩 U), and P(s2 兩 U), would be inappropriate. The Management Science in Action, Medical Screening Test at Duke University Medical Center, shows how posterior probability information and decision analysis helped management understand the risks and costs associated with a new screening procedure.
TABLE 13.8 BRANCH PROBABILITIES FOR THE PDC CONDOMINIUM PROJECT BASED ON AN UNFAVORABLE MARKET RESEARCH REPORT States of Nature sj s1 s2
Prior Probabilities P(sj) 0.8 0.2 1.0
Conditional Probabilities P(U | sj) 0.10 0.75
Joint Probabilities P(U > sj) 0.08 0.15 P(U) 0.23
Posterior Probabilities P(sj | U ) 0.35 0.65 1.00
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MANAGEMENT SCIENCE IN ACTION MEDICAL SCREENING TEST AT DUKE UNIVERSITY MEDICAL CENTER* A medical screening test developed at the Duke University Medical Center involved using blood samples from newborns to screen for metabolic disorders. A positive test result indicated that a deficiency was present, while a negative test result indicated that a deficiency was not present. However, it was understood that the screening test was not a perfect predictor; that is, false-positive test results as well as false-negative test results were possible. A false-positive test result meant that the test detected a deficiency when in fact no deficiency was present. This case resulted in unnecessary further testing as well as unnecessary worry for the parents of the newborn. A false-negative test result meant that the test did not detect the presence of an existing deficiency. Using probability and decision analysis, a research team analyzed the role and value of the screening test. A decision tree with six nodes, 13 branches, and eight outcomes was used to model the screening test procedure. A decision node with the decision branches Test and No Test was placed at the start of the decision tree. Chance nodes and branches were used to describe the possible sequences of a positive test result, a negative test result, a deficiency present, and a deficiency not present. The particular deficiency in question was rare, occurring at a rate of one case for every 250,000
newborns. Thus, the prior probability of a deficiency was 1兾250,000 0.000004. Based on judgments about the probabilities of false-positive and false-negative test results, Bayes’ theorem was used to calculate the posterior probability that a newborn with a positive test result actually had a deficiency. This posterior probability was 0.074. Thus, while a positive test result increased the probability the newborn had a deficiency from 0.000004 to 0.074, the probability that the newborn had a deficiency was still relatively low (0.074). The probability information was helpful to doctors in reassuring worried parents that even though further testing was recommended, the chances were greater than 90% that a deficiency was not present. After the assignment of costs to the eight possible outcomes, decision analysis showed that the decision alternative to conduct the test provided the optimal decision strategy. The expected cost criterion established the expected cost to be approximately $6 per test. Decision analysis helped provide a realistic understanding of the risks and costs associated with the screening test. *Based on James E. Smith and Robert L. Winkler, “Casey’s Problem: Interpreting and Evaluating a New Test,” Interfaces 29, no. 3 (May/June 1999): 63–76.
SUMMARY Decision analysis can be used to determine a recommended decision alternative or an optimal decision strategy when a decision maker is faced with an uncertain and risk-filled pattern of future events. The goal of decision analysis is to identify the best decision alternative or the optimal decision strategy given information about the uncertain events and the possible consequences or payoffs. The uncertain future events are called chance events and the outcomes of the chance events are called states of nature. We showed how influence diagrams, payoff tables, and decision trees could be used to structure a decision problem and describe the relationships among the decisions, the chance events, and the consequences. We presented three approaches to decision making without probabilities: the optimistic approach, the conservative approach, and the minimax regret approach. When probability assessments are provided for the states of nature, the expected value approach can be used to identify the recommended decision alternative or decision strategy. In cases where sample information about the chance events is available, a sequence of decisions has to be made. First we must decide whether to obtain the sample information.
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Glossary
If the answer to this decision is yes, an optimal decision strategy based on the specific sample information must be developed. In this situation, decision trees and the expected value approach can be used to determine the optimal decision strategy. Even though the expected value approach can be used to obtain a recommended decision alternative or optimal decision strategy, the payoff that actually occurs will usually have a value different from the expected value. A risk profile provides a probability distribution for the possible payoffs and can assist the decision maker in assessing the risks associated with different decision alternatives. Finally, sensitivity analysis can be conducted to determine the effect changes in the probabilities for the states of nature and changes in the values of the payoffs have on the recommended decision alternative. Decision analysis has been widely used in practice. The Management Science in Action, Investing in a Transmission System at Oglethorpe Power, describes the use of decision analysis to decide whether to invest in a major transmission system between Georgia and Florida. MANAGEMENT SCIENCE IN ACTION INVESTING IN A TRANSMISSION SYSTEM AT OGLETHORPE POWER* Oglethorpe Power Corporation (OPC) provides wholesale electrical power to consumer-owned cooperatives in the state of Georgia. Florida Power Corporation proposed that OPC join in the building of a major transmission line from Georgia to Florida. Deciding whether to become involved in the building of the transmission line was a major decision for OPC because it would involve the commitment of substantial OPC resources. OPC worked with Applied Decision Analysis, Inc., to conduct a comprehensive decision analysis of the problem. In the problem formulation step, three decisions were identified: (1) build a transmission line from Georgia to Florida; (2) upgrade existing transmission facilities; and (3) who would control the new facilities. Oglethorpe was faced with five chance events: (1) construction costs, (2) competition, (3) demand in Florida, (4) OPC’s share of the operation, and (5) pricing. The consequence or payoff was measured in terms of dollars saved. The influence diagram for the problem had three decision nodes, five chance nodes, a consequence node, and several intermediate nodes that described
intermediate calculations. The decision tree for the problem had more than 8000 paths from the starting node to the terminal branches. An expected value analysis of the decision tree provided an optimal decision strategy for OPC. However, the risk profile for the optimal decision strategy showed that the recommended strategy was very risky and had a significant probability of increasing OPC’s cost rather than providing a savings. The risk analysis led to the conclusion that more information about the competition was needed in order to reduce OPC’s risk. Sensitivity analysis involving various probabilities and payoffs showed that the value of the optimal decision strategy was stable over a reasonable range of input values. The final recommendation from the decision analysis was that OPC should begin negotiations with Florida Power Corporation concerning the building of the new transmission line. *Based on Adam Borison, “Oglethorpe Power Corporation Decides About Investing in a Major Transmission System,” Interfaces (March/April 1995): 25–36.
GLOSSARY Decision alternatives Options available to the decision maker. Chance event An uncertain future event affecting the consequence, or payoff, associated with a decision. Consequence The result obtained when a decision alternative is chosen and a chance event occurs. A measure of the consequence is often called a payoff.
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States of nature The possible outcomes for chance events that affect the payoff associated with a decision alternative. Influence diagram A graphical device that shows the relationship among decisions, chance events, and consequences for a decision problem. Node
An intersection or junction point of an influence diagram or a decision tree.
Decision nodes Chance nodes
Nodes indicating points where a decision is made. Nodes indicating points where an uncertain event will occur.
Consequence nodes occur.
Nodes of an influence diagram indicating points where a payoff will
Payoff A measure of the consequence of a decision such as profit, cost, or time. Each combination of a decision alternative and a state of nature has an associated payoff (consequence). Payoff table
A tabular representation of the payoffs for a decision problem.
Decision tree A graphical representation of the decision problem that shows the sequential nature of the decision-making process. Branch Lines showing the alternatives from decision nodes and the outcomes from chance nodes. Optimistic approach An approach to choosing a decision alternative without using probabilities. For a maximization problem, it leads to choosing the decision alternative corresponding to the largest payoff; for a minimization problem, it leads to choosing the decision alternative corresponding to the smallest payoff. Conservative approach An approach to choosing a decision alternative without using probabilities. For a maximization problem, it leads to choosing the decision alternative that maximizes the minimum payoff; for a minimization problem, it leads to choosing the decision alternative that minimizes the maximum payoff. Minimax regret approach An approach to choosing a decision alternative without using probabilities. For each alternative, the maximum regret is computed, which leads to choosing the decision alternative that minimizes the maximum regret. Opportunity loss, or regret The amount of loss (lower profit or higher cost) from not making the best decision for each state of nature. Expected value approach An approach to choosing a decision alternative based on the expected value of each decision alternative. The recommended decision alternative is the one that provides the best expected value. Expected value (EV) For a chance node, it is the weighted average of the payoffs. The weights are the state-of-nature probabilities. Expected value of perfect information (EVPI) The expected value of information that would tell the decision maker exactly which state of nature is going to occur (i.e., perfect information). Risk analysis The study of the possible payoffs and probabilities associated with a decision alternative or a decision strategy. Sensitivity analysis The study of how changes in the probability assessments for the states of nature or changes in the payoffs affect the recommended decision alternative. Risk profile The probability distribution of the possible payoffs associated with a decision alternative or decision strategy.
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Problems
Prior probabilities The probabilities of the states of nature prior to obtaining sample information. Sample information New information obtained through research or experimentation that enables an updating or revision of the state-of-nature probabilities. Posterior (revised) probabilities The probabilities of the states of nature after revising the prior probabilities based on sample information. Decision strategy A strategy involving a sequence of decisions and chance outcomes to provide the optimal solution to a decision problem. Expected value of sample information (EVSI) The difference between the expected value of an optimal strategy based on sample information and the “best” expected value without any sample information. Efficiency The ratio of EVSI to EVPI as a percentage; perfect information is 100% efficient. Bayes’ theorem A theorem that enables the use of sample information to revise prior probabilities. Conditional probability The probability of one event given the known outcome of a (possibly) related event. Joint probabilities The probabilities of both sample information and a particular state of nature occurring simultaneously.
PROBLEMS 1. The following payoff table shows profit for a decision analysis problem with two decision alternatives and three states of nature: State of Nature Decision Alternative d1 d2
s2 100 100
s1 250 100
s3 25 75
a. Construct a decision tree for this problem. b. If the decision maker knows nothing about the probabilities of the three states of nature, what is the recommended decision using the optimistic, conservative, and minimax regret approaches? 2. Suppose that a decision maker faced with four decision alternatives and four states of nature develops the following profit payoff table: State of Nature Decision Alternative d1 d2 d3 d4
s1 14 11 9 8
s2 9 10 10 10
s3 10 8 10 11
s4 5 7 11 13
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a. If the decision maker knows nothing about the probabilities of the four states of nature, what is the recommended decision using the optimistic, conservative, and minimax regret approaches? b. Which approach do you prefer? Explain. Is establishing the most appropriate approach before analyzing the problem important for the decision maker? Explain. c. Assume that the payoff table provides cost rather than profit payoffs. What is the recommended decision using the optimistic, conservative, and minimax regret approaches? 3. Southland Corporation’s decision to produce a new line of recreational products resulted in the need to construct either a small plant or a large plant. The best selection of plant size depends on how the marketplace reacts to the new product line. To conduct an analysis, marketing management has decided to view the possible long-run demand as low, medium, or high. The following payoff table shows the projected profit in millions of dollars: Long-Run Demand Plant Size Small Large a. b. c. d.
Low 150 50
Medium 200 200
High 200 500
What is the decision to be made, and what is the chance event for Southland’s problem? Construct an influence diagram. Construct a decision tree. Recommend a decision based on the use of the optimistic, conservative, and minimax regret approaches.
4. The following profit payoff table was presented in Problem 1. Suppose that the decision maker obtained the probability assessments P(s1) 0.65, P(s2) 0.15, and P(s3) 0.20. Use the expected value approach to determine the optimal decision. State of Nature Decision Alternative d1 d2
s1 250 100
s2 100 100
s3 25 75
5. An investor wants to select one of seven mutual funds for the coming year. Data showing the percentage annual return for each fund during five typical one-year periods are shown here. The assumption is that one of these five-year periods will occur again during the coming year. Thus, years A, B, C, D, and E are the states of nature for the mutual fund decision. State of Nature Mutual Fund Large-Cap Stock Mid-Cap Stock Small-Cap Stock Energy/Resources Sector Health Sector Technology Sector Real Estate Sector
Year A 35.3 32.3 20.8 25.3 49.1 46.2 20.5
Year B 20.0 23.2 22.5 33.9 5.5 21.7 44.0
Year C 28.3 0.9 6.0 20.5 29.7 45.7 21.1
Year D 10.4 49.3 33.3 20.9 77.7 93.1 2.6
Year E 9.3 22.8 6.1 2.5 24.9 20.1 5.1
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Problems
a. Assume that the investor is conservative. What is the recommended mutual fund? Using this mutual fund, what are the minimum and maximum annual returns? b. Suppose that an experienced financial analyst reviews the five states of nature and provides the following probabilities: 0.1, 0.3, 0.1, 0.1, and 0.4. Using the expected value, what is the recommended mutual fund? What is the expected annual return? Using this mutual fund, what are the minimum and maximum annual returns? c. What is the expected annual return for the mutual fund recommended in part (a)? How much of an increase in the expected annual return can be obtained by following the recommendation in part (b)? d. Which of the two mutual funds appears to have more risk? Why? Is the expected annual return greater for the mutual fund with more risk? e. What mutual fund would you recommend to the investor? Explain. 6. Amy Lloyd is interested in leasing a new Saab and has contacted three automobile dealers for pricing information. Each dealer offered Amy a closed-end 36-month lease with no down payment due at the time of signing. Each lease includes a monthly charge and a mileage allowance. Additional miles receive a surcharge on a per-mile basis. The monthly lease cost, the mileage allowance, and the cost for additional miles follow:
Dealer Forno Saab Midtown Motors Hopkins Automotive
Monthly Cost $299 $310 $325
Mileage Allowance 36,000 45,000 54,000
Cost per Additional Mile $0.15 $0.20 $0.15
Amy decided to choose the lease option that will minimize her total 36-month cost. The difficulty is that Amy is not sure how many miles she will drive over the next three years. For purposes of this decision she believes it is reasonable to assume that she will drive 12,000 miles per year, 15,000 miles per year, or 18,000 miles per year. With this assumption Amy estimated her total costs for the three lease options. For example, she figures that the Forno Saab lease will cost her $10,764 if she drives 12,000 miles per year, $12,114 if she drives 15,000 miles per year, or $13,464 if she drives 18,000 miles per year. a. What is the decision, and what is the chance event? b. Construct a payoff table for Amy’s problem. c. If Amy has no idea which of the three mileage assumptions is most appropriate, what is the recommended decision (leasing option) using the optimistic, conservative, and minimax regret approaches? d. Suppose that the probabilities that Amy drives 12,000, 15,000, and 18,000 miles per year are 0.5, 0.4, and 0.1, respectively. What option should Amy choose using the expected value approach? e. Develop a risk profile for the decision selected in part (d). What is the most likely cost, and what is its probability? f. Suppose that after further consideration Amy concludes that the probabilities that she will drive 12,000, 15,000, and 18,000 miles per year are 0.3, 0.4, and 0.3, respectively. What decision should Amy make using the expected value approach? 7. Hudson Corporation is considering three options for managing its data processing operation: continuing with its own staff, hiring an outside vendor to do the managing (referred to as outsourcing), or using a combination of its own staff and an outside vendor. The cost
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of the operation depends on future demand. The annual cost of each option (in thousands of dollars) depends on demand as follows:
Demand Staffing Options Own staff Outside vendor Combination
High 650 900 800
Medium 650 600 650
Low 600 300 500
a. If the demand probabilities are 0.2, 0.5, and 0.3, which decision alternative will minimize the expected cost of the data processing operation? What is the expected annual cost associated with that recommendation? b. Construct a risk profile for the optimal decision in part (a). What is the probability of the cost exceeding $700,000? 8. The following payoff table shows the profit for a decision problem with two states of nature and two decision alternatives:
State of Nature Decision Alternative d1 d2
s1 10 4
s2 1 3
a. Use graphical sensitivity analysis to determine the range of probabilities of state of nature s1 for which each of the decision alternatives has the largest expected value. b. Suppose P(s1) 0.2 and P(s2) 0.8. What is the best decision using the expected value approach? c. Perform sensitivity analysis on the payoffs for decision alternative d1. Assume the probabilities are as given in part (b) and find the range of payoffs under states of nature s1 and s2 that will keep the solution found in part (b) optimal. Is the solution more sensitive to the payoff under state of nature s1 or s2? 9. Myrtle Air Express decided to offer direct service from Cleveland to Myrtle Beach. Management must decide between a full-price service using the company’s new fleet of jet aircraft and a discount service using smaller capacity commuter planes. It is clear that the best choice depends on the market reaction to the service Myrtle Air offers. Management developed estimates of the contribution to profit for each type of service based upon two possible levels of demand for service to Myrtle Beach: strong and weak. The following table shows the estimated quarterly profits (in thousands of dollars):
Demand for Service Service Full price Discount
Strong $960 $670
Weak $490 $320
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Problems
a. What is the decision to be made, what is the chance event, and what is the consequence for this problem? How many decision alternatives are there? How many outcomes are there for the chance event? b. If nothing is known about the probabilities of the chance outcomes, what is the recommended decision using the optimistic, conservative, and minimax regret approaches? c. Suppose that management of Myrtle Air Express believes that the probability of strong demand is 0.7 and the probability of weak demand is 0.3. Use the expected value approach to determine an optimal decision. d. Suppose that the probability of strong demand is 0.8 and the probability of weak demand is 0.2. What is the optimal decision using the expected value approach? e. Use graphical sensitivity analysis to determine the range of demand probabilities for which each of the decision alternatives has the largest expected value. 10. Video Tech is considering marketing one of two new video games for the coming holiday season: Battle Pacific or Space Pirates. Battle Pacific is a unique game and appears to have no competition. Estimated profits (in thousands of dollars) under high, medium, and low demand are as follows:
Demand Battle Pacific Profit Probability
High $1000 0.2
Medium $700 0.5
Low $300 0.3
Video Tech is optimistic about its Space Pirates game. However, the concern is that profitability will be affected by a competitor’s introduction of a video game viewed as similar to Space Pirates. Estimated profits (in thousands of dollars) with and without competition are as follows:
Space Pirates with Competition Profit Probability Space Pirates without Competition Profit Probability
Demand High $800 0.3
Medium $400 0.4
Low $200 0.3
Demand High $1600 0.5
Medium $800 0.3
Low $400 0.2
a. Develop a decision tree for the Video Tech problem. b. For planning purposes, Video Tech believes there is a 0.6 probability that its competitor will produce a new game similar to Space Pirates. Given this probability of competition, the director of planning recommends marketing the Battle Pacific video game. Using expected value, what is your recommended decision? c. Show a risk profile for your recommended decision. d. Use sensitivity analysis to determine what the probability of competition for Space Pirates would have to be for you to change your recommended decision alternative.
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11. For the Pittsburgh Development Corporation problem in Section 13.3, the decision alternative to build the large condominium complex was found to be optimal using the expected value approach. In Section 13.4 we conducted a sensitivity analysis for the payoffs associated with this decision alternative. We found that the large complex remained optimal as long as the payoff for the strong demand was greater than or equal to $17.5 million and as long as the payoff for the weak demand was greater than or equal to –$19 million. a. Consider the medium complex decision. How much could the payoff under strong demand increase and still keep decision alternative d3 the optimal solution? b. Consider the small complex decision. How much could the payoff under strong demand increase and still keep decision alternative d3 the optimal solution? 12. The distance from Potsdam to larger markets and limited air service have hindered the town in attracting new industry. Air Express, a major overnight delivery service, is considering establishing a regional distribution center in Potsdam. However, Air Express will not establish the center unless the length of the runway at the local airport is increased. Another candidate for new development is Diagnostic Research, Inc. (DRI), a leading producer of medical testing equipment. DRI is considering building a new manufacturing plant. Increasing the length of the runway is not a requirement for DRI, but the planning commission feels that doing so will help convince DRI to locate their new plant in Potsdam. Assuming that the town lengthens the runway, the Potsdam planning commission believes that the probabilities shown in the following table are applicable:
Air Express Center No Air Express Center
DRI Plant 0.30 0.40
No DRI Plant 0.10 0.20
For instance, the probability that Air Express will establish a distribution center and DRI will build a plant is 0.30. The estimated annual revenue to the town, after deducting the cost of lengthening the runway, is as follows:
Air Express Center No Air Express Center
DRI Plant $600,000 $250,000
No DRI Plant $150,000 $200,000
If the runway expansion project is not conducted, the planning commission assesses the probability DRI will locate their new plant in Potsdam at 0.6; in this case, the estimated annual revenue to the town will be $450,000. If the runway expansion project is not conducted and DRI does not locate in Potsdam, the annual revenue will be $0 because no cost will have been incurred and no revenues will be forthcoming. a. What is the decision to be made, what is the chance event, and what is the consequence? b. Compute the expected annual revenue associated with the decision alternative to lengthen the runway. c. Compute the expected annual revenue associated with the decision alternative not to lengthen the runway.
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Problems
d. Should the town elect to lengthen the runway? Explain. e. Suppose that the probabilities associated with lengthening the runway were as follows:
Air Express Center No Air Express Center
DRI Plant 0.40 0.30
No DRI Plant 0.10 0.20
What effect, if any, would this change in the probabilities have on the recommended decision? 13. Seneca Hill Winery recently purchased land for the purpose of establishing a new vineyard. Management is considering two varieties of white grapes for the new vineyard: Chardonnay and Riesling. The Chardonnay grapes would be used to produce a dry Chardonnay wine, and the Riesling grapes would be used to produce a semidry Riesling wine. It takes approximately four years from the time of planting before new grapes can be harvested. This length of time creates a great deal of uncertainty about future demand and makes the decision concerning the type of grapes to plant difficult. Three possibilities are being considered: Chardonnay grapes only; Riesling grapes only; and both Chardonnay and Riesling grapes. Seneca management decided that for planning purposes it would be adequate to consider only two demand possibilities for each type of wine: strong or weak. With two possibilities for each type of wine it was necessary to assess four probabilities. With the help of some forecasts in industry publications management made the following probability assessments:
Riesling Demand Chardonnay Demand Weak Strong
Weak 0.05 0.25
Strong 0.50 0.20
Revenue projections show an annual contribution to profit of $20,000 if Seneca Hill only plants Chardonnay grapes and demand is weak for Chardonnay wine, and $70,000 if they only plant Chardonnay grapes and demand is strong for Chardonnay wine. If they only plant Riesling grapes, the annual profit projection is $25,000 if demand is weak for Riesling grapes and $45,000 if demand is strong for Riesling grapes. If Seneca plants both types of grapes, the annual profit projections are shown in the following table:
Riesling Demand Chardonnay Demand Weak Strong
Weak $22,000 $26,000
Strong $40,000 $60,000
a. What is the decision to be made, what is the chance event, and what is the consequence? Identify the alternatives for the decisions and the possible outcomes for the chance events. b. Develop a decision tree.
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c. Use the expected value approach to recommend which alternative Seneca Hill Winery should follow in order to maximize expected annual profit. d. Suppose management is concerned about the probability assessments when demand for Chardonnay wine is strong. Some believe it is likely for Riesling demand to also be strong in this case. Suppose the probability of strong demand for Chardonnay and weak demand for Riesling is 0.05 and that the probability of strong demand for Chardonnay and strong demand for Riesling is 0.40. How does this change the recommended decision? Assume that the probabilities when Chardonnay demand is weak are still 0.05 and 0.50. e. Other members of the management team expect the Chardonnay market to become saturated at some point in the future, causing a fall in prices. Suppose that the annual profit projections fall to $50,000 when demand for Chardonnay is strong and Chardonnay grapes only are planted. Using the original probability assessments, determine how this change would affect the optimal decision. 14. The following profit payoff table was presented in Problems 1 and 4:
State of Nature Decision Alternative d1 d2
s1 250 100
s2 100 100
s3 25 75
The probabilities for the states of nature are P(s1) 0.65, P(s2) 0.15, and P(s3) 0.20. a. What is the optimal decision strategy if perfect information were available? b. What is the expected value for the decision strategy developed in part (a)? c. Using the expected value approach, what is the recommended decision without perfect information? What is its expected value? d. What is the expected value of perfect information? 15. The Lake Placid Town Council decided to build a new community center to be used for conventions, concerts, and other public events, but considerable controversy surrounds the appropriate size. Many influential citizens want a large center that would be a showcase for the area. But the mayor feels that if demand does not support such a center, the community will lose a large amount of money. To provide structure for the decision process, the council narrowed the building alternatives to three sizes: small, medium, and large. Everybody agreed that the critical factor in choosing the best size is the number of people who will want to use the new facility. A regional planning consultant provided demand estimates under three scenarios: worst case, base case, and best case. The worst-case scenario corresponds to a situation in which tourism drops significantly; the base-case scenario corresponds to a situation in which Lake Placid continues to attract visitors at current levels; and the best-case scenario corresponds to a significant increase in tourism. The consultant has provided probability assessments of 0.10, 0.60, and 0.30 for the worst-case, base-case, and best-case scenarios, respectively. The town council suggested using net cash flow over a five-year planning horizon as the criterion for deciding on the best size. The following projections of net cash flow (in thousands of dollars) for a five-year planning horizon have been developed. All costs, including the consultant’s fee, have been included.
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Problems
Demand Scenario Center Size Small Medium Large
Worst Case 400 250 400
Base Case 500 650 580
Best Case 660 800 990
a. What decision should Lake Placid make using the expected value approach? b. Construct risk profiles for the medium and large alternatives. Given the mayor’s concern over the possibility of losing money and the result of part (a), which alternative would you recommend? c. Compute the expected value of perfect information. Do you think it would be worth trying to obtain additional information concerning which scenario is likely to occur? d. Suppose the probability of the worst-case scenario increases to 0.2, the probability of the base-case scenario decreases to 0.5, and the probability of the best-case scenario remains at 0.3. What effect, if any, would these changes have on the decision recommendation? e. The consultant has suggested that an expenditure of $150,000 on a promotional campaign over the planning horizon will effectively reduce the probability of the worstcase scenario to zero. If the campaign can be expected to also increase the probability of the best-case scenario to 0.4, is it a good investment? 16. Consider a variation of the PDC decision tree shown in Figure 13.9. The company must first decide whether to undertake the market research study. If the market research study is conducted, the outcome will either be favorable (F) or unfavorable (U). Assume there are only two decision alternatives d1 and d2 and two states of nature s1 and s2. The payoff table showing profit is as follows:
State of Nature Decision Alternative d1 d2
s1 100 400
s2 300 200
a. Show the decision tree. b. Using the following probabilities, what is the optimal decision strategy? P(F ) = 0.56 P(U ) = 0.44
P(s1 ƒ F ) = 0.57 P(s2 ƒ F ) = 0.43
P(s1 ƒ U ) = 0.18 P(s2 ƒ U ) = 0.82
P(s1) = 0.40 P(s2 ) = 0.60
17. Hemmingway, Inc., is considering a $5 million research and development (R&D) project. Profit projections appear promising, but Hemmingway’s president is concerned because the probability that the R&D project will be successful is only 0.50. Secondly, the president knows that even if the project is successful, it will require that the company build a new production facility at a cost of $20 million in order to manufacture the product. If the facility is built, uncertainty remains about the demand and thus uncertainty about the profit
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FIGURE 13.16
Decision Analysis
DECISION TREE FOR HEMMINGWAY, INC. Profit ($ millions)
Building Facility ($20 million)
Successful 0.5
Start R&D Project ($5 million)
1
2
Do Not Start the R&D Project
34
Medium Demand 0.3
20
Low Demand 0.2
10
3
Sell Rights
Not Successful 0.5
4
High Demand 0.5
20
5 0
that will be realized. Another option is that if the R&D project is successful, the company could sell the rights to the product for an estimated $25 million. Under this option, the company would not build the $20 million production facility. The decision tree is shown in Figure 13.16. The profit projection for each outcome is shown at the end of the branches. For example, the revenue projection for the high demand outcome is $59 million. However, the cost of the R&D project ($5 million) and the cost of the production facility ($20 million) show the profit of this outcome to be $59 $5 $20 $34 million. Branch probabilities are also shown for the chance events. a. Analyze the decision tree to determine whether the company should undertake the R&D project. If it does, and if the R&D project is successful, what should the company do? What is the expected value of your strategy? b. What must the selling price be for the company to consider selling the rights to the product? c. Develop a risk profile for the optimal strategy. 18. Dante Development Corporation is considering bidding on a contract for a new office building complex. Figure 13.17 shows the decision tree prepared by one of Dante’s analysts. At node 1, the company must decide whether to bid on the contract. The cost of preparing the bid is $200,000. The upper branch from node 2 shows that the company has a 0.8 probability of winning the contract if it submits a bid. If the company wins the bid, it will have to pay $2,000,000 to become a partner in the project. Node 3 shows that the company will then consider doing a market research study to forecast demand for the office units prior to beginning construction. The cost of this study is $150,000. Node 4 is a chance node showing the possible outcomes of the market research study. Nodes 5, 6, and 7 are similar in that they are the decision nodes for Dante to either build the office complex or sell the rights in the project to another developer. The decision to build the complex will result in an income of $5,000,000 if demand is high and
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Problems
FIGURE 13.17
DECISION TREE FOR THE DANTE DEVELOPMENT CORPORATION Profit ($1000s)
Build Complex Forecast High 0.6 Market Research
5
2
4 Forecast Moderate 6 0.4
7 Sell
1
9
Sell
3
No Market Research
Moderate Demand 0.15
650 1150
High Demand 0.225
2650
Moderate Demand 0.775
650 1150
Build Complex Bid
2650
Sell
Build Complex
Win Contract 0.8
8
High Demand 0.85
10
High Demand 0.6
2800
Moderate Demand 0.4
800 1300
Lose Contract 0.2
200
Do Not Bid
$3,000,000 if demand is moderate. If Dante chooses to sell its rights in the project to another developer, income from the sale is estimated to be $3,500,000. The probabilities shown at nodes 4, 8, and 9 are based on the projected outcomes of the market research study. a. Verify Dante’s profit projections shown at the ending branches of the decision tree by calculating the payoffs of $2,650,000 and $650,000 for first two outcomes. b. What is the optimal decision strategy for Dante, and what is the expected profit for this project? c. What would the cost of the market research study have to be before Dante would change its decision about the market research study? d. Develop a risk profile for Dante. 19. Hale’s TV Productions is considering producing a pilot for a comedy series in the hope of selling it to a major television network. The network may decide to reject the series, but it may also decide to purchase the rights to the series for either one or two years. At this point in time, Hale may either produce the pilot and wait for the network’s decision or transfer the rights for the pilot and series to a competitor for $100,000. Hale’s decision alternatives and profits (in thousands of dollars) are as follows: State of Nature Decision Alternative Produce pilot, d1 Sell to competitor, d2
Reject, s1 100 100
1 Year, s2 50 100
2 Years, s3 150 100
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The probabilities for the states of nature are P(s1) 0.20, P(s2) 0.30, and P(s3) 0.50. For a consulting fee of $5000, an agency will review the plans for the comedy series and indicate the overall chances of a favorable network reaction to the series. Assume that the agency review will result in a favorable (F) or an unfavorable (U) review and that the following probabilities are relevant:
P(F ) = 0.69 P(U ) = 0.31
P(s1 ƒ F ) = 0.09 P(s2 ƒ F ) = 0.26 P(s3 ƒ F ) = 0.65
P(s1 P(s2 P(s3
ƒ U ) = 0.45 ƒ U ) = 0.39 ƒ U ) = 0.16
a. Construct a decision tree for this problem. b. What is the recommended decision if the agency opinion is not used? What is the expected value? c. What is the expected value of perfect information? d. What is Hale’s optimal decision strategy assuming the agency’s information is used? e. What is the expected value of the agency’s information? f. Is the agency’s information worth the $5000 fee? What is the maximum that Hale should be willing to pay for the information? g. What is the recommended decision? 20. Embassy Publishing Company received a six-chapter manuscript for a new college textbook. The editor of the college division is familiar with the manuscript and estimated a 0.65 probability that the textbook will be successful. If successful, a profit of $750,000 will be realized. If the company decides to publish the textbook and it is unsuccessful, a loss of $250,000 will occur. Before making the decision to accept or reject the manuscript, the editor is considering sending the manuscript out for review. A review process provides either a favorable (F) or unfavorable (U) evaluation of the manuscript. Past experience with the review process suggests probabilities P(F) 0.7 and P(U) 0.3 apply. Let s1 the textbook is successful, and s2 the textbook is unsuccessful. The editor’s initial probabilities of s1 and s2 will be revised based on whether the review is favorable or unfavorable. The revised probabilities are as follows:
P(s1 ƒ F ) = 0.75 P(s 2 ƒ F ) = 0.25
P(s1 ƒ U ) = 0.417 P(s2 ƒ U ) = 0.583
a. Construct a decision tree assuming that the company will first make the decision of whether to send the manuscript out for review and then make the decision to accept or reject the manuscript. b. Analyze the decision tree to determine the optimal decision strategy for the publishing company. c. If the manuscript review costs $5000, what is your recommendation? d. What is the expected value of perfect information? What does this EVPI suggest for the company? 21. A real estate investor has the opportunity to purchase land currently zoned residential. If the county board approves a request to rezone the property as commercial within the next year, the investor will be able to lease the land to a large discount firm that wants to open a new store on the property. However, if the zoning change is not approved, the investor
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Problems
will have to sell the property at a loss. Profits (in thousands of dollars) are shown in the following payoff table: State of Nature Rezoning Approved s1 600 0
Decision Alternative Purchase, d1 Do not purchase, d2
Rezoning Not Approved s2 200 0
a. If the probability that the rezoning will be approved is 0.5, what decision is recommended? What is the expected profit? b. The investor can purchase an option to buy the land. Under the option, the investor maintains the rights to purchase the land anytime during the next three months while learning more about possible resistance to the rezoning proposal from area residents. Probabilities are as follows: Let P(H ) = 0.55 P(L) = 0.45
H = High resistance to rezoning L = Low resistance to rezoning P(s1 ƒ H ) = 0.18 P(s1 ƒ L) = 0.89
P(s2 ƒ H ) = 0.82 P(s2 ƒ L) = 0.11
What is the optimal decision strategy if the investor uses the option period to learn more about the resistance from area residents before making the purchase decision? c. If the option will cost the investor an additional $10,000, should the investor purchase the option? Why or why not? What is the maximum that the investor should be willing to pay for the option? 22. Lawson’s Department Store faces a buying decision for a seasonal product for which demand can be high, medium, or low. The purchaser for Lawson’s can order 1, 2, or 3 lots of the product before the season begins but cannot reorder later. Profit projections (in thousands of dollars) are shown. State of Nature Decision Alternative Order 1 lot, d1 Order 2 lots, d2 Order 3 lots, d3
High Demand s1 60 80 100
Medium Demand s2 60 80 70
Low Demand s3 50 30 10
a. If the prior probabilities for the three states of nature are 0.3, 0.3, and 0.4, respectively, what is the recommended order quantity? b. At each preseason sales meeting, the vice president of sales provides a personal opinion regarding potential demand for this product. Because of the vice president’s enthusiasm and optimistic nature, the predictions of market conditions have always been either “excellent” (E) or “very good” (V). Probabilities are as follows: P(E ) = 0.70 P(V ) = 0.30
P(s1 ƒ E ) = 0.34 P(s2 ƒ E ) = 0.32 P(s3 ƒ E ) = 0.34
What is the optimal decision strategy?
P(s1 ƒ V ) = 0.20 P(s2 ƒ V ) = 0.26 P(s3 ƒ V ) = 0.54
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c. Use the efficiency of sample information and discuss whether the firm should consider a consulting expert who could provide independent forecasts of market conditions for the product. 23. Suppose that you are given a decision situation with three possible states of nature: s1, s2, and s3. The prior probabilities are P(s1) 0.2, P(s2) 0.5, and P(s3) 0.3. With sample information I, P(I 兩 s1) 0.1, P(I 兩 s2) 0.05, and P(I 兩 s3) 0.2. Compute the revised or posterior probabilities: P(s1 兩 I), P(s2 兩 I), and P(s3 兩 I). 24. To save on expenses, Rona and Jerry agreed to form a carpool for traveling to and from work. Rona preferred to use the somewhat longer but more consistent Queen City Avenue. Although Jerry preferred the quicker expressway, he agreed with Rona that they should take Queen City Avenue if the expressway had a traffic jam. The following payoff table provides the one-way time estimate in minutes for traveling to or from work: State of Nature Expressway Open s1 30 25
Decision Alternative Queen City Avenue, d1 Expressway, d2
Expressway Jammed s2 30 45
Based on their experience with traffic problems, Rona and Jerry agreed on a 0.15 probability that the expressway would be jammed. In addition, they agreed that weather seemed to affect the traffic conditions on the expressway. Let C = clear O = overcast R = rain The following conditional probabilities apply: P(C ƒ s1) = 0.8 P(C ƒ s2 ) = 0.1
P(O ƒ s1) = 0.2 P(O ƒ s2 ) = 0.3
P(R ƒ s1) = 0.0 P(R ƒ s2 ) = 0.6
a. Use Bayes’ theorem for probability revision to compute the probability of each weather condition and the conditional probability of the expressway open s1 or jammed s2 given each weather condition. b. Show the decision tree for this problem. c. What is the optimal decision strategy, and what is the expected travel time? 25. The Gorman Manufacturing Company must decide whether to manufacture a component part at its Milan, Michigan, plant or purchase the component part from a supplier. The resulting profit is dependent upon the demand for the product. The following payoff table shows the projected profit (in thousands of dollars): State of Nature Decision Alternative Manufacture, d1 Purchase, d2
Low Demand s1 20 10
Medium Demand s2 40 45
High Demand s3 100 70
Case Problem 1
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The state-of-nature probabilities are P(s1) 0.35, P(s2) 0.35, and P(s3) 0.30. a. Use a decision tree to recommend a decision. b. Use EVPI to determine whether Gorman should attempt to obtain a better estimate of demand. c. A test market study of the potential demand for the product is expected to report either a favorable (F) or unfavorable (U) condition. The relevant conditional probabilities are as follows: P(F ƒ s1) = 0.10 P(F ƒ s2 ) = 0.40 P(F ƒ s3) = 0.60
P(U ƒ s1) = 0.90 P(U ƒ s2 ) = 0.60 P(U ƒ s3) = 0.40
What is the probability that the market research report will be favorable? d. What is Gorman’s optimal decision strategy? e. What is the expected value of the market research information? f. What is the efficiency of the information?
Case Problem 1
PROPERTY PURCHASE STRATEGY
Glenn Foreman, president of Oceanview Development Corporation, is considering submitting a bid to purchase property that will be sold by sealed bid at a county tax foreclosure. Glenn’s initial judgment is to submit a bid of $5 million. Based on his experience, Glenn estimates that a bid of $5 million will have a 0.2 probability of being the highest bid and securing the property for Oceanview. The current date is June 1. Sealed bids for the property must be submitted by August 15. The winning bid will be announced on September 1. If Oceanview submits the highest bid and obtains the property, the firm plans to build and sell a complex of luxury condominiums. However, a complicating factor is that the property is currently zoned for single-family residences only. Glenn believes that a referendum could be placed on the voting ballot in time for the November election. Passage of the referendum would change the zoning of the property and permit construction of the condominiums. The sealed-bid procedure requires the bid to be submitted with a certified check for 10% of the amount bid. If the bid is rejected, the deposit is refunded. If the bid is accepted, the deposit is the down payment for the property. However, if the bid is accepted and the bidder does not follow through with the purchase and meet the remainder of the financial obligation within six months, the deposit will be forfeited. In this case, the county will offer the property to the next highest bidder. To determine whether Oceanview should submit the $5 million bid, Glenn conducted some preliminary analysis. This preliminary work provided an assessment of 0.3 for the probability that the referendum for a zoning change will be approved and resulted in the following estimates of the costs and revenues that will be incurred if the condominiums are built: Cost and Revenue Estimates Revenue from condominium sales $15,000,000 Cost Property $5,000,000 Construction expenses $8,000,000
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If Oceanview obtains the property and the zoning change is rejected in November, Glenn believes that the best option would be for the firm not to complete the purchase of the property. In this case, Oceanview would forfeit the 10% deposit that accompanied the bid. Because the likelihood that the zoning referendum will be approved is such an important factor in the decision process, Glenn suggested that the firm hire a market research service to conduct a survey of voters. The survey would provide a better estimate of the likelihood that the referendum for a zoning change would be approved. The market research firm that Oceanview Development has worked with in the past has agreed to do the study for $15,000. The results of the study will be available August 1, so that Oceanview will have this information before the August 15 bid deadline. The results of the survey will be either a prediction that the zoning change will be approved or a prediction that the zoning change will be rejected. After considering the record of the market research service in previous studies conducted for Oceanview, Glenn developed the following probability estimates concerning the accuracy of the market research information: P(A ƒ s1) = 0.9 P(A ƒ s2 ) = 0.2
P(N ƒ s1) = 0.1 P(N ƒ s2 ) = 0.8
where A N s1 s2
= = = =
prediction of zoning change approval prediction that zoning change will not be approved the zoning change is approved by the voters the zoning change is rejected by the voters
Managerial Report Perform an analysis of the problem facing the Oceanview Development Corporation, and prepare a report that summarizes your findings and recommendations. Include the following items in your report: 1. A decision tree that shows the logical sequence of the decision problem 2. A recommendation regarding what Oceanview should do if the market research information is not available 3. A decision strategy that Oceanview should follow if the market research is conducted 4. A recommendation as to whether Oceanview should employ the market research firm, along with the value of the information provided by the market research firm Include the details of your analysis as an appendix to your report.
Case Problem 2
LAWSUIT DEFENSE STRATEGY
John Campbell, an employee of Manhattan Construction Company, claims to have injured his back as a result of a fall while repairing the roof at one of the Eastview apartment buildings. He filed a lawsuit against Doug Reynolds, the owner of Eastview Apartments, asking for damages of $1,500,000. John claims that the roof had rotten sections and that his fall could have been prevented if Mr. Reynolds had told Manhattan Construction about the problem. Mr. Reynolds notified his insurance company, Allied Insurance, of the lawsuit. Allied must defend Mr. Reynolds and decide what action to take regarding the lawsuit.
Appendix 13.1
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Some depositions and a series of discussions took place between both sides. As a result, John Campbell offered to accept a settlement of $750,000. Thus, one option is for Allied to pay John $750,000 to settle the claim. Allied is also considering making John a counteroffer of $400,000 in the hope that he will accept a lesser amount to avoid the time and cost of going to trial. Allied’s preliminary investigation shows that John’s case is strong; Allied is concerned that John may reject their counteroffer and request a jury trial. Allied’s lawyers spent some time exploring John’s likely reaction if they make a counteroffer of $400,000. The lawyers concluded that it is adequate to consider three possible outcomes to represent John’s possible reaction to a counteroffer of $400,000: (1) John will accept the counteroffer and the case will be closed; (2) John will reject the counteroffer and elect to have a jury decide the settlement amount; or (3) John will make a counteroffer to Allied of $600,000. If John does make a counteroffer, Allied has decided that they will not make additional counteroffers. They will either accept John’s counteroffer of $600,000 or go to trial. If the case goes to a jury trial, Allied considers three outcomes possible: (1) the jury may reject John’s claim and Allied will not be required to pay any damages; (2) the jury will find in favor of John and award him $750,000 in damages; or (3) the jury will conclude that John has a strong case and award him the full amount of $1,500,000. Key considerations as Allied develops its strategy for disposing of the case are the probabilities associated with John’s response to an Allied counteroffer of $400,000 and the probabilities associated with the three possible trial outcomes. Allied’s lawyers believe the probability that John will accept a counteroffer of $400,000 is 0.10, the probability that John will reject a counteroffer of $400,000 is 0.40, and the probability that John will, himself, make a counteroffer to Allied of $600,000 is 0.50. If the case goes to court, they believe that the probability the jury will award John damages of $1,500,000 is 0.30, the probability that the jury will award John damages of $750,000 is 0.50, and the probability that the jury will award John nothing is 0.20.
Managerial Report Perform an analysis of the problem facing Allied Insurance and prepare a report that summarizes your findings and recommendations. Be sure to include the following items: 1. A decision tree 2. A recommendation regarding whether Allied should accept John’s initial offer to settle the claim for $750,000 3. A decision strategy that Allied should follow if they decide to make John a counteroffer of $400,000 4. A risk profile for your recommended strategy
Appendix 13.1
DECISION ANALYSIS WITH TREEPLAN
TreePlan* is an Excel add-in that can be used to develop decision trees for decision analysis problems. The software package is provided at the website that accompanies this text. Instructions for installing TreePlan are included with the software. A manual containing additional information on starting and using TreePlan is also at the website. In this *TreePlan was developed by Professor Michael R. Middleton at the University of San Francisco and modified for use by Professor James E. Smith at Duke University. The TreePlan website is www.treeplan.com.
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FIGURE 13.18
Decision Analysis
PDC DECISION TREE Strong (s1) Small (d1)
2
P(s1) = 0.8 Weak (s 2) P(s2) = 0.2 Strong (s1)
1
Medium (d 2 )
3
P(s1) = 0.8 Weak (s2) P(s2) = 0.2 Strong (s1)
Large (d 3)
4
P(s1) = 0.8 Weak (s2) P(s2) = 0.2
8
7
14
5
20
–9
appendix we show how to use TreePlan to build a decision tree and solve the PDC problem presented in Section 13.3. The decision tree for the PDC problem is shown in Figure 13.18.
Getting Started: An Initial Decision Tree We begin by assuming that TreePlan has been installed and an Excel worksheet is open. To build a TreePlan version of the PDC decision tree, proceed as follows: Step 1. Select cell A1 Step 2. Select the Add-Ins tab and choose Decision Tree from the Menu Commands group Step 3. When the TreePlan Acad. - New Tree dialog box appears: Click New Tree A decision tree with one decision node and two branches appears as follows:
A B C D E F G 1 TreePlan Academic Version Only For Academic Use 2 Alternative 1 3 0 4 0 0 5 1 6 0 7 Alternative 2 8 0 9 0 0
Appendix 13.1
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Adding a Branch The PDC problem has three decision alternatives (small, medium, and large condominium complexes), so we must add another decision branch to the tree. Step 1. Select cell B5 Step 2. Select Decision Tree from the Menu Commands group Step 3. When the TreePlan Acad. - Decision Node dialog box appears: Select Add branch Click OK A revised tree with three decision branches now appears in the Excel worksheet.
Naming the Decision Alternatives The decision alternatives can be named by selecting the cells containing the labels Alternative 1, Alternative 2, and Alternative 3, and then entering the corresponding PDC names Small, Medium, and Large. After naming the alternatives, the PDC tree with three decision branches appears as follows:
A B C D E F G 1 TreePlan Academic Version Only For Academic Use 2 Small 3 0 4 0 0 5 6 7 Medium 8 0 1 9 0 0 0 10 11 12 Large 13 0 14 0 0
Adding Chance Nodes The chance event for the PDC problem is the demand for the condominiums, which may be either strong or weak. Thus, a chance node with two branches must be added at the end of each decision alternative branch. Step 1. Select cell F3 Step 2. Select Decision Tree from the Menu Commands group Step 3. When the TreePlan Acad. - Terminal Node dialog box appears: Select Change to event node Select Two in the Branches section Click OK
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The tree now appears as follows:
A B C D E F G H I J K 1 TreePlan Academic Version 0.5 Only For Academic Use 2 Outcome 4 3 0 4 Small 0 0 5 6 0 0 0.5 7 Outcome 5 8 0 9 0 0 10 11 1 12 0 Medium 13 0 14 0 0 15 16 17 Large 18 0 19 0 0
We next select the cells containing Outcome 4 and Outcome 5 and rename them Strong and Weak to provide the proper names for the PDC states of nature. After doing so we can copy the subtree for the chance node in cell F5 to the other two decision branches to complete the structure of the PDC decision tree. Step 1. Select cell F5 Step 2. Select Decision Tree from the Menu Commands group Step 3. When the TreePlan Acad. - Event Node dialog box appears: Select Copy subtree Click OK Step 4. Select cell F13 Step 5. Select Decision Tree from the Menu Commands group Step 6. When the TreePlan Acad. - Terminal Node dialog box appears: Select Paste subtree Click OK This copy/paste procedure places a chance node at the end of the Medium decision branch. Repeating the same copy/paste procedure for the Large decision branch completes the structure of the PDC decision tree as shown in Figure 13.19.
Inserting Probabilities and Payoffs TreePlan provides the capability of inserting probabilities and payoffs into the decision tree. In Figure 13.19 we see that TreePlan automatically assigned an equal probability 0.5 to each of the chance outcomes. For PDC, the probability of strong demand is 0.8 and the probability of weak demand is 0.2. We can select cells H1, H6, H11, H16, H21, and H26 and insert the appropriate probabilities. The payoffs for the chance outcomes are inserted in cells H4, H9, H14, H19, H24, and H29. After inserting the PDC probabilities and payoffs, the PDC decision tree appears as shown in Figure 13.20.
Appendix 13.1
FIGURE 13.19
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THE PDC DECISION TREE DEVELOPED BY TREEPLAN
A B C D E F G H 1 TreePlan Academic Version 0.5 2 Strong 3 4 Small 0 5 6 0 0 0.5 7 Weak 8 9 0 10 11 0.5 12 Strong 13 14 Medium 0 1 15 16 0 0 0 0.5 17 Weak 18 19 0 20 21 0.5 22 Strong 23 24 Large 0 25 26 0 0 0.5 27 Weak 28 29 0
I J K Only For Academic Use 0 0
0 0
0 0
0 0
0 0
0 0
Note that the payoffs also appear in the right-hand margin of the decision tree. The payoffs in the right margin are computed by a formula that adds the payoffs on all of the branches leading to the associated terminal node. For the PDC problem, no payoffs are associated with the decision alternatives branches so we leave the default values of zero in cells D6, D16, and D24. The PDC decision tree is now complete.
Interpreting the Result When probabilities and payoffs are inserted, TreePlan automatically makes the backward pass computations necessary to determine the optimal solution. Optimal decisions are identified by the number in the corresponding decision node. In the PDC decision tree in Figure 13.20, cell B15 contains the decision node. Note that a 3 appears in this node, which tells us that decision alternative branch 3 provides the optimal decision. Thus, decision analysis recommends PDC construct the Large condominium complex. The expected value of this decision appears at the beginning of the tree in cell A16. Thus, we see the optimal expected value is $14.2 million. The expected values of the other decision alternatives are displayed at the end of the corresponding decision branch. Thus, referring to cells E6 and E16, we see that the expected value of the Small complex is $7.8 million and the expected value of the Medium complex is $12.2 million.
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FIGURE 13.20
WEB
file
PDC Tree
Decision Analysis
THE PDC DECISION TREE WITH BRANCH PROBABILITIES AND PAYOFFS
A B C D E F G H 1 TreePlan Academic Version 0.8 2 Strong 3 4 Small 8 5 6 0 7.8 0.2 7 Weak 8 9 7 10 11 0.8 12 Strong 13 14 Medium 14 15 3 16 14.2 0 12.2 0.2 17 Weak 18 19 5 20 21 0.8 22 Strong 23 24 Large 20 25 26 0 14.2 0.2 27 Weak 28 29 -9
I J K Only For Academic Use 8 8
7 7
14 14
5 5
20 20
-9 -9
Other Options TreePlan defaults to a maximization objective. If you would like a minimization objective, follow these steps: Step 1. Select Decision Tree from the Menu Commands group Step 2. Select Options Step 3. Choose Minimize (costs) Click OK In using a TreePlan decision tree, we can modify probabilities and payoffs and quickly observe the impact of the changes on the optimal solution. Using this “what-if” type of sensitivity analysis, we can identify changes in probabilities and payoffs that would change the optimal decision. Also, because TreePlan is an Excel add-in, most of Excel’s capabilities are available. For instance, we could use boldface to highlight the name of the optimal decision alternative on the final decision tree solution. A variety of other options TreePlan provides are contained in the TreePlan manual at the website that accompanies this text. Computer software packages such as TreePlan make it easier to do a thorough analysis of a decision problem.
CHAPTER
14
Multicriteria Decisions CONTENTS 14.1 GOAL PROGRAMMING: FORMULATION AND GRAPHICAL SOLUTION Developing the Constraints and the Goal Equations Developing an Objective Function with Preemptive Priorities Graphical Solution Procedure Goal Programming Model 14.2 GOAL PROGRAMMING: SOLVING MORE COMPLEX PROBLEMS Suncoast Office Supplies Problem Formulating the Goal Equations Formulating the Objective Function Computer Solution
14.3 SCORING MODELS 14.4 ANALYTIC HIERARCHY PROCESS Developing the Hierarchy 14.5 ESTABLISHING PRIORITIES USING AHP Pairwise Comparisons Pairwise Comparison Matrix Synthesization Consistency Other Pairwise Comparisons for the Car Selection Problem 14.6 USING AHP TO DEVELOP AN OVERALL PRIORITY RANKING
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In previous chapters we showed how a variety of quantitative methods can help managers make better decisions. Whenever we desired an optimal solution, we utilized a single criterion (e.g., maximize profit, minimize cost, minimize time). In this chapter we discuss techniques that are appropriate for situations in which the decision maker needs to consider multiple criteria in arriving at the overall best decision. For example, consider a company involved in selecting a location for a new manufacturing plant. The cost of land and construction may vary from location to location, so one criterion in selecting the best site could be the cost involved in building the plant; if cost were the sole criterion of interest, management would simply select the location that minimizes land cost plus construction cost. Before making any decision, however, management might also want to consider additional criteria such as the availability of transportation from the plant to the firm’s distribution centers, the attractiveness of the proposed location in terms of hiring and retaining employees, energy costs at the proposed site, and state and local taxes. In such situations the complexity of the problem increases because one location may be more desirable in terms of one criterion and less desirable in terms of one or more of the other criteria. To introduce the topic of multicriteria decision making, we consider a technique referred to as goal programming. This technique has been developed to handle multiplecriteria situations within the general framework of linear programming. We next consider a scoring model as a relatively easy way to identify the best decision alternative for a multicriteria problem. Finally, we introduce a method known as the analytical hierarchy process (AHP), which allows the user to make pairwise comparisons among the criteria and a series of pairwise comparisons among the decision alternatives in order to arrive at a prioritized ranking of the decision alternatives.
14.1
GOAL PROGRAMMING: FORMULATION AND GRAPHICAL SOLUTION To illustrate the goal programming approach to multicriteria decision problems, let us consider a problem facing Nicolo Investment Advisors. A client has $80,000 to invest and, as an initial strategy, would like the investment portfolio restricted to two stocks:
Stock U.S. Oil Hub Properties
Price/Share $25 $50
Estimated Annual Return/Share $3 $5
Risk Index/Share 0.50 0.25
U.S. Oil, which has a return of $3 on a $25 share price, provides an annual rate of return of 12%, whereas Hub Properties provides an annual rate of return of 10%. The risk index per share, 0.50 for U.S. Oil and 0.25 for Hub Properties, is a rating Nicolo assigned to measure the relative risk of the two investments. Higher risk index values imply greater risk; hence, Nicolo judged U.S. Oil to be the riskier investment. By specifying a maximum portfolio risk index, Nicolo will avoid placing too much of the portfolio in high-risk investments. To illustrate how to use the risk index per share to measure the total portfolio risk, suppose that Nicolo chooses a portfolio that invests all $80,000 in U.S. Oil, the higher risk, but higher return, investment. Nicolo could purchase $80,000/$25 3200 shares of U.S. Oil, and the portfolio would have a risk index of 3200(0.50) 1600. Conversely, if Nicolo purchases no shares of either stock, the portfolio will have no risk, but also no return. Thus, the portfolio risk index will vary from 0 (least risk) to 1600 (most risk).
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Nicolo’s client would like to avoid a high-risk portfolio; thus, investing all funds in U.S. Oil would not be desirable. However, the client agreed that an acceptable level of risk would correspond to portfolios with a maximum total risk index of 700. Thus, considering only risk, one goal is to find a portfolio with a risk index of 700 or less. Another goal of the client is to obtain an annual return of at least $9000. This goal can be achieved with a portfolio consisting of 2000 shares of U.S. Oil [at a cost of 2000($25) $50,000] and 600 shares of Hub Properties [at a cost of 600($50) $30,000]; the annual return in this case would be 2000($3) 600($5) $9000. Note, however, that the portfolio risk index for this investment strategy would be 2000(0.50) 600(0.25) 1150; thus, this portfolio achieves the annual return goal but does not satisfy the portfolio risk index goal. Thus, the portfolio selection problem is a multicriteria decision problem involving two conflicting goals: one dealing with risk and one dealing with annual return. The goal programming approach was developed precisely for this kind of problem. Goal programming can be used to identify a portfolio that comes closest to achieving both goals. Before applying the methodology, the client must determine which, if either, goal is more important. Suppose that the client’s top-priority goal is to restrict the risk; that is, keeping the portfolio risk index at 700 or less is so important that the client is not willing to trade the achievement of this goal for any amount of an increase in annual return. As long as the portfolio risk index does not exceed 700, the client seeks the best possible return. Based on this statement of priorities, the goals for the problem are as follows: Primary Goal (Priority Level 1) Goal 1: Find a portfolio that has a risk index of 700 or less. Secondary Goal (Priority Level 2) Goal 2: Find a portfolio that will provide an annual return of at least $9000. In goal programming with preemptive priorities, we never permit trade-offs between higher and lower level goals.
The primary goal is called a priority level 1 goal, and the secondary goal is called a priority level 2 goal. In goal programming terminology, they are called preemptive priorities because the decision maker is not willing to sacrifice any amount of achievement of the priority level 1 goal for the lower priority goal. The portfolio risk index of 700 is the target value for the priority level 1 (primary) goal, and the annual return of $9000 is the target value for the priority level 2 (secondary) goal. The difficulty in finding a solution that will achieve these goals is that only $80,000 is available for investment.
Developing the Constraints and the Goal Equations We begin by defining the decision variables: U = number of shares of U.S. Oil purchased H = number of shares of Hub Properties purchased Constraints for goal programming problems are handled in the same way as in an ordinary linear programming problem. In the Nicolo Investment Advisors problem, one constraint corresponds to the funds available. Because each share of U.S. Oil costs $25 and each share of Hub Properties costs $50, the constraint representing the funds available is 25U + 50H … 80,000 To complete the formulation of the model, we must develop a goal equation for each goal. Let us begin by writing the goal equation for the primary goal. Each share of U.S. Oil has a risk index of 0.50 and each share of Hub Properties has a risk index of 0.25; therefore,
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the portfolio risk index is 0.50U 0.25H. Depending on the values of U and H, the portfolio risk index may be less than, equal to, or greater than the target value of 700. To represent these possibilities mathematically, we create the goal equation 0.50U 0.25H 700 d 1 d1
where d1+ = the amount by which the portfolio risk index exceeds the target value of 700 d1 = the amount by which the portfolio risk index is less than the target value of 700 To achieve a goal exactly, the two deviation variables must both equal zero.
In goal programming, d1+ and d1- are called deviation variables. The purpose of deviation variables is to allow for the possibility of not meeting the target value exactly. Consider, for example, a portfolio that consists of U 2000 shares of U.S. Oil and H 0 shares of Hub Properties. The portfolio risk index is 0.50(2000) 0.25(0) 1000. In this case, d1+ 300 reflects the fact that the portfolio risk index exceeds the target value by 300 units; note also that because d 1 is greater than zero, the value of d 1 must be zero. For a portfolio consisting of U 0 shares of U.S. Oil and H 1000 shares of Hub Properties, the portfolio risk index would be 0.50(0) 0.25(1000) 250. In this case, d1 450 and + d1 0, indicating that the solution provides a portfolio risk index of 450 less than the target value of 700. In general, the letter d is used for deviation variables in a goal programming model. A superscript of plus () or minus () is used to indicate whether the variable corresponds to a positive or negative deviation from the target value. If we bring the deviation variables to the left-hand side, we can rewrite the goal equation for the primary goal as 0.50U + 0.25H - d1+ + d1- = 700 Note that the value on the right-hand side of the goal equation is the target value for the goal. The left-hand side of the goal equation consists of two parts: 1. A function that defines the amount of goal achievement in terms of the decision variables (e.g., 0.50U 0.25H) 2. Deviation variables representing the difference between the target value for the goal and the level achieved To develop a goal equation for the secondary goal, we begin by writing a function representing the annual return for the investment: Annual return 3U 5H Then we define two deviation variables that represent the amount of over- or underachievement of the goal. Doing so, we obtain d2+ = the amount by which the annual return for the portfolio is greater than the target value of $9000 d2 = the amount by which the annual return for the portfolio is less than the target value of $9000 Using these two deviation variables, we write the goal equation for goal 2 as 3U + 5H = 9000 + d2+ - d2-
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Goal Programming: Formulation and Graphical Solution
or -
3U + 5H - d2+ + d2 = 9000 This step completes the development of the goal equations and the constraints for the Nicolo portfolio problem. We are now ready to develop an appropriate objective function for the problem.
Developing an Objective Function with Preemptive Priorities
We must solve one linear program for each priority level.
The objective function in a goal programming model calls for minimizing a function of the deviation variables. In the portfolio selection problem, the most important goal, denoted P1, is to find a portfolio with a risk index of 700 or less. This problem has only two goals, and the client is unwilling to accept a portfolio risk index greater than 700 to achieve the secondary annual return goal. Therefore, the secondary goal is denoted P2. As we stated previously, these goal priorities are referred to as preemptive priorities because the satisfaction of a higher level goal cannot be traded for the satisfaction of a lower level goal. Goal programming problems with preemptive priorities are solved by treating priority level 1 goals (P1) first in an objective function. The idea is to start by finding a solution that comes closest to satisfying the priority level 1 goals. This solution is then modified by solving a problem with an objective function involving only priority level 2 goals (P2); however, revisions in the solution are permitted only if they do not hinder achievement of the P1 goals. In general, solving a goal programming problem with preemptive priorities involves solving a sequence of linear programs with different objective functions; P1 goals are considered first, P2 goals second, P3 goals third, and so on. At each stage of the procedure, a revision in the solution is permitted only if it causes no reduction in the achievement of a higher priority goal. The number of linear programs that we must solve in sequence to develop the solution to a goal programming problem is determined by the number of priority levels. One linear program must be solved for each priority level. We will call the first linear program solved the priority level 1 problem, the second linear program solved the priority level 2 problem, and so on. Each linear program is obtained from the one at the next higher level by changing the objective function and adding a constraint. We first formulate the objective function for the priority level 1 problem. The client stated that the portfolio risk index should not exceed 700. Is underachieving the target value of 700 a concern? Clearly, the answer is no because portfolio risk index values of less than 700 correspond to less risk. Is overachieving the target value of 700 a concern? The answer is yes because portfolios with a risk index greater than 700 correspond to unacceptable levels of risk. Thus, the objective function corresponding to the priority level 1 linear program should minimize the value of d1+ . The goal equations and the funds available constraint have already been developed. Thus, the priority level 1 linear program can now be stated. P1 Problem Min s.t.
d1+ 25U + 50H … 80,000 0.50U + 0.25H - d1+ + d1= 700 + 3U + 5H - d2 + d2 = 9000 U, H, d1+ , d1-, d2+ , d2- Ú 0
Funds available P1 goal P2 goal
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Graphical Solution Procedure One approach that can often be used to solve a difficult problem is to break the problem into two or more smaller or easier problems. The linear programming procedure we use to solve the goal programming problem is based on this approach.
The graphical solution procedure for goal programming is similar to that for linear programming presented in Chapter 2. The only difference is that the procedure for goal programming involves a separate solution for each priority level. Recall that the linear programming graphical solution procedure uses a graph to display the values for the decision variables. Because the decision variables are nonnegative, we consider only that portion of the graph where U 0 and H 0. Recall also that every point on the graph is called a solution point. We begin the graphical solution procedure for the Nicolo Investment problem by identifying all solution points that satisfy the available funds constraint: 25U + 50H … 80,000 The shaded region in Figure 14.1, feasible portfolios, consists of all points that satisfy this constraint—that is, values of U and H for which 25U 50H 80,000. The objective for the priority level 1 linear program is to minimize d1+ , the amount by which the portfolio index exceeds the target value of 700. Recall that the P1 goal equation is 0.50U + 0.25H - d1+ + d1- = 700 When the P1 goal is met exactly, d1+ 0 and d1- 0; the goal equation then reduces to 0.50U 0.25H 700. Figure 14.2 shows the graph of this equation; the shaded region identifies all solution points that satisfy the available funds constraint and also result in the value of d1+ 0. Thus, the shaded region contains all the feasible solution points that achieve the priority level 1 goal. At this point, we have solved the priority level 1 problem. Note that alternative optimal solutions are possible; in fact, all solution points in the shaded region in Figure 14.2 maintain a portfolio risk index of 700 or less, and hence d 1 0.
FIGURE 14.1 PORTFOLIOS THAT SATISFY THE AVAILABLE FUNDS CONSTRAINT
Number of Shares of Hub Properties
H 3000
2000
1000
Available Funds: 25U + 50 H = 80,000 Feasible Portfolios 0
1000
2000 3000 Number of Shares of U.S. Oil
4000
U
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FIGURE 14.2 PORTFOLIOS THAT SATISFY THE P1 GOAL
Number of Shares of Hub Properties
H 3000
Priority Level 1 Goal Equation – + with d 1 = d 1 = 0; 0.5U + 0.25H = 700
2000
+
1000
d1 = 0 Feasible Portfolios That Will Achieve Priority Level 1 Goal 0
Available Funds: 25U + 50 H = 80,000 +
d1 > 0
1000 2000 3000 Number of Shares of U.S. Oil
4000
U
The priority level 2 goal for the Nicolo Investment problem is to find a portfolio that will provide an annual return of at least $9000. Is overachieving the target value of $9000 a concern? Clearly, the answer is no because portfolios with an annual return of more than $9000 correspond to higher returns. Is underachieving the target value of $9000 a concern? The answer is yes because portfolios with an annual return of less than $9000 are not acceptable to the client. Thus, the objective function corresponding to the priority level 2 linear program should minimize the value of d2- . However, because goal 2 is a secondary goal, the solution to the priority level 2 linear program must not degrade the optimal solution to the priority level 1 problem. Thus, the priority level 2 linear program can now be stated. P2 Problem Min s.t.
d225U + 50H 0.50U + 0.25H - d1+ + d13U + 5H - d2+ + d2+ d1+
… 80,000 = 700 = 9000 = 0
Funds available P1 goal P2 goal Maintain achievement of P1 goal
U, H, d1+, d1-, d2+, d2- Ú 0 Note that the priority level 2 linear program differs from the priority level 1 linear program in two ways. The objective function involves minimizing the amount by which the portfolio annual return underachieves the level 2 goal, and another constraint has been added to ensure that no amount of achievement of the priority level 1 goal is sacrificed. Let us now continue the graphical solution procedure. The goal equation for the priority level 2 goal is 3U + 5H - d2+ + d2- = 9000
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FIGURE 14.3 BEST SOLUTION WITH RESPECT TO BOTH GOALS (SOLUTION TO P2 PROBLEM) H Number of Shares of Hub Properties
666
3000
Priority Level 1 Goal Equation – + with d 2 = d 1 = 0; 0.5U + 0.25H = 700 U = 800, H = 1200 The best solution for the secondary goal that does not degrade the solution for the primary goal
2000
Priority Level 2 Goal Equation – + with d 2 = d 2 = 0; 3U + 5H = 9000 + d2 > 0
+
d1 = 0 1000 Feasible – Portfolios d2 > 0 That Will Achieve Priority Level 1 Goal 0
1000
Available Funds: 25U + 50 H = 80,000
2000 3000 Number of Shares of U.S. Oil
4000
U
When both d2+ and d2- equal zero, this equation reduces to 3U 5H 9000; we show the graph with this equation in Figure 14.3. At this stage, we cannot consider any solution point that will degrade the achievement of the priority level 1 goal. Figure 14.3 shows that no solution points will achieve the priority level 2 goal and maintain the values we were able to achieve for the priority level 1 goal. In fact, the best solution that can be obtained when considering the priority level 2 goal is given by the point (U 800, H 1200); in other words, this point comes the closest to satisfying the priority level 2 goal from among those solutions satisfying the priority level 1 goal. Because the annual return corresponding to this solution point is $3(800) $5(1200) $8400, identifying a portfolio that will satisfy both the priority level 1 and the priority level 2 goals is impossible. In fact, the best solution underachieves goal 2 by d2- $9000 $8400 $600. Thus, the goal programming solution for the Nicolo Investment problem recommends that the $80,000 available for investment be used to purchase 800 shares of U.S. Oil and 1200 shares of Hub Properties. Note that the priority level 1 goal of a portfolio risk index of 700 or less has been achieved. However, the priority level 2 goal of at least a $9000 annual return is not achievable. The annual return for the recommended portfolio is $8400. In summary, the graphical solution procedure for goal programming involves the following steps: Step 1. Identify the feasible solution points that satisfy the problem constraints. Step 2. Identify all feasible solutions that achieve the highest priority goal; if no feasible solutions will achieve the highest priority goal, identify the solution(s) that comes closest to achieving it. Step 3. Move down one priority level, and determine the “best” solution possible without sacrificing any achievement of higher priority goals. Step 4. Repeat step 3 until all priority levels have been considered.
14.1
Problem 2 will test your ability to formulate a goal programming model and use the graphical solution procedure to obtain a solution.
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Although the graphical solution procedure is a convenient method for solving goal programming problems involving two decision variables, the solution of larger problems requires a computer-aided approach. In Section 14.2 we illustrate how to use a computer software package to solve more complex goal programming problems.
Goal Programming Model As we stated, preemptive goal programming problems are solved as a sequence of linear programs: one linear program for each priority level. However, notation that permits writing a goal programming problem in one concise statement is helpful. In writing the overall objective for the portfolio selection problem, we must write the objective function in a way that reminds us of the preemptive priorities. We can do so by writing the objective function as Min
P1(d1+ ) + P2(d2- )
The priority levels P1 and P2 are not numerical weights on the deviation variables, but simply labels that remind us of the priority levels for the goals. We now write the complete goal programming model as Min s.t.
P1(d1+ ) + P2(d2- ) 25U + 50H … 80,000 0.50U + 0.25H - d1+ + d1= 700 + 3U + 5H - d2 + d2 = 9000 U, H, d1+, d1-, d2+ , d2- Ú 0
Funds available P1 goal P2 goal
With the exception of the P1 and P2 priority levels in the objective function, this model is a linear programming model. The solution of this linear program involves solving a sequence of linear programs involving goals at decreasing priority levels. We now summarize the procedure used to develop a goal programming model. Step 1. Identify the goals and any constraints that reflect resource capacities or other restrictions that may prevent achievement of the goals. Step 2. Determine the priority level of each goal; goals with priority level P1 are most important, those with priority level P2 are next most important, and so on. Step 3. Define the decision variables. Step 4. Formulate the constraints in the usual linear programming fashion. Step 5. For each goal, develop a goal equation, with the right-hand side specifying the target value for the goal. Deviation variables di+ and di- are included in each goal equation to reflect the possible deviations above or below the target value. Step 6. Write the objective function in terms of minimizing a prioritized function of the deviation variables. NOTES AND COMMENTS 1. The constraints in the general goal programming model are of two types: goal equations and ordinary linear programming constraints. Some analysts call the goal equations goal
constraints and the ordinary linear programming constraints system constraints. (continued)
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2. You might think of the general goal programming model as having “hard” and “soft” constraints. The hard constraints are the ordinary linear programming constraints that cannot be violated. The soft constraints are the ones resulting from the goal equations. Soft constraints can be violated but with a penalty for doing so. The penalty is reflected by the coefficient of the deviation variable in the objective function. In Section 14.2
14.2
we illustrate this point with a problem that has a coefficient of 2 for one of the deviation variables. 3. Note that the constraint added in moving from the linear programming problem at one priority level to the linear programming problem at the next lower priority level is a hard constraint that ensures that no amount of achievement of the higher priority goal is sacrificed to achieve the lower priority goal.
GOAL PROGRAMMING: SOLVING MORE COMPLEX PROBLEMS In Section 14.1 we formulated and solved a goal programming model that involved one priority level 1 goal and one priority level 2 goal. In this section we show how to formulate and solve goal programming models that involve multiple goals within the same priority level. Although specially developed computer programs can solve goal programming models, these programs are not as readily available as general purpose linear programming software packages. Thus, the computer solution procedure outlined in this section develops a solution to a goal programming model by solving a sequence of linear programming models with a general purpose linear programming software package.
Suncoast Office Supplies Problem The management of Suncoast Office Supplies establishes monthly goals, or quotas, for the types of customers contacted. For the next four weeks, Suncoast’s customer contact strategy calls for the salesforce, which consists of four salespeople, to make 200 contacts with established customers who have previously purchased supplies from the firm. In addition, the strategy calls for 120 contacts of new customers. The purpose of this latter goal is to ensure that the salesforce is continuing to investigate new sources of sales. After making allowances for travel and waiting time, as well as for demonstration and direct sales time, Suncoast allocated two hours of salesforce effort to each contact of an established customer. New customer contacts tend to take longer and require three hours per contact. Normally, each salesperson works 40 hours per week, or 160 hours over the fourweek planning horizon; under a normal work schedule, the four salespeople will have 4(160) 640 hours of salesforce time available for customer contacts. Management is willing to use some overtime, if needed, but is also willing to accept a solution that uses less than the scheduled 640 hours available. However, management wants both overtime and underutilization of the workforce limited to no more than 40 hours over the four-week period. Thus, in terms of overtime, management’s goal is to use no more than 640 40 680 hours of salesforce time; and in terms of labor utilization, management’s goal is to use at least 640 40 600 hours of salesforce time. In addition to the customer contact goals, Suncoast established a goal regarding sales volume. Based on its experience, Suncoast estimates that each established customer contacted will generate $250 of sales and that each new customer contacted will generate $125 of sales. Management wants to generate sales revenue of at least $70,000 for the next month. Given Suncoast’s small salesforce and the short time frame involved, management decided that the overtime goal and the labor utilization goal are both priority level 1 goals. Management also concluded that the $70,000 sales revenue goal should be a priority level 2
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Goal Programming: Solving More Complex Problems
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goal and that the two customer contact goals should be priority level 3 goals. Based on these priorities, we can now summarize the goals. Priority Level 1 Goals Goal 1: Do not use any more than 680 hours of salesforce time. Goal 2: Do not use any less than 600 hours of salesforce time. Priority Level 2 Goal Goal 3: Generate sales revenue of at least $70,000. Priority Level 3 Goals Goal 4: Call on at least 200 established customers. Goal 5: Call on at least 120 new customers.
Formulating the Goal Equations Next, we must define the decision variables whose values will be used to determine whether we are able to achieve the goals. Let E = the number of established customers contacted N = the number of new customers contacted Using these decision variables and appropriate deviation variables, we can develop a goal equation for each goal. The procedure used parallels the approach introduced in the preceding section. A summary of the results obtained is shown for each goal. Goal 1 2 E + 3N - d1+ + d1- = 680 where d1+ = the amount by which the number of hours used by the salesforce is greater than the target value of 680 hours d1 = the amount by which the number of hours used by the salesforce is less than the target value of 680 hours Goal 2 2 E + 3N - d2+ + d2- = 600 where d2+ = the amount by which the number of hours used by the salesforce is greater than the target value of 600 hours d2- = the amount by which the number of hours used by the salesforce is less than the target value of 600 hours Goal 3 250E + 125N - d3+ + d3- = 70,000
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where d3+ = the amount by which the sales revenue is greater than the target value of $70,000 d3 = the amount by which the sales revenue is less than the target value of $70,000 Goal 4 E - d4+ + d4- = 200 where d4+ = the amount by which the number of established customer contacts is greater than the target value of 200 established customer contacts d4- = the amount by which the number of established customer contacts is less than the target value of 200 established customer contacts Goal 5 N - d5+ + d5- = 120 where d5+ = the amount by which the number of new customer contacts is greater than the target value of 120 new customer contacts d5 = the amount by which the number of new customer contacts is less than the target value of 120 new customer contacts
Formulating the Objective Function To develop the objective function for the Suncoast Office Supplies problem, we begin by considering the priority level 1 goals. When considering goal 1, if d1+ 0, we will have found a solution that uses no more than 680 hours of salesforce time. Because solutions for which d1+ is greater than zero represent overtime beyond the desired level, the objective function should minimize the value of d1+ . When considering goal 2, if d2- 0, we will have found a solution that uses at least 600 hours of sales force time. If d2- is greater than zero, however, labor utilization will not have reached the acceptable level. Thus, the objective function for the priority level 1 goals should minimize the value of d2- . Because both priority level 1 goals are equally important, the objective function for the priority level 1 problem is Min
d1+ + d2-
In considering the priority level 2 goal, we note that management wants to achieve sales revenues of at least $70,000. If d3- 0, Suncoast will achieve revenues of at least $70,000, and if d3- >0, revenues of less than $70,000 will be obtained. Thus, the objective function for the priority level 2 problem is Min d3Next, we consider what the objective function must be for the priority level 3 problem. When considering goal 4, if d4- 0, we will have found a solution with at least 200 established
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customer contacts; however, if d4- 0, we will have underachieved the goal of contacting at least 200 established customers. Thus, for goal 4 the objective is to minimize d4- . When considering goal 5, if d5- 0, we will have found a solution with at least 120 new customer contacts; however, if d5- 0, we will have underachieved the goal of contacting at least 120 new customers. Thus, for goal 5 the objective is to minimize d5- . If goals 4 and 5 are equal in importance, the objective function for the priority level 3 problem would be Min
d4- + d5-
However, suppose that management believes that generating new customers is vital to the long-run success of the firm and that goal 5 should be weighted more than goal 4. If management believes that goal 5 is twice as important as goal 4, the objective function for the priority level 3 problem would be Min
d4- + 2d5-
Combining the objective functions for all three priority levels, we obtain the overall objective function for the Suncoast Office Supplies problem: Min
P1(d1+ ) + P1(d2- ) + P2(d3- ) + P3(d4- ) + P3(2d5- )
As we indicated previously, P1, P2, and P3 are simply labels that remind us that goals 1 and 2 are the priority level 1 goals, goal 3 is the priority level 2 goal, and goals 4 and 5 are the priority level 3 goals. We can now write the complete goal programming model for the Sun-coast Office Supplies problem as follows: Min P1(d1+ ) + P1(d2- ) + s.t. 2 E + 3N - d1+ 2 E + 3N 250E + 125N E N E, N, d1+, d1-,
P2(d3- ) + P3(d4- ) + P3(2d5- ) + d1- d2+ + d2- d3+ + d3- d4+ + d4- d5+ + d5+ + + d2 , d2 , d3 , d3 , d4 , d4-, d5+, d5-
= 680 = 600 = 70,000 = 200 = 120 Ú 0
Goal 1 Goal 2 Goal 3 Goal 4 Goal 5
Computer Solution The following computer procedure develops a solution to a goal programming model by solving a sequence of linear programming problems. The first problem comprises all the constraints and all the goal equations for the complete goal programming model; however, the objective function for this problem involves only the P1 priority level goals. Again, we refer to this problem as the P1 problem. Whatever the solution to the P1 problem, a P2 problem is formed by adding a constraint to the P1 model that ensures that subsequent problems will not degrade the solution obtained for the P1 problem. The objective function for the priority level 2 problem takes into consideration only the P2 goals. We continue the process until we have considered all priority levels.
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FIGURE 14.4 THE SOLUTION OF THE P1 PROBLEM Optimal Objective Value = 0.00000 Variable -------------D1PLUS D2MINUS E N D1MINUS D2PLUS D3PLUS D3MINUS D4PLUS D4MINUS D5PLUS D5MINUS
Value --------------0.00000 0.00000 250.00000 60.00000 0.00000 80.00000 0.00000 0.00000 50.00000 0.00000 0.00000 60.00000
Reduced Cost ----------------1.00000 1.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000
To solve the Suncoast Office Supplies problem, we begin by solving the P1 problem: Min d1+ + s.t. 2E 2E 250E E
d2+ 3N - d1+ + d1+ 3N - d2+ + d2+ 125N - d3+ + d3- d4+ + d4N - d5+ + d5E, N, d1+, d1-, d2+, d2- , d3+, d3-, d4+, d4-, d5+, d5-
= 680 = 600 = 70,000 = 200 = 120 Ú 0
Goal 1 Goal 2 Goal 3 Goal 4 Goal 5
In Figure 14.4 we show the solution for this linear program. Note that D1PLUS refers to d1+ , D2MINUS refers to d2-, D1MINUS refers to d1- , and so on. The solution shows E 250 established customer contacts and N 60 new customer contacts. Because D1PLUS 0 and D2MINUS 0, we see that the solution achieves both goals 1 and 2. Alternatively, the value of the objective function is 0, confirming that both priority level 1 goals have been achieved. Next, we consider goal 3, the priority level 2 goal, which is to minimize D3MINUS. The solution in Figure 14.4 shows that D3MINUS 0. Thus, the solution of E 250 established customer contacts and N 60 new customer contacts also achieves goal 3, the priority level 2 goal, which is to generate a sales revenue of at least $70,000. The fact that D3PLUS 0 indicates that the current solution satisfies goal 3 exactly at $70,000. Finally, the solution in Figure 14.4 shows D4PLUS 50 and D5MINUS 60. These values tell us that goal 4 of the priority level 3 goals is overachieved by 50 established customers, but goal 5 is underachieved by 60 new customers. As this point, both the priority level 1 and 2 goals have been achieved, but we need to solve another linear program to determine whether a solution can be identified that will satisfy both of the priority level 3 goals. Therefore, we go directly to the P3 problem.
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FIGURE 14.5 THE SOLUTION OF THE P3 PROBLEM Optimal Objective Value = 120.00000 Variable -------------D1PLUS D2MINUS E N D1MINUS D2PLUS D3PLUS D3MINUS D4PLUS D4MINUS D5PLUS D5MINUS
Value --------------0.00000 0.00000 250.00000 60.00000 0.00000 80.00000 0.00000 0.00000 50.00000 0.00000 0.00000 60.00000
Reduced Cost ----------------0.00000 1.00000 0.00000 0.00000 1.00000 0.00000 0.08000 0.00000 0.00000 1.00000 2.00000 0.00000
The linear programming model for the P3 problem is a modification of the linear programming model for the P1 problem. Specifically, the objective function for the P3 problem is expressed in terms of the priority level 3 goals. Thus, the P3 problem objective function becomes to minimize D4MINUS 2D5MINUS. The original five constraints of the P1 problem appear in the P3 problem. However, two additional constraints must be added to ensure that the solution to the P3 problem continues to satisfy the priority level 1 and priority level 2 goals. Thus, we add the priority level 1 constraint D1PLUS D2MINUS 0 and the priority level 2 constraint D3MINUS 0. Making these modifications to the P1 problem, we obtain the solution to the P3 problem shown in Figure 14.5. Referring to Figure 14.5, we see the objective function value of 120 indicates that the priority level 3 goals cannot be achieved. Because D5MINUS 60, the optimal solution of E 250 and N 60 results in 60 fewer new customer contacts than desired. However, the fact that we solved the P3 problem tells us the goal programming solution comes as close as possible to satisfying priority level 3 goals given the achievement of both the priority level 1 and 2 goals. Because all priority levels have been considered, the solution procedure is finished. The optimal solution for Suncoast is to contact 250 established customers and 60 new customers. Although this solution will not achieve management’s goal of contacting at least 120 new customers, it does achieve each of the other goals specified. If management isn’t happy with this solution, a different set of priorities could be considered. Management must keep in mind, however, that in any situation involving multiple goals at different priority levels, rarely will all the goals be achieved with existing resources. NOTES AND COMMENTS 1. Not all goal programming problems involve multiple priority levels. For problems with one priority level, only one linear program need be solved to obtain the goal programming solution. The analyst simply minimizes the weighted
deviations from the goals. Trade-offs are permitted among the goals because they are all at the same priority level. (continued)
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2. The goal programming approach can be used when the analyst is confronted with an infeasible solution to an ordinary linear program. Reformulating some constraints as goal equations with deviation variables allows a solution that minimizes the weighted sum of the deviation variables. Often, this approach will suggest a reasonable solution.
14.3
3. The approach that we used to solve goal programming problems with multiple priority levels is to solve a sequence of linear programs. These linear programs are closely related so that complete reformulation and solution are not necessary. By changing the objective function and adding a constraint, we can go from one linear program to the next.
SCORING MODELS A scoring model is a relatively quick and easy way to identify the best decision alternative for a multicriteria decision problem. We will demonstrate the use of a scoring model for a job selection application. Assume that a graduating college student with a double major in finance and accounting received job offers for the following three positions: • • •
A financial analyst for an investment firm located in Chicago An accountant for a manufacturing firm located in Denver An auditor for a CPA firm located in Houston
When asked about which job is preferred, the student made the following comments: “The financial analyst position in Chicago provides the best opportunity for my long-run career advancement. However, I would prefer living in Denver rather than in Chicago or Houston. On the other hand, I liked the management style and philosophy at the Houston CPA firm the best.” The student’s statement points out that this example is clearly a multicriteria decision problem. Considering only the long-run career advancement criterion, the financial analyst position in Chicago is the preferred decision alternative. Considering only the location criterion, the best decision alternative is the accountant position in Denver. Finally, considering only the management style criterion, the best alternative is the auditor position with the CPA firm in Houston. For most individuals, a multicriteria decision problem that requires a trade-off among the several criteria is difficult to solve. In this section, we describe how a scoring model can assist in analyzing a multicriteria decision problem and help identify the preferred decision alternative. The steps required to develop a scoring model are as follows: A scoring model enables a decision maker to identify the criteria and indicate the weight or importance of each criterion.
Step 1. Develop a list of the criteria to be considered. The criteria are the factors that the decision maker considers relevant for evaluating each decision alternative. Step 2. Assign a weight to each criterion that describes the criterion’s relative importance. Let wi = the weight for criterion i Step 3. Assign a rating for each criterion that shows how well each decision alternative satisfies the criterion. Let rij = the rating for criterion i and decision alternative j Step 4. Compute the score for each decision alternative. Let Sj = score for decision alternative j
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The equation used to compute Sj is as follows: Sj = a wi rij
(14.1)
i
Step 5. Order the decision alternatives from the highest score to the lowest score to provide the scoring model’s ranking of the decision alternatives. The decision alternative with the highest score is the recommended decision alternative. Let us return to the multicriteria job selection problem the graduating student was facing and illustrate the use of a scoring model to assist in the decision-making process. In carrying out step 1 of the scoring model procedure, the student listed seven criteria as important factors in the decision-making process. These criteria are as follows: • • • • • • •
Career advancement Location Management style Salary Prestige Job security Enjoyment of the work
In step 2, a weight is assigned to each criterion to indicate the criterion’s relative importance in the decision-making process. For example, using a five-point scale, the question used to assign a weight to the career advancement criterion would be as follows: Relative to the other criteria you are considering, how important is career advancement? Importance Very important Somewhat important Average importance Somewhat unimportant Very unimportant
Weight 5 4 3 2 1
By repeating this question for each of the seven criteria, the student provided the criterion weights shown in Table 14.1. Using this table, we see that career advancement and enjoyment of the work are the two most important criteria, each receiving a weight of 5. The TABLE 14.1 WEIGHTS FOR THE SEVEN JOB SELECTION CRITERIA Criterion Career advancement Location Management style Salary Prestige Job security Enjoyment of the work
Importance Very important Average importance Somewhat important Average importance Somewhat unimportant Somewhat important Very important
Weight (wi ) 5 3 4 3 2 4 5
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management style and job security criteria are both considered somewhat important, and thus each received a weight of 4. Location and salary are considered average in importance, each receiving a weight of 3. Finally, because prestige is considered to be somewhat unimportant, it received a weight of 2. The weights shown in Table 14.1 are subjective values provided by the student. A different student would most likely choose to weight the criteria differently. One of the key advantages of a scoring model is that it uses the subjective weights that most closely reflect the preferences of the individual decision maker. In step 3, each decision alternative is rated in terms of how well it satisfies each criterion. For example, using a nine-point scale, the question used to assign a rating for the “financial analyst in Chicago” alternative and the career advancement criterion would be as follows: To what extent does the financial analyst position in Chicago satisfy your career advancement criterion? Level of Satisfaction Extremely high Very high High Slightly high Average Slightly low Low Very low Extremely low
Rating 9 8 7 6 5 4 3 2 1
A score of 8 on this question would indicate that the student believes the financial analyst position would be rated “very high” in terms of satisfying the career advancement criterion. This scoring process must be completed for each combination of decision alternative and decision criterion. Because seven decision criteria and three decision alternatives need to be considered, 7 3 21 ratings must be provided. Table 14.2 summarizes the student’s responses. Scanning this table provides some insights about how the student rates each decision criterion and decision alternative combination. For example, a rating of 9, TABLE 14.2 RATINGS FOR EACH DECISION CRITERION AND EACH DECISION ALTERNATIVE COMBINATION
Criterion Career advancement Location Management style Salary Prestige Job security Enjoyment of the work
Decision Alternative Financial Analyst Accountant Chicago Denver 8 6 3 8 5 6 6 7 7 5 4 7 8 6
Auditor Houston 4 7 9 5 4 6 5
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corresponding to an extremely high level of satisfaction, only appears for the management style criterion and the auditor position in Houston. Thus, considering all combinations, the student rates the auditor position in Houston as the very best in terms of satisfying the management criterion. The lowest rating in the table is a 3 that appears for the location criterion of the financial analyst position in Chicago. This rating indicates that Chicago is rated “low” in terms of satisfying the student’s location criterion. Other insights and interpretations are possible, but the question at this point is how a scoring model uses the data in Tables 14.1 and 14.2 to identify the best overall decision alternative. Step 4 of the procedure shows that equation (14.1) is used to compute the score for each decision alternative. The data in Table 14.1 provide the weight for each criterion (wi) and the data in Table 14.2 provide the ratings of each decision alternative for each criterion (rij). Thus, for decision alternative 1, the score for the financial analyst position in Chicago is By comparing the scores for each criterion, a decision maker can learn why a particular decision alternative has the highest score.
S1 = a wi ri1 = 5(8) + 3(3) + 4(5) + 3(6) + 2(7) + 4(4) + 5(8) = 157 i
The scores for the other decision alternatives are computed in the same manner. The computations are summarized in Table 14.3. From Table 14.3, we see that the highest score of 167 corresponds to the accountant position in Denver. Thus, the accountant position in Denver is the recommended decision alternative. The financial analyst position in Chicago, with a score of 157, is ranked second, and the auditor position in Houston, with a score of 149, is ranked third. The job selection example that illustrates the use of a scoring model involved seven criteria, each of which was assigned a weight from 1 to 5. In other applications the weights assigned to the criteria may be percentages that reflect the importance of each of the criteria. In addition, multicriteria problems often involve additional subcriteria that enable the decision maker to incorporate additional detail into the decision process. For instance, consider the location criterion in the job selection example. This criterion might be further subdivided into the following three subcriteria: • • •
Affordability of housing Recreational opportunities Climate
TABLE 14.3 COMPUTATION OF SCORES FOR THE THREE DECISION ALTERNATIVES
Criterion Career advancement Location Management style Salary Prestige Job security Enjoyment of the work Score
Weight wi 5 3 4 3 2 4 5
Financial Analyst Chicago Rating Score ri 1 wi ri 1 8 40 3 9 5 20 6 18 7 14 4 16 8 40 157
Decision Alternative Accountant Denver Rating Score ri 2 wi ri 2 6 30 8 24 6 24 7 21 5 10 7 28 6 30 167
Auditor Houston Rating Score ri 3 wi ri 3 4 20 7 21 9 36 5 15 4 8 6 24 5 25 149
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In this case, the three subcriteria would have to be assigned weights, and a score for each decision alternative would have to be computed for each subcriterion. The Management Science in Action, Scoring Model at Ford Motor Company, illustrates how scoring models can be applied for a problem involving four criteria, each of which has several subcriteria. This example also demonstrates the use of percentage weights for the criteria and the wide applicability of scoring models in more complex problem situations. MANAGEMENT SCIENCE IN ACTION SCORING MODEL AT FORD MOTOR COMPANY* Ford Motor Company needed benchmark data in order to set performance targets for future and current model automobiles. A detailed proposal was developed and sent to five suppliers. Three suppliers were considered acceptable for the project. Because the three suppliers had different capabilities in terms of teardown analysis and testing, Ford developed three project alternatives:
Alternative 1: Supplier C does the entire project alone.
Alternative 2: Supplier A does the testing portion of the project and works with Supplier B to complete the remaining parts of the project. Alternative 3: Supplier A does the testing portion of the project and works with Supplier C to complete the remaining parts of the project. For routine projects, selecting the lowest cost alternative might be appropriate. However, because this project involved many nonroutine tasks, Ford incorporated four criteria into the decision process. The four criteria selected by Ford were as follows: 1. Skill level (effective project leader and a skilled team) 2. Cost containment (ability to stay within approved budget) 3. Timing containment (ability to meet program timing requirements) 4. Hardware display (location and functionality of teardown center and user friendliness) Using team consensus, a weight of 25% was assigned to each of these criteria; note that these weights indicate that members of the Ford project team considered each criterion to be equally important in the decision process. Each of the four criteria was further subdivided into subcriteria. For example, the skill-level criterion had four subcriteria: project manager leadership; team structure organization; team
players’ communication; and past Ford experience. In total, 17 subcriteria were considered. A team-consensus weighting process was used to develop percentage weights for the subcriteria. The weights assigned to the skill-level subcriteria were 40% for project manager leadership; 20% for team structure organization; 20% for team players’ communication; and 20% for past Ford experience. Team members visited all the suppliers and individually rated them for each subcriterion using a 1–10 scale (1-worst, 10-best). Then, in a team meeting, consensus ratings were developed. For Alternative 1, the consensus ratings developed for the skill-level subcriteria were 8 for project manager leadership, 8 for team structure organization, 7 for team players’ communication, and 8 for past Ford experience. Because the weights assigned to the skill-level subcriteria were 40%, 20%, 20%, and 20%, the rating for Alternative 1 corresponding to the skill-level criterion was Rating = 0.4(8) + 0.2(8) + 0.2(7) + 0.2(8) = 7.8
In a similar fashion, ratings for Alternative 1 corresponding to each of the other criteria were developed. The results obtained were a rating of 6.8 for cost containment, 6.65 for timing containment, and 8 for hardware display. Using the initial weights of 25% assigned to each criterion, the final rating for Alternative 1 0.25(7.8) 0.25(6.8) 0.25(6.65) 0.25(8) 7.3. In a similar fashion, a final rating of 7.4 was developed for Alternative 2, and a final rating of 7.5 was developed for Alternative 3. Thus, Alternative 3 was the recommended decision. Subsequent sensitivity analysis on the weights assigned to the criteria showed that Alternative 3 still received equal or higher ratings than Alternative 1 or Alternative 2. These results increased the team’s confidence that Alternative 3 was the best choice. *Based on Senthil A. Gurusami, “Ford’s Wrenching Decision,” OR/MS Today (December 1998): 36–39.
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Analytic Hierarchy Process
ANALYTIC HIERARCHY PROCESS The analytic hierarchy process (AHP), developed by Thomas L. Saaty,1 is designed to solve complex multicriteria decision problems. AHP requires the decision maker to provide judgments about the relative importance of each criterion and then specify a preference for each decision alternative using each criterion. The output of AHP is a prioritized ranking of the decision alternatives based on the overall preferences expressed by the decision maker. To introduce AHP, we consider a car purchasing decision problem faced by Diane Payne. After a preliminary analysis of the makes and models of several used cars, Diane narrowed her list of decision alternatives to three cars: a Honda Accord, a Saturn, and a Chevrolet Cavalier. Table 14.4 summarizes the information Diane collected about these cars. Diane decided that the following criteria were relevant for her car selection decision process: • • • •
AHP allows a decision maker to express personal preferences and subjective judgments about the various aspects of a multicriteria problem.
Price Miles per gallon (MPG) Comfort Style
Data regarding the Price and MPG are provided in Table 14.4. However, measures of Comfort and Style cannot be specified so directly. Diane will need to consider factors such as the car’s interior, type of audio system, ease of entry, seat adjustments, and driver visibility in order to determine the comfort level of each car. The style criterion will have to be based on Diane’s subjective evaluation of the color and the general appearance of each car. Even when a criterion such as price can be easily measured, subjectivity becomes an issue whenever a decision maker indicates his or her personal preference for the decision alternatives based on price. For instance, the price of the Accord ($13,100) is $3600 more than the price of the Cavalier ($9500). The $3600 difference might represent a great deal of money to one person, but not much of a difference to another person. Thus, whether the Accord is considered “extremely more expensive” than the Cavalier or perhaps only “moderately more expensive” than the Cavalier depends upon the financial status and the subjective opinion of the person making the comparison. An advantage of AHP is that it can handle situations in which the unique subjective judgments of the individual decision maker constitute an important part of the decision-making process.
TABLE 14.4 INFORMATION FOR THE CAR SELECTION PROBLEM
Characteristics Price Color Miles per gallon Interior Body type Sound system
1
Accord $13,100 Black 19 Deluxe 4-door midsize AM/FM, tape, CD
Decision Alternative Saturn $11,200 Red 23 Above Average 2-door sport AM/FM
Cavalier $9500 Blue 28 Standard 2-door compact AM/FM
T. Saaty, Decision Making for Leaders: The Analytic Hierarchy Process for Decisions in a Complex World, 3d. ed., RWS, 1999.
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FIGURE 14.6 HIERARCHY FOR THE CAR SELECTION PROBLEM Overall Goal:
Select the Best Car
Criteria:
Price
MPG
Comfort
Style
Accord
Accord
Accord
Accord
Saturn
Saturn
Saturn
Saturn
Cavalier
Cavalier
Cavalier
Cavalier
Decision Alternatives:
Developing the Hierarchy The first step in AHP is to develop a graphical representation of the problem in terms of the overall goal, the criteria to be used, and the decision alternatives. Such a graph depicts the hierarchy for the problem. Figure 14.6 shows the hierarchy for the car selection problem. Note that the first level of the hierarchy shows that the overall goal is to select the best car. At the second level, the four criteria (Price, MPG, Comfort, and Style) each contribute to the achievement of the overall goal. Finally, at the third level, each decision alternative— Accord, Saturn, and Cavalier—contributes to each criterion in a unique way. Using AHP, the decision maker specifies judgments about the relative importance of each of the four criteria in terms of its contribution to the achievement of the overall goal. At the next level, the decision maker indicates a preference for each decision alternative based on each criterion. A mathematical process is used to synthesize the information on the relative importance of the criteria and the preferences for the decision alternatives to provide an overall priority ranking of the decision alternatives. In the car selection problem, AHP will use Diane’s personal preferences to provide a priority ranking of the three cars in terms of how well each car meets the overall goal of being the best car.
14.5
ESTABLISHING PRIORITIES USING AHP In this section we show how AHP uses pairwise comparisons expressed by the decision maker to establish priorities for the criteria and priorities for the decision alternatives based on each criterion. Using the car selection example, we show how AHP determines priorities for each of the following: 1. 2. 3. 4. 5.
How the four criteria contribute to the overall goal of selecting the best car How the three cars compare using the Price criterion How the three cars compare using the MPG criterion How the three cars compare using the Comfort criterion How the three cars compare using the Style criterion
In the following discussion we demonstrate how to establish priorities for the four criteria in terms of how each contributes to the overall goal of selecting the best car. The priorities of the three cars using each criterion can be determined similarly.
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TABLE 14.5 COMPARISON SCALE FOR THE IMPORTANCE OF CRITERIA USING AHP Verbal Judgment Extremely more important Very strongly more important Strongly more important Moderately more important Equally important
Numerical Rating 9 8 7 6 5 4 3 2 1
Pairwise Comparisons Pairwise comparisons form the fundamental building blocks of AHP. In establishing the priorities for the four criteria, AHP will require Diane to state how important each criterion is relative to each other criterion when the criteria are compared two at a time (pairwise). That is, with the four criteria (Price, MPG, Comfort, and Style) Diane must make the following pairwise comparisons: Price compared to MPG Price compared to Comfort Price compared to Style MPG compared to Comfort MPG compared to Style Comfort compared to Style In each comparison, Diane must select the more important criterion and then express a judgment of how much more important the selected criterion is. For example, in the Price-MPG pairwise comparison, assume that Diane indicates that Price is more important than MPG. To measure how much more important Price is compared to MPG, AHP uses a scale with values from 1 to 9. Table 14.5 shows how the decision maker’s verbal description of the relative importance between the two criteria is converted into a numerical rating. In the car selection example, suppose that Diane states that Price is “moderately more important” than MPG. In this case, a numerical rating of 3 is assigned to the Price-MPG pairwise comparison. From Table 14.5, we see “strongly more important” receives a numerical rating of 5, whereas “very strongly more important” receives a numerical rating of 7. Intermediate judgments such as “strongly to very strongly more important” are possible and would receive a numerical rating of 6. Table 14.6 provides a summary of the six pairwise comparisons Diane provided for the car selection problem. Using the information in this table, Diane has specified that Price is moderately more important than MPG. Price is equally to moderately more important than Comfort. Price is equally to moderately more important than Style. Comfort is moderately to strongly more important than MPG. Style is moderately to strongly more important than MPG. Style is equally to moderately more important than Comfort.
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TABLE 14.6 SUMMARY OF DIANE PAYNE’S PAIRWISE COMPARISONS OF THE FOUR CRITERIA FOR THE CAR SELECTION PROBLEM
Pairwise Comparison Price–MPG Price–Comfort Price–Style MPG–Comfort MPG–Style Comfort–Style
AHP uses the numerical ratings from the pairwise comparisons to establish a priority or importance measure for each criterion.
More Important Criterion Price Price Price Comfort Style Style
How Much More Important Moderately Equally to moderately Equally to moderately Moderately to strongly Moderately to strongly Equally to moderately
Numerical Rating 3 2 2 4 4 2
As shown, the flexibility of AHP can accommodate the unique preferences of each individual decision maker. First, the choice of the criteria that are considered can vary depending upon the decision maker. Not everyone would agree that Price, MPG, Comfort, and Style are the only criteria to be considered in a car selection problem. Perhaps you would want to add safety, resale value, and/or other criteria if you were making the car selection decision. AHP can accommodate any set of criteria specified by the decision maker. Of course, if additional criteria are added, more pairwise comparisons will be necessary. In addition, if you agree with Diane that Price, MPG, Comfort, and Style are the four criteria to use, you would probably disagree with her as to the relative importance of the criteria. Using the format of Table 14.6, you could provide your own assessment of the importance of each pairwise comparison, and AHP would adjust the numerical ratings to reflect your personal preferences.
Pairwise Comparison Matrix To determine the priorities for the four criteria, we need to construct a matrix of the pairwise comparison ratings provided in Table 14.6. Using the four criteria, the pairwise comparison matrix will consist of four rows and four columns as shown here:
Price
MPG
Comfort
Style
Price MPG Comfort Style
Each of the numerical ratings in Table 14.6 must be entered into the pairwise comparison matrix. As an illustration of this process consider the numerical rating of 3 for the Price-MPG pairwise comparison. Table 14.6 shows that for this pairwise comparison that Price is the most important criterion. Thus, we must enter a 3 into the row labeled Price and the column labeled MPG in the pairwise comparison matrix. In general, the entries in the column labeled Most Important Criterion in Table 14.6 indicate which row of the pairwise comparison matrix the numerical rating must be placed in. As another illustration, consider
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the MPG-Comfort pairwise comparison. Table 14.6 shows that Comfort is the most important criterion for this pairwise comparison and that the numerical rating is 4. Thus, we enter a 4 into the row labeled Comfort and into the column labeled MPG. Following this procedure for the other pairwise comparisons shown in Table 14.6, we obtain the following pairwise comparison matrix: Price Price MPG Comfort Style
MPG
Comfort
Style
3
2
2
4 4
2
Because the diagonal elements are comparing each criterion to itself, the diagonal elements of the pairwise comparison matrix are always equal to 1. For example, if Price is compared to Price, the verbal judgment would be “equally important” with a rating of 1; thus, a 1 would be placed into the row labeled Price and into the column labeled Price in the pairwise comparison matrix. At this point, the pairwise comparison matrix appears as follows:
Price MPG Comfort Style
Price
MPG
Comfort
Style
1
3 1 4 4
2
2
1 2
1
All that remains is to complete the entries for the remaining cells of the matrix. To illustrate how these values are obtained, consider the numerical rating of 3 for the PriceMPG pairwise comparison. This rating implies that the MPG-Price pairwise comparison should have a rating of 1⁄3. That is, because Diane already indicated Price is moderately more important than MPG (a rating of 3), we can infer that a pairwise comparison of MPG relative to Price should be 1⁄3. Similarly, because the Comfort-MPG pairwise comparison has a rating of 4, the MPG-Comfort pairwise comparison would be 1⁄4. Thus, the complete pairwise comparison matrix for the car selection criteria is as follows:
Price MPG Comfort Style
Price
MPG
Comfort
Style
1 ¹⁄₃ ¹⁄₂ ¹⁄₂
3 1 4 4
2 ¹⁄₄ 1 2
2 ¹⁄₄ ¹⁄₂ 1
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Synthesization Using the pairwise comparison matrix, we can now calculate the priority of each criterion in terms of its contribution to the overall goal of selecting the best car. This aspect of AHP is referred to as synthesization. The exact mathematical procedure required to perform synthesization is beyond the scope of this text. However, the following three-step procedure provides a good approximation of the synthesization results: 1. Sum the values in each column of the pairwise comparison matrix. 2. Divide each element in the pairwise comparison matrix by its column total; the resulting matrix is referred to as the normalized pairwise comparison matrix. 3. Compute the average of the elements in each row of the normalized pairwise comparison matrix; these averages provide the priorities for the criteria. To show how the synthesization process works, we carry out this three-step procedure for the criteria pairwise comparison matrix. Step 1. Sum the values in each column. Price
MPG
1
¹⁄₂
3 1 4 4
2.333
12.000
Price MPG Comfort Style
¹⁄₃ ¹⁄₂
Sum
Comfort
Style
2
2
¹⁄₄
¹⁄₄
1 2
¹⁄₂
5.250
3.750
1
Step 2. Divide each element of the matrix by its column total.
Price MPG Comfort Style
Price
MPG
Comfort
Style
0.429 0.143 0.214 0.214
0.250 0.083 0.333 0.333
0.381 0.048 0.190 0.381
0.533 0.067 0.133 0.267
Step 3. Average the elements in each row to determine the priority of each criterion.
Price MPG Comfort Style
Price
MPG
Comfort
Style
Priority
0.429 0.143 0.214 0.214
0.250 0.083 0.333 0.333
0.381 0.048 0.190 0.381
0.533 0.067 0.133 0.267
0.398 0.085 0.218 0.299
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The AHP synthesization procedure provides the priority of each criterion in terms of its contribution to the overall goal of selecting the best car. Thus, using Diane’s pairwise comparisons provided in Table 14.6, AHP determines that Price, with a priority of 0.398, is the most important criterion in the car selection process. Style, with a priority of 0.299, ranks second in importance and is closely followed by Comfort, with a priority of 0.218. MPG is the least important criterion, with a priority of 0.085.
Consistency
A consistency ratio greater than 0.10 indicates inconsistency in the pairwise comparisons. In such cases, the decision maker should review the pairwise comparisons before proceeding.
A key step in AHP is the making of several pairwise comparisons, as previously described. An important consideration in this process is the consistency of the pairwise judgments provided by the decision maker. For example, if criterion A compared to criterion B has a numerical rating of 3 and if criterion B compared to criterion C has a numerical rating of 2, perfect consistency of criterion A compared to criterion C would have a numerical rating of 3 2 6. If the A to C numerical rating assigned by the decision maker was 4 or 5, some inconsistency would exist among the pairwise comparison. With numerous pairwise comparisons, perfect consistency is difficult to achieve. In fact, some degree of inconsistency can be expected to exist in almost any set of pairwise comparisons. To handle the consistency issue, AHP provides a method for measuring the degree of consistency among the pairwise comparisons provided by the decision maker. If the degree of consistency is unacceptable, the decision maker should review and revise the pairwise comparisons before proceeding with the AHP analysis. AHP provides a measure of the consistency for the pairwise comparisons by computing a consistency ratio. This ratio is designed in such a way that a value greater than 0.10 indicates an inconsistency in the pairwise judgments. Thus, if the consistency ratio is 0.10 or less, the consistency of the pairwise comparisons is considered reasonable, and the AHP process can continue with the synthesization computations. Although the exact mathematical computation of the consistency ratio is beyond the scope of this text, an approximation of the ratio can be obtained with little difficulty. The step-by-step procedure for estimating the consistency ratio for the criteria of the car selection problem follows: Step 1. Multiply each value in the first column of the pairwise comparison matrix by the priority of the first item; multiply each value in the second column of the pairwise comparison matrix by the priority of the second item; continue this process for all columns of the pairwise comparison matrix. Sum the values across the rows to obtain a vector of values labeled “weighted sum.” This computation for the car selection problem is as follows: 1
3 2 2 ¹⁄₂ ¹⁄₄ 1 0.398 ≥ ¥ + 0.085 ≥ ¥ + 0.218 ≥ ¥ + 0.299≥ ¥ = ¹⁄₂ ¹⁄₂ 4 1 ¹⁄₂ 4 2 1 ¹⁄₃
0.398 0.255 0.436 0.598 1.687 0.133 0.085 0.054 0.075 0.347 ≥ ¥ + ≥ ¥ + ≥ ¥ + ≥ ¥ = ≥ ¥ 0.199 0.340 0.218 0.149 0.907 0.199 0.340 0.436 0.299 1.274
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Step 2. Divide the elements of the weighted sum vector obtained in step 1 by the corresponding priority for each criterion. 1.687 0.398 0.347 0.085 0.907 0.218 1.274 0.299
Price MPG Comfort Style
= 4.236 = 4.077 = 4.163 = 4.264
Step 3. Compute the average of the values found in step 2; this average is denoted lmax. l max =
(4.236 + 4.077 + 4.163 + 4.264) 4
= 4.185
Step 4. Compute the consistency index (CI) as follows: CI =
l max - n n - 1
where n is the number of items being compared. Thus, we have CI =
4.185 - 4 = 0.0616 4 - 1
Step 5. Compute the consistency ratio, which is defined as CR =
CI RI
where RI is the consistency index of a randomly generated pairwise comparison matrix. The value of RI depends on the number of items being compared and is given as follows: n
3
4
5
6
7
8
RI
0.58
0.90
1.12
1.24
1.32
1.41
Thus, for the car selection problem with n 4 criteria, we have RI 0.90 and a consistency ratio CR = Problem 16 will give you practice with the synthesization calculations and determining the consistency ratio.
0.0616 = 0.068 0.90
As mentioned previously, a consistency ratio of 0.10 or less is considered acceptable. Because the pairwise comparisons for the car selection criteria show CR 0.068, we can conclude that the degree of consistency in the pairwise comparisons is acceptable.
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Other Pairwise Comparisons for the Car Selection Problem Continuing with the AHP analysis of the car selection problem, we need to use the pairwise comparison procedure to determine the priorities for the three cars using each of the criteria: Price, MPG, Comfort, and Style. Determining these priorities requires Diane to express pairwise comparison preferences for the cars using each criterion one at a time. For example, using the Price criterion, Diane must make the following pairwise comparisons: the Accord compared to the Saturn the Accord compared to the Cavalier the Saturn compared to the Cavalier In each comparison, Diane must select the more preferred car and then express a judgment of how much more preferred the selected car is. For example, using Price as the basis for comparison, assume that Diane considers the Accord-Saturn pairwise comparison and indicates that the less expensive Saturn is preferred. Table 14.7 shows how AHP uses Diane’s verbal description of the preference between the Accord and Saturn to determine a numerical rating of the preference. For example, suppose that Diane states that based on Price, the Saturn is “moderately more preferred” to the Accord. Thus, using the Price criterion, a numerical rating of 3 is assigned to the Saturn row and Accord column of the pairwise comparison matrix. Table 14.8 shows the summary of the car pairwise comparisons that Diane provided for each criterion of the car selection problem. Using this table and referring to selected pairwise comparison entries, we see that Diane stated the following preferences: In terms of Price, the Cavalier is moderately to strongly more preferred than the Accord. In terms of MPG, the Cavalier is moderately more preferred than the Saturn. In terms of Comfort, the Accord is very strongly to extremely more preferred than the Cavalier. In terms of Style, the Saturn is moderately more preferred than the Accord. Practice setting up a pairwise comparison matrix and determine whether judgments are consistent by working Problem 20.
Using the pairwise comparison matrixes in Table 14.8, many other insights may be gained about the preferences Diana expressed for the cars. However, at this point AHP continues by synthesizing each of the four pairwise comparison matrixes in Table 14.8 in order to determine the priority of each car using each criterion. A synthesization is conducted for each pairwise comparison matrix, using the three-step procedure described previously for the criteria pairwise comparison matrix. Four synthesization computations provide the four
TABLE 14.7 PAIRWISE COMPARISON SCALE FOR THE PREFERENCE OF DECISION ALTERNATIVES USING AHP Verbal Judgment Extremely preferred Very strongly preferred Strongly preferred Moderately preferred Equally preferred
Numerical Rating 9 8 7 6 5 4 3 2 1
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TABLE 14.8 PAIRWISE COMPARISON MATRIXES SHOWING PREFERENCES FOR THE CARS USING EACH CRITERION Price
MPG
Accord Saturn Cavalier
Accord
Saturn
Cavalier
1 3 4
¹⁄₃
¹⁄₄
1 2
¹⁄₂
Accord
Saturn
Cavalier
1 ¹⁄₂ ¹⁄₈
2 1 ¹⁄₆
8 6 1
Saturn
Cavalier
1 4 6
¹⁄₄
¹ ⁄₆
1 3
¹⁄₃
Accord
Saturn
Cavalier
1 3 ¹⁄₄
¹⁄₃
4 7 1
Accord Saturn Cavalier
1
Comfort Accord Saturn Cavalier
Accord
1
Style Accord Saturn Cavalier
1 ¹⁄₇
TABLE 14.9 PRIORITIES FOR EACH CAR USING EACH CRITERION
Accord Saturn Cavalier
Price
Criterion MPG Comfort
Style
0.123 0.320 0.557
0.087 0.274 0.639
0.265 0.656 0.080
0.593 0.341 0.065
sets of priorities shown in Table 14.9. Using this table, we see that the Cavalier is the preferred alternative based on Price (0.557), the Cavalier is the preferred alternative based on MPG (0.639), the Accord is the preferred alternative based on Comfort (0.593), and the Saturn is the preferred alternative based on Style (0.656). At this point, no car is the clear, overall best. The next section shows how to combine the priorities for the criteria and the priorities in Table 14.9 to develop an overall priority ranking for the three cars.
14.6
USING AHP TO DEVELOP AN OVERALL PRIORITY RANKING In Section 14.5 we used Diane’s pairwise comparisons of the four criteria to develop the priorities of 0.398 for Price, 0.085 for MPG, 0.218 for Comfort, and 0.299 for Style. We now want to use these priorities and the priorities shown in Table 14.9 to develop an overall priority ranking for the three cars. The procedure used to compute the overall priority is to weight each car’s priority shown in Table 14.9 by the corresponding criterion priority. For example, the Price criterion has a priority of 0.398, and the Accord has a priority of 0.123 in terms of the Price criterion. Thus, 0.398 0.123 0.049 is the priority value of the Accord based on the Price criterion. To obtain the overall priority of the Accord, we need to make similar computations
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for the MPG, Comfort, and Style criteria and then add the values to obtain the overall priority. This calculation is as follows: Overall Priority of the Accord: 0.398(0.123) + 0.085(0.087) + 0.218(0.593) + 0.299(0.265) = 0.265 Repeating this calculation for the Saturn and the Cavalier, we obtain the following results: Overall Priority of the Saturn: 0.398(0.320) + 0.085(0.274) + 0.218(0.341) + 0.299(0.656) = 0.421 Overall Priority of the Cavalier: 0.398(0.557) + 0.085(0.639) + 0.218(0.065) + 0.299(0.080) = 0.314 Ranking these priorities, we have the AHP ranking of the decision alternatives: Car 1. Saturn 2. Cavalier 3. Accord
Priority 0.421 0.314 0.265
These results provide a basis for Diane to make a decision regarding the purchase of a car. As long as Diane believes that her judgments regarding the importance of the criteria and her preferences for the cars using each criterion are valid, the AHP priorities show that the Saturn is preferred. In addition to the recommendation of the Saturn as the best car, the AHP analysis helped Diane gain a better understanding of the trade-offs in the decisionmaking process and a clearer understanding of why the Saturn is the AHP recommended alternative.
Work Problem 24 and determine the AHP priorities for the two decision alternatives.
NOTES AND COMMENTS 1. The scoring model in Section 14.3 used the following equation to compute the overall score of a decision alternative: Sj = a wi rij i
where wi = the weight for criterion i rij = the rating for criterion i and decision alternative j In Section 14.5 AHP used the same calculation to determine the overall priority of each decision alternative. The difference between the two approaches is that the scoring model required the decision maker to estimate the values of wi and rij directly. AHP used synthesization to compute the criterion priorities wi and the
decision alternative priorities rij based on the pairwise comparison information provided by the decision maker. 2. The software package Expert Choice® marketed by Decision Support Software provides a userfriendly procedure for implementing AHP on a personal computer. Expert Choice takes the decision maker through the pairwise comparison process in a step-by-step manner. Once the decision maker responds to the pairwise comparison prompts, Expert Choice automatically constructs the pairwise comparison matrix, conducts the synthesization calculations, and presents the overall priorities. Expert Choice is a software package that should warrant consideration by a decision maker who anticipates solving a variety of multicriteria decision problems.
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SUMMARY In this chapter we used goal programming to solve problems with multiple goals within the linear programming framework. We showed that the goal programming model contains one or more goal equations and an objective function designed to minimize deviations from the goals. In situations where resource capacities or other restrictions affect the achievement of the goals, the model will contain constraints that are formulated and treated in the same manner as constraints in an ordinary linear programming model. In goal programming problems with preemptive priorities, priority level 1 goals are treated first in an objective function to identify a solution that will best satisfy these goals. This solution is then revised by considering an objective function involving only the priority level 2 goals; solution modifications are considered only if they do not degrade the solution obtained for the priority level 1 goals. This process continues until all priority levels have been considered. We showed how a variation of the linear programming graphical solution procedure can be used to solve goal programming problems with two decision variables. Specialized goal programming computer packages are available for solving the general goal programming problem, but such computer codes are not as readily available as are general purpose linear programming computer packages. As a result, we showed how linear programming can be used to solve a goal programming problem. We then presented a scoring model as a quick and relatively easy way to identify the most desired decision alternative in a multicriteria problem. The decision maker provides a subjective weight indicating the importance of each criterion. Then the decision maker rates each decision alternative in terms of how well it satisfies each criterion. The end result is a score for each decision alternative that indicates the preference for the decision alternative considering all criteria. We also presented an approach to multicriteria decision making called the analytic hierarchy process (AHP). We showed that a key part of AHP is the development of judgments concerning the relative importance of, or preference for, the elements being compared. A consistency ratio is computed to determine the degree of consistency exhibited by the decision maker in making the pairwise comparisons. Values of the consistency ratio less than or equal to 0.10 are considered acceptable. Once the set of all pairwise comparisons has been developed, a process referred to as synthesization is used to determine the priorities for the elements being compared. The final step of the analytic hierarchy process involves multiplying the priority levels established for the decision alternatives relative to each criterion by the priority levels reflecting the importance of the criteria themselves; the sum of these products over all the criteria provides the overall priority level for each decision alternative.
GLOSSARY Goal programming A linear programming approach to multicriteria decision problems whereby the objective function is designed to minimize the deviations from goals. Preemptive priorities Priorities assigned to goals that ensure that the satisfaction of a higher level goal cannot be traded for the satisfaction of a lower level goal. Target value A value specified in the statement of the goal. Based on the context of the problem, management will want the solution to the goal programming problem to result in a value for the goal that is less than, equal to, or greater than the target value.
Problems
691
Goal equation An equation whose right-hand side is the target value for the goal; the left-hand side of the goal equation consists of (1) a function representing the level of achievement and (2) deviation variables representing the difference between the target value for the goal and the level achieved. Deviation variables Variables that are added to the goal equation to allow the solution to deviate from the goal’s target value. Scoring model An approach to multicriteria decision making that requires the user to assign weights to each criterion that describe the criterion’s relative importance and to assign a rating that shows how well each decision alternative satisfies each criterion. The output is a score for each decision alternative. Analytic hierarchy process (AHP) An approach to multicriteria decision making based on pairwise comparisons for elements in a hierarchy. Hierarchy A diagram that shows the levels of a problem in terms of the overall goal, the criteria, and the decision alternatives. Pairwise comparison matrix A matrix that consists of the preference, or relative importance, ratings provided during a series of pairwise comparisons. Synthesization A mathematical process that uses the preference or relative importance values in the pairwise comparison matrix to develop priorities. Normalized pairwise comparison matrix The matrix obtained by dividing each element of the pairwise comparison matrix by its column total. This matrix is computed as an intermediate step in the synthesization of priorities. Consistency A concept developed to assess the quality of the judgments made during a series of pairwise comparisons. It is a measure of the internal consistency of these comparisons. Consistency ratio A numerical measure of the degree of consistency in a series of pairwise comparisons. Values less than or equal to 0.10 are considered reasonable.
PROBLEMS 1. The RMC Corporation blends three raw materials to produce two products: a fuel additive and a solvent base. Each ton of fuel additive is a mixture of ²⁄₅ ton of material 1 and ³⁄₅ ton of material 3. A ton of solvent base is a mixture of ¹⁄₂ ton of material 1, ¹⁄₅ ton of material 2, and ³⁄₁₀ ton of material 3. RMC’s production is constrained by a limited availability of the three raw materials. For the current production period, RMC has the following quantities of each raw material: material 1, 20 tons; material 2, 5 tons; material 3, 21 tons. Management wants to achieve the following P1 priority level goals: Goal 1: Produce at least 30 tons of fuel additive. Goal 2: Produce at least 15 tons of solvent base. Assume there are no other goals. a. Is it possible for management to achieve both P1 level goals given the constraints on the amounts of each material available? Explain. b. Treating the amounts of each material available as constraints, formulate a goal programming model to determine the optimal product mix. Assume that both P1 priority level goals are equally important to management. c. Use the graphical goal programming procedure to solve the model formulated in part (b). d. If goal 1 is twice as important as goal 2, what is the optimal product mix?
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2. DJS Investment Services must develop an investment portfolio for a new client. As an initial investment strategy, the new client would like to restrict the portfolio to a mix of two stocks:
Stock AGA Products Key Oil
Price/Share $ 50 100
Estimated Annual Return (%) 6 10
The client wants to invest $50,000 and established the following two investment goals: Priority Level 1 Goal Goal 1: Obtain an annual return of at least 9%. Priority Level 2 Goal Goal 2: Limit the investment in Key Oil, the riskier investment, to no more than 60% of the total investment. a. Formulate a goal programming model for the DJS Investment problem. b. Use the graphical goal programming procedure to obtain a solution. 3. The L. Young & Sons Manufacturing Company produces two products, which have the following profit and resource requirement characteristics:
Characteristic Profit/unit Dept. A hours/unit Dept. B hours/unit
Product 1 $4 1 2
Product 2 $2 1 5
Last month’s production schedule used 350 hours of labor in department A and 1000 hours of labor in department B. Young’s management has been experiencing workforce morale and labor union problems during the past six months because of monthly departmental workload fluctuations. New hiring, layoffs, and interdepartmental transfers have been common because the firm has not attempted to stabilize workload requirements. Management would like to develop a production schedule for the coming month that will achieve the following goals: Goal 1: Use 350 hours of labor in department A. Goal 2: Use 1000 hours of labor in department B. Goal 3: Earn a profit of at least $1300. a. Formulate a goal programming model for this problem, assuming that goals 1 and 2 are P1 level goals and goal 3 is a P2 level goal; assume that goals 1 and 2 are equally important. b. Solve the model formulated in part (a) using the graphical goal programming procedure. c. Suppose that the firm ignores the workload fluctuations and considers the 350 hours in department A and the 1000 hours in department B as the maximum available. Formulate and solve a linear programming problem to maximize profit subject to these constraints. d. Compare the solutions obtained in parts (b) and (c). Discuss which approach you favor, and why.
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e. Reconsider part (a) assuming that the priority level 1 goal is goal 3 and the priority level 2 goals are goals 1 and 2; as before, assume that goals 1 and 2 are equally important. Solve this revised problem using the graphical goal programming procedure, and compare your solution to the one obtained for the original problem. 4. Industrial Chemicals produces two adhesives used in the manufacturing process for airplanes. The two adhesives, which have different bonding strengths, require different amounts of production time: the IC-100 adhesive requires 20 minutes of production time per gallon of finished product, and the IC-200 adhesive uses 30 minutes of production time per gallon. Both products use 1 pound of a highly perishable resin for each gallon of finished product. Inventory currently holds 300 pounds of the resin, and more can be obtained if necessary. However, because of the limited shelf life of the material, any amount not used in the next two weeks will be discarded. The firm has existing orders for 100 gallons of IC-100 and 120 gallons of IC-200. Under normal conditions, the production process operates eight hours per day, five days per week. Management wants to schedule production for the next two weeks to achieve the following goals: Priority Level 1 Goals Goal 1: Avoid underutilization of the production process. Goal 2: Avoid overtime in excess of 20 hours for the two weeks. Priority Level 2 Goals Goal 3: Satisfy existing orders for the IC-100 adhesive; that is, produce at least 100 gallons of IC-100. Goal 4: Satisfy existing orders for the IC-200 adhesive; that is, produce at least 120 gallons of IC-200. Priority Level 3 Goal Goal 5: Use all the available resin. a. Formulate a goal programming model for the Industrial Chemicals problem. Assume that both priority level 1 goals and both priority level 2 goals are equally important. b. Use the graphical goal programming procedure to develop a solution for the model formulated in part (a). 5. Standard Pump recently won a $14 million contract with the U.S. Navy to supply 2000 custom-designed submersible pumps over the next four months. The contract calls for the delivery of 200 pumps at the end of May, 600 pumps at the end of June, 600 pumps at the end of July, and 600 pumps at the end of August. Standard’s production capacity is 500 pumps in May, 400 pumps in June, 800 pumps in July, and 500 pumps in August. Management would like to develop a production schedule that will keep monthly ending inventories low while at the same time minimizing the fluctuations in inventory levels from month to month. In attempting to develop a goal programming model of the problem, the company’s production scheduler let xm denote the number of pumps produced in month m and sm denote the number of pumps in inventory at the end of month m. Here, m 1 refers to May, m 2 refers to June, m 3 refers to July, and m 4 refers to August. Management asks you to assist the production scheduler in model development. a. Using these variables, develop a constraint for each month that will satisfy the following demand requirement: a
This Month’s Ending Current Beginning b b = a b - a b + a Demand Inventory Production Inventory
b. Write goal equations that represent the fluctuations in the production level from May to June, June to July, and July to August.
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c.
Inventory carrying costs are high. Is it possible for Standard to avoid carrying any monthly ending inventories over the scheduling period of May to August? If not, develop goal equations with a target of zero for the ending inventory in May, June, and July. d. Besides the goal equations developed in parts (b) and (c), what other constraints are needed in the model? e. Assuming the production fluctuation and inventory goals are of equal importance, develop and solve a goal programming model to determine the best production schedule. f. Can you find a way to reduce the variables and constraints needed in your model by eliminating the goal equations and deviation variables for ending inventory levels? Explain. 6. Michigan Motors Corporation (MMC) just introduced a new luxury touring sedan. As part of its promotional campaign, the marketing department decided to send personalized invitations to test-drive the new sedan to two target groups: (1) current owners of an MMC luxury automobile and (2) owners of luxury cars manufactured by one of MMC’s competitors. The cost of sending a personalized invitation to each customer is estimated to be $1 per letter. Based on previous experience with this type of advertising, MMC estimates that 25% of the customers contacted from group 1 and 10% of the customers contacted from group 2 will test-drive the new sedan. As part of this campaign, MMC set the following goals: Goal 1: Get at least 10,000 customers from group 1 to test-drive the new sedan. Goal 2: Get at least 5000 customers from group 2 to test-drive the new sedan. Goal 3: Limit the expense of sending out the invitations to $70,000. Assume that goals 1 and 2 are P1 priority level goals and that goal 3 is a P2 priority level goal. a. Suppose that goals 1 and 2 are equally important; formulate a goal programming model of the MMC problem. b. Use the goal programming computer procedure illustrated in Section 14.2 to solve the model formulated in part (a). c. If management believes that contacting customers from group 2 is twice as important as contacting customers from group 1, what should MMC do? 7. A committee in charge of promoting a Ladies Professional Golf Association tournament is trying to determine how best to advertise the event during the two weeks prior to the tournament. The committee obtained the following information about the three advertising media they are considering using:
Category TV Radio Newspaper
Audience Reached per Advertisement 200,000 50,000 100,000
Cost per Advertisement $2500 $ 400 $ 500
Maximum Number of Advertisements 10 15 20
The last column in this table shows the maximum number of advertisements that can be run during the next two weeks; these values should be treated as constraints. The committee established the following goals for the campaign: Priority Level 1 Goal Goal 1: Reach at least 4 million people. Priority Level 2 Goal Goal 2: The number of television advertisements should be at least 30% of the total number of advertisements. Priority Level 3 Goal Goal 3: The number of radio advertisements should not exceed 20% of the total number of advertisements.
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Problems
Priority Level 4 Goal Goal 4: Limit the total amount spent for advertising to $20,000. a. Formulate a goal programming model for this problem. b. Use the goal programming computer procedure illustrated in Section 14.2 to solve the model formulated in part (a). 8. Morley Company is attempting to determine the best location for a new machine in an existing layout of three machines. The existing machines are located at the following x1, x2 coordinates on the shop floor: Machine 1: Machine 2: Machine 3:
x1 = 1, x2 = 7 x1 = 5, x2 = 9 x1 = 6, x2 = 2
a. Develop a goal programming model that can be solved to minimize the total distance of the new machine from the three existing machines. The distance is to be measured rectangularly. For example, if the location of the new machine is (x1 3, x2 5), it is considered to be a distance of 兩3 – 1兩 兩5 – 7兩 2 2 4 from machine 1. Hint: In the goal programming formulation, let x1 = first coordinate of the new machine location x2 = second coordinate of the new machine location di+ = amount by which the x1 coordinate of the new machine exceeds the x1 coordinate of machine i (i = 1, 2, 3) di = amount by which the x1 coordinate of machine i exceeds the x1 coordinate of the new machine (i = 1, 2, 3) ei+ = amount by which the x2 coordinate of the new machine exceeds the x2 coordinate of machine i (i = 1, 2, 3) ei- = amount by which the x2 coordinate of machine i exceeds the x2 coordinate of the new machine (i = 1, 2, 3) b. What is the optimal location for the new machine? 9. One advantage of using the multicriteria decision-making methods presented in this chapter is that the criteria weights and the decision alternative ratings may be modified to reflect the unique interests and preferences of each individual decision maker. For example, assume that another graduating college student had the same three job offers described in Section 14.3. This student provided the following scoring model information. Rank the overall preference for the three positions. Which position is recommended? Ratings Criteria Career advancement Location Management style Salary Prestige Job security Enjoyment of the work
Weight
Analyst Chicago
Accountant Denver
Auditor Houston
5 2 5 4 4 2 4
7 5 6 7 8 4 7
4 6 5 8 5 5 5
4 4 7 4 6 8 5
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10. The Kenyon Manufacturing Company is interested in selecting the best location for a new plant. After a detailed study of 10 sites, the three location finalists are Georgetown, Kentucky; Marysville, Ohio; and Clarksville, Tennessee. The Kenyon management team provided the following data on location criteria, criteria importance, and location ratings. Use a scoring model to determine the best location for the new plant. Ratings Criteria Land cost Labor cost Labor availability Construction cost Transportation Access to customers Long-range goals
Weight
Georgetown, Kentucky
Marysville, Ohio
Clarksville, Tennessee
4 3 5 4 3 5 4
7 6 7 6 5 6 7
4 5 8 7 7 8 6
5 8 6 5 4 5 5
11. The Davis family of Atlanta, Georgia, is planning its annual summer vacation. Three vacation locations along with criteria weights and location ratings follow. What is the recommended vacation location? Ratings Criteria Travel distance Vacation cost Entertainment available Outdoor activities Unique experience Family fun
Weight
Myrtle Beach, South Carolina
Smoky Mountains
Branson, Missouri
2 5 3 2 4 5
5 5 7 9 6 8
7 6 4 6 7 7
3 4 8 5 8 7
12. A high school senior is considering attending one of the following four colleges or universities. Eight criteria, criteria weights, and school ratings are also shown. What is the recommended choice? Ratings Criteria School prestige Number of students Average class size Cost Distance from home Sports program Housing desirability Beauty of campus
Weight
Midwestern University
State College at Newport
Handover College
Tecumseh State
3 4 5 5 2 4 4 3
8 3 4 5 7 9 6 5
6 5 5 8 8 5 5 3
7 8 8 3 7 4 7 8
5 7 7 6 6 6 6 5
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13. A real estate investor is interested in purchasing condominium property in Naples, Florida. The three most preferred condominiums are listed along with criteria weights and rating information. Which condominium is preferred?
Criteria
Weight
Park Shore
Ratings The Terrace
5 4 5 2 4 1 3 4 3
5 7 7 5 8 7 5 8 6
6 4 4 8 7 2 4 7 8
Cost Location Appearance Parking Floor plan Swimming pool View Kitchen Closet space
Gulf View 5 9 7 5 5 3 9 6 4
14. Clark and Julie Anderson are interested in purchasing a new boat and have limited their choice to one of three boats manufactured by Sea Ray, Inc.: the 220 Bowrider, the 230 Overnighter, and the 240 Sundancer. The Bowrider weighs 3100 pounds, has no overnight capability, and has a price of $28,500. The 230 Overnighter weighs 4300 pounds, has a reasonable overnight capability, and has a price of $37,500. The 240 Sundancer weighs 4500 pounds, has an excellent overnight capability (kitchen, bath, and bed), and has a price of $48,200. The Andersons provided the scoring model information separately, as shown here: Clark Anderson
Criteria Cost Overnight capability Kitchen/bath facilities Appearance Engine/speed Towing/handling Maintenance Resale value
Ratings Weight
220 Bowrider
230 Overnighter
240 Sundancer
5 3 2 5 5 4 4 3
8 2 1 7 6 8 7 7
5 6 4 7 8 5 5 5
3 9 7 6 4 2 3 6
Julie Anderson
Criteria Cost Overnight capability Kitchen/bath facilities Appearance Engine/speed Towing/handling Maintenance Resale value
Ratings Weight
220 Bowrider
230 Overnighter
240 Sundancer
3 5 5 4 2 2 1 2
7 1 1 5 4 8 6 5
6 6 3 7 5 6 5 6
5 8 7 7 3 2 4 6
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a. Which boat does Clark Anderson prefer? b. Which boat does Julie Anderson prefer? 15. Use the pairwise comparison matrix for the price criterion shown in Table 14.8 to verify that the priorities after synthesization are 0.123, 0.320, and 0.557. Compute the consistency ratio and comment on its acceptability. 16. Use the pairwise comparison matrix for the style criterion, as shown in Table 14.8, to verify that the priorities after synthesization are 0.265, 0.656, and 0.080. Compute the consistency ratio and comment on its acceptability. 17. Dan Joseph was considering entering one of two graduate schools of business to pursue studies for an MBA degree. When asked how he compared the two schools with respect to reputation, he responded that he preferred school A strongly to very strongly to school B. a. Set up the pairwise comparison matrix for this problem. b. Determine the priorities for the two schools relative to this criterion. 18. An organization was investigating relocating its corporate headquarters to one of three possible cities. The following pairwise comparison matrix shows the president’s judgments regarding the desirability for the three cities:
City 1 1 ¹⁄₅ ¹⁄₇
City 1 City 2 City 3
City 2 5 1 ¹⁄₃
City 3 7 3 1
a. Determine the priorities for the three cities. b. Is the president consistent in terms of the judgments provided? Explain. 19. The following pairwise comparison matrix contains the judgments of an individual regarding the fairness of two proposed tax programs, A and B:
A B
A 1 ¹⁄₃
B 3 1
a. Determine the priorities for the two programs. b. Are the individual’s judgments consistent? Explain. 20. Asked to compare three soft drinks with respect to flavor, an individual stated that A is moderately more preferable than B. A is equally to moderately more preferable than C. B is strongly more preferable than C. a. Set up the pairwise comparison matrix for this problem. b. Determine the priorities for the soft drinks with respect to the flavor criterion. c. Compute the consistency ratio. Are the individual’s judgments consistent? Explain.
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Problems
21. Refer to Problem 20. Suppose that the individual had stated the following judgments instead of those given in Problem 20: A is strongly more preferable than C. B is equally to moderately more preferable than A. B is strongly more preferable than C. Answer parts (a), (b), and (c) as stated in Problem 20. 22. The national sales director for Jones Office Supplies needs to determine the best location for the next national sales meeting. Three locations have been proposed: Dallas, San Francisco, and New York. One criterion considered important in the decision is the desirability of the location in terms of restaurants, entertainment, and so on. The national sales manager made the following judgments with regard to this criterion: New York is very strongly more preferred than Dallas. New York is moderately more preferred than San Francisco. San Francisco is moderately to strongly more preferred than Dallas. a. Set up the pairwise comparison matrix for this problem. b. Determine the priorities for the desirability criterion. c. Compute the consistency ratio. Are the sales manager’s judgments consistent? Explain. 23. A study comparing four personal computers resulted in the following pairwise comparison matrix for the performance criterion: 1 1 ¹⁄₃ ¹⁄₇ 3
1 2 3 4
2 3 1 ¹⁄₄ 4
3 7 4 1 6
4 ¹⁄₃ ¹⁄₄ ¹⁄₆
1
a. Determine the priorities for the four computers relative to the performance criterion. b. Compute the consistency ratio. Are the judgments regarding performance consistent? Explain. 24. An individual was interested in determining which of two stocks to invest in, Central Computing Company (CCC) or Software Research, Inc. (SRI). The criteria thought to be most relevant in making the decision are the potential yield of the stock and the risk associated with the investment. The pairwise comparison matrixes for this problem are Criterion Yield Risk
Yield 1 ¹⁄₂
Risk 2 1
Yield CCC SRI
Risk
CCC
SRI
1 ¹⁄₃
3 1
CCC SRI
CCC
SRI
1 2
¹⁄₂
1
a. Compute the priorities for each pairwise comparison matrix. b. Determine the overall priority for the two investments, CCC and SRI. Which investment is preferred based on yield and risk?
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25. The vice president of Harling Equipment needs to select a new director of marketing. The two possible candidates are Bill Jacobs and Sue Martin, and the criteria thought to be most relevant in the selection are leadership ability (L), personal skills (P), and administrative skills (A). The following pairwise comparison matrixes were obtained: Criterion L 1 3 4
L P A
Leadership
P
A
¹⁄₃
¹⁄₄
1 ¹⁄₂
2 1
Jacobs Martin
Jacobs 1 ¹⁄₄
Jacobs Martin
Jacobs 1 ¹⁄₂
Personal Jacobs Martin
Jacobs 1 3
Martin 4 1
Administrative
Martin ¹⁄₃ 1
Martin 2 1
a. Compute the priorities for each pairwise comparison matrix. b. Determine an overall priority for each candidate. Which candidate is preferred? 26. A woman considering the purchase of a custom sound stereo system for her car looked at three different systems (A, B, and C), which varied in terms of price, sound quality, and FM reception. The following pairwise comparison matrixes were developed: Criterion Price Sound Reception
Price 1 ¹⁄₃ ¹⁄₄
Sound 3 1 ¹⁄₃
Price
Reception 4 3 1
A B C
A 1 ¹⁄₄ ¹⁄₂
A B C
B
C
¹⁄₂
¹⁄₄ ¹⁄₃
1 3
C 2 ¹⁄₃ 1
Reception
Sound A 1 2 4
B 4 1 3
1
A B C
A 1 ¹⁄₄ ¹⁄₂
B 4 1 1
C 2 1 1
a. Compute the priorities for each pairwise comparison matrix. b. Determine an overall priority for each system. Which stereo system is preferred?
Case Problem EZ TRAILERS, INC. EZ Trailers, Inc., manufactures a variety of general-purpose trailers, including a complete line of boat trailers. Two of their best-selling boat trailers are the EZ-190 and the EZ-250. The EZ-190 is designed for boats up to 19 feet in length, and the EZ-250 can be used for boats up to 25 feet in length.
Appendix 14.1
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Scoring Models with Excel
EZ Trailers would like to schedule production for the next two months for these two models. Each unit of the EZ-190 requires four hours of production time, and each unit of the EZ-250 uses six hours of production time. The following orders have been received for March and April: Model EZ-190 EZ-250
March 800 1100
April 600 1200
The ending inventory from February was 200 units of the EZ-190 and 300 units of the EZ-250. The total number of hours of production time used in February was 6300 hours. The management of EZ Trailers is concerned about being able to satisfy existing orders for the EZ-250 for both March and April. In fact, it believes that this goal is the most important one that a production schedule should meet. Next in importance is satisfying existing orders for the EZ-190. In addition, management doesn’t want to implement any production schedule that would involve significant labor fluctuations from month to month. In this regard, its goal is to develop a production schedule that would limit fluctuations in labor hours used to a maximum of 1000 hours from one month to the next.
Managerial Report Perform an analysis of EZ Trailers’ production scheduling problem, and prepare a report for EZ’s president that summarizes your findings. Include a discussion and analysis of the following items in your report: 1. The production schedule that best achieves the goals as specified by management. 2. Suppose that EZ Trailers’ storage facilities would accommodate only a maximum of 300 trailers in any one month. What effect would this have on the production schedule? 3. Suppose that EZ Trailers can store only a maximum of 300 trailers in any one month. In addition, suppose management would like to have an ending inventory in April of at least 100 units of each model. What effect would both changes have on the production schedule? 4. What changes would occur in the production schedule if the labor fluctuation goal were the highest priority goal?
Appendix 14.1
SCORING MODELS WITH EXCEL
Excel provides an efficient way to analyze a multicriteria decision problem that can be described by a scoring model. We will use the job selection application from Section 14.3 to demonstrate this procedure. A worksheet for the job selection scoring model is shown in Figure 14.7. The criteria weights are placed into cells B6 to B12. The ratings for each criterion and decision alternative are entered into cells C6 to E12. The calculations used to compute the score for each decision alternative are shown in the bottom portion of the worksheet. The calculation for cell C18 is provided by the cell formula $B6*C6
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FIGURE 14.7 WORKSHEET FOR THE JOB SELECTION SCORING MODEL A
WEB
file
Scoring
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26
B
C
D
E
Analyst Chicago 8 3 5 6 7 4 8
Ratings Accountant Denver 6 8 6 7 5 7 6
Auditor Houston 4 7 9 5 4 6 5
Analyst Chicago 40 9 20 18 14 16 40
Accountant Denver 30 24 24 21 10 28 30
Auditor Houston 20 21 36 15 8 24 25
157
167
149
F
Job Selection Scoring Model
Criteria Career Advancement Location Management Salary Prestige Job Security Enjoy the Work
Weight 5 3 4 3 2 4 5
Scoring Calculations Criteria Career Advancement Location Management Salary Prestige Job Security Enjoy the Work Score
This cell formula can be copied from cell C18 to cells C18:E24 to provide the results shown in rows 18 to 24. The score for the financial analyst position in Chicago is found by placing the following formula in cell C26: SUM(C18:C24) Copying cell C26 to cells D26:E26 provides the scores for the accountant in Denver and the auditor in Houston positions.
CHAPTER
15
Time Series Analysis and Forecasting CONTENTS 15.1 TIME SERIES PATTERNS Horizontal Pattern Trend Pattern Seasonal Pattern Trend and Seasonal Pattern Cyclical Pattern Selecting a Forecasting Method 15.2 FORECAST ACCURACY 15.3 MOVING AVERAGES AND EXPONENTIAL SMOOTHING Moving Averages Weighted Moving Averages Exponential Smoothing
15.4 TREND PROJECTION Linear Trend Nonlinear Trend 15.5 SEASONALITY Seasonality Without Trend Seasonality and Trend Models Based on Monthly Data
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A forecast is simply a prediction of what will happen in the future. Managers must learn to accept the fact that regardless of the technique used, they will not be able to develop perfect forecasts.
The purpose of this chapter is to provide an introduction to time series analysis and forecasting. Suppose we are asked to provide quarterly forecasts of sales for one of our company’s products over the coming one-year period. Production schedules, raw material purchasing, inventory policies, and sales quotas will all be affected by the quarterly forecasts we provide. Consequently, poor forecasts may result in poor planning and increased costs for the company. How should we go about providing the quarterly sales forecasts? Good judgment, intuition, and an awareness of the state of the economy may give us a rough idea or “feeling” of what is likely to happen in the future, but converting that feeling into a number that can be used as next year’s sales forecast is difficult. Forecasting methods can be classified as qualitative or quantitative. Qualitative methods generally involve the use of expert judgment to develop forecasts. Such methods are appropriate when historical data on the variable being forecast are either not applicable or unavailable. Quantitative forecasting methods can be used when (1) past information about the variable being forecast is available, (2) the information can be quantified, and (3) it is reasonable to assume that the pattern of the past will continue into the future. We will focus exclusively on quantitative forecasting methods in this chapter. If the historical data are restricted to past values of the variable to be forecast, the forecasting procedure is called a time series method and the historical data are referred to as a time series. The objective of time series analysis is to discover a pattern in the historical data or time series and then extrapolate the pattern into the future; the forecast is based solely on past values of the variable and/or on past forecast errors. In Section 15.1 we discuss the various kinds of time series that a forecaster might be faced with in practice. These include a constant or horizontal pattern, trends, seasonal patterns, both a trend and a seasonal pattern, and cyclical patterns. In order to build a quantitative forecasting model, it is necessary to have a measurement of forecast accuracy. Different measurements, and their respective advantages and disadvantages, are discussed in Section 15.2. In Section 15.3 we consider the simplest case, which is a horizontal or constant pattern. For this pattern, we develop the classical moving average and exponential smoothing models. We show how the best parameters can be selected using an optimization model, which provides a good application of the optimization tools developed in Chapters 2 through 8. Many time series have a trend, and taking this trend into account is important. In Section 15.4 we give optimization models for finding the best model parameters when a trend is present. Finally, in Section 15.5 we show how to incorporate both a trend and seasonality into a forecasting model.
Time Series Analysis and Forecasting
MANAGEMENT SCIENCE IN ACTION FORECASTING ENERGY NEEDS IN THE UTILITY INDUSTRY* Duke Energy is a diversified energy company with a portfolio of natural gas and electric businesses and an affiliated real estate company. In 2006, Duke Energy merged with Cinergy of Cincinnati, Ohio, to create one of North America’s largest energy companies, with assets totaling more than $70 billion. As a result of this merger the Cincinnati Gas & Electric Company became part of Duke Energy. Today, Duke Energy services over 5.5 million retail electric and gas customers in North
Carolina, South Carolina, Ohio, Kentucky, Indiana, and Ontario, Canada. Forecasting in the utility industry offers some unique perspectives. Because electricity cannot take the form of finished goods or inprocess inventories, this product must be generated to meet the instantaneous requirements of the customers. Electrical shortages are not just lost sales, but “brownouts” or “blackouts.” This situation places an unusual burden on the utility
15.1
forecaster. On the positive side, the demand for energy and the sale of energy are more predictable than for many other products. Also, unlike the situation in a multiproduct firm, a great amount of forecasting effort and expertise can be concentrated on the two products: gas and electricity. The largest observed electric demand for any given period, such as an hour, a day, a month, or a year, is defined as the peak load. The forecast of the annual electric peak load guides the timing decision for constructing future generating units, and the financial impact of this decision is great. Obviously, a timing decision that leads to having the unit available no sooner than necessary is crucial.
15.1
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The energy forecasts are important in other ways also. For example, purchases of coal as fuel for the generating units are based on the forecast levels of energy needed. The revenue from the electric operations of the company is determined from forecasted sales, which in turn enters into the planning of rate changes and external financing. These planning and decision-making processes are among the most important managerial activities in the company. It is imperative that the decision makers have the best forecast information available to assist them in arriving at these decisions. *Based on information provided by Dr. Richard Evans of Cincinnati Gas & Electric Company, Cincinnati, Ohio.
TIME SERIES PATTERNS A time series is a sequence of observations on a variable measured at successive points in time or over successive periods of time. The measurements may be taken every hour, day, week, month, or year, or at any other regular interval.1 The pattern of the data is an important factor in understanding how the time series has behaved in the past. If such behavior can be expected to continue in the future, we can use it to guide us in selecting an appropriate forecasting method. To identify the underlying pattern in the data, a useful first step is to construct a time series plot. A time series plot is a graphical presentation of the relationship between time and the time series variable; time is on the horizontal axis and the time series values are shown on the vertical axis. Let us review some of the common types of data patterns that can be identified when examining a time series plot.
Horizontal Pattern A horizontal pattern exists when the data fluctuate around a constant mean. To illustrate a time series with a horizontal pattern, consider the 12 weeks of data in Table 15.1. These data show the number of gallons of gasoline sold by a gasoline distributor in Bennington, Vermont, over the past 12 weeks. The average value or mean for this time series is 19.25, or 19,250 gallons per week. Figure 15.1 shows a time series plot for these data. Note how the data fluctuate around the sample mean of 19,250 gallons. Although random variability is present, we would say that these data follow a horizontal pattern. The term stationary time series2 is used to denote a time series whose statistical properties are independent of time. In particular this means that 1. The process generating the data has a constant mean. 2. The variability of the time series is constant over time. 1
We limit our discussion to time series in which the values of the series are recorded at equal intervals. Cases in which the observations are made at unequal intervals are beyond the scope of this text. 2 For a formal definition of stationarity see Box, G. E. P., G. M. Jenkins, and G. C. Reinsell (1994), Time Series Analysis: Forecasting and Control, 3rd ed., Prentice-Hall, p. 23.
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TABLE 15.1 GASOLINE SALES TIME SERIES
WEB
Week 1 2 3 4 5 6 7 8 9 10 11 12
file
Gasoline
Sales (1000s of gallons) 17 21 19 23 18 16 20 18 22 20 15 22
A time series plot for a stationary time series will always exhibit a horizontal pattern. But simply observing a horizontal pattern is not sufficient evidence to conclude that the time series is stationary. More advanced texts on forecasting discuss procedures for determining whether a time series is stationary and provide methods for transforming a time series that is not stationary into a stationary series. FIGURE 15.1 GASOLINE SALES TIME SERIES PLOT
25
Sales (1000s of gallons)
20
15
10
5
1
2
3
4
5
6 Week
7
8
9
10
11
12
15.1
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Time Series Patterns
Changes in business conditions can often result in a time series that has a horizontal pattern shifting to a new level. For instance, suppose the gasoline distributor signs a contract with the Vermont Sate Police to provide gasoline for state police cars located in southern Vermont. With this new contract, the distributor expects to see a major increase in weekly sales starting in week 13. Table 15.2 shows the number of gallons of gasoline sold for the original time series and the 10 weeks after signing the new contract. Figure 15.2 shows the corresponding time series plot. Note the increased level of the time series beginning in week 13. This change in the level of the time series makes it more difficult to choose an appropriate forecasting method. Selecting a forecasting method that adapts well to changes in the level of a time series is an important consideration in many practical applications.
Trend Pattern Although time series data generally exhibit random fluctuations, a time series may also show gradual shifts or movements to relatively higher or lower values over a longer period of time. If a time series plot exhibits this type of behavior, we say that a trend pattern exists. Trend is usually the result of long-term factors such as population increases or decreases, changing demographic characteristics of the population, technology, and/or consumer preferences.
TABLE 15.2 GASOLINE SALES TIME SERIES AFTER OBTAINING THE CONTRACT WITH THE VERMONT STATE POLICE
WEB
file
GasolineRevised
Week 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22
Sales (1000s of gallons) 17 21 19 23 18 16 20 18 22 20 15 22 31 34 31 33 28 32 30 29 34 33
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FIGURE 15.2 GASOLINE SALES TIME SERIES PLOT AFTER OBTAINING THE CONTRACT WITH THE VERMONT STATE POLICE
40
Sales (1000s of gallons)
35 30 25 20 15 10 5 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 Week
To illustrate a time series with a trend pattern, consider the time series of bicycle sales for a particular manufacturer over the past 10 years, as shown in Table 15.3 and Figure 15.3. Note that 21,600 bicycles were sold in year 1, 22,900 were sold in year 2, and so on. In year 10, the most recent year, 31,400 bicycles were sold. Visual inspection of the time series plot shows some up and down movement over the past 10 years, but the time series seems to also have a systematically increasing or upward trend. The trend for the bicycle sales time series appears to be linear and increasing over time, but sometimes a trend can be described better by other types of patterns. For instance, the
TABLE 15.3 BICYCLE SALES TIME SERIES
WEB
file
Bicycle
Year 1 2 3 4 5 6 7 8 9 10
Sales (1000s) 21.6 22.9 25.5 21.9 23.9 27.5 31.5 29.7 28.6 31.4
15.1
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FIGURE 15.3 BICYCLE SALES TIME SERIES PLOT
32
Sales (1000s)
30 28 26 24 22 20
1
2
3
4
5
6
7
8
9
10
Year
data in Table 15.4 and the corresponding time series plot in Figure 15.4 show the sales revenue for a cholesterol drug since the company won FDA approval for it 10 years ago. The time series increases in a nonlinear fashion; that is, the rate of change of revenue does not increase by a constant amount from one year to the next. In fact the revenue appears to be growing in an exponential fashion. Exponential relationships such as this are appropriate when the percentage change from one period to the next is relatively constant.
Seasonal Pattern The trend of a time series can be identified by analyzing multiyear movements in historical data. Seasonal patterns are recognized by seeing the same repeating patterns over successive periods of time. For example, a manufacturer of swimming pools expects low sales
TABLE 15.4 CHOLESTEROL REVENUE TIME SERIES ($ MILLIONS)
WEB
file
Cholesterol
Year 1 2 3 4 5 6 7 8 9 10
Revenue 23.1 21.3 27.4 34.6 33.8 43.2 59.5 64.4 74.2 99.3
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FIGURE 15.4 CHOLESTEROL REVENUE TIMES SERIES PLOT ($ MILLIONS)
120
Revenue
100 80 60 40 20
1
2
3
4
5
6
7
8
9
10
Year
activity in the fall and winter months, with peak sales in the spring and summer months. Manufacturers of snow removal equipment and heavy clothing, however, expect just the opposite yearly pattern. Not surprisingly, the pattern for a time series plot that exhibits a repeating pattern over a one-year period due to seasonal influences is called a seasonal pattern. Although we generally think of seasonal movement in a time series as occurring within one year, time series data can also exhibit seasonal patterns of less than one year in duration. For example, daily traffic volume shows within-the-day “seasonal” behavior, with peak levels occurring during rush hours, moderate flow during the rest of the day and early evening, and light flow from midnight to early morning. As an example of a seasonal pattern, consider the number of umbrellas sold at a clothing store over the past five years. Table 15.5 shows the time series and Figure 15.5 shows the corresponding time series plot. The time series plot does not indicate any long-term trend in sales. In fact, unless you look carefully at the data, you might conclude that the data follow a horizontal pattern. But closer inspection of the time series plot reveals a regular pattern in the data. That is, the first and third quarters have moderate sales, the second quarter has the highest sales, and the fourth quarter tends to have the lowest sales volume. Thus, we would conclude that a quarterly seasonal pattern is present.
Trend and Seasonal Pattern Some time series include a combination of a trend and seasonal pattern. For instance, the data in Table 15.6 and the corresponding time series plot in Figure 15.6 show television set sales for a particular manufacturer over the past four years. Clearly, an increasing trend is present. But Figure 15.6 also indicates that sales are lowest in the second quarter of each year and increase in quarters 3 and 4. Thus, we conclude that a seasonal pattern also exists for television set sales. In such cases we need to use a forecasting method that has the capability to deal with both trend and seasonality.
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Time Series Patterns
TABLE 15.5 UMBRELLA SALES TIME SERIES Year 1
WEB
Quarter 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4
2
file
Umbrella
3
4
5
FIGURE 15.5 UMBRELLA SALES TIME SERIES PLOT
180 160 140 Sales
120 100 80 60 40 20 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Time Period
Sales 125 153 106 88 118 161 133 102 138 144 113 80 109 137 125 109 130 165 128 96
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TABLE 15.6 QUARTERLY TELEVISION SET SALES TIME SERIES Year 1
Quarter 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4
2
WEB
file
TVSales
3
4
Sales (1000s) 4.8 4.1 6.0 6.5 5.8 5.2 6.8 7.4 6.0 5.6 7.5 7.8 6.3 5.9 8.0 8.4
FIGURE 15.6 QUARTERLY TELEVISION SET SALES TIME SERIES PLOT
Quarterly Television Set Sales (1000s)
9.0
8.0
7.0
6.0
5.0
4.0 1
2
3
Year 1
4
1
2
3
Year 2
4
1
2
3
Year 3
Year/Quarter
4
1
2
3
Year 4
4
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Cyclical Pattern A cyclical pattern exists if the time series plot shows an alternating sequence of points below and above the trend line lasting more than one year. Many economic time series exhibit cyclical behavior with regular runs of observations below and above the trend line. Often, the cyclical component of a time series is due to multiyear business cycles. For example, periods of moderate inflation followed by periods of rapid inflation can lead to time series that alternate below and above a generally increasing trend line (e.g., a time series for housing costs). Business cycles are extremely difficult, if not impossible, to forecast. As a result, cyclical effects are often combined with long-term trend effects and referred to as trend-cycle effects. In this chapter we do not deal with cyclical effects that may be present in the time series.
Selecting a Forecasting Method The underlying pattern in the time series is an important factor in selecting a forecasting method. Thus, a time series plot should be one of the first things developed when trying to determine which forecasting method to use. If we see a horizontal pattern, then we need to select a method appropriate for this type of pattern. Similarly, if we observe a trend in the data, then we need to use a forecasting method that has the capability to handle trends effectively. The next two sections illustrate methods that can be used in situations where the underlying pattern is horizontal; in other words, no trend or seasonal effects are present. We then consider methods appropriate when trend and or seasonality are present in the data.
15.2
FORECAST ACCURACY In this section we begin by developing forecasts for the gasoline time series shown in Table 15.1, using the simplest of all the forecasting methods, an approach that uses the most recent week’s sales volume as the forecast for the next week. For instance, the distributor sold 17 thousand gallons of gasoline in week 1; this value is used as the forecast for week 2. Next, we use 21, the actual value of sales in week 2, as the forecast for week 3, and so on. The forecasts obtained for the historical data using this method are shown in Table 15.7 in the column labeled Forecast. Because of its simplicity, this method is often referred to as a naïve forecasting method. How accurate are the forecasts obtained using this naïve forecasting method? To answer this question, we will introduce several measures of forecast accuracy. These measures are used to determine how well a particular forecasting method is able to reproduce the time series data that are already available. By selecting the method that has the best accuracy for the data already known, we hope to increase the likelihood that we will obtain better forecasts for future time periods. The key concept associated with measuring forecast accuracy is forecast error, defined as follows: Forecast Error Actual Value Forecast For instance, because the distributor actually sold 21 thousand gallons of gasoline in week 2 and the forecast, using the sales volume in week 1, was 17 thousand gallons, the forecast error in week 2 is Forecast Error in week 2 21 17 4
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TABLE 15.7 COMPUTING FORECASTS AND MEASURES OF FORECAST ACCURACY USING THE MOST RECENT VALUE AS THE FORECAST FOR THE NEXT PERIOD
Week 1 2 3 4 5 6 7 8 9 10 11 12
Time Series Value 17 21 19 23 18 16 20 18 22 20 15 22
Forecast
Forecast Error
Absolute Value of Forecast Error
Squared Forecast Error
Percentage Error
Absolute Value of Percentage Error
17 21 19 23 18 16 20 18 22 20 15
4 2 4 5 2 4 2 4 2 5 7
4 2 4 5 2 4 2 4 2 5 7
16 4 16 25 4 16 4 16 4 25 49
19.05 10.53 17.39 27.78 12.50 20.00 11.11 18.18 10.00 33.33 31.82
19.05 10.53 17.39 27.78 12.50 20.00 11.11 18.18 10.00 33.33 31.82
Totals
5
41
179
1.19
211.69
The fact that the forecast error is positive indicates that in week 2 the forecasting method underestimated the actual value of sales. Next, we use 21, the actual value of sales in week 2, as the forecast for week 3. Because the actual value of sales in week 3 is 19, the forecast error for week 3 is 19 21 2. In this case the negative forecast error indicates that in week 3 the forecast overestimated the actual value. Thus, the forecast error may be positive or negative, depending on whether the forecast is too low or too high. A complete summary of the forecast errors for this naïve forecasting method is shown in Table 15.7 in the column labeled Forecast Error. A simple measure of forecast accuracy is the mean or average of the forecast errors. Table 15.7 shows that the sum of the forecast errors for the gasoline sales time series is 5; thus, the mean or average error is 5/11 0.45. Note that although the gasoline time series consists of 12 values, to compute the mean error we divided the sum of the forecast errors by 11 because there are only 11 forecast errors. Because the mean forecast error is positive, the method is under-forecasting; in other words, the observed values tend to be greater than the forecasted values. Because positive and negative forecast errors tend to offset one another, the mean error is likely to be small; thus, the mean error is not a very useful measure of forecast accuracy. The mean absolute error, denoted MAE, is a measure of forecast accuracy that avoids the problem of positive and negative forecast errors offsetting one another. As you might expect given its name, MAE is the average of the absolute values of the forecast errors. Table 15.7 shows that the sum of the absolute values of the forecast errors is 41; thus MAE average of the absolute value of forecast errors =
41 = 3.73 11
Another measure that avoids the problem of positive and negative errors offsetting each other is obtained by computing the average of the squared forecast errors. This measure of
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forecast accuracy, referred to as the mean squared error, is denoted MSE. From Table 15.7, the sum of the squared errors is 179; hence, 179 = 16.27 11 The size of MAE and MSE depend upon the scale of the data. As a result it is difficult to make comparisons for different time intervals, such as comparing a method of forecasting monthly gasoline sales to a method of forecasting weekly sales, or to make comparisons across different time series. To make comparisons like these, we need to work with relative or percentage error measures. The mean absolute percentage error, denoted MAPE, is such a measure. To compute MAPE, we must first compute the percentage error for each forecast. For example, the percentage error corresponding to the forecast of 17 in week 2 is computed by dividing the forecast error in week 2 by the actual value in week 2 and multiplying the result by 100. For week 2 the percentage error is computed as follows: MSE average of the sum of squared forecast errors =
Percentage error for week 2 =
4 (100) = 19.05% 21
Thus, the forecast error for week 2 is 19.05% of the observed value in week 2. A complete summary of the percentage errors is shown in Table 15.7 in the column labeled Percentage Error. In the next column, we show the absolute value of the percentage error. Table 15.7 shows that the sum of the absolute values of the percentage errors is 211.69; thus MAPE average of the absolute value of percentage 211.69 = 19.24% forecast errors = 11 Summarizing, using the naïve (most recent observation) forecasting method, we obtained the following measures of forecast accuracy: MAE 3.73 MSE 16.27 MAPE 19.24% These measures of forecast accuracy simply measure how well the forecasting method is able to forecast historical values of the time series. Now, suppose we want to forecast sales for a future time period, such as week 13. In this case the forecast for week 13 is 22, the actual value of the time series in week 12. Is this an accurate estimate of sales for week 13? Unfortunately, there is no way to address the issue of accuracy associated with forecasts for future time periods. However, if we select a forecasting method that works well for the historical data and we think that the historical pattern will continue into the future, we should obtain results that will ultimately be shown to be good. Before closing this section, let us consider another method for forecasting the gasoline sales time series in Table 15.1. Suppose we use the average of all the historical data available as the forecast for the next period. We begin by developing a forecast for week 2. Because there is only one historical value available prior to week 2, the forecast for week 2 is just the time series value in week 1; thus, the forecast for week 2 is 17 thousand gallons of gasoline. To compute the forecast for week 3, we take the average of the sales values in weeks 1 and 2. Thus, Forecast for week 3 =
17 + 21 = 19 2
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Similarly, the forecast for week 4 is Forecast for week 4 =
17 + 21 + 19 = 19 3
The forecasts obtained using this method for the gasoline time series are shown in Table 15.8 in the column labeled Forecast. Using the results shown in Table 15.8, we obtained the following values of MAE, MSE, and MAPE: MAE
=
26.81 = 2.44 11
MSE
=
89.07 = 8.10 11
MAPE =
141.34 = 12.85% 11
We can now compare the accuracy of the two forecasting methods we have considered in this section by comparing the values of MAE, MSE, and MAPE for each method. Naïve Method MAE MSE MAPE
Average of Past Values
3.73 16.27 19.24%
2.44 8.10 12.85%
For every measure, the average of past values provides more accurate forecasts than using the most recent observation as the forecast for the next period. In general, if the underlying time series is stationary, the average of all the historical data will always provide the best results. TABLE 15.8 COMPUTING FORECASTS AND MEASURES OF FORECAST ACCURACY USING THE AVERAGE OF ALL THE HISTORICAL DATA AS THE FORECAST FOR THE NEXT PERIOD
Week 1 2 3 4 5 6 7 8 9 10 11 12
Time Series Value 17 21 19 23 18 16 20 18 22 20 15 22
Absolute Value of Forecast Error
Squared Forecast Error
Percentage Error
Absolute Value of Percentage Error
Forecast
Forecast Error
17.00 19.00 19.00 20.00 19.60 19.00 19.14 19.00 19.33 19.40 19.00
4.00 0.00 4.00 2.00 3.60 1.00 1.14 3.00 0.67 4.40 3.00
4.00 0.00 4.00 2.00 3.60 1.00 1.14 3.00 0.67 4.40 3.00
16.00 0.00 16.00 4.00 12.96 1.00 1.31 9.00 0.44 19.36 9.00
19.05 0.00 17.39 11.11 22.50 5.00 6.35 13.64 3.33 29.33 13.64
19.05 0.00 17.39 11.11 22.50 5.00 6.35 13.64 3.33 29.33 13.64
Totals
4.52
26.81
89.07
2.75
141.34
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Moving Averages and Exponential Smoothing
717
But suppose that the underlying time series is not stationary. In Section 15.1 we mentioned that changes in business conditions can often result in a time series that has a horizontal pattern shifting to a new level. We discussed a situation in which the gasoline distributor signed a contract with the Vermont Sate Police to provide gasoline for state police cars located in southern Vermont. Table 15.2 shows the number of gallons of gasoline sold for the original time series and the 10 weeks after signing the new contract, and Figure 15.2 shows the corresponding time series plot. Note the change in level in week 13 for the resulting time series. When a shift to a new level like this occurs, it takes a long time for the forecasting method that uses the average of all the historical data to adjust to the new level of the time series. But in this case the simple naïve method adjusts very rapidly to the change in level because it uses the most recent observation available as the forecast. Measures of forecast accuracy are important factors in comparing different forecasting methods; but we have to be careful to not rely upon them too heavily. Good judgment and knowledge about business conditions that might affect the forecast also have to be carefully considered when selecting a method. In addition, historical forecast accuracy is not the only consideration, especially if the time series is likely to change in the future. In the next section we will introduce more sophisticated methods for developing forecasts for a time series that exhibits a horizontal pattern. Using the measures of forecast accuracy developed here, we will be able to determine whether such methods provide more accurate forecasts than we obtained using the simple approaches illustrated in this section. The methods that we will introduce also have the advantage that they adapt well in situations where the time series changes to a new level. The ability of a forecasting method to adapt quickly to changes in level is an important consideration, especially in short-term forecasting situations.
15.3
MOVING AVERAGES AND EXPONENTIAL SMOOTHING In this section we discuss three forecasting methods that are appropriate for a time series with a horizontal pattern: moving averages, weighted moving averages, and exponential smoothing. These methods also adapt well to changes in the level of a horizontal pattern such as what we saw with the extended gasoline sales time series (Table 15.2 and Figure 15.2). However, without modification they are not appropriate when significant trend, cyclical, or seasonal effects are present. Because the objective of each of these methods is to “smooth out” the random fluctuations in the time series, they are referred to as smoothing methods. These methods are easy to use and generally provide a high level of accuracy for shortrange forecasts, such as a forecast for the next time period.
Moving Averages The moving averages method uses the average of the most recent k data values in the time series as the forecast for the next period. Mathematically, a moving average forecast of order k is as follows: (most recent k data values) Y1 + Yt-1 + Á + Yt-k+1 = Ft+1 = a k k where Ft1 forecast of the time series for period t 1
(15.1)
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The term moving is used because every time a new observation becomes available for the time series, it replaces the oldest observation in the equation and a new average is computed. As a result, the average will change, or move, as new observations become available. To illustrate the moving averages method, let us return to the gasoline sales data in Table 15.1 and Figure 15.1. The time series plot in Figure 15.1 indicates that the gasoline sales time series has a horizontal pattern. Thus, the smoothing methods of this section are applicable. To use moving averages to forecast a time series, we must first select the order, or number of time series values, to be included in the moving average. If only the most recent values of the time series are considered relevant, a small value of k is preferred. If more past values are considered relevant, then a larger value of k is better. As mentioned earlier, a time series with a horizontal pattern can shift to a new level over time. A moving average will adapt to the new level of the series and resume providing good forecasts in k periods. Thus, a smaller value of k will track shifts in a time series more quickly. But larger values of k will be more effective in smoothing out the random fluctuations over time. So managerial judgment based on an understanding of the behavior of a time series is helpful in choosing a good value for k. To illustrate how moving averages can be used to forecast gasoline sales, we will use a three-week moving average (k 3). We begin by computing the forecast of sales in week 4 using the average of the time series values in weeks 1–3. F4 = average of weeks 1- 3 =
17 + 21 + 19 = 19 3
Thus, the moving average forecast of sales in week 4 is 19, or 19,000 gallons of gasoline. Because the actual value observed in week 4 is 23, the forecast error in week 4 is 23 19 4. Next, we compute the forecast of sales in week 5 by averaging the time series values in weeks 2–4. F5 = average of weeks 2- 4 =
21 + 19 + 23 = 21 3
Hence, the forecast of sales in week 5 is 21 and the error associated with this forecast is 18 21 3. A complete summary of the three-week moving average forecasts for the gasoline sales time series is provided in Table 15.9. Figure 15.7 shows the original time series plot and the three-week moving average forecasts. Note how the graph of the moving average forecasts has tended to smooth out the random fluctuations in the time series. To forecast sales in week 13, the next time period in the future, we simply compute the average of the time series values in weeks 10, 11, and 12. F13 = average of weeks 10 - 12 =
20 + 15 + 22 = 19 3
Thus, the forecast for week 13 is 19, or 19,000 gallons of gasoline. Forecast Accuracy In Section 15.2 we discussed three measures of forecast accuracy: mean absolute error (MAE), mean squared error (MSE), and mean absolute percentage error (MAPE). Using the three-week moving average calculations in Table 15.9, the values for these three measures of forecast accuracy are
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TABLE 15.9 SUMMARY OF THREE-WEEK MOVING AVERAGE CALCULATIONS
Time Series Value 17 21 19 23 18 16 20 18 22 20 15 22
Week 1 2 3 4 5 6 7 8 9 10 11 12
Forecast Error
Forecast
Absolute Value of Forecast Error
Squared Forecast Error
Percentage Error
Absolute Value of Percentage Error
19 21 20 19 18 18 20 20 19
4 3 4 1 0 4 0 5 3
4 3 4 1 0 4 0 5 3
16 9 16 1 0 16 0 25 9
17.39 16.67 25.00 5.00 0.00 18.18 0.00 33.33 13.64
17.39 16.67 25.00 5.00 0.00 18.18 0.00 33.33 13.64
Totals
24
92
20.79
129.21
FIGURE 15.7 GASOLINE SALES TIME SERIES PLOT AND THREE-WEEK MOVING AERAGE FORECASTS
Three-week moving average forecasts
25
Sales (1000s of gallons)
20
15
10
5
1
2
3
4
5
6 Week
7
8
9
10
11
12
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MAE =
24 = 2.67 9
MSE =
92 = 10.22 9
MAPE = In situations where you need to compare forecasting methods for different time periods, such as comparing a forecast of weekly sales to a forecast of monthly sales, relative measures such as MAPE are preferred.
129.21 = 14.36% 9
In Section 15.2 we showed that using the most recent observation as the forecast for the next week (a moving average of order k 1) resulted in values of MAE 3.73; MSE 16.27; and MAPE 19.24%. Thus, in each case the three-week moving average approach provided more accurate forecasts than simply using the most recent observation as the forecast. To determine whether a moving average with a different order k can provide more accurate forecasts, we recommend using trial and error to determine the value of k that minimizes MSE. For the gasoline sales time series, it can be shown that the minimum value of MSE corresponds to a moving average of order k 6 with MSE 6.79. If we are willing to assume that the order of the moving average that is best for the historical data will also be best for future values of the time series, the most accurate moving average forecasts of gasoline sales can be obtained using a moving average of order k 6.
Weighted Moving Averages In the moving averages method, each observation in the moving average calculation receives the same weight. One variation, known as weighted moving averages, involves selecting a different weight for each data value and then computing a weighted average of the most recent k values as the forecast. In most cases, the most recent observation receives the most weight, and the weight decreases for older data values. Let us use the gasoline sales time series to illustrate the computation of a weighted three-week moving average. We assign a weight of 3⁄6 to the most recent observation, a weight of 2⁄6 to the second most recent observation, and a weight of 1⁄6 to the third most recent observation. Using this weighted average, our forecast for week 4 is computed as follows: Forecast for week 4 1⁄6(17) 2⁄6(21) 3⁄6(19) 19.33 Note that for the weighted moving average method the sum of the weights is equal to 1. A moving average forecast of order k 3 is just a special case of the weighted moving averages method in which each weight is equal to 1⁄3.
Forecast Accuracy To use the weighted moving averages method, we must first select the number of data values to be included in the weighted moving average and then choose weights for each of the data values. In general, if we believe that the recent past is a better predictor of the future than the distant past, larger weights should be given to the more recent observations. However, when the time series is highly variable, selecting approximately equal weights for the data values may be best. The only requirements in selecting the weights are that they be nonnegative and that their sum must equal 1. To determine whether one particular combination of number of data values and weights provides a more accurate forecast than another combination, we recommend using MSE as the measure of forecast accuracy. That is, if we assume that the combination that is best for the past will also be best for the future, we would use the combination of the number of data values and weights that minimized MSE for the historical time series to forecast the next value in the time series.
15.3
Moving Averages and Exponential Smoothing
721
Exponential Smoothing There are a number of exponential smoothing procedures. Because it has a single smoothing constant ␣, the method presented here is often referred to as single exponential smoothing.
Exponential smoothing also uses a weighted average of past time series values as a forecast; it is a special case of the weighted moving averages method in which we select only one weight—the weight for the most recent observation. The weights for the other data values are computed automatically and become smaller as the observations move farther into the past. The exponential smoothing model follows:
Ft+1 = aYt + (1 - a)Ft
(15.2)
where Ft1 forecast of the time series for period t 1 Yt actual value of the time series in period t Ft forecast of the time series for period t a smoothing constant (0 … a … 1) Equation (15.2) shows that the forecast for period t 1 is a weighted average of the actual value in period t and the forecast for period t. The weight given to the actual value in period t is the smoothing constant a and the weight given to the forecast in period t is 1 a. It turns out that the exponential smoothing forecast for any period is actually a weighted average of all the previous actual values of the time series. Let us illustrate by working with a time series involving only three periods of data: Y1, Y2, and Y3. To initiate the calculations, we let F1 equal the actual value of the time series in period 1; that is, F1 Y1. Hence, the forecast for period 2 is F2 = aY1 + (1 - a)F1 = aY1 + (1 - a)Y1 = Y1 We see that the exponential smoothing forecast for period 2 is equal to the actual value of the time series in period 1. The forecast for period 3 is F3 = aY2 + (1 -a)F2 = aY2 + (1 -a)Y1 Finally, substituting this expression for F3 into the expression for F4, we obtain F4 = aY3 + (1 -a)F3 = aY3 + (1 -a)[aY2 + (1 - a)Y1] = aY3 + a(1 -a)Y2 + (1 -a)2Y1 The term exponential smoothing comes from the exponential nature of the weighting scheme for the historical values.
We now see that F4 is a weighted average of the first three time series values. The sum of the coefficients, or weights, for Y1, Y2, and Y3 equals 1. A similar argument can be made to show that, in general, any forecast Ft1 is a weighted average of all the previous time series values. Despite the fact that exponential smoothing provides a forecast that is a weighted average of all past observations, all past data do not need to be saved to compute the forecast
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for the next period. In fact, Equation (15.2) shows that once the value for the smoothing constant a is selected, only two pieces of information are needed to compute the forecast: Yt, the actual value of the time series in period t; and Ft, the forecast for period t. To illustrate the exponential smoothing approach to forecasting, let us again consider the gasoline sales time series in Table 15.1 and Figure 15.2. As indicated previously, to start the calculations we set the exponential smoothing forecast for period 2 equal to the actual value of the time series in period 1. Thus, with Y1 17, we set F2 17 to initiate the computations. Referring to the time series data in Table 15.1, we find an actual time series value in period 2 of Y2 21. Thus, period 2 has a forecast error of 21 17 4. Continuing with the exponential smoothing computations using a smoothing constant of a 0.2, we obtain the following forecast for period 3: F3 = 0.2Y2 + 0.8F2 = 0.2(21) + 0.8(17) = 17.8 Once the actual time series value in period 3, Y3 19, is known, we can generate a forecast for period 4 as follows: F4 = 0.2Y3 + 0.8F3 = 0.2(19) + 0.8(17.8) = 18.04 Continuing the exponential smoothing calculations, we obtain the weekly forecast values shown in Table 15.10. Note that we have not shown an exponential smoothing forecast or a forecast error for week 1 because no forecast was made. For week 12, we have Y12 22 and F12 18.48. We can use this information to generate a forecast for week 13. F13 = 0.2Y12 + 0.8F12 = 0.2(22) + 0.8(18.48) = 19.18 Thus, the exponential smoothing forecast of the amount sold in week 13 is 19.18, or 19,180 gallons of gasoline. With this forecast, the firm can make plans and decisions accordingly. TABLE 15.10 SUMMARY OF THE EXPONENTIAL SMOOTHING FORECASTS AND FORECAST ERRORS FOR THE GASOLINE SALES TIME SERIES WITH SMOOTHING CONSTANT 0.2
Week 1 2 3 4 5 6 7 8 9 10 11 12
Time Series Value 17 21 19 23 18 16 20 18 22 20 15 22
Forecast
Forecast Error
Squared Forecast Error
17.00 17.80 18.04 19.03 18.83 18.26 18.61 18.49 19.19 19.35 18.48
4.00 1.20 4.96 –1.03 –2.83 1.74 –0.61 3.51 0.81 –4.35 3.52
16.00 1.44 24.60 1.06 8.01 3.03 0.37 12.32 0.66 18.92 12.39
Totals
10.92
98.80
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FIGURE 15.8 ACTUAL AND FORECAST GASOLINE TIME SERIES WITH SMOOTHING CONSTANT 0.2
25
Actual time series
Sales (1000s of gallons)
20
15 Forecast time series with = .2 10
5
1
2
3
4
5
6
7
8
9
10
11
12
Week
Figure 15.8 shows the time series plot of the actual and forecast time series values. Note in particular how the forecasts “smooth out” the irregular or random fluctuations in the time series. Forecast Accuracy In the preceding exponential smoothing calculations, we used a smoothing constant of a 0.2. Although any value of a between 0 and 1 is acceptable, some values will yield better forecasts than others. Insight into choosing a good value for a can be obtained by rewriting the basic exponential smoothing model as follows:
Ft+1 = aYt + (1 - a)Ft Ft+1 = aYt + Ft - aFt Ft+1 = Ft + a(Yt - Ft)
(15.3)
Thus, the new forecast Ft1 is equal to the previous forecast Ft plus an adjustment, which is the smoothing constant a times the most recent forecast error, Yt Ft. That is, the forecast in period t 1 is obtained by adjusting the forecast in period t by a fraction of the forecast error. If the time series contains substantial random variability, a small value of
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the smoothing constant is preferred. The reason for this choice is that if much of the forecast error is due to random variability, we do not want to overreact and adjust the forecasts too quickly. For a time series with relatively little random variability, forecast errors are more likely to represent a change in the level of the series. Thus, larger values of the smoothing constant provide the advantage of quickly adjusting the forecasts; this allows the forecasts to react more quickly to changing conditions. The criterion we will use to determine a desirable value for the smoothing constant a is the same as the criterion we proposed for determining the number of periods of data to include in the moving averages calculation. That is, we choose the value of a that minimizes the mean squared error (MSE). A summary of the MSE calculations for the exponential smoothing forecast of gasoline sales with a 0.2 is shown in Table 15.10. Note that there is one less squared error term than the number of time periods because we had no past values with which to make a forecast for period 1. The value of the sum of squared forecast errors is 98.80; hence MSE 98.80/11 8.98. Would a different value of a provide better results in terms of a lower MSE value? Determining the value of a that minimizes MSE is a nonlinear optimization problem, as discussed in Chapter 8 (see Problem 8.12). These types of optimization models are often referred to as curve-fitting models. The objective is to minimize the sum of the squared error (note that this is equivalent to minimizing MSE), subject to the smoothing parameter requirement, 0 … a … 1. The smoothing parameter a is treated as a variable in the optimization model. In addition, we define a set of variables Ft, the forecast for period t, for t 1, . . . , 12. The objective of minimizing the sum of squared error is then Minimize {(21 - F2)2 + (19 - F3)2 + (23 - F4)2 + (18 - F5)2 + (16 - F6)2 + (20 - F7)2 + (18 - F8)2 + (22 - F9)2 + (20 - F10)2 + (15 - F11)2 + (22 - F12)2} The first set of constraints defines the forecasts as a function of observed and forecasted values as defined by equation (15.2). Recall that we set the forecast in period 1 to the observed time series value in period 1: F1 17 F2 a17 (1a)F1 F3 a21 (1a)F2 F4 a19 (1a)F3 F5 a23 (1a)F4 F6 a18 (1a)F5 F7 a16 (1a)F6 F8 a20 (1a)F7 F9 a18 (1a)F8 F10 a22 (1a)F9 F11 a20 (1a)F10 F12 a15 (1a)F11 Finally, the value of a is restricted to 0 … a … 1
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The complete nonlinear curve-fitting optimization model is: Minimize {(21 - F2)2 + (19 - F3)2 + (23 - F4)2 + (18 - F5)2 + (16 - F6)2 + (20 - F7)2 + (18 - F8)2 + (22 - F9)2 + (20 - F10)2 + (15 - F11)2 + (22 - F12)2} s.t.
WEB
F1 17 F2 a17 (1a)F1 F3 a21 (1a)F2 F4 a19 (1a)F3 F5 a23 (1a)F4 F6 a18 (1a)F5 F7 a16 (1a)F6 F8 a20 (1a)F7 F9 a18 (1a)F8 F10 a22 (1a)F9 F11 a20 (1a)F10 F12 a15 (1a)F11
file
Gasoline_ES
0 … a … 1 We may use Excel Solver or LINGO to solve for the best value of a. The optimal value of a 0.17439 with a sum of squared error of 98.56 and an MSE of 98.56/11 8.96. So, our initial value of a .2 is very close to the best we can do to minimize MSE. It will not always be the case that our guess will be so close to optimal, so we recommend you solve the nonlinear optimization for the best value of a. The general optimization problem for exponential smoothing with n time periods and observed values Yt is n
Min a (Yt - Ft)2
(15.4)
t=2
s.t. Ft = aYt - 1 + (1 - a)Ft-1
t = 2, 3, Á , n
(15.5)
F1 Y1
(15.6)
0 … a … 1
(15.7)
The objective function (equation 15.4) is to minimize the sum of the squared errors. As in Table 15.10, we have errors (observed data – forecast) only for time periods 2 through n, and we initialize F1 to Y1. The optimal value of a can be used in the exponential smoothing model to provide forecasts for the future. At a later date, after new time series observations are obtained, we may analyze the newly collected time series data to determine whether the smoothing constant should be revised to provide better forecasting results. Revised forecasts may be obtained by solving the model in (15.4)–(15.7), including any new observations.
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NOTES AND COMMENTS 1. Spreadsheet packages are an effective tool for implementing exponential smoothing. With the time series data and the forecasting formulas in a spreadsheet as shown in Table 15.10, you can solve the nonlinear model described by equations (15.4)–(15.7) using Solver. Notice that in equation set (15.5) each forecast variable Ft is defined in terms of the smoothing parameter a and the previous periods forecast variable. Thus, these are what we have called definitional variables. In the Solver spreadsheet model, only a needs to be declared a decision variable. The forecast variables Ft are simply calculatons in
15.4
the spreadsheet. We give details for doing this for the gasoline data in Appendix 15.1. 2. We presented the moving average and exponential smoothing methods in the context of a stationary time series. These methods can also be used to forecast a nonstationary time series which shifts in level, but exhibits no trend or seasonality. Moving averages with small values of k adapt more quickly than moving averages with larger values of k. Exponential smoothing models with smoothing constants closer to one adapt more quickly than models with smaller values of the smoothing constant.
TREND PROJECTION We present two forecasting methods in this section that are appropriate for a time series exhibiting a trend pattern. First, we show how curve fitting may be used to forecast a time series with a linear trend. Second, we show how curve fitting can also be used to forecast time series with a curvilinear or nonlinear trend.
Linear Trend In Section 15.1 we used the bicycle sales time series in Table 15.3 and Figure 15.3 to illustrate a time series with a trend pattern. Let us now use this time series to illustrate how curve fitting can be used to forecast a time series with a linear trend. The data for the bicycle time series are repeated in Table 15.11 and Figure 15.9. Although the time series plot in Figure 15.9 shows some up and down movement over the past 10 years, we might agree that the linear trend line shown in Figure 15.10 provides
TABLE 15.11 BICYCLE SALES TIME SERIES
WEB
file
Bicycle
Year 1 2 3 4 5 6 7 8 9 10
Sales (1000s) 21.6 22.9 25.5 21.9 23.9 27.5 31.5 29.7 28.6 31.4
15.4
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Trend Projection
FIGURE 15.9 BICYCLE SALES TIME SERIES PLOT
32 30
Sales (1000s)
28 26 24 22 20
1
2
3
4
5
6
7
8
9
10
Year
a reasonable approximation of the long-run movement in the series. We can use curve fitting to develop such a linear trend line for the bicycle sales time series. Curve fitting can be used to find a best-fitting line to a set of data that exhibits a linear trend. The criterion used to determine the best-fitting line is one we used in the previous section. Curve fitting minimizes the sum of squared error between the observed and fitted time series data where the model is a trend line. We build a nonlinear optimization model TREND REPRESENTED BY A LINEAR FUNCTION FOR THE BICYCLE SALES TIME SERIES
32 30 Sales (1000s)
FIGURE 15.10
28 26 24 22 20
1
2
3
4
5 Year
6
7
8
9
10
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that is similar to the model we used to find the best value of a for exponential smoothing. In the case of a straight line y a mx, our objective is to find the best values of parameters a and m, so that the line provides forecasts that minimize sum of squared error. For estimating the linear trend in a time series, we will use the following notation for a line:
Tt = b0 + b1t
(15.8)
where Tt linear trend forecast in period t b0 the intercept of the linear trend line b1 the slope of the linear trend line t the time period In equation (15.8), the time variable begins at t 1 corresponding to the first time series observation (year 1 for the bicycle sales time series) and continues until t n corresponding to the most recent time series observation (year 10 for the bicycle sales time series). Thus, for the bicycle sales time series t 1 corresponds to the oldest time series value and t 10 corresponds to the most recent year. Let us formulate the curve-fitting model that will give us the best values of b0 and b1 in equation (15.8) for the bicycle sales data. The objective is to minimize the sum of squared error between the observed values of the time series given in Table 15.11 and the forecasted values for each period: Min {(21.6 T1)2 (22.9 T2)2 (22.5 T3)2 (21.9 T4)2 (23.9 T5)2 (27.5 T6)2 (31.5 T7)2 (29.7 T8)2 (28.6 T9)2 (31.4 T10)2} The only constraints then are to define the forecasts as a linear function of parameters b0 and b1 as described by equation (15.8): T1 b0 b11 T2 b0 b12 T3 b0 b13 T4 b0 b14 T5 b0 b15 T6 b0 b16 T7 b0 b17 T8 b0 b18 T9 b0 b19 T10 b0 b110 The entire nonlinear curve-fitting optimization model is: Min {(21.6 T1)2 (22.9 T2)2 (22.5 T3)2 (21.9 T4)2 (23.9 T5)2 (27.5 T6)2 (31.5 T7)2 (29.7 T8)2 (28.6 T9)2 (31.4 T10)2}
15.4
729
Trend Projection
s.t. T1 b0 b11 T2 b0 b12
WEB
T3 b0 b13
file
T4 b0 b14
Bicycle_Linear
T5 b0 b15 T6 b0 b16 T7 b0 b17 T8 b0 b18 T9 b0 b19 T10 b0 b110 Note that b0, b1, and Tt are decision variables and that none are restricted to be nonnegative. The solution to this problem may be obtained using Excel Solver or LINGO. The solution is b0 20.4 and b1 1.1 with a sum of squared error of 30.7. Therefore, the trend equation is Tt 20.4 1.1t The slope of 1.1 indicates that over the past 10 years the firm experienced an average growth in sales of about 1100 units per year. If we assume that the past 10-year trend in sales is a good indicator of the future, this trend equation can be used to develop forecasts for future time periods. For example, substituting t 11 into the equation yields next year’s trend projection or forecast, T11. T11 20.4 1.1(11) 32.5 Thus, using trend projection, we would forecast sales of 32,500 bicycles for year 11. Table 15.12 shows the computation of the minimized sum of squared errors for the bicycle sales time series. As previously noted, minimizing sum of squared error also minimizes the commonly used measure of accuracy, mean squared error (MSE). For the bicycle sales time series n
2 a (Yt - Ft)
MSE =
t=1
n
=
30.7 = 3.07 10
We may write a general optimization curve-fitting model for linear trend curve fitting for a time series with n data points. Let Yt the observed value of the time series in period t. The general model is n
Min a (Yt - Tt)2
(15.9)
t=1
s.t. Tt b0 b1t
t 1,2,3 . . . . n
(15.10)
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TABLE 15.12 SUMMARY OF THE LINEAR TREND FORECASTS AND FORECAST ERRORS FOR THE BICYCLE SALES TIME SERIES
Week 1 2 3 4 5 6 7 8 9 10
Sales (1000s) Yt 21.6 22.9 25.5 21.9 23.9 27.5 31.5 29.7 28.6 31.4
Forecast Tt 21.5 22.6 23.7 24.8 25.9 27.0 28.1 29.2 30.3 31.4
Forecast Error 0.1 0.3 1.8 2.9 2.0 0.5 3.4 0.5 1.7 0.0 Total
Squared Forecast Error 0.01 0.09 3.24 8.41 4.00 0.25 11.56 0.25 2.89 0.00 30.70
The decision variables in this optimization model are b0 the intercept and b1 the slope of the line. The variables Tt, the fitted forecast for period t, are definitional variables, as discussed in Chapter 5. Note that none of these are restricted to be nonnegative. This model will have n 2 decision variables and n constraints, one for each data point in the time series.
NOTES AND COMMENTS 1. The optimization model given by equations (15.9) and (15.10) is easily generalized for other types of models. Given the objective is to minimize the sum of squared errors, to test a different forecasting model, you only need to change the form of equation (15.10). We will see an example of this in the forthcoming seciton on nonlinear trend. Examples of both LINGO and Excel Solver models are provided in the appendices to this chapter.
2. Statistical packages such as Minitab and SAS, as well as Excel have routines to perform curve fitting under the label regression analysis. Regression analysis solves the curve-fitting problem of minimizing the sum of squared error, but also under certain assumptions, allows the analyst to make statistical statements about the parameters and the forecasts.
Nonlinear Trend The use of a linear function to model trend is common. However, as we discussed previously, sometimes time series have a curvilinear or nonlinear trend. As an example, consider the annual revenue in millions of dollars for a cholesterol drug for the first ten years of sales. Table 15.13 shows the time series and Figure 15.11 shows the corresponding time series plot. For instance, revenue in year 1 was $23.1 million; revenue in year 2 was $21.3 million; and so on. The time series plot indicates an overall increasing or upward trend. But, unlike the bicycle sales time series, a linear trend does not appear to be appropriate. Instead, a curvilinear function appears to be needed to model the long-term trend.
15.4
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Trend Projection
TABLE 15.13 CHOLESTEROL REVENUE TIME SERIES ($ MILLIONS)
WEB
Year 1 2 3 4 5 6 7 8 9 10
file
Cholesterol
Revenue ($ millions) 23.1 21.3 27.4 34.6 33.8 43.2 59.5 64.4 74.2 99.3
Quadratic Trend Equation A variety of nonlinear functions can be used to develop an estimate of the trend for the cholesterol time series. For instance, consider the following quadratic trend equation: Tt b 0 b1t b 2t 2
(15.11)
For the cholesterol time series, t 1 corresponds to year 1, t 2 corresponds to year 2, and so on. Let us construct the optimization model to find the values of b0, b1, and b2 that minimize the sum of squared errors. Note that we need the value of t and the value of t2 for each period.
CHOLESTEROL REVENUE TIMES SERIES PLOT ($ MILLIONS)
120 100 Revenue
FIGURE 15.11
80 60 40 20
1
2
3
4
5 Year
6
7
8
9
10
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The model to find the best values of b0, b1, and b2 so that the sum of squared error is minimized is as follows: Min {(23.1 T1)2 (21.3 T2)2 (27.4 T3)2 (34.6 T4)2 (33.8 T5)2 (43.2 T6)2 (59.5 T7)2 (64.4 T8)2 (74.2 T9)2 (99.3 T10)2} s.t. T1 b0 b11 b21
WEB file
T2 b0 b12 b24
Cholesterol_Quad
T3 b0 b13 b29 T4 b0 b14 b216 T5 b0 b15 b225 T6 b0 b16 b236 T7 b0 b17 b249 T8 b0 b18 b264 T9 b0 b19 b281 T10 b0 b110 b2100 This model may be solved with Excel Solver or LINGO. The optimal values from this optimization are b0 24.182, b1 –2.11, and b2 0.922 with a sum of squared errors of 110.65 and an MSE 110.65/10 11.065. The fitted curve is therefore Tt 24.182 2.11 t 0.922 t2 Figure 15.12 shows the observed data along with this curve. TIME SERIES QUADRATIC TREND FOR THE CHOLESTEROL SALES TIME SERIES
120 100 Revenue
FIGURE 15.12
80 60
Revenue
40 Forecast
20
1
2
3
4
5 Year
6
7
8
9
10
15.5
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Seasonality
Exponential Trend Equation Another alternative that can be used to model the nonlinear pattern exhibited by the cholesterol time series is to fit an exponential model to the data. For instance, consider the following exponential growth trend equation:
Tt b0 (b1)t
(15.12)
Like equation (15.11), this model is a nonlinear function of period t. As with the quadratic case, we can update equation (15.12) to yield the values of b0 and b1 that minimize the sum of squared errors. For the cholesterol sales data, minimizing the sum of squared errors yields the following curve-fitting model: Min {(23.1 T1)2 (21.3 T2)2 (27.4 T3)2 (34.6 T4)2 (33.8 T5)2 (43.2 T6)2 (59.5 T7)2 (64.4 T8)2 (74.2 T9)2 (99.3 T10)2} s.t. T1 b0 b11
WEB
T2 b0 b12
file
T3 b0 b13 T4 b0 b14
Cholesterol_Exp
T5 b0 b15 T6 b0 b16 T7 b0 b17 T8 b0 b18 T9 b0 b19 T10 b0 b110 This may be solved with LINGO or Excel Solver. The optimal values are b0 15.42 and b1 1.2 with a sum of squared errors of 123.12 and an MSE 123.12/10 12.312. Based on MSE, the quadratic model provides a better fit than the exponential model. NOTES AND COMMENTS The exponential model (15.12) is nonlinear and the curve-fitting optimization based on it can be difficult to solve. We suggest using a number of different starting values to ensure that the solution found
15.5
is a global optimum. Also, we found it helpful to bound b0 and b1 away from zero (add constraints b0 Ú 0.01 and b1 Ú 0.01).
SEASONALITY In this section we show how to develop forecasts for a time series that has a seasonal pattern. To the extent that seasonality exists, we need to incorporate it into our forecasting models to ensure accurate forecasts. We begin the section by considering a seasonal time series with no trend and then discuss how to model seasonality with trend.
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Seasonality Without Trend As an example, consider the number of umbrellas sold at a clothing store over the past five years. Table 15.14 shows the time series and Figure 15.13 shows the corresponding time series plot. The time series plot does not indicate any long-term trend in sales. In fact, unless you look carefully at the data, you might conclude that the data follow a horizontal pattern and that single exponential smoothing could be used to forecast sales. However, closer inspection of the time series plot reveals a pattern in the data. That is, the first and third quarters have moderate sales, the second quarter has the highest sales, and the fourth quarter tends to be the lowest quarter in terms of sales volume. Thus, we would conclude that a quarterly seasonal pattern is present. We can model a time series with a seasonal pattern by treating the season as a categorical variable. Categorical variables are data used to categorize observations of data. When a categorical variable has k levels, k 1 dummy or 0-1 variables are required. So, if there are four seasons, we need three dummy variables. For instance, in the umbrella sales time series the quarter each observation corresponds to is treated as a season; it is a categorical variable with four levels: Quarter 1, Quarter 2, Quarter 3, and Quarter 4. Thus, to model the seasonal effects in the umbrella time series we need 4 1 3 dummy variables. The three dummy variables can be coded as follows: Qtr1 = e
1 if Quarter 1 0 otherwise
Qtr2= e
1 if Quarter 2 0 otherwise
Qtr3 = e
1 if Quarter 3 0 otherwise
Using Ft to denote the forecasted value of sales for period t, the general form of the equation relating the number of umbrellas sold to the quarter the sale takes place follows: Ft b0 b1 Qtr1t b2 Qtr2t b3 Qtr3t TABLE 15.14 UMBRELLA SALES TIME SERIES Year 1
2
WEB
file
Umbrella
3
4
5
Quarter 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4
Sales 125 153 106 88 118 161 133 102 138 144 113 80 109 137 125 109 130 165 128 96
15.5
FIGURE 15.13
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Seasonality
UMBRELLA SALES TIME SERIES PLOT
180 160 140 Sales
120 100 80 60 40 20 0
1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 Year 1
Year 2
Year 3
Year 4
Year 5
Year/Quarter
Table 15.15 is the umbrella sales time series with the coded values of the dummy variables shown. We may use an optimization model to find the values of b0, b1, b2, and b3 that minimize the sum of squared error. The model is as follows: Min {(125 F1)2 (153 F2)2 (106 F3)2 . . . (96 F20)2}
WEB
file
Umbrella_Seas
Note that we have numbered the observations in Table 15.15 as periods 1–20. For example, year 3, quarter 3 is observation 11.
s.t. F1 b0 1b1 0b2 0b3 F2 b0 0b1 1b2 0b3 F3 b0 0b1 0b2 1b3 F4 b0 0b1 0b2 0b3 . . . F17 b0 1b1 0b2 0b3 F18 b0 0b1 1b2 0b3 F19 b0 0b1 0b2 1b3 F20 b0 0b1 0b2 0b3 This model may be solved with LINGO or Excel Solver. Using the data in Table 15.15 and the above optimization model, we obtained the following equation:
Ft 95.0 29.0 Qtr1t 57.0 Qtr2t 26.0 Qtr3t
(15.13)
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TABLE 15.15 Period 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Time Series Analysis and Forecasting
UMBRELLA SALES TIME SERIES WITH DUMMY VARIABLES Year 1
2
3
4
5
Quarter 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4
Qtr1 1 0 0 0 1 0 0 0 1 0 0 0 1 0 0 0 1 0 0 0
Qtr2 0 1 0 0 0 1 0 0 0 1 0 0 0 1 0 0 0 1 0 0
Qtr3 0 0 1 0 0 0 1 0 0 0 1 0 0 0 1 0 0 0 1 0
Sales 125 153 106 88 118 161 133 102 138 144 113 80 109 137 125 109 130 165 128 96
We can use equation (15.13) to forecast quarterly sales for next year. Quarter 1: Sales 95.0 29.0(1) 57.0(0) 26.0(0) 124 Quarter 2: Sales 95.0 29.0(0) 57.0(1) 26.0(0) 152 Quarter 3: Sales 95.0 29.0(0) 57.0(0) 26.0(1) 121 Quarter 4: Sales 95.0 29.0(0) 57.0(1) 26.0(0) 95 It is interesting to note that we could have obtained the quarterly forecasts for next year by simply computing the average number of umbrellas sold in each quarter, as shown in the following table:
Year 1 2 3 4 5 Average
Quarter 1 125 118 138 109 130 124
Quarter 2 153 161 144 137 165 152
Quarter 3 106 133 113 125 128 121
Quarter 4 88 102 80 109 96 95
Nonetheless, for more complex types of problem situations, such as dealing with a time series that has both trend and seasonal effects, this simple averaging approach will not work.
15.5
737
Seasonality
TABLE 15.16
TELEVISION SET SALES TIME SERIES Year 1
Quarter 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4
2
WEB
file
TVSales
3
4
Sales (1000s) 4.8 4.1 6.0 6.5 5.8 5.2 6.8 7.4 6.0 5.6 7.5 7.8 6.3 5.9 8.0 8.4
Seasonality and Trend We now extend the curve-fitting approach to include situations where the time series contains both a seasonal effect and a linear trend, by showing how to forecast the quarterly television set sales time series introduced in Section 15.1. The data for the television set time series are shown in Table 15.16. The time series plot in Figure 15.14 indicates that sales are lowest in the second quarter of each year and increase in quarters 3 and 4. Thus, we conclude that a seasonal pattern exists for television set sales. But the time series also has an upward linear trend that will need to be accounted for in order to develop accurate forecasts of quarterly sales. This is easily done by combining the dummy variable approach for handling seasonality with the approach we discussed in Section 15.3 for handling linear trend. The general form of the equation for modeling both the quarterly seasonal effects and the linear trend in the television set time series is Ft b0 b1 Qtr1t b2 Qtr2t b3 Qtr3t b4t where
WEB
file
TVSales_Seas_Trend
Ft forecast of sales in period t Qtr1t 1 if time period t corresponds to the first quarter of the year; 0 otherwise Qtr2t 1 if time period t corresponds to the second quarter of the year; 0 otherwise Qtr3t 1 if period t corresponds to the third quarter of the year; 0 otherwise t time period Table 15.17 is the revised television set sales time series that includes the coded values of the dummy variables and the time period t. Using the data in Table 15.17 with the sum
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Time Series Analysis and Forecasting
TELEVISION SET SALES TIME SERIES PLOT
9.0 Quarterly Television Set Sales (1000s)
FIGURE 15.14
Chapter 15
8.0
7.0
6.0
5.0
4.0 1
2
3
4
1
Year 1
2
3
4
Year 2
1
2
3
4
1
Year 3
2
3
4
Year 4
Year/Quarter
TABLE 15.17 TELEVISION SET SALES TIME SERIES WITH DUMMY VARIABLES AND TIME PERIOD Period 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Year 1
2
3
4
Quarter 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4
Qtr1 1 0 0 0 1 0 0 0 1 0 0 0 1 0 0 0
Qtr2 0 1 0 0 0 1 0 0 0 1 0 0 0 1 0 0
Qtr3 0 0 1 0 0 0 1 0 0 0 1 0 0 0 1 0
Period 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Sales (1000s) 4.8 4.1 6.0 6.5 5.8 5.2 6.8 7.4 6.0 5.6 7.5 7.8 6.3 5.9 8.0 8.4
15.5
Seasonality
739
of squared error minimization model with the seasonal and trend components, we obtain the following equation: Ft 6.07 1.36 Qtr1t 2.03 Qtr2t 0.304 Qtr3t 0.146 t
(15.14)
We can now use equation (15.14) to forecast quarterly sales for next year. Next year is year 5 for the television set sales time series; that is, time periods 17, 18, 19, and 20. Forecast for Time Period 17 (quarter 1 in year 5) F17 6.07 1.36(1) 2.03(0) 0.304(0) 0.146(17) 7.19 Forecast for Time Period 18 (quarter 2 in year 5) F18 6.07 1.36(0) 2.03(1) 0.304(0) 0.146(18) 6.67 Forecast for Time Period 19 (quarter 3 in year 5) F19 6.07 1.36(0) 2.03(0) 0.304(1) 0.146(19) 8.54 Forecast for Time Period 20 (quarter 4 in year 5) F20 6.07 1.36(0) 2.03(0) 0.304(0) 0.146(20) 8.99 Thus, accounting for the seasonal effects and the linear trend in television set sales, the estimates of quarterly sales in year 5 are 7190, 6670, 8540, and 8990. The dummy variables in the equation actually provide four equations, one for each quarter. For instance, if time period t corresponds to quarter 1, the estimate of quarterly sales is Quarter 1: Sales 6.07 1.36(1) 2.03(0) 0.304(0) 0.146t 4.71 0.146t Similarly, if time period t corresponds to quarters 2, 3, and 4, the estimates of quarterly sales are Quarter 2: Sales 6.07 1.36(0) 2.03(1) 0.304(0) 0.146t 4.04 0.146t Quarter 3: Sales 6.07 1.36(0) 2.03(0) 0.304(1) 0.146t 5.77 0.146t Quarter 4: Sales 6.07 1.36(0) 2.03(0) 0.304(0) 0.146t 6.07 0.146t The slope of the trend line for each quarterly forecast equation is 0.146, indicating a growth in sales of about 146 sets per quarter. The only difference in the four equations is that they have different intercepts.
Models Based on Monthly Data In the preceding television set sales example, we showed how dummy variables can be used to account for the quarterly seasonal effects in the time series. Because there were four levels for the categorical variable season, three dummy variables were required. However, many businesses use monthly rather than quarterly forecasts. For monthly data, season is a
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categorical variable with 12 levels and thus 12 - 1 = 11 dummy variables are required. For example, the 11 dummy variables could be coded as follows: Month1 = e
1 if January 0 otherwise
Month2 = e
1 if February 0 otherwise
. . .
Whenever a categorical variable such as season has k levels, k – 1 dummy variables are required.
Month11 = e
1 if November 0 otherwise
Other than this change, the approach for handling seasonality remains the same.
SUMMARY This chapter provided an introduction to the basic methods of time series analysis and forecasting. First, we showed that the underlying pattern in the time series can often be identified by constructing a time series plot. Several types of data patterns can be distinguished, including a horizontal pattern, a trend pattern, and a seasonal pattern. The forecasting methods we have discussed are based on which of these patterns are present in the time series. For a time series with a horizontal pattern, we showed how moving averages and exponential smoothing can be used to develop a forecast. The moving averages method consists of computing an average of past data values and then using that average as the forecast for the next period. In the exponential smoothing method, a weighted average of past time series values is used to compute a forecast. These methods also adapt well when a horizontal pattern shifts to a different level but maintains a horizontal pattern at the new level. An important factor in determining what forecasting method to use involves the accuracy of the method. We discussed three measures of forecast accuracy: mean absolute error (MAE), mean squared error (MSE), and mean absolute percentage error (MAPE). Each of these measures is designed to determine how well a particular forecasting method is able to reproduce the time series data that are already available. By selecting a method that has the best accuracy for the data already known, we hope to increase the likelihood that we will obtain better forecasts for future time periods. For time series that have only a long-term linear trend, we showed how curve fitting can be used to make trend projections. For a time series with a curvilinear or nonlinear trend, we showed how curve-fitting optimization can be used to fit a quadratic trend equation or an exponential trend equation to the data. For a time series with a seasonal trend, we showed how the use of dummy variables can be used to develop an equation with seasonal effects. We then extended the approach to include situations where the time series contains both a seasonal and a linear trend effect by showing how to combine the dummy variable approach for handling seasonality with the approach for handling linear trend.
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GLOSSARY Time series A sequence of observations on a variable measured at successive points in time or over successive periods of time. Time series plot A graphical presentation of the relationship between time and the time series variable. Time is shown on the horizontal axis and the time series values are shown on the verical axis. Stationary time series A time series whose statistical properties are independent of time. For a stationary time series the process generating the data has a constant mean and the variability of the time series is constant over time. Trend pattern A trend pattern exists if the time series plot shows gradual shifts or movements to relatively higher or lower values over a longer period of time. Seasonal pattern A seasonal pattern exists if the time series plot exhibits a repeating pattern over successive periods. The successive periods are often one-year intervals, which is where the name seasonal pattern comes from. Cyclical pattern A cyclical pattern exists if the time series plot shows an alternating sequence of points below and above the trend line lasting more than one year. Forecast error
The difference between the actual time series value and the forecast.
Mean absolute error (MAE) The average of the absolute values of the forecast errors. Mean squared error (MSE)
The average of the sum of squared forecast errors.
Mean absolute percentage error (MAPE) percentage forecast errors.
The average of the absolute values of the
Moving averages A forecasting method that uses the average of the most recent k data values in the time series as the forecast for the next period. Weighted moving averages A forecasting method that involves selecting a different weight for the most recent k data values values in the time series and then computing a weighted average of the values. The sum of the weights must equal 1. Exponential smoothing A forecasting method that uses a weighted average of past time series values as the forecast; it is a special case of the weighted moving averages method in which we select only one weight—the weight for the most recent observation. Smoothing constant A parameter of the exponential smoothing model that provides the weight given to the most recent time series value in the calculation of the forecast value.
PROBLEMS 1. Consider the following time series data: Week
1
2
3
4
5
6
Value
18
13
16
11
17
14
Using the naïve method (most recent value) as the forecast for the next week, compute the following measures of forecast accuracy: a. Mean absolute error b. Mean squared error
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c. Mean absolute percentage error d. What is the forecast for week 7? 2. Refer to the time series data in Problem 1. Using the average of all the historical data as a forecast for the next period, compute the following measures of forecast accuracy: a. Mean absolute error b. Mean squared error c. Mean absolute percentage error d. What is the forecast for week 7? 3. Problems 1 and 2 used different forecasting methods. Which method appears to provide the more accurate forecasts for the historical data? Explain. 4. Consider the following time series data: Month
1
2
3
4
5
6
7
Value
24
13
20
12
19
23
15
a. Compute MSE using the most recent value as the forecast for the next period. What is the forecast for month 8? b. Compute MSE using the average of all the data available as the forecast for the next period. What is the forecast for month 8? c. Which method appears to provide the better forecast? 5. Consider the following time series data: Week
1
2
3
4
5
6
Value
18
13
16
11
17
14
a. Construct a time series plot. What type of pattern exists in the data? b. Develop a three-week moving average for this time series. Compute MSE and a forecast for week 7. c. Use a 0.2 to compute the exponential smoothing values for the time series. Compute MSE and a forecast for week 7. d. Compare the three-week moving average forecast with the exponential smoothing forecast using a 0.2. Which appears to provide the better forecast based on MSE? Explain. e. Use Excel Solver or LINGO to find the value of a that minimizes MSE. (Hint: Minimize the sum of squared error.) 6. Consider the following time series data: Month
1
2
3
4
5
6
7
Value
24
13
20
12
19
23
15
a. Construct a time series plot. What type of pattern exists in the data? b. Develop a three-week moving average for this time series. Compute MSE and a forecast for week 8. c. Use a 0.2 to compute the exponential smoothing values for the time series. Compute MSE and a forecast for week 8.
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Problems
d. Compare the three-week moving average forecast with the exponential smoothing forecast using a 0.2. Which appears to provide the better forecast based on MSE? e. Use Excel Solver or LINGO to find the value of a that minimizes MSE. (Hint: Minimize the sum of squared error.)
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Gasoline
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Gasoline
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Gasoline
7. Refer to the gasoline sales time series data in Table 15.1. a. Compute four-week and five-week moving averages for the time series. b. Compute the MSE for the four-week and five-week moving average forecasts. c. What appears to be the best number of weeks of past data (three, four, or five) to use in the moving average computation? Recall that MSE for the three-week moving average is 10.22. 8. Refer again to the gasoline sales time series data in Table 15.1. a. Using a weight of ¹⁄₂ for the most recent observation, ¹⁄₃ for the second most recent, and ¹⁄₆ for third most recent, compute a three-week weighted moving average for the time series. b. Compute the MSE for the weighted moving average in part (a). Do you prefer this weighted moving average to the unweighted moving average? Remember that the MSE for the unweighted moving average is 10.22. c. Suppose you are allowed to choose any weights as long as they sum to 1. Could you always find a set of weights that would make the MSE at least as small as for a weighted moving average than for an unweighted moving average? Why or why not? 9.
With the gasoline time series data from Table 15.1, show the exponential smoothing forecasts using a 0.1. a. Applying the MSE measure of forecast accuracy, would you prefer a smoothing constant of a 0.1 or a 0.2 for the gasoline sales time series? b. Are the results the same if you apply MAE as the measure of accuracy? c. What are the results if MAPE is used?
10. With a smoothing constant of a 0.2, equation (15.5) shows that the forecast for week 13 of the gasoline sales data from Table 15.1 is given by F13 0.2Y12 0.8F12. However, the forecast for week 12 is given by F12 0.2Y11 0.8F11. Thus, we could combine these two results to show that the forecast for week 13 can be written F13 0.2Y12 0.8(0.2Y11 0.8F11) 0.2Y12 0.16Y11 0.64F11 a. Making use of the fact that F11 0.2Y10 0.8F10 (and similarly for F10 and F9), continue to expand the expression for F13 until it is written in terms of the past data values Y12, Y11, Y10, Y9, Y8, and the forecast for period 8. b. Refer to the coefficients or weights for the past values Y12, Y11, Y10, Y9, Y8; what observation can you make about how exponential smoothing weights past data values in arriving at new forecasts? Compare this weighting pattern with the weighting pattern of the moving averages method. 11. For the Hawkins Company, the monthly percentages of all shipments received on time over the past 12 months are 80, 82, 84, 83, 83, 84, 85, 84, 82, 83, 84, and 83. a. Construct a time series plot. What type of pattern exists in the data? b. Compare a three-month moving average forecast with an exponential smoothing forecast for a 0.2. Which provides the better forecasts using MSE as the measure of model accuracy? c. What is the forecast for next month? 12. Corporate triple A bond interest rates for 12 consecutive months follow: 9.5
9.3
9.4
9.6
9.8
9.7
9.8
10.5
9.9
9.7
9.6
9.6
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a. Construct a time series plot. What type of pattern exists in the data? b. Develop three-month and four-month moving averages for this time series. Does the three-month or four-month moving average provide the better forecasts based on MSE? Explain. c. What is the moving average forecast for the next month? 13. The values of Alabama building contracts (in millions of dollars) for a 12-month period follow: 240
350
230
260
280
320
220
310
240
310
240
230
a. Construct a time series plot. What type of pattern exists in the data? b. Compare a three-month moving average forecast with an exponential smoothing forecast. Use a 0.2. Which provides the better forecasts based on MSE? c. What is the forecast for the next month? 14. The following time series shows the sales of a particular product over the past 12 months: Month
Sales
Month
Sales
1 2 3 4 5 6
105 135 120 105 90 120
7 8 9 10 11 12
145 140 100 80 100 110
a. Construct a time series plot. What type of pattern exists in the data? b. Use a 0.3 to compute the exponential smoothing values for the time series. c. Use Excel Solver or LINGO to find the value of a that minimizes MSE. (Hint: Minimize the sum of squared error.) 15. Ten weeks of data on the Commodity Futures Index are 7.35, 7.40, 7.55, 7.56, 7.60, 7.52, 7.52, 7.70, 7.62, and 7.55. a. Construct a time series plot. What type of pattern exists in the data? b. Use Excel Solver or LINGO to find the value of a that minimizes MSE. (Hint: Minimize the sum of squared error.)
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Masters
16. The Nielsen ratings (percentage of U.S. households that tuned in) for the Masters golf tournament from 1997 through 2008 follow (Golf Magazine, January 2009):
Year 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Rating 11.2 8.6 7.9 7.6 10.7 8.1 6.9 6.7 8.0 6.9 7.6 7.3
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Problems
The rating of 11.2 in 1997 indicates that 11.2% of U.S. households tuned in to watch Tiger Woods win his first major golf tournament and become the first African-American to win the Masters. Tiger Woods also won the Masters in 2001 and 2005. a. Construct a time series plot. What type of pattern exists in the data? Discuss some of the factors that may have resulted in the pattern exhibited in the time series plot for this time series. b. Given the pattern of the time series plot developed in part (a), do you think the forecasting methods discussed in this section are appropriate to develop forecasts for this time series? Explain. c. Would you recommend using only the Nielsen ratings for 2002–2008 to forecast the rating for 2009, or should the entire time series from 1997–2008 be used? Explain. 17. Consider the following time series: t
1
2
3
4
5
Yt
6
11
9
14
15
a. Construct a time series plot. What type of pattern exists in the data? b. Use Excel Solver or LINGO to find the parameters for the line that minimizes MSE this time series. c. What is the forecast for t 6? 18. The following table reports the percentage of stocks in a portfolio for nine quarters from 2007 to 2009: Quarter
Stock %
1st—2007 2nd—2007 3rd—2007 4th—2007 1st—2008 2nd—2008 3rd—2008 4th—2008 1st—2009
29.8 31.0 29.9 30.1 32.2 31.5 32.0 31.9 30.0
a. Construct a time series plot. What type of pattern exists in the data? b. Use exponential smoothing to forecast this time series. Using Excel Solver or LINGO find the value of a that minimizes the sum of squared error. c. What is the forecast of the percentage of stocks in a typical portfolio for the second quarter of 2009? 19. Consider the following time series: t Yt
1
2
120 110
3
4
5
6
7
100
96
94
92
88
a. Construct a time series plot. What type of pattern exists in the data? b. Use Excel Solver or LINGO to find the parameters for the line that minimizes MSE this time series. c. What is the forecast for t 8?
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20. Consider the following time series: t
1
2
3
4
5
6
7
Yt
82
60
44
35
30
29
35
a. Construct a time series plot. What type of pattern exists in the data? b. Using LINGO or EXCEL Solver, develop the quadratic trend equation for the time series. c. What is the forecast for t 8? 21. Because of high tuition costs at state and private universities, enrollments at community colleges have increased dramatically in recent years. The following data show the enrollment (in thousands) for Jefferson Community College from 2001–2009: Year
Period (t)
Enrollment (1000s)
2001 2002 2003 2004 2005 2006 2007 2008 2009
1 2 3 4 5 6 7 8 9
6.5 8.1 8.4 10.2 12.5 13.3 13.7 17.2 18.1
a. Construct a time series plot. What type of pattern exists in the data? b. Use Excel Solver or LINGO to find the parameters for the line that minimizes MSE this time series. c. What is the forecast for 2010? 22. The Seneca Children’s Fund (SCC) is a local charity that runs a summer camp for disadvantaged children. The fund’s board of directors has been working very hard over recent years to decrease the amount of overhead expenses, a major factor in how charities are rated by independent agencies. The following data show the percentage of the money SCC has raised that were spent on administrative and fund-raising expenses for 2003–2009: Year
Period (t)
Expense (%)
2003 2004 2005 2006 2007 2008 2009
1 2 3 4 5 6 7
13.9 12.2 10.5 10.4 11.5 10.0 8.5
a. Construct a time series plot. What type of pattern exists in the data? b. Use Excel Solver or LINGO to find the parameters for the line that minimizes MSE this time series. c. Forecast the percentage of administrative expenses for 2010. d. If SCC can maintain their current trend in reducing administrative expenses, how long will it take them to achieve a level of 5% or less?
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Problems
23. The president of a small manufacturing firm is concerned about the continual increase in manufacturing costs over the past several years. The following figures provide a time series of the cost per unit for the firm’s leading product over the past eight years: Year
Cost/Unit ($)
Year
Cost/Unit ($)
1 2 3 4
20.00 24.50 28.20 27.50
5 6 7 8
26.60 30.00 31.00 36.00
a. Construct a time series plot. What type of pattern exists in the data? b. Use Excel Solver or LINGO to find the parameters for the line that minimizes MSE this time series. c. What is the average cost increase that the firm has been realizing per year? d. Compute an estimate of the cost/unit for next year.
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Exchange Rate
24. FRED® (Federal Reserve Economic Data), a database of more than 3000 U.S. economic time series, contains historical data on foreign exchange rates. The following data show the foreign exchange rate for the United States and China (http://research.stlouisfed.org/fred2/). The units for Rate are the number of Chinese yuan renmimbis to one U.S. dollar. Year
Month
Rate
2007 2007 2007 2008 2008 2008 2008 2008 2008 2008
October November December January February March April May June July
7.5019 7.4210 7.3682 7.2405 7.1644 7.0722 6.9997 6.9725 6.8993 6.8355
a. Construct a time series plot. Does a linear trend appear to be present? b. Use Excel Solver or LINGO to find the parameters for the line that minimizes MSE this time series. c. Use the trend equation to forecast the exchange rate for August 2008. d. Would you feel comfortable using the trend equation to forecast the exchange rate for December 2008? 25. Automobile unit sales at B. J. Scott Motors, Inc., provided the following 10-year time series: Year
Sales
Year
Sales
1 2 3 4 5
400 390 320 340 270
6 7 8 9 10
260 300 320 340 370
a. Construct a time series plot. Comment on the appropriateness of a linear trend. b. Using Excel Solver or LINGO, develop a quadratic trend equation that can be used to forecast sales.
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c. Using the trend equation developed in part (b), forecast sales in year 11. d. Suggest an alternative to using a quadratic trend equation to forecast sales. Explain.
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Pasta
26. Giovanni Food Products produces and sells frozen pizzas to public schools throughout the eastern United States. Using a very aggressive marketing strategy they have been able to increase their annual revenue by approximately $10 million over the past 10 years. But, increased competition has slowed their growth rate in the past few years. The annual revenue, in millions of dollars, for the previous 10 years is shown below. Year
Revenue
1 2 3 4 5 6 7 8 9 10
8.53 10.84 12.98 14.11 16.31 17.21 18.37 18.45 18.40 18.43
a. Construct a time series plot. Comment on the appropriateness of a linear trend. b. Using Excel Solver or LINGO, develop a quadratic trend equation that can be used to forecast revenue. c. Using the trend equation developed in part (b), forecast revenue in year 11.
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NFL Value
27. Forbes magazine (www.Forbes.com) ranks NFL teams by value each year. The data below are the value of the Indianapolis Colts from 1998 to 2008. Year
Period
Value ($ million)
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
1 2 3 4 5 6 7 8 9 10 11
227 305 332 367 419 547 609 715 837 911 1076
a. Construct a time series plot. What type of pattern exists in the data? b. Using Excel Solver or LINGO, develop the quadratic trend equation that can be used to forecast the team’s value. c. Using Excel Solver or LINGO, develop the exponential trend equation that can be used to forecast the team’s value. d. Using Excel Solver or LINGO, develop the linear trend equation that can be used to forecast the team’s value. e. Which equation would you recommend using to estimate the team’s value in 2009? f. Use the model you recommended in part (e) to forecast the value of the Colts in 2009.
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28. Consider the following time series: Quarter
Year 1
Year 2
Year 3
1 2 3 4
71 49 58 78
68 41 60 81
62 51 53 72
a. Construct a time series plot. What type of pattern exists in the data? b. Use an Excel or LINGO model with dummy variables as follows to develop an equation to account for seasonal effects in the data. Qtr1 1 if Quarter 1, 0 otherwise; Qtr2 1 if Quarter 2, 0 otherwise; Qtr3 1 if Quarter 3, 0 otherwise. c. Compute the quarterly forecasts for next year. 29. Consider the following time series data: Quarter
Year 1
Year 2
Year 3
1 2 3 4
4 2 3 5
6 3 5 7
7 6 6 8
a. Construct a time series plot. What type of pattern exists in the data? b. Use an Excel or LINGO model with dummy variables as follows to develop an equation to account for seasonal effects in the data. Qtr1 1 if Quarter 1, 0 otherwise; Qtr2 1 if Quarter 2, 0 otherwise; Qtr3 1 if Quarter 3, 0 otherwise. c. Compute the quarterly forecasts for next year. 30. The quarterly sales data (number of copies sold) for a college textbook over the past three years follow: Quarter
Year 1
Year 2
Year 3
1 2 3 4
1690 940 2625 2500
1800 900 2900 2360
1850 1100 2930 2615
a. Construct a time series plot. What type of pattern exists in the data? b. Use an Excel or LINGO model with dummy variables as follows to develop an equation to account for seasonal effects in the data. Qtr1 1 if Quarter 1, 0 otherwise; Qtr2 1 if Quarter 2, 0 otherwise; Qtr3 1 if Quarter 3, 0 otherwise. c. Compute the quarterly forecasts for next year. d. Let t 1 to refer to the observation in quarter 1 of year 1; t 2 to refer to the observation in quarter 2 of year 1; . . . and t 12 to refer to the observation in quarter 4 of year 3. Using the dummy variables defined in part (b) and t, develop an equation to account for seasonal effects and any linear trend in the time series. Based upon the seasonal effects in the data and linear trend, compute the quarterly forecasts for next year.
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Pollution
31. Air pollution control specialists in southern California monitor the amount of ozone, carbon dioxide, and nitrogen dioxide in the air on an hourly basis. The hourly time series data exhibit seasonality, with the levels of pollutants showing patterns that vary over the hours
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in the day. On July 15, 16, and 17, the following levels of nitrogen dioxide were observed for the 12 hours from 6:00 A.M. to 6:00 P.M.
July 15: July 16: July 17:
25 28 35
28 30 42
35 35 45
50 48 70
60 60 72
60 65 75
40 50 60
35 40 45
30 35 40
25 25 25
25 20 25
20 20 25
a. Construct a time series plot. What type of pattern exists in the data? b. Use an Excel or LINGO model with dummy variables as follows to develop an equation to account for seasonal effects in the data: Hour1 1 if the reading was made between 6:00 A.M. and 7:00 A.M.; 0 otherwise Hour2 1 if the reading was made between 7:00 A.M. and 8:00 A.M.; 0 otherwise . . . Hour11 1 if the reading was made between 4:00 P.M. and 5:00 P.M., 0 otherwise. Note that when the values of the 11 dummy variables are equal to 0, the observation corresponds to the 5:00 P.M. to 6:00 P.M. hour. c. Using the equation developed in part (b), compute estimates of the levels of nitrogen dioxide for July 18. d. Let t 1 refer to the observation in hour 1 on July 15; t 2 to refer to the observation in hour 2 of July 15; . . . and t 36 to refer to the observation in hour 12 of July 17. Using the dummy variables defined in part (b) and ts, develop an equation to account for seasonal effects and any linear trend in the time series. Based upon the seasonal effects in the data and the linear trend, compute estimates of the levels of nitrogen dioxide for July 18.
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SouthShore
32. South Shore Construction builds permanent docks and seawalls along the southern shore of Long Island, New York. Although the firm has been in business only five years, revenue has increased from $308,000 in the first year of operation to $1,084,000 in the most recent year. The following data show the quarterly sales revenue in thousands of dollars: Quarter
Year 1
Year 2
Year 3
Year 4
Year 5
1 2 3 4
20 100 175 13
37 136 245 26
75 155 326 48
92 202 384 82
176 282 445 181
a. Construct a time series plot. What type of pattern exists in the data? b. Use an Excel or LINGO model with dummy variables as follows to develop an equation to account for seasonal effects in the data. Qtr1 1 if Quarter 1, 0 otherwise; Qtr2 1 if Quarter 2, 0 otherwise; Qtr3 1 if Quarter 3, 0 otherwise. c. Let Period 1 to refer to the observation in quarter 1 of year 1; Period 2 to refer to the observation in quarter 2 of year 1; . . . and Period 20 refer to the observation in quarter 4 of year 5. Using the dummy variables defined in part (b) and Period, develop an equation to account for seasonal effects and any linear trend in the time series. Based upon the seasonal effects in the data and linear trend, compute estimates of quarterly sales for year 6.
Case Problem 2
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Forecasting Lost Sales
TABLE 15.18 FOOD AND BEVERAGE SALES FOR THE VINTAGE RESTAURANT ($1000s)
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Vintage
Month January February March April May June July August September October November December
Case Problem 1
First Year 242 235 232 178 184 140 145 152 110 130 152 206
Second Year 263 238 247 193 193 149 157 161 122 130 167 230
Third Year 282 255 265 205 210 160 166 174 126 148 173 235
FORECASTING FOOD AND BEVERAGE SALES
The Vintage Restaurant, on Captiva Island near Fort Myers, Florida, is owned and operated by Karen Payne. The restaurant just completed its third year of operation. During that time, Karen sought to establish a reputation for the restaurant as a high-quality dining establishment that specializes in fresh seafood. Through the efforts of Karen and her staff, her restaurant has become one of the best and fastest-growing restaurants on the island. To better plan for future growth of the restaurant, Karen needs to develop a system that will enable her to forecast food and beverage sales by month for up to one year in advance. Table 15.18 shows the value of food and beverage sales ($1000s) for the first three years of operation.
Managerial Report Perform an analysis of the sales data for the Vintage Restaurant. Prepare a report for Karen that summarizes your findings, forecasts, and recommendations. Include the following: 1. A time series plot. Comment on the underlying pattern in the time series. 2. Using the dummy variable approach, forecast sales for January through December of the fourth year. Assume that January sales for the fourth year turn out to be $295,000. What was your forecast error? If this error is large, Karen may be puzzled about the difference between your forecast and the actual sales value. What can you do to resolve her uncertainty in the forecasting procedure?
Case Problem 2
FORECASTING LOST SALES
The Carlson Department Store suffered heavy damage when a hurricane struck on August 31. The store was closed for four months (September through December), and Carlson is now involved in a dispute with its insurance company about the amount of lost sales during the time the store was closed. Two key issues must be resolved: (1) the
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TABLE 15.19 SALES FOR CARLSON DEPARTMENT STORE ($ MILLIONS)
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CarlsonSales
Month January February March April May June July August September October November December
Year 1
1.71 1.90 2.74 4.20
Year 2 1.45 1.80 2.03 1.99 2.32 2.20 2.13 2.43 1.90 2.13 2.56 4.16
Year 3 2.31 1.89 2.02 2.23 2.39 2.14 2.27 2.21 1.89 2.29 2.83 4.04
Year 4 2.31 1.99 2.42 2.45 2.57 2.42 2.40 2.50 2.09 2.54 2.97 4.35
Year 5 2.56 2.28 2.69 2.48 2.73 2.37 2.31 2.23
amount of sales Carlson would have made if the hurricane had not struck, and (2) whether Carlson is entitled to any compensation for excess sales due to increased business activity after the storm. More than $8 billion in federal disaster relief and insurance money came into the county, resulting in increased sales at department stores and numerous other businesses. Table 15.19 gives Carlson’s sales data for the 48 months preceding the storm. Table 15.20 reports total sales for the 48 months preceding the storm for all department stores in the county, as well as the total sales in the county for the four months the Carlson Department Store was closed. Carlson’s managers asked you to analyze these data and develop estimates of the lost sales at the Carlson Department Store for the months of September through December. They also asked you to determine whether a case can be made for excess storm-related sales during the same period. If such a case can be made, Carlson is entitled to compensation for excess sales it would have earned in addition to ordinary sales.
TABLE 15.20 DEPARTMENT STORE SALES FOR THE COUNTY ($ MILLIONS)
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CountySales
Month January February March April May June July August September October November December
Year 1
55.80 56.40 71.40 117.60
Year 2 46.80 48.00 60.00 57.60 61.80 58.20 56.40 63.00 57.60 53.40 71.40 114.00
Year 3 46.80 48.60 59.40 58.20 60.60 55.20 51.00 58.80 49.80 54.60 65.40 102.00
Year 4 43.80 45.60 57.60 53.40 56.40 52.80 54.00 60.60 47.40 54.60 67.80 100.20
Year 5 48.00 51.60 57.60 58.20 60.00 57.00 57.60 61.80 69.00 75.00 85.20 121.80
Appendix 15.1
Forecasting with Excel Data Analysis Tools
753
Managerial Report Prepare a report for the managers of the Carlson Department Store that summarizes your findings, forecasts, and recommendations. Include the following: 1. An estimate of sales for Carlson Department Store had there been no hurricane 2. An estimate of countywide department store sales had there been no hurricane 3. An estimate of lost sales for the Carlson Department Store for September through December In addition, use the countywide actual department stores sales for September through December and the estimate in part (2) to make a case for or against excess storm-related sales.
Appendix 15.1
FORECASTING WITH EXCEL DATA ANALYSIS TOOLS
In this appendix we show how Excel can be used to develop forecasts using three forecasting methods: moving averages, exponential smoothing, and trend projection. We also show how to use Excel Solver for least-squares fitting of models to data.
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Gasoline
Moving Averages To show how Excel can be used to develop forecasts using the moving averages method, we will develop a forecast for the gasoline sales time series in Table 15.1 and Figure 15.1. The sales data for the 12 weeks are entered into worksheet rows 2 through 13 of column B. The following steps can be used to produce a three-week moving average. Step 1. Click the Data tab on the Ribbon Step 2. In the Analysis group, click Data Analysis Step 3. Choose Moving Average from the list of Analysis Tools Click OK Step 4. When the Moving Average dialog box appears: Enter B2:B13 in the Input Range box Enter 3 in the Interval box Enter C2 in the Output Range box Click OK The three-week moving averages will appear in column C of the worksheet. The forecast for week 4 appears next to the sales value for week 3, and so on. Forecasts for periods of other length can be computed easily by entering a different value in the Interval box.
Exponential Smoothing To show how Excel can