Module 5

Modeling Decisions
Sensitivity Analysis

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 Module 5
Sensitivity Analysis
Topics
-sensitivity analysis issues on decision modeling
-identifying and structuring problems
-dominance consideration in sensitivity analysis
-sensitivity analysis and probabilities
-tornado diagram and one-and two-way sensitivity graphs
-sensitivity analysis performance using TopRank and
Precision Tree program

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 Sensitivity Analysis
Learning Objectives
Effect of sensitivity analysis to the overall
decision-modeling strategy
Problem identification and structure
Solving the right problem
Error of the third kind

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 Sensitivity Analysis
Learning Objectives
Dominance among alternative
Use of tornado diagram
One and two-way sensitivity analysis
Probability assessment
Use of computer program TopRank for sensitivity
analysis

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 Sensitivity Analysis
The purpose of sensitivity analysis is to
refine the decision model
what makes a difference in each decision
Provide guidance for the development of a
requisite decision model
Eagle Airlines example

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 Eagle Airline
President of Eagle Airline would like to
expand his operation with the companys
extra cash
The mixture of charter flights and short
schedule flights are profitable, but this is
impossible without more aircraft
A piper Seneca is for sale at a price of
$95,000 with five seats for passengers

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 Eagle Airline
Operating cost:
Approximately $245 per hour
Annual fixed costs including insurance is about
$20,000
The company need to borrow 40% of the
money with 9.5% interest rate

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 Eagle Airline
Total revenue:
The Eagle Airline could charge $100 per person per
hour on schedule flight
Approximate 800 hours flight per year
If Eagle Airline lease the airplane for year with the
option to buy it would cost the company between $2500
to $4000
The Eagle Airline CEO could invest the extra cash in
the money market and expect to earn about 8%

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Problem Identification and Structure

As we discussed in chapter one, sensitivity

analysis can lead the decision maker to
reconsider the very nature of the problem
Are we solving the right problem?
Answering different question/addressing a
different problem or satisfying different
objective can lead to a very different
decision
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Problem Identification and Structure

Solving the wrong problem is called error

of the third kind or type III error
It implies that the wrong question was asked
To avoid the type III error, keep asking
whether the problem on the surface is the
real problem

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Problem Identification and Structure

Example: Eagle Airline

In this case Carothers (CEO of Eagle
Airline) eager to expand the operation by
acquiring more aircraft
The real question may be how to satisfy
Carotherss desires for expand rather than
simply how to acquire more airplanes

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Problem Identification and Structure
Decision situation can be represented in a variety
of different ways
Sensitivity Analysis can help to identify the
appropriate perspective on the problem as well as
by identifying the specific issues that matter to the
decision maker
In Eagle Airline case, the alternative to purchase
the airplane is the option to buy or neither

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Problem Identification and Structure

The main objective for Eagle Airline is to

maximize the profit
Using influence diagram to assess the
probabilities associated with various
unknown quantities such as operating costs,
amount of business

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Problem Identification and Structure

Paste figure 5.1 on page 178

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Problem Identification and Structure
Paste table 5.1 on page 179

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Problem Identification and Structure
By using the estimated variable in table 5.1 we can
calculate the annual profit
The annual profit would be the total annual
revenue minus the total annual cost:
Total Revenue = Revenue from charters +
Revenue from schedule flights
= (charter proportion x Hours flown x charter price)+[(1-charter
proportion) x hours flown x ticket price x number of passenger seats x
capacity of schedule flight]
= (0.5 x 800 x $325) + (0.5 x 800 x $100 x 5 x 0.5) = $230,000

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Problem Identification and Structure

Total Cost = (hours flown x operation cost)

+ insurance + finance cost
= (hours flown x operation cost) +
insurance + (price x proportion
financed x interest rate)
= (800 x $245) + $20,000 +
($87,500 x 0.4 x 11.5%)
= $220,025
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Problem Identification and Structure
By using the base values, Eagle Airline annual
profit is estimated to be $230,000 - $220,025 =
$9975
This represents a return of approximately 19% on
his investment of $52,500 (60% of the purchase
price)
He could place the $ 52,500 in money market
account with the 8% interest and earn $4200

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 Dominance Consideration
In chapter 4 we learned that alternative can
be screened on the basis of Dominance
Dominance means that one alternative,
called the dominating alternative, is always
preferred over another alternative
Identifying dominant alternative can be
viewed as a version of sensitivity analysis

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 Dominance Consideration
In case of Eagle Airline, the question is
whether purchasing the option is a
dominated alternative
Lets look at the option to purchase the new
airplane within a year:
It would let the Eagle Airline lock in a
favorable price
Wait and see if the economic climate change for
expansion becomes more favorable
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 Dominance Consideration
It is clear that, unless an inexpensive information-
gathering strategy presents itself, purchasing the
option probably is a dominated alternative
For the purpose of the further analysis, we will
assume that no such a information-gathering
strategy exists, and that purchasing the option is
unattractive
Two alternative will be consider:
Buying the airplane
Investing in the money market

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 Sensitivity Analysis Graphical
Techniques
One-Way Sensitivity Analysis (one
variable analysis)
In Eagle Airline case, what variables really make a
difference in terms of the decision at hand?
Lets consider Hours Flown in Eagle Airline case
Flown hours from table 5.1 can be between 500 to
1000 hours

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 One-Way Sensitivity Analysis
Paste figure 5.2 on page 180

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 One-Way Sensitivity Analysis
Con.figure 5.2 on page 180

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 Tornado Diagram
A tornado diagram allows us to compare
one-way sensitivity analysis for many input
variable at once
Tornado diagram for Eagle Airline

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 Tornado Diagram
Paste figure 5.3 from page 181

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 Two-Way Sensitivity Analysis
Two-Way Sensitivity Analysis ( Impact of
several variables at one time)
Two-Way Sensitivity Graph for Eagle
Airline:
Operating Cost
Capacity of Schedule Flight

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 Two-Way Sensitivity Analysis
Paste figure 5.4 on page 183

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 Sensitivity to Probabilities
In this section we will see how the two-way
sensitivity analysis can be used in
conjunction with probabilities
The three uncertain Critical Variables for
Eagle Airline
Capacity of Schedule Flights
Operation Cost
Hours Flown
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 Sensitivity to Probabilities
Paste figure 5.5 on page 185

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 Sensitivity to Probabilities
Paste figure 5.6 on page 186

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 Sensitivity to Probabilities
Paste figure 5.7 on page 186

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 Sensitivity to Probabilities
EMV (Purchase) =
0.5 {q[-9725r-4225(1-r)] + 18,275(1-0.8r)]} + 0.5{q[675r
+ 10,175(1-r]+(1-q)[16,925(0.8r) + 32,675(1-0.8r)]}
After algebraic simplification the equation become:
EMV (Purchase) = q(3500r-22,500) 11,000r + 25,475
Solve the inequality for q and r, If EMV (purchase) > 4200
then purchase the airplane
21,275-11,000r/22,500-3500r > q

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 Sensitivity to Probabilities
Paste figure 5.8 on page 188

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 Sensitivity Analysis
Sensitivity Analysis using Computer
programs:
Sensitivity Analysis using TopRank
Sensitivity Analysis using Precision Tree
Eagle Airline example using TopRank
Eagle Airline example using Precision Tree

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 Chapter 5 Summary
Sensitivity Analysis and decision modeling
Problem identification and structure
Dominance consideration in sensitivity analysis
Graphical sensitivity analysis such as tornado
diagrams, one-and two-way sensitivity graphs
We also discuss ways to perform sensitivity
analysis using computer software such as
TopRank and precision Tree

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