Whether you are deciding about getting a haircut today, building a multimillion-dollar plant, or buying a new camera, the steps in making a good decision are basically the same:

We use the Thompson Lumber Company case as an example to illustrate these decision theory steps. John Thompson is the founder and president of Thompson Lumber Company, a profitable firm located in Portland, Oregon.

1. Step 1. The problem that John Thompson identifies is whether to expand his product line by manufacturing and marketing a new product, backyard storage sheds.

2. Step 2. Thompson’s second step is to generate the alternatives that are available to him. In decision theory, an alternative is defined as a course of action or a strategy that the decision maker can choose. John decides that his alternatives are to construct (1) a large new plant to manufacture the storage sheds, (2) a small plant, or (3) no plant at all (i.e., he has the option of not developing the new product line).

   One of the biggest mistakes that decision makers make is to leave out some important alternatives. Although a particular alternative may seem to be inappropriate or of little value, it might turn out to be the best choice.

   The next step involves identifying the possible outcomes of the various alternatives. A common mistake is to forget about some of the possible outcomes. Optimistic decision makers tend to ignore bad outcomes, whereas pessimistic managers may discount a favorable outcome. If you don’t consider all possibilities, you will not be making a logical decision, and the results may be undesirable. If you do not think the worst can happen, you may design another Edsel automobile. In decision theory, those outcomes over which the decision maker has little or no control are called states of nature.

3. Step 3. Thompson determines that there are only two possible outcomes: the market for the storage sheds could be favorable, meaning that there is a high demand for the product, or it could be unfavorable, meaning that there is a low demand for the sheds.

   Once the alternatives and states of nature have been identified, the next step is to express the payoff resulting from each possible combination of alternatives and outcomes. In decision theory, we call such payoffs or profits conditional values. Not every decision, of course, can be based on money alone–-any appropriate means of measuring benefit is acceptable.

4. Step 4. Because Thompson wants to maximize his profits, he can use profit to evaluate each consequence.

   John Thompson has already evaluated the potential profits associated with the various outcomes. With a favorable market, he thinks a large facility would result in a net profit of $200,000 to his firm. This $200,000 is a conditional value because Thompson’s receiving the money is conditional upon both his building a large factory and having a good market. The conditional value if the market is unfavorable would be a $180,000 net loss. A small plant would result in a net profit of $100,000 in a favorable market, but a net loss of $20,000 would occur if the market was unfavorable. Finally, doing nothing would result in $0 profit in either market. The easiest way to present these values is by constructing a decision table, sometimes called a payoff table. A decision table for Thompson’s conditional values is shown in Table 3.1. All of the alternatives are listed down the left side of the table, and all of the possible outcomes or states of nature are listed across the top. The body of the table contains the actual payoffs.

5. Steps 5 and 6. The last two steps are to select a decision theory model and apply it to the data to help make the decision. Selecting the model depends on the environment in which you’re operating and the amount of risk and uncertainty involved.