Assessment & Performance

Session IV Regular, July 2009

Decision Tree

A Simple Decision Problem

In six months a proposal is due for an electronic timing system for the 2000 Olympic Game. The company develop a new microprocessor, a critical component in timing system. Unsure whether can produce the microprocessor in time. If success, excellent chance winning the $1,000,000 contract. Otherwise, small chance of winning. If continue, must invest $200,000 in research and development; $50,000 for developing prototype; and $150,000 to produce.

Qualitative Structuring
What are my alternatives ? What are the critical uncertainties that

affect the outcomes of my decisions ? What objectives am I trying to achieve in making a decision ? What decision criteria will I use to choose among the competing alternatives ?

Alternatives
Abandon the project altogether.

Avoid the

risks of failing to develop the microprocessor. Continue to invest in the project. At some point in time, may need to decide whether to make a proposal.

Uncertainties
Have to make decision without knowing

exactly what will happen in the future. Must consider the major uncertainties and make judgments about how likely these uncertain events are to occur.

Objectives
Decision making as means of achieving

objectives. What is the objective in this case ? Maximizing net cash flow. Choose alternative that yields the largest positive net cash flow.

Expected Monetary Value

How do you compare $10 vs. $20 ? $25 for sure vs. 0.50 chance at $60 ? Expected monetary value of 0.50 chance

at $60 is 0.50($60) + 0.50($0) = $30. Risk averse: $30 for sure is prefer to 0.50 chance at $60. Risk prone: 0.50 chance at $60 is prefer to $30 for sure.

It is six months prior to the proposal date, what can we do ? Abandoning the project Continue to invest in the project.

Continue

If continue, then what ?

Abandon

If abandon, then what ?

Succeed

Then what ?

Continue

Fail

Then what ?

Abandon

Make Proposal Succeed

Dont Make Proposal Continue Make Proposal Fail

Abandon

Dont Make Proposal

Win Make Proposal Succeed Lose

Dont Make Proposal Continue Make Proposal Fail

Win

Lose Dont Make Proposal Abandon

Uncertainty

Uncertainty is measured by probability. If the probability of an event is 0,then the event is impossible. If an even will happen for sure, then the probability of the event is 1. In our case, need to estimate the probability of successfully developing the microprocessor in 6 months, the probability of winning the contract in the case of success developing microprocessor, and the probability of winning contract in the case of failure in developing the microprocessor.

Win 0.90 Make Proposal Succeed 0.40 Dont Make Proposal Continue Make Proposal Fail 0.60 Dont Make Proposal Abandon Lose 0.95 Lose 0.10 Win 0.05

Win $515,000 Make Proposal $515,000 Succeed 0.40 $86,000 Continue -$200,000 -$200,000 Dont Make Proposal Make Proposal $86,000 Fail -$207,500 Lose Dont Make Proposal Abandon $0 0.95 Lose 0.90

$600,000

-$250,000

0.10 Win 0.05 $600,000

-$250,000

0.60

-$200,000

Sensitivity Analysis

Proactive Decision Making

Does not limit the evaluation of an

alternative to a single estimate of its potential performance. Acknowledge the likelihood of the possibilities.

Case: Holiday trinket

Development of holiday trinket for childrens breakfast cereal. Based on childrens preference panels, the trinket would expected to result in a 12 percent increase in volume. Childrens test panels are notoriously unreliable; the increase could be anywhere between 8 and 14 percent. It was forecasted that the sales without the trinket during the period is 6.5 million boxes plus or minus 2 percent. The production process and the distribution system are sufficiently flexible to permit production to match demand.

Case: Holiday trinket (Cont.)

The trinket cost: $0.10 per unit (if the supplier who has worked on its development can resume production in a timely fashion after a recent fire). Alternative sources for the trinket: additional trinket cost for $0.010 or $0.015 per unit. The trinket will be featured on the front and back of the box and the alteration to the boxs artwork would cost $125,000. Neither the art layout nor the production modification have been finalized, it is believed the final cost could be 20 percent higher to 5 percent lower than the initial estimate. The contribution per unit $1.48.

Best-Estimate Scenario
Assumption Forecast error in base volume Volume increase percentage Unit cost per trinket Artwork cost variance Base volume (boxes) Volume increase (boxes) Increase in contribution Trinket cost Artwork cost Incremental gross margin 0% 12% $0.10 0% 6,500,000 780.000 $1,154,400 $728,000 $125,000 $301,400

Optimistic and Pessimistic Scenarios

Assumption Forecast error in base volume Volume increase percentage Unit cost per trinket Artwork cost variance Base volume (boxes) Volume increase (boxes) Increase in contribution Trinket cost Artwork cost Incremental gross margin Optimistic Pessimistic 2% -2% 14% 8% $0.10 $0.115 -5% 20% 6,630,000 928,200 $1,373,736 $755,820 $118,750 $499,166 6,370,000 509,600 $754,208 $791,154 $150,000 ($186,946)

One-at-a-Time Sensitivity Analysis: Volume Increase Percentage

Assumption Forecast error in base volume Volume increase percentage Unit cost per trinket Artwork cost variance Base volume (boxes) Volume increase (boxes) Increase in contribution Trinket cost Artwork cost Incremental gross margin Lowest 0% 8% $0.10 0% 6,500,000 520,000 $769,600 $702,000 $125,000 ($57,400) Highest 0% 14% $0.10 0% 6,500,000 910,000 $1,346,800 $741,000 $125,000 $480,800

One-at-a-Time Sensitivity Analysis: All Uncertainties

Uncertainties Forecast error Volume increase percentage Unit cost per trinket Art cost variance

Lowest Value Value Performance -2% $292,872 8% - $57,400 $0.10 $301,400 -5% $307,650

Highest Value Value Performance 2% $309,928 14% $480,800 $0.115 $192,200 20% $276,400

Tornado Diagram
8% 14%

Volume increase percentage

$0.115

$0.10

Unit cost per trinket

20%

-5%

Artwork cost variance

-2%

2%

Forecast error

-100,000

100,000

200,000

300,000

400,000

500,000

Incremental gross margin

Threshold Analysis
The incremental gross margin is negative (-$57,400) whenever the volume increase percentage is 8%. At what value the volume increase percentage that make the gross margin is zero ?

Volume Increase Percentage 8% 9% 8.5%

Incremental Gross Margin - $57,400 $32,300 - $12,550

Algebraic Approach
X be the volume increase percentage that make the incremental gross margin is zero. The incremental gross margin: the increase in contribution, the trinket cost, the artwork cost. The increase in contribution: $1.48 * (6,500,000 * X) The trinket cost: $0.10 * (6,500,000 + (6,500,000 * X)) The artwork cost: $125,000 $1,48 * (6,500,000 * X) = $0.10 * (6,500,000 + (6,500,000 * X)) + $125,000 X = 0.0864