Question

The product design group of Iyengar Electric​ Supplies, Inc., has determined that it needs to design a new series of switches. It must decide on one of three design strategies. The market forecast is for

200,000

units. The better and more sophisticated the design strategy and the more time spent on value​ engineering, the less will be the variable cost. The chief of engineering​ design, Dr. W. L.​ Berry, has decided that the following costs are a good estimate of the initial and variable costs connected with each of the three strategies explained below.

​Low-tech​:

a​ low-technology, low-cost process consisting of hiring several new junior engineers. This option has a fixed cost of

​40,000

and​ variable-cost probabilities of

0.5

for

​$0.54

0.1

for

​$0.49

and

0.4

for

​$0.47

Subcontract​:

a​ medium-cost approach using a good outside design staff. This approach would have a fixed cost of

​60,000

and​ variable-cost probabilities of

0.70.7

of

​$0.52

0.2

of

​$0.47

and

0.1

of

​$0.37

​High-tech​:

a​ high-technology approach using the very best of the inside staff and the latest​ computer-aided design technology. This approach has a fixed cost of

85,000

and​ variable-cost probabilities of

0.90

of

​$0.39

and

0.1

of

​$0.38

What is the best decision based on an expected monetary value​ (EMV) criterion?

​(Note​:

We want the lowest​ EMV, as we are dealing with costs in this​ problem.)

High-tech

Subcontract

Low-tech

Answer 1

We find EMV of each decision as shown below:

Low-tech option:

Fixed Cost = 40,000

Based on probability, expected variable cost = (0.5 * $0.54) + (0.1 * $0.49) + (0.4 * $0.47) = $0.507‬

Total Cost = Fixed cost + Total Variable cost = 40,000 + 0.507 * 200,000 units = $141,400‬

Subcontract​ option:

Fixed Cost = 60,000

Based on probability, expected variable cost = (0.7 * $0.52) + (0.2 * $0.47) + (0.1 * $0.37) = $0.495

Total Cost = Fixed cost + Total Variable cost = 60,000 + 0.495 * 200,000 units = $159,000

High-tech option:

Fixed Cost = 85,000

Based on probability, expected variable cost = (0.9 * $0.39) + (0.1 * $0.38) = $0.389

Total Cost = Fixed cost + Total Variable cost = 85,000 + 0.389 * 200,000 units = $162,800‬

As seen from above, low-tech has the lowest expected cost.

Hence, the best decision based on an expected monetary value​ (EMV) criterion is Low-tech

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