Question

Decision Making Tree Scenarios

• For the past several years, you’ve been purchasing a product from a supplier at a high-volume cost and reselling the product at a lower price than your customers could buy it.
• You’d like to improve the product, but the manufacturer isn’t interested in doing this
• Would it make sense (cents) to buy the equipment and make it yourself with better quality?

Create decision trees using the following Scenario Information. There are 2 Scenarios;

Scenario A

• Expected Money Value (EVM) or Expected Value
• Equipment = $500,000 + 100,000 for training
• Chances of a good market next year are 60% so chances of a poor market are 40%
• A good market will yield $1,000,000 in gross revenue; a poor market will yield $200,00 in gross revenue
• If you continue selling the product as you currently do, a good market will generate $300,000 in gross revenue and a poor market $50,000 in gross revenue. Estimated costs for working with your supplier are $30,000/yr.

Scenario B

• What if with a higher quality product, the probability for good market increases to 80% and the probability of a good/poor market for purchasing remain the same

Answer 1

Scenario A:

The Make cost of equipment and training for the make option = 600000

God Market = 60% chance

Poor Market = 40% chance

Hence the expected profit from the make option in both the conditions using the chances are as shown in the decision tree

Similarly, for the purchasing option, the expected profit is calculated.

Expected Profit for Make option = 8000

Expected profit for purchases option = 170000

Comparing the expected profits the purchase option yields better expected profits than the make option. So, it does not make sense to make it with better quality.

Scenario B:

In Scenario B, the probability of a good market increases with a higher quality product. So the probability of a good market for make option increases to 0.8 and the chances of poor market becomes 0.2. The revenue and cost are the same as scenario A, hence the calculation is as mentioned in the decision tree.

The probability of a poor market for purchasing remains the same. The chance of a poor market is 0.4. So in the purchase option, the chances of both good and poor remain the same as scenario A. the expected profit is as mentioned in the decision tree.

Expected Profit for Make option = 204000

Expected profit for purchases option = 170000

Comparing the expected profits of both the options, the expected profit of the make option with a higher quality product is more than the purchasing option. Hence making option should be considered.