Question

Case 9.4

The Ventron Engineering Company has just been awarded a $2 million development contract by the U.S. Army Aviation Systems Command to develop a blade spar for its Heavy Lift Helicopter program. The blade spar is a metal tube that runs the length of and provides strength to the helicopter blade. Due to the unusual length and size of the Heavy Lift Helicopter blade, Ventron is unable to produce a single-piece blade spar of the required dimensions using existing extrusion equipment and material. The engineering department has prepared two alternatives for developing the blade spar:

• (1)

  sectioning or

• (2)

  an improved extrusion process.

Ventron must decide which process to use. (Backing out of the contract at any point is not an option.) The risk report has been prepared by the engineering department. The information from this report is explained next.

The sectioning option involves joining several shorter lengths of extruded metal into a blade spar of sufficient length. This work will require extensive testing and rework over a 12-month period at a total cost of $1.8 million. Although this process will definitely produce an adequate blade spar, it merely represents an extension of existing technology.

To improve the extrusion process, on the other hand, it will be necessary to perform two steps:

• (1)

  improve the material used, at a cost of $300,000, and

• (2)

  modify the extrusion press, at a cost of $960,000.

The first step will require six months of work, and if this first step is successful, the second step will require another six months of work. If both steps are successful, the blade spar will be available at that time, that is, a year from now. The engineers estimate that the probabilities of succeeding in steps 1 and 2 are 0.9 and 0.75, respectively. However, if either step is unsuccessful (which will be known only in six months for step 1 and in a year for step 2), Ventron will have no alternative but to switch to the sectioning process—and incur the sectioning cost on top of any costs already incurred.

Development of the blade spar must be completed within 18 months to avoid holding up the rest of the contract. If necessary, the sectioning work can be done on an accelerated basis in a six-month period, but the cost of sectioning will then increase from $1.8 million to $2.4 million. The director of engineering, Dr. Smith, wants to try developing the improved extrusion process. He reasons that this is not only cheaper (if successful) for the current project, but its expected side benefits for future projects could be sizable. Although these side benefits are difficult to gauge, Dr. Smith’s best guess is an additional $2 million. (These side benefits are obtained only if both steps of the modified extrusion process are completed successfully.)

1. Develop a decision tree to maximize Ventron’s EMV. This includes the revenue from this project, the side benefits (if applicable) from an improved extrusion process, and relevant costs. You don’t need to worry about the time value of money; that is, no discounting or net present values are required. Summarize your findings in words in the spreadsheet.

Answer 1

The decision tree looks like this

Total Revenue = $ 2 Mn

• Sectioning :
  • Cost = $ 1.8 Mn
  • Profit = $ 0.2 Mn
• Improvement :
  • Step 1 cost = 0.3 Mn, P(Success) = 0.9
  • Step 2 cost = 0.96 Mn P(Success) = 0.75
    • Step 1 Failure --> Sectioning -1
      • Cost = $1.8 Mn + $0.3 Mn = $ 2.1 Mn
      • Revenue = $ 2 Mn
      • Profit = $(0.1) Mn
    • Step 1 Success
      • Step 2 Success
        • Cost = $0.3 Mn + $0.96 Mn
        • Revenue = $ 2 Mn
        • Side benefits = $ 2 Mn
        • Profit = $ 2.74 Mn
      • Step 2 Failure --> Accelerated Sectioning
        • Cost = $2.4 Mn + $0.3 Mn + $0.96 Mn
        • Revenue = $ 2 Mn
        • Profit = $(1.66) Mn

1. EMV (Sectioning ) = P(Success) * Profit = 1 * $0.2 Mn = $ 0.2 Mn
2. EMV ( Improvement) =    (P(Success) * Profit) = (0.9 *0.75 *2.74 )+ (0.1 * {-0.1}) +( 0.9 * 0.25 * {-1.66})

= $ 1.8495 Mn + ( - .01) + (-0.3735 Mn)

= $ 1.466 Mn

Thus, Ventron should go with the improvement plan as it has higher EMV of $1.466 Mn as against $200K for the standard sectioning process.

Thanks

Harshal