Question

 

3. Management is currently deciding whether to investigate a cost variance that was identified by the accounting system. To help address this question, you have generated the following data:

Possible States of Nature:

1. The underlying operation is in control (i.e., it is operating normally).

2. The underlying operation is out of control (and therefore needs an intervention).

Possible Decisions/Courses of Action:

1. Investigate the variance (to determine its underlying cause(s)).

2. Do not investigate the variance

Estimated Costs and Probabilities:

1. Cost of investigating the variance = I = $5,000.

2. Cost of correcting an out-of-control process (if the process is found to be out of control) = C = $10,000.

3. Losses from not correcting an out-of-control process = L = $110,000.

4. Probability, p, of the process being out of control = 60%

REQUIRED:

E. What is the expected value of perfect information? Show calculations and circle your answer. Provide a one-sentence description of what this means to the management of this company.

Answer 1

Solution :	(a) Calculation of cost of perfect information
		Amount in $
	Losses from not correcting the out of control process	110000
	Probability	60%
	Expected losses from not correcting the out of control process	66000
	Cost of investigating the variance	-5000
	Cost of correcting an out of control process	-10000
	Expected value of investigation and correction	51000
	Maximum loss when the probability of process is being out of control	110000
	(at 100% probability)
	Less: Expected value of investigation	-51000
	Value of perfect information	59000
	(b) Description on means of perfect information to management
	Information does not cost more than $ 59000 to collect, it would be worth having.