Question

Aba Manufacturing has contracted to provide Zyz Electronics with printed circuit ( PC ) boards under the following terms: (1) 100,000 PC boards will be delivered to Zyz in one month, and (2) Zyz has an option to take delivery of an additional 100,000 boards in three months by giving Aba 30 days notice. Zyz will pay $5.00 for each board that it purchases. Aba manufactures the PC boards using a batch process, and manufacturing costs are as follows: (1) there is a fixed setup cost of $250,000 for any manufacturing batch run, regardless of the size of the run, and (2) there is a marginal manufacturing cost of $2.00 per board regardless of the size of the batch run. Aba must decide whether to manufacture all 200,000 PC boards now or whether to only manufacture 100,000 now and manufacture the other 100,000 boards only if Zyz exercises its option to buy those boards. If Aba manufactures 200,000 now and Zyz does not exercise its option, then the manufacturing cost of the extra 100,000 boards will be totally lost. Aba believes there is a 50% chance Zyz will exercise its option to buy the additional 100,000 PC boards.

• Explain why it might potentially be more profitable to manufacture all 200,000 boards now.
• Draw a decision tree for the decision that Aba faces.
• Determine the preferred course of action for Aba assuming it uses expected profit as its decision criterion.

Answer 1