Assessment & PerformanceAssessment & PerformanceSession IVSession IV

Regular, July 2009Regular, July 2009

Decision TreeDecision Tree

A Simple Decision ProblemA Simple Decision ProblemIn six months a proposal is due for an electronic In six months a proposal is due for an electronic timing system for the 2000 Olympic Game.timing system for the 2000 Olympic Game.The company develop a new microprocessor, a The company develop a new microprocessor, a critical component in timing system.critical component in timing system.Unsure whether can produce the microprocessor in Unsure whether can produce the microprocessor in time.time.If success, excellent chance winning the $1,000,000 If success, excellent chance winning the $1,000,000 contract. Otherwise, small chance of winning.contract. Otherwise, small chance of winning.If continue, must invest $200,000 in research and If continue, must invest $200,000 in research and development; $50,000 for developing prototype; and development; $50,000 for developing prototype; and $150,000 to produce.$150,000 to produce.

Qualitative StructuringQualitative Structuring

What are my alternatives ?What are my alternatives ?What are the critical uncertainties that What are the critical uncertainties that affect the outcomes of my decisions ?affect the outcomes of my decisions ?What objectives am I trying to achieve in What objectives am I trying to achieve in making a decision ? What decision criteria making a decision ? What decision criteria will I use to choose among the competing will I use to choose among the competing alternatives ?alternatives ?

AlternativesAlternatives

Abandon the project altogether. Avoid the Abandon the project altogether. Avoid the risks of failing to develop the risks of failing to develop the microprocessor.microprocessor.Continue to invest in the project. At some Continue to invest in the project. At some point in time, may need to decide whether point in time, may need to decide whether to make a proposal.to make a proposal.

UncertaintiesUncertainties

Have to make decision without knowing Have to make decision without knowing exactly what will happen in the future.exactly what will happen in the future.Must consider the major uncertainties and Must consider the major uncertainties and make judgments about how likely these make judgments about how likely these uncertain events are to occur.uncertain events are to occur.

ObjectivesObjectives

Decision making as means of achieving Decision making as means of achieving objectives.objectives.What is the objective in this case ?What is the objective in this case ?Maximizing net cash flow.Maximizing net cash flow.Choose alternative that yields the largest Choose alternative that yields the largest positive net cash flow.positive net cash flow.

Expected Monetary ValueExpected Monetary Value

How do you compare $10 vs. $20 ?How do you compare $10 vs. $20 ?$25 for sure vs. 0.50 chance at $60 ?$25 for sure vs. 0.50 chance at $60 ?Expected monetary value of 0.50 chance Expected monetary value of 0.50 chance at $60 is 0.50($60) + 0.50($0) = $30.at $60 is 0.50($60) + 0.50($0) = $30.Risk averse: $30 for sure is prefer to 0.50 Risk averse: $30 for sure is prefer to 0.50 chance at $60.chance at $60.Risk prone: 0.50 chance at $60 is prefer to Risk prone: 0.50 chance at $60 is prefer to $30 for sure. $30 for sure.

It is six months prior to the proposal date, what can we do ?

Abandoning the project

Continue to invest in the project.

Continue

Abandon

If continue, then what ?

If abandon, then what ?

Succeed

Fail

Then what ?

Then what ?

Continue

Abandon

Make Proposal

Make Proposal

Don’t Make Proposal

Don’t Make Proposal

Continue

Abandon

Succeed

Fail

Continue

Abandon

Succeed

Fail

Make Proposal

Make Proposal

Don’t Make Proposal

Don’t Make Proposal

Win

Lose

Win

Lose

UncertaintyUncertaintyUncertainty is measured by probability.Uncertainty is measured by probability.If the probability of an event is 0,then the event If the probability of an event is 0,then the event is impossible.is impossible.If an even will happen for sure, then the If an even will happen for sure, then the probability of the event is 1.probability of the event is 1.In our case, need to estimate the probability of In our case, need to estimate the probability of successfully developing the microprocessor in 6 successfully developing the microprocessor in 6 months, the probability of winning the contract in months, the probability of winning the contract in the case of success developing microprocessor, the case of success developing microprocessor, and the probability of winning contract in the and the probability of winning contract in the case of failure in developing the microprocessor.case of failure in developing the microprocessor.

Continue

Abandon

Succeed

Fail

Make Proposal

Make Proposal

Don’t Make Proposal

Don’t Make Proposal

Win

Lose

Win

Lose

0.40

0.60

0.90

0.10

0.05

0.95

Continue

Abandon

Succeed

Fail

Make Proposal

Make Proposal

Don’t Make Proposal

Don’t Make Proposal

Win

Lose

Win

Lose

0.40

0.60

0.90

0.10

0.05

0.95

$600,000

$600,000

-$250,000

-$250,000

-$200,000$0

-$200,000

$515,000

$515,000

-$207,500-$200,000

$86,000

$86,000

Sensitivity AnalysisSensitivity Analysis

Proactive Decision MakingProactive Decision Making

Does not limit the evaluation of an Does not limit the evaluation of an alternative to a single estimate of its alternative to a single estimate of its potential performance.potential performance.Acknowledge the likelihood of the Acknowledge the likelihood of the possibilities.possibilities.

Case: Holiday trinketCase: Holiday trinket

Development of holiday trinket for childrenDevelopment of holiday trinket for children’’s breakfast s breakfast cereal.cereal.Based on childrenBased on children’’s preference panels, the trinket would s preference panels, the trinket would expected to result in a 12 percent increase in volume.expected to result in a 12 percent increase in volume.ChildrenChildren’’s test panels are notoriously unreliable; the s test panels are notoriously unreliable; the increase could be anywhere between 8 and 14 percent.increase could be anywhere between 8 and 14 percent.It was forecasted that the sales without the trinket during It was forecasted that the sales without the trinket during the period is 6.5 million boxes plus or minus 2 percent.the period is 6.5 million boxes plus or minus 2 percent.The production process and the distribution system are The production process and the distribution system are sufficiently flexible to permit production to match sufficiently flexible to permit production to match demand.demand.

Case: Holiday trinket (Cont.)Case: Holiday trinket (Cont.)The trinket cost: $0.10 per unit (if the supplier who has The trinket cost: $0.10 per unit (if the supplier who has worked on its development can resume production in a worked on its development can resume production in a timely fashion after a recent fire).timely fashion after a recent fire).Alternative sources for the trinket: additional trinket Alternative sources for the trinket: additional trinket cost for $0.010 or $0.015 per unit.cost for $0.010 or $0.015 per unit.The trinket will be featured on the front and back of the The trinket will be featured on the front and back of the box and the alteration to the boxbox and the alteration to the box’’s artwork would cost s artwork would cost $125,000.$125,000.Neither the art layout nor the production modification Neither the art layout nor the production modification have been finalized, it is believed the final cost could have been finalized, it is believed the final cost could be 20 percent higher to 5 percent lower than the initial be 20 percent higher to 5 percent lower than the initial estimate.estimate.The contribution per unit $1.48.The contribution per unit $1.48.

BestBest--Estimate ScenarioEstimate ScenarioAssumption

Forecast error in base volume 0%Volume increase percentage 12%Unit cost per trinket $0.10Artwork cost variance 0%

Base volume (boxes) 6,500,000Volume increase (boxes) 780.000

Increase in contribution $1,154,400Trinket cost $728,000Artwork cost $125,000

Incremental gross margin $301,400

Optimistic and Pessimistic ScenariosOptimistic and Pessimistic Scenarios

Assumption Optimistic PessimisticForecast error in base volume 2% -2%Volume increase percentage 14% 8%Unit cost per trinket $0.10 $0.115Artwork cost variance -5% 20%

Base volume (boxes) 6,630,000 6,370,000Volume increase (boxes) 928,200 509,600

Increase in contribution $1,373,736 $754,208Trinket cost $755,820 $791,154Artwork cost $118,750 $150,000

Incremental gross margin $499,166 ($186,946)

OneOne--atat--aa--Time Sensitivity Analysis: Volume Increase Time Sensitivity Analysis: Volume Increase PercentagePercentage

Assumption Lowest HighestForecast error in base volume 0% 0%Volume increase percentage 8% 14%Unit cost per trinket $0.10 $0.10Artwork cost variance 0% 0%

Base volume (boxes) 6,500,000 6,500,000Volume increase (boxes) 520,000 910,000

Increase in contribution $769,600 $1,346,800Trinket cost $702,000 $741,000Artwork cost $125,000 $125,000

Incremental gross margin ($57,400) $480,800

OneOne--atat--aa--Time Sensitivity Analysis: All UncertaintiesTime Sensitivity Analysis: All Uncertainties

Lowest Value Highest ValueUncertainties Value Performance Value Performance

Forecast error -2% $292,872 2% $309,928Volume increase percentage 8% - $57,400 14% $480,800Unit cost per trinket $0.10 $301,400 $0.115 $192,200Art cost variance -5% $307,650 20% $276,400

Tornado DiagramTornado Diagram

-100,000 0 100,000 200,000 300,000 400,000 500,000

8% 14%

$0.115 $0.10

-5%20%

2%-2%

Volume increase percentage

Unit cost per trinket

Artwork cost variance

Forecast error

Incremental gross margin

Threshold AnalysisThreshold AnalysisThe incremental gross margin is negative (-$57,400) whenever the volume increase percentage is 8%.

At what value the volume increase percentage that make the grossmargin is zero ?

Volume Increase Percentage Incremental Gross Margin8% - $57,4009% $32,300

8.5% - $12,550

Algebraic ApproachAlgebraic ApproachX be the volume increase percentage that make the incremental gross margin is zero.

The incremental gross margin: the increase in contribution, the trinket cost, the artwork cost.

The increase in contribution: $1.48 * (6,500,000 * X)

The trinket cost: $0.10 * (6,500,000 + (6,500,000 * X))

The artwork cost: $125,000

$1,48 * (6,500,000 * X) = $0.10 * (6,500,000 + (6,500,000 * X)) + $125,000

X = 0.0864