Question

Tri-products is trying to decide whether to make or buy an accessory item for one of their products. It is projected that this item will sell for $10 each. If the item is outsourced, there is virtually no cost other than the $6 per unit that they would pay their supplier. Internally, they have two choices. Process A requires an investment of $120,000 for design and equipment, but results in a $4 per unit cost. Process B requires only a $100,000 investment, but its per unit cost is $5. Regardless of whether the item is subcontracted or produced internally, there is a 50% chance that they will sell 50,000 units, and a 50% chance that they will sell 100,000 units. Draw the decision tree appropriate to the alternatives and outcomes stated. Using the decision tree and Expected Values, what is their best choice?

Answer 1

Answer:

The best choice is process A since it has the highest EMV of $330000

Explanation:

there is a 50% chance that they will sell 50,000 units, and a 50% chance that they will sell 100,000 units

The decision tree is attached below, the calculations for the decision tree is given as:

The item sells for $10. Process A requires an investment of $120,000 for design and equipment, but results in a $4 per unit cost.

If there is high demand, they will sell 100,000 units, The profit = 100000($10-$4) - $120000 = $480000.

If there is low demand, they will sell 50,000 units, The profit = 50000($10-$4) - $120000 = $180000.

The EMV of process A = 0.5($480000) + 0.5($180000) = $330000

Process B requires only a $100,000 investment, but its per unit cost is $5

If there is high demand, they will sell 100,000 units, The profit = 100000($10-$5) - $100000 = $400000.

If there is low demand, they will sell 50,000 units, The profit = 50000($10-$5) - $100000 = $150000.

The EMV of process B = 0.5($400000) + 0.5($150000) = $275000

If the item is outsourced, there is virtually no cost other than the $6 per unit that they would pay their supplier

If there is high demand, they will sell 100,000 units, The profit = 100000($10-$6) = $400000.

If there is low demand, they will sell 50,000 units, The profit = 50000($10-$6) = $200000.

The EMV of Buying = 0.5($400000) + 0.5($200000) = $300000

The best choice is process A since it has the highest EMV