Reliability and Decision Theory (1)

Reliability and Decision Theory

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Reliability and Decision Theory

Introduction

From time to time firms are faced with decisions that are critical to their future operations. This requires the firms to make the most effective decision, which would safeguard its present and future wellbeing. Making decisions requires firms to use various tools at their disposal to ensure they make the best possible decision. They should not make decisions haphazardly as this may jeopardize not only the profitability but also the mere existence of the firm (Kim & Mauborgne, 2014). A firm should ensure it evaluates the risks and returns of decisions and make the best decisions based on the level of risk that is acceptable within the firm or industry. Use of a decision tree is one of the most common practices that firms use to make decisions (Kerzner, 2014). In this paper, a decision tree is used to determine the most appropriate decision that a cereal producer should make.

Decisions to Choose From

The cereal can make three decisions, A, B, or C. In the first large scale investment (A), it can purchase a new cooker, which would require it to invest 3,750,000 SAR. Investment in the new cooker would have a 40% chance of having a payoff of 9,375,000 SAR. Investment in the new cooker also has a 60% chance of having a payoff of only 3,000,000 SAR, which would be a 750,000 SAR loss to the company.

The company can also implement a smaller scale project (B), which would involve the refurbishing of the existing cooker. This would cost the company 1,875,000 SAR. Even though option (B) is less expensive than option (A), it also has less payoff. There is a 30% chance that the payoff of (B) would be 3,750,000. Option (B) also has a 70% chance of having a payoff of 1,875,000, which would enable the company to recoup only the amount it invested in the project without having any profits. The decision tree of the projects is shown below.

DECISION

No change (C)

Smaller-scale investment (B)

Large-scale investment (A)

4

5

6

7

1

2

3

9,375,000

3,000,000

3,750,000

1,875,000

DECISION

No change (C)

Smaller-scale investment (B)

Large-scale investment (A)

4

5

6

7

1

2

3

9,375,000

3,000,000

3,750,000

1,875,000

Figure 1: Decision tree

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The decision tree shows the expected revenues of each decision.

Path to terminal node 4: This would involve the purchase of a new cooker at a cost of 3,750,000 SAR, which would have a payoff of 9,375,000 SAR. Therefore, the expected returns of this decision is 9,375,000 – 3,750,000 = 5,625,000 SAR.

Path to terminal node 5: This would involve the purchase of a new cooker at a cost of 3,750,000 SAR, which would have a payoff of 3,000,000 SAR. Therefore, the expected returns of this decision is 3,000,000 – 3,750,000 = -750,000 SAR.

Path to terminal node 6: This would involve refurbishing the existing cooker at a cost of 1,875,000 SAR, which would have a payoff of 3,750,000 SAR. Therefore, the expected returns of this decision is 3,750,000 – 1,875,000 = 1,875,000 SAR.

Path to terminal node 7: This would involve refurbishing the existing cooker at a cost of 1,875,000 SAR, which would have a payoff of 1,875,000 SAR. Therefore, the expected returns of this decision is 1,875,000 – 1,875,000 = 0 SAR.

Path to terminal node 3: This would involve continuing the present operations of the company without any change. This would cost nothing to the company. However, it would also yield no payoff.

The expected monetary values (EMV) from the decision tree by backward induction are shown below.

Large-scale investment (A)

EMV = 0.4 (5,625,000) + 0.4 (-750,000)

= 2,700,000 SAR

Smaller-scale project (B)

EMV = 0.3 (1,875,000) + 0.7 (0)

= 562,000 SAR

No change (C)

EMV = 0

Recommended Decision

Choosing option (A), large-scale investment in a new cooker would provide the cereal producer with the best capital investment. This is because it would provide the cereal producer with an opportunity to have a much higher pay-off than the amount it invests in the project. This is highlighted by the fact that the option has the highest EMV in its net returns. According to Winston and Albright (2015), the optimal decision should be the one that has the most expected return value. However, making this decision would also be associated with certain consequences. It requires the cereal producer to invest 3,750,000 SAR in the purchase of a new cooker. This may have a significant impact on the finances of the firm as it may require the company to use funds meant to other activities. However, when the expected returns of the investments are compared against amount of money that is required to purchase the new cooker, making the investment is worth the chance. It would lead to a significant increase in the revenues of the cereal producer. Therefore, it is the most cost effective of the available options available to the firm.

The decision to purchase a new cooker would also pose a risk of losses. The potential losses of the decision would occur due to the high cost of purchasing the new cooker. The company should invest 3,750,000 SAR into the purchase of the new cooker. There is a chance that the investment would provide a payoff of 5,625,000 if everything goes well. However, if the decision goes wrong, it may have a lower-payoff than the amount that was invested in the purchase of a new cooker. The pay-off from the decision would be 3,000,000 SAR, which would be lower than the 3,750,000 SAR that the firm invested in the purchase of the new cooker. Therefore, the firm would incur a loss of 750,000 SAR.

Conclusion

Firms make decisions based on the risks and returns of the decisions. Decisions that have high returns are also associated with higher risks than other decisions. Nevertheless, if a firm can measure the risks and determine that they are within the acceptable range, it should choose the option as it would provide the firm with significant profits (Taylor, 2004). In the case involving the cereal producer should option (A) would provide the firm with the highest potential benefits. The decision may be 5,625,000 SAR. However, it requires the firm to invest 3,750,000 SAR in the purchase of a new cooker. If everything does not go according to plan, the decision would also subject the company to losses. The company would incur losses due to the high price of the new cooker. It would have a payoff of 3,000,000 SAR, which is still a high amount nonetheless. However, the payoff cannot offset the cost that the firm would incur in the purchase of the new cooker. Therefore, it would incur a loss of 750,000 SAR. This amount may jeopardize the operations of the firm Nevertheless, making the large-scale investment presents the firm with an opportunity that it should not let go to waste. It provides the company with an opportunity to improve its profitability significantly. Making the large-scale investment would enable the company benefit from economies of scale and reduction in the cost of production.

Reference

Kerzner, H. (2014). Project Management Case Studies. Hoboken, NJ: John Wiley & Sons.

Kim, W. C., & Mauborgne, R. (2014). Blue ocean strategy, expanded edition: How to create uncontested market space and make the competition irrelevant. Boston, MA: Harvard business review Press.

Taylor, F. W. (2004). Scientific Management. New York, NY: Routledge.

Winston, W. L., & Albright, S. C. (2015). Practical Management Science. Mason, OH: Cengage Learning.