Decision making under uncertainty

1. Sports ltd is a company which makes and sells tennis rackets. its sales for the past few
years and profit have been constant and as follows:

Sales 1500000

VC 500000

Contribution 1000000

Fixed cost 800000

Profit 200000

In preparing a budget for the next year, there is uncertainty

about several key points
a. Sports ltd has tendered for two contracts ,each to apply
an overseas customer.
Sales value
Contract A 500000
Contract B 300000

For each these orders, variable costs (including selling and

shipping cost) would be 40% of sales value. Total fixed
costs would be unaffected by the order. The company hopes
to win both orders, but thinks it more likely that it will win
Contracts A but Contract B.

b. A new product, a model squash racket is due to be

launched next year. Expected sales are 30,000 per month
with variable cost of 50% of sales and fixed costs of Rs
5000 per month. The most likely launch date of new
product is in midyear (i.e 6 months into the year) but it
could be launched as early as the end of month 4 or as
the end of month 9.
c. although it is expected on balance that sales price and
costs will not go up, there is a reasonable possibility that
variable costs on the current product range will go up by
10%

Required

a) prepare a most likely , a pessimists and optimistic budget

b) comment on this type of budget
2. A manufacturer makes product, of which the principal
ingredient is chemical X. At the moment the mfg spends Rs
1000 on his supply of X, but here is a possibility that the price
may soon increase 4 times its present because of a world
shortage of the chemical .There is another chemicals Y, which
the manufactures could use in conjunction with third chemical
Z, in order to five the same effect as chemical X. chemical Y
and Z together cost Rs 3000 pa; but there prices are unlikely
to rise.
What action should manufacturer take? Apply the Maximin and
Minimax criteria for decision making and give two sets of
solutions.
3. The manager of a company wants to choose between mutually
exclusive options X and Y and the probable outcomes of each
options are as follows:

Option X Option Y
Probability profit Probability profit
0.7 10000 0.1 -5000
0.3 12000 0.2 10000
0.6 15000
0.1 16000
You are required to state –
a. Which option should be chosen by manger, if the
outcome occurs many times a year?
b. Which option to be chosen where such outcomes occur
annually?
4. the following is the proabilty distribution of sales of Company
for the year 2015.

Sales in units Probability

20000 0.10
24000 0.15
28000 0.25
32000 0.30
36000 0.20
The company forecast of sales demand has presumed a selling
price of Rs 12 per units. Budget variable costs are Rs 9 per
unit and fixed costs for the year are Rs 75000/-

What is likelihood that ---

a. The company will at least break even in the period
b. The company will make a profit of at least Rs 24000.
5. Company sales a single product which has a unit variable cost of
Rs 16. Fixed costs are Rs 1,10,000 per annum. The company’s
marketing manager is having a selling price review and has reduced
the choice of price of either Rs 20 or Rs 21 per unit. the volume of
sales on each of the prices has been estimated has probability
distribution as follows:

Selling price Rs 20 Selling price Rs 21

Sales probability Sales probability
volume volume
20000 0.1 15000 0.1
30000 0.3 20000 0.2
40000 0.4 25000 0.4
50000 0.1 30000 0.3
60000 0.1 - -

You are required to show which selling price should be selected

based on EV of contribution and profit.

Decision Theory

There are four types of criteria that we will look at.

Expected Value (Realist)

Compute the expected value under each action and then pick the action with the
largest expected value. This is the only method of the four that incorporates the
probabilities of the states of nature. The expected value criterion is also called the
Bayesian principle.

Maximax (Optimist)

The maximax looks at the best that could happen under each action and then
chooses the action with the largest value. They assume that they will get the most
possible and then they take the action with the best best case scenario. The
maximum of the maximums or the "best of the best". This is the lotto player; they
see large payoffs and ignore the probabilities.

Maximin (Pessimist)

The maximin person looks at the worst that could happen under each action and then
choose the action with the largest payoff. They assume that the worst that can
happen will, and then they take the action with the best worst case scenario. The
 maximum of the minimums or the "best of the worst". This is the person who puts
their money into a savings account because they could lose money at the stock
market.

Minimax (Opportunist)

Minimax decision making is based on opportunistic loss. They are the kind that look
back after the state of nature has occurred and say "Now that I know what happened,
if I had only picked this other action instead of the one I actually did, I could have
done better". So, to make their decision (before the event occurs), they create an
opportunistic loss (or regret) table. Then they take the minimum of the maximum.
That sounds backwards, but remember, this is a loss table. This similar to the
maximin principle in theory; they want the best of the worst losses.
Example: A bicycle shop
Zed and Adrian and run a small bicycle shop called "Z to A Bicycles". They must order
bicycles for the coming season. Orders for the bicycles must be placed in quantities of
twenty (20). The cost per bicycle is $70 if they order 20, $67 if they order 40, $65 if they
order 60, and $64 if they order 80. The bicycles will be sold for $100 each. Any bicycles left
over at the end of the season can be sold (for certain) at $45 each. If Zed and Adrian run out
of bicycles during the season, then they will suffer a loss of "goodwill" among their
customers. They estimate this goodwill loss to be $5 per customer who was unable to buy a
bicycle. Zed and Adrian estimate that the demand for bicycles this season will be 10, 30, 50,
or 70 bicycles with probabilities of 0.2, 0.4, 0.3, and 0.1 respectively.

Actions

There are four actions available to Zed and Adrian. They have to decide which of the
actions is the best one under each criteria.

1. Buy 20 bicycles
2. Buy 40 bicycles
3. Buy 60 bicycles
4. Buy 80 bicycles

Zed and Adrian have control over which action they choose. That is the whole point
of decision theory - deciding which action to take.

States of Nature

There are four possible states of nature. A state of nature is an outcome.

1. The demand is 10 bicycles

2. The demand is 30 bicycles
3. The demand is 50 bicycles
4. The demand is 70 bicycles

Zed and Adrian have no control over which state of nature will occur. They can only
plan and make the best decision based on the appropriate decision criteria.

Payoff Table

After deciding on each action and state of nature, create a payoff table. The numbers
in parentheses for each state of nature represent the probability of that state
occurring.
 Action

State of Nature Buy Buy 40 Buy 60 Buy 80

20

Demand 10 50 -330 -650 -970

(0.2)

Demand 30 550 770 450 130

(0.4)

Demand 50 450 1270 1550 1230

(0.3)

Demand 70 350 1170 2050 2330

(0.1)

Demand is 50, buy 60:

They bought 60 at $65 each for $3900. That is -$3900 since that is money they
spent. Now, they sell 50 bicycles at $100 each for $5000. They had 10 bicycles left
over at the end of the season, and they sold those at $45 each of $450. That makes
$5000 + 450 - 3900 = $1550.

Demand is 70, buy 40:

They bought 40 at $67 each for $2680. That is a negative $2680 since that is money
they spent. Now, they sell 40 bicycles (that's all they had) at $100 each for $4000.
The other 30 customers that wanted a bicycle, but couldn't get one, left mad and Zed
and Adrian lost $5 in goodwill for each of them. That's 30 customers at -$5 each or -
$150. That makes $4000 - 2680 - 150 = $1170.

Opportunistic Loss Table

The opportunistic loss (regret) table is calculated from the payoff table. It is only
needed for the minimax criteria, but let's go ahead and calculate it now while we're
thinking about it.

The maximum payoffs under each state of nature are shown in bold in the payoff
table above. For example, the best that Zed and Adrian could do if the demand was
30 bicycles is to make $770.

Each element in the opportunistic loss table is found taking each state of nature, one
at a time, and subtracting each payoff from the largest payoff for that state of nature.
In the way we have the table written above, we would subtract each number in the
row from the largest number in the row.

Action

State of Nature Buy Buy 40 Buy 60 Buy 80

20

Demand 10 0 380 700 1020

Demand 30 220 0 320 640

Demand 50 1100 280 0 320

Demand 70 1980 1160 280 0

Remember that the numbers in this table are losses and so the smaller the number,
the better.

Expected Value Criterion

Compute the expected value for each action.

For each action, do the following: Multiply the payoff by the probability of that payoff
occurring. Then add those values together. Matrix multiplication works really well for
this as it multiplied pairs of numbers together and adds them. If you place the
probabilities into a 1x4 matrix and use the 4x4 matrix shown above, then you can
multiply the matrices to get a 1x4 matrix with the expected value for each action.

Here is an example of the "Buy 60" action if you wish to do it by hand.

0.2(-650) + 0.4(450) + 0.3(1550) + 0.1(2050) = 720

The expected values for buying 20, 40, 60, and 80 bicycles are $400, 740, 720, and
460 respectively. Since the best that you could expect to do is $740, you would buy
40 bicycles.

Maximax Criterion

The maximax criterion is much easier to do than the expected value. You simply look
at the best you could do under each action (the largest number in each column). You
then take the best (largest) of these.

The largest payoff if you buy 20, 40, 60, and 80 bicycles are $550, 1270, 2050, and
2330 respectively. Since the largest of those is $2330, you would buy 80 bicycles.
Maximin Criterion

The maximin criterion is as easy to do as the maximax. Except instead of taking the
largest number under each action, you take the smallest payoff under each action
(smallest number in each column). You then take the best (largest of these).

The smallest payoff if you buy 20, 40, 60, and 80 bicycles are $50, -330, -650, and
-970 respectively. Since the largest of those is $50, you would buy 20 bicycles.

Minimax Criterion

Be sure to use the opportunistic loss (regret) table for the minimax criterion. You take
the largest loss under each action (largest number in each column). You then take
the smallest of these (it is loss, afterall).

The largest losses if you buy 20, 40, 60, and 80 bicycles are $1980, 1160, 700, and
1020 respectively. Since the smallest of those is $700, you would buy 60 bicycles.

Putting it all together.

Here is a table that summarizes each criteria and the best decision.

Action

Criterion Buy Buy 40 Buy 60 Buy 80 Best Action

20

Expected Value 400 740 720 460 Buy 40

Maximax 550 1270 2050 2330 Buy 80

Maximin 50 -330 -650 -970 Buy 20

Minimax 1980 1160 700 1020 Buy 60

Practice Problem
Finicky's Jewelers sells watches for $50 each. During the next month, they estimate that they will sell
15, 25, 35, or 45 watches with respective probabilities of 0.35, 0.25, 0.20, and ... (figure it out). They
can only buy watches in lots of ten from their dealer. 10, 20, 30, 40, and 50 watches cost $40, 39, 37,
36, and 34 per watch respectively. Every month, Finicky's has a clearance sale and will get rid of any
unsold watches for $24 (watches are only in style for a month and so they have to buy the latest
model each month). Any customer that comes in during the month to buy a watch, but is unable to,
costs Finicky's $6 in lost goodwill.

1.1 A factory produces Products A and B and the cost of production and gross profit in
respect of each for august 2015 are given below. Comment on the profitability of the
products and state which products and state which product will give more profitability
during the heavy demand.

Product A Product B
Units produced 400 100
Direct material cost per unit 100 350
Direct wages per unit 200 100
Variable overhead per unit 100 50
Fixed overhead 400 200
Sales price 1000 1000

1.2 Two businesses X ltd and Y ltd manufactures and sell the same type of product in the
same type of market .The budged profit and loss accounts for the coming year are:

X ltd Y ltd
Sales Rs 30000 30000
Variable cost 24000 20000
Fixed cost 3000 7000
Estimated profit 3000 3000

You are required to-

 calculate the breakeven point and margin of safety of each business:
 state which business is likely to earn greater profits in conditions of :
o heavy demand for the product
o low demand for the product and
 Calculate the percentage change increase in sales in both the cases to absorb a
50% increase fixed overhead in each case.

1.3Following information in respect of Product A and B:

 Product A Product B
Selling Price(Rs) 100 64
Direct Material 40 40
Direct labour Hr(Rs0.5 per 20 20
hour

Variable overhead - 100% direct wages. Fixed overhead =Rs 3000

Present the above information to show that the profitability of products during labour
shortage.

From the above information recommend which of the following sales mix should be adopted
–

(i) 100 units of A and 50 units of B

(ii) 50 units of A and 100 units of B
(iii) 150 units of A only.

What recommendation would you make if due to labour shortage, the direct labour hours
are 1200 hours only. Assume that the maximum production capacity otherwise available
for each of the products A & B is 200 units.

1.4 The following particulars are obtained from records of a company engaged in
manufacturing of two products A and B from a certain raw material:
Product A Product B
Sales Rs per unit 100 200
Material cost (Rs 10 per kg) 20 50
Direct wages(Rs 6 per hour) 30 60
Variable overhead 10 20
Total fixed cost= Rs 10000
Comment on the profitability on each product when-
i. total sales potential in units is limited
ii. total sales potential in value is limited
iii. raw material is in short supply
iv. production capacity is limiting factor
v. when total avaibalbilty of raw material is 4000 kg and maximum sales potential of
each product 1000 units .find the product mix to yield optimum profit
vi. If total material available is 3000 kg and it is decided to product at least 200 units
each products .calculate the optimal profit.
2- A company manufacturers small tools has completed the 1st order of 10 units of special
tool at contract price of Rs 5000 and has received an enquiry for another 20 units of the
special tools.
The cost details of the 1st order are:
Per unit in Rs
Material cost 50
Wages 300
Tools 10
Variable overhead 80
Fixed overhead 20
Total cost 460
Profit 40
Selling price 500

The company expects 80% learning rate in respect of labor and variable overhead but
material cost, labor cost and variable overhead will rise by 10% in the future. The company
wants 20% profit on cost. The amount of Rs 100 spent on tools will not be required for the
second order. Fixed overhead for the second order will be 200. You are required to ascertain
the contract price for the repeat order.

3-engine ltd manufactures engine mountings for the wide bodies’ airlines. They have been
asked to bid on a prospective contract for 90 engine mountings for the jet aircraft. They have
just completed initial run of 30 of these mountings at the following costs-
Rs
Direct material 20000
Direct labor (6000@Rs 4) 24000
Tooling cost (reusable) 3000
Variable overhead (Rs 0.50 per labour hrs) 3000
Fixed cost 6000
Total cost 56000

An 80% learning rate is thought to be pertinent in this case. The marketing director believe
that the quotation unlikely to be accepted if it exceeds Rs 1,10,000/- and company are short
of work, he believes the contract is vital.
you are required to comment whether it is worth accepting at Rs Rs 1,10,000/-.
Example1
P Co operates a standard costing system. The standard labour time per batch for its newest
product was estimated to be 200 hours, and resource allocation and cost data were prepared
on this basis.

The actual number of batches produced during the first six months and the actual time taken
to produce them is shown below:

Incremental Incremental
number of labour hours
Month batches taken to
produced produce the
each month batches
June 1 200
July 1 152
August 2 267.52
September 4 470.8
October 8 1,090.32
November 16 2,180.64
Required
(a) Calculate the monthly learning rate that arose during the period
Problem 1:

The initial external tank for NASA’s Space Shuttle took 400 hours of labor to produce. The
learning rate is 80%. How long will the twentieth tank take?

Problem 2:

An operation has a 90% learning curve and the first unit produced took 28 minutes. The labor
cost is $20 per hour.

(a) How long will the second unit take?

(b) How much should the second unit cost?

Problem 3:

Using the data from Problem 1, how long will it take to produce all 20 tanks?
 ANSWERS

Solution
(a) Monthly rates of learning

Cumulative
Incremental Cumulativ Cumulativ
Incremental average
Month number of e number e total
total hours hours per
batches of batches hours
batch
June 1 200 1 200 200
July 1 152 2 352 176
August 2 267.52 4 619.52 154.88
Septembe
4 470.8 8 1090.32 136.29
r
October 8 1090.32 16 2180.64 136.29
November 16 2180.64 32 4361.28 136.29

Learning rate:
176/200 = 88%
154.88/176 = 88%
136.29/154.88 = 88%

Therefore the monthly rate of learning was 88%.

Problem 1:

From Table E.3 where N = 20 and an 80% learning rate:

Learning curve coefficient C = .381

Y20 = Y1C = .381 * 400 = 152.4 hours

Problem 2:

(a) TN + T2C = 28 * 0.9 = 25.2 minutes

(b) Cost = (25.2 minutes/60 minutes) ($20 per hour) = $8.40

Problem 3:

From Table E.3 where N = 20 and an 80% learning rate:

Total time = 10.485

TN = T1C = 400hr * 10.485 = 4,194 hours

 CVP analysis for single product
1. A company producing single article sells it at Rs 10 each. The variable cost of
production is Rs 6 each and fixed cost is Rs400.
Calculate:
i. the profit for annual sales of 1 units, 50 units, 100 units and 400 units
ii. the P/V ratio
iii. the breakeven sales
iv. the sales to earn a profit of Rs500
v. profit at sales Rs 3000;
vi. new breakeven point if sales price is reduced by 10%

2. Calculate the margin of safety when profit earned is Rs200 and P/V ratio is 40%(data
same as previous illustrations)
3. The following information is obtained from company A.(13.5)
Sales- Rs1,00,000
Variable cost : Rs 60,000
Fixed cost: Rs 30000
 Find the P/V ratio , breakeven point and margin of safety at this level.
 Calculate the effect of –
I. 20% increase in selling price
II. 10% decrease in selling price
III. 5% decrease in sales volume
IV. 10% decrease in fixed cost
V. 10% decrease in variable cost
VI. 20% increase in selling price accompanied by increase in fixed
overhead by Rs10000
VII. 20% increase in selling price, 10% increase in fixed cost and 10%
decrease in variable cost.
4. An electronics company is invested in product which is sold at Rs 8 per unit. The
variable cost of is Rs 4.80 per unit while the fixed costs amounts to Rs 24000. How
many units of must be produced and sold so that the company breaks even? How
much sales would be made at this level of activity?
a. How many units to be sold if the firm desires a profit of Rs 16000.
b. The manager on the basis of general economic and market conditions expects
sales of 9000 units. What will be margin of safety?
5. following are the details of XYZ company
Rs
Selling price per unit 10
Trade discount 5%
Direct material cost 3
Direct labor cost per unit 2
Fixed overhead Rs 10000

Variable overheads 100% on direct labour cost

If sales are a) 10% and b) 15% above the break even volume.
Determine the net profit.