Expected value can be used to assess the options or alternatives available and make the decisions that are best suited to the organisation. There can be multiple outcomes of a single decision and hence the values of all the alternatives needs to be analysed and the highest value should be chosen in case of revenues and lowest in case of costs.
Formula for EV :
EV = Summation of the (probability of outcome x value of outcomes)
Purchase | Probability of getting contract | Probability of not getting contract | Expected value | Calculation | |
Probability | 0.4 | 0.6 | |||
Drill Press | 40000 | (8000) |
|
40,000x0.4+(8000)x 0.6 | |
Lathe | 20000 | 4000 |
|
20000 x 0.4+4000x 0.6 | |
Grinder | 12000 | 10000 |
|
12000x 0.4+10000x0.6 |
The above matrix shows the expected value of the profit and loss for each of the purchases and since it is related profits we choose the highest value as the best option.
Drill Press is the best option as it has the highest expected monteary value -: $ 11,200
B | It is assumed the contractor has been hired and the report is favourable or unfavourable and the | |||||
EMV has been calculated . Hence probability of awarding the contract is not considered. | ||||||
Price paid to the contractor = Highest price in table below - Highest price in (a) above | ||||||
=27200-11200=16000 | ||||||
Tabular representation using Decision tree analysis | ||||||
If | Nature of Report | Alternative | Amounts | Probability | EMV of alternatives | |
Contract is awarded | ( Jt prob x Amount ) | |||||
0.4 | Favourable report | Drill Press | $ 40,000 | 0.7 | $ 28,000.00 | |
0.7 | Lathe | $ 20,000 | $ 14,000.00 | |||
Grinder | $ 12,000 | $ 8,400.00 | ||||
Unfavourable report | Drill Press | $ 40,000 | 0.2 | $ 8,000.00 | ||
0.2 | Lathe | $ 20,000 | $ 4,000.00 | |||
Grinder | $ 12,000 | $ 2,400.00 | ||||
Contract is not awarded | Favourable report | Drill Press | $ (8,000) | 0.3 | $ (2,400.00) | |
0.3 | Lathe | $ 4,000 | $ 1,200.00 | |||
0.6 | Grinder | $ 10,000 | $ 3,000.00 | |||
Unfavourable report | ||||||
0.8 | Drill Press | $ (8,000) | 0.8 | $ (6,400.00) | ||
Lathe | $ 4,000 | $ 3,200.00 | ||||
Grinder | $ 10,000 | $ 8,000.00 | ||||
EMV for Drill = | 28000+8000-2400-6400 | $ 27,200 | ||||
EMV for Lathe = | 14000+4000+1200+3200 | $ 22,400 | ||||
EMV for Grinder = | 8400+2400+3000+8000 | $ 21,800 |
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