Question

David Smiley is the manager of Photobonics Manufacturing. He notices that the operation in the last four weeks has had an unfavorable materials usage variance of $25,000. He is trying to decide whether to investigate this variance. If he investigates and discovers that the process is out of control Le, not due to a random occurrence and therefore not likely to correct itself), corrective actions will likely cost the firm $9100. The cost of investigation is expected to be $4,000. The company would suffer an estimated total loss (in present-value terms) of $59,100 if the out-of-control operation continues. Smiley estimates the probability the operation is out of control is 60% Required: 1. What are the expected costs of investigating and of not investigating? Should the operation be investigated? 2. What is the indifference probability that the operation is out of control? Round your answer to 2 decimal places 3. What is the expected value of perfect information (EVP/) in this case? 1 Expected costs of investigating Expected costs of not investigating Should the operation be n vestigated? 2 Indifference probabit

Answer 1

1.

Expected cost of investigating = Cost of investigation + Probability of operation out of control * Cost of corrective action

= $4,000 + 0.6 $9,100 = $9,460

Expected cost of not investigating = Probability of operation out of control * Cost of loss

= 0.60 * $59,100 = $35,460

As, the expected cost of investigating is less, the operation needs to be investigated.

2.

The indifference probability that the operation is out of control is 0.60

3.

Expected value of perfect information = Expected cost without perfect information - Expected cost with perfect information

Expected value without perfect information = Expected cost of not investigating = $35,460

Expected value with perfect information = Probability of operation out of control * Cost of corrective action = 0.6 $9,100 = $5,460

Expected value of perfect information = $35,460 - $5,460 = $30,000