Question

The internal auditor of Apex Company estimates the probability of its internal control procedure being in control to be 80%. She estimates the cost to conduct an investigation to find areas for improvement to be about $28,000 and the cost to revise and improve the internal control procedure to be approximately $67,000. The present value of savings from having the new procedure is expected to be $202,000.

3. What is the expected value of perfect information? Note: The expected value of perfect information (EVPI) is defined as the maximum value the manager would pay to have knowledge (i.e., certainty) of whether the process is in control or out of control. In the present context, the EVPI can be thought of as the difference between the expected cost with perfect information and the expected cost without perfect information. (To calculate the former, we need to choose for each possible state of nature the best course of action [decision] and then multiply the associated “cost” by the probability of that state of nature occurring. We then sum these resulting expected costs to get the expected cost with perfect information.) (Hint: For this problem, the expected cost under perfect information is $19,000.)

Answer 1

Expected value of perfect information

= expected cost with perfect information -  expected cost without perfect information

= [(cost to conduct an investigation to find areas for improvement * Probability) +  (cost to revise and improve the internal control procedure * Probability)] - (cost to revise and improve the internal control procedure * Probability)

= [$28,000 * (1-0.80) + $67,000 * (1-0.80)] - [$67,000 * (1-0.80)]

= ($5,600 + $13,400) - 13,400

= $19,000 - 13,400

= $5,600