Question

As operations manager of Holz Furniture, you must make a decision about adding a line of rustic furniture. Your decision will affect the business performance in the next decision horizon (the next five years). We assume a 16 percent interest rate. In discussing the possibilities with your sales manager, Steve Gilbert, you decide that there will definitely be a market and that your firm should enter that market. However, because rustic furniture has a different finish than your standard offering, you decide you need another process line. There is no doubt in your mind about the decision, and you are sure that you should have a second process. But you do question how large to make it. A large process line is going to cost $400,000; a small process line will cost $300,000. The question, therefore, is the demand for rustic furniture. After extensive discussion with Mr. Gilbert and Tim Ireland of Ireland Market Research, Inc., you determine that the best estimate you can make is that there is a two-out-of-three chance of profit from sales as high as $150,000 per year and a one-out-of-three chance as low as $90,000 per year. With a large process line, you could handle the high figure of $150,000 per year. However, with a small process line you could not and would be forced to expand (at a cost of $120,000), after which time your profit from sales would be $140,000 per year rather than the $150,000 per year because of the lost time in expanding the process. If you do not expand the small process, your profit from sales when the demand is high would be held to $95,000 per year, and $90,000 per year when the demand is low. If you build a small process and the demand is low, you can handle all of the demand. Should you open a large or small process line?

Answer 1