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You currently manufacture imitation Beany Babies. Manufacturing capacity is at 100,000, and cost is at $3...

You currently manufacture imitation Beany Babies. Manufacturing capacity is at 100,000, and cost is at $3 each. There is a 40% probability that demand will be high, with demand for 250,000 units at a price of $5 each. Otherwise demand will be low, with maximum sales at 80,000 units at a price of $4 each. You have the option of spending $100,000 to increase production capacity to 200,000 units. Should you increase capacity? How much would you pay for a perfectly accurate forecast of demand? For an 80% accurate forecast? Illustrate your answer using a decision tree.

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Answer #1

Sales value with high demand = 250000 * 5 = 1250000

Sales value with low demand = 80000 * 4 = 320000

Expected demand = Probability of high demand * sales value of high demand + probability of low demand * sales value of low demand = 0.4 * 1250000 + 0.6 * 320000 = 692000

Expected demand = 250000 * 0.4 + 80000 * 0.6 = 148000

Manifacturing cost of expected demand = 148000 * 3 = 444000

Profit = Sales value - manufacturing cost = 692000 - 444000 = 248000

The amount of investment is 200000 so yes we should invest in the same as the profit is higher than the expected profit.

with 80% accuracy expected profit = 248000 * 0.8 = 198400

For a perfectly accurate demand we are ready to pay 198400

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