Question

Recent research has expanded the internal risk analysis to supply chain opportunities by integrating risk management techniques into a comprehensive supply chain risk management program: management of supply, products, demand, and information.7 Mr. MacDonald has been very impressed with his staff’s implementation of risk management over the past two years. One example of what has helped him “sleep better at night” was the purchase of an electrical generator to avoid potentially disastrous effects of an extended power outage. His design manager, Jeanie Johnston, had come to him last year with data from the local electric company on historical occurrences of power outages and their durations. Over the past 10 years, the probably of an outage lasting more than 24 hours was 0.5%. She had then explained that the loss of data and process set-backs that would occur with an outage lasting more than 24 hours could reach $1.5M! Jim quickly agreed to invest $35,000 for their new generator.

Issues:  

Over 10 years - power outages last more than 24 hours 0.5% of the time

Power outages over 24 hours could results in $1.5M in loses

$35,000 investment

Question - 1. Evaluate the expected value of the threat from an electric outage. Was Jim’s investment in a stand-by generator a good business decision? Rationalize your answer.

Answer 1

The probability of an outage lasting more than 24 hours was 0.5% (which is 0.5/100=0.005 )

The payoff due to Power outages over 24 hours is -$1.5 M

The expected value of the  threat from an electric outage is

the expected value of the threat from an electric outage is -$7500

An investment of $35,000 to mitigate an expected loss of $7,500 is not an optimal decision to make, if maximizing the expected value is the decision criteria.

Hence Jim’s investment in a stand-by generator is not a good business decision if he wants to maximize the expected value.