A company manufactures specialty pollution-sensing devices for the offshore oil industry. One particular device has reached maturity, and the company is considering whether to replace it with a newer model

Question

Technologies have not changed dramatically, so the new device would have similar functionality to the existing one, but would be smaller and lighter in weight. The firm's three choices are: 1. keep the old model, 2. design a replacement device with internal resources, 3 . and purchase a new design from a firm that is one of its suppliers. The market for these devices will be either "receptive" or "neutral" of the replacement model. The financial estimates are as follows: Keeping the old design will yield a profit of $6 million dollars. Designing the replacement internally will yield $10 million if the market is "receptive," but a $3 million loss if the market is "neutral." Acquiring the new design from the supplier will profit $4 million under "receptive," $1 million under "neutral." The company feels that the market has a 70 percent chance of being "receptive" and a 30 percent chance of being "neutral." Draw the appropriate decision tree. Calculate expected value for all courses of action. What action yields the highest expected value?

Answer 1

The three expected monetary values are:
Develop replacement internally: $10,000,000 × .7 - $3,000,000 × .3 = $6.1 million
Purchase new design: $4,000,000 × .7 + $1,000,000 × .3 = $3.1 million
Stay with current design: $6 million
The company should choose the highest value, and develop a replacement product design with internal resources.