In the northeast United States and in eastern Canada, many people heat their hou
ID: 2669996 • Letter: I
Question
In the northeast United States and in eastern Canada, many people heat their houses with heating oil. Imagine you are one of these people, and you are expecting a cold winter, so you are planning your heating oil requirements for the season. The current price is $2.25 per US gallon, but you think that in six months, when you'll need the oil, the price could be $3.00, or it could be $1.50.
If you need 350 gallons to survive the winter, how much difference does the potential price variance make to your heating bills?
If your friend Tom is running a heating oil business, and selling 100,000 gallons over the winter season, how does the price variance affect Tom?
Which one of you benefits from the price increase? Which of you benefits from price decrease?
What are two strategies you can use to reduce the risk you face? Could you make an agreement with Tom to mitigate your risk?
Assuming you are both risk-averse, does such an agreement make you both better off?
In the northeast United States and in eastern Canada, many people heat their houses with heating oil. Imagine you are one of these people, and you are expecting a cold winter, so you are planning your heating oil requirements for the season. The current price is $2.25 per US gallon, but you think that in six months, when you'll need the oil, the price could be $3.00, or it could be $1.50.
If you need 350 gallons to survive the winter, how much difference does the potential price variance make to your heating bills?
If your friend Tom is running a heating oil business, and selling 100,000 gallons over the winter season, how does the price variance affect Tom?
Which one of you benefits from the price increase? Which of you benefits from price decrease?
What are two strategies you can use to reduce the risk you face? Could you make an agreement with Tom to mitigate your risk?
Assuming you are both risk-averse, does such an agreement make you both better off?
Explanation / Answer
The current price is $2.25 per US galloon,
350*2.25 = $787.5
350*1.5= $525.00
350*3= $1050
The price variance (Vmp) of a material is computed as follows:
Vmp = (Actual unit cost - Standard unit cost) * Actual Quantity Purchased
Vmp= ($525.00-$787.5)
Vmp2=(1050-787.5)
Vmp1 = - 262.5, Vmp2= 262.5
In either cases, potential price variance is $262.5
As mentioned above, Tom will not have any potential price variance
If the price increases then Tom will benefit and I will be at loss if the price decreases.
The strategy is to get an agreement with Tom to make sure that he sells the galloons at the same price if there is any increase of price in future. However, if there is a decrease in the price, he should sell the galloons at that current price(decreased price).
The other strategy would be buy the galloons in installments rather than buying all at once.
Yes, keeping the risk factors the agreement with Tom will benefit both the parties.
Hope this information would suffice you. Please let me know, if you need anything further in detail.
Thanks and Regards,
Hareen Kumar
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