A car company is planning the introduction of a new luxury sports car. There are

Question

A car company is planning the introduction of a new luxury sports car. There are two options for production. One is to produce the electric car at the company’s existing plant in Illinois, sharing production with its other products that are currently being produced there. If the sales of the new car are moderate, this will work out well as there is significant capacity to produce all of the products there. However, if sales of the new car are strong, this option would necessitate adding a 3rd shift, which would lead to significantly higher costs.

Another option is to build a new plant in Missouri. The new plant would have sufficient capacity to meet whatever level of demand for the new car. However, if sales of the new car not strong, the plant would be underutilized and less efficient.

Since this is a new product, sales are hard to predict. The forecast indicates there is a chance of strong sales (annual sales of 2,000,000), and a chance of moderate sales (annual sales of 500,000). The average revenue per car sold is $50k.

Production costs per car for the new car are dependent on sales. This is indicated in the data below.

Moderate Sales Strong Sales

Shared Site in IL $32k per car $38k per car

Dedicated Site in MO $28k per car $25k per car

The cost, including construction and all fixed costs, for the Missouri plant is $500 million regardless of sales volume. The cost, including construction and all fixed costs, for the Illinois plant is $200 million regardless of sales volume. Due to the uncertainty in expected sales for the new car, this company is considering conducting a market survey to determine customer attitudes toward it and better predict the likelihood of strong sales. The marketing survey would give one of two results—a positive attitude or a negative attitude toward the design. This tactic has been used this before for other vehicles. Since this is a new design, there is an equal chance that the results will be positive or negative. If positive, the likelihood of strong sales is projected to be 80%. If negative, the likelihood of strong sales is projected to be 35%.

Assuming such a survey is conducted, construct a decision tree to determine how the company should proceed and what the expected annual profit would be (ignoring the cost of the survey).

1. Draw a decision tree for this problem.

2. What should management do to achieve the highest expected payoff?

Explanation / Answer

1. Lets first consider the Moderate Sales and Site at Illinois.

The total production cost = Fixed cost + Car production cost = 200,000,000 + (500,000 * 32,000) = 16,200 M

The total revenue = (500,000 * 50,000) = 25,000 M.

So total profit = 8,800 M.

2. Lets consider Moderate Sales and Site at Missourie.

The total production cost = Fixed cost + Car production cost = 500,000,000 + (500,000 * 28,000) = 14,500 M

The total revenue = (500,000 * 50,000) = 25,000 M.

So total profit = 10,500 M.

3. Lets consider Strong Sales and Site at Illinois.

The total production cost = Fixed cost + Car production cost = 200,000,000 + (2,000,000 * 32,000) = 64,200 M

The total revenue = (500,000 * 50,000) = 100,000 M.

So total profit = 35,800 M.

4. Lets consider Strong Sales and Site at Missourie.

The total production cost = Fixed cost + Car production cost = 500,000,000 + (2,000,000 * 28,000) = 56,500 M

The total revenue = (500,000 * 50,000) = 100,000 M.

So total profit = 43,500 M.

So the site at Missourie provide more profit in all possible scenario.

Hence opening a site at Missourie will be the right decision.

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