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REVISED

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M O D U L E

Decision Theory and the Normal Distribution

TEACHING SUGGESTIONS
Teaching Suggestion M3.1: Reviewing the Normal Curve. Most of the material in this supplement requires the use of the normal curve. A review of the basic principles of the normal curve found in the probability chapter (Chapter 2) would be helpful before this module is started. Teaching Suggestion M3.2: Covering Break-Even Analysis First. Covering break-even calculations rst helps students get into decision theory and normal curve analysis. This material will also help students get back into the fundamental principles of normal curve theory. Once break-even analysis has been mastered by students, they should be ready for the rest of the material in this module. Teaching Suggestion M3.3: Spending More Time on EVPI and the Normal Distribution. EVPI and the normal distribution concepts are difcult for many students. You may need to spend more time on this topic and reinforce the basic steps involved. Some instructors reduce coverage or eliminate this topic.

information to the number you obtained in step two. EVPI will always be equal to EOL. M3-5.

VC/U = $16 P/U = $24 FC = $160,000

M = 60,000 = 10,000

a.

BE =

FC 160, 000 = = 20, 000 P / U VC / U 24 16

books

SOLUTIONS TO QUESTIONS AND PROBLEMS


M3-1. The purpose of break-even analysis is to help a manager determine at what point overall revenue will equal overall cost. It can also help the manager to determine at a certain sales volume what revenues will be generated. This knowledge can assist the manager in making decisions as to whether or not to introduce a new product to the market. M3-2. The normal distribution can be used in break-even analysis when sales are symmetrical around the mean expected demand and follow a bell-shaped distribution (when demand is normally distributed), and when there is only one random variable. Usually, the normal distribution represents the demand for a new product. M3-3. The relationship between EMV and the state of nature must be linear when you use the computations presented in Equation M3-5 in determining EMV from the mean and the standard deviation. When this relationship is not linear, the approach used in computing EMV cannot be used. M3-4. When EVPI is to be computed using a state of nature that follows a normal distribution, three steps are required. The rst step is to determine the opportunity loss function. The second step is to determine the opportunity loss using the unit normal loss integral. The third step is to equate the expected value of perfect

b. EMV (P/U VC/U)(M) FC (24 16)(60,000) 160,000 $480,000 $160,000 $320,000 M3-6. a. OLF K(BE X) for X BE OLF 0 where K (P/U VC/U) 8 Thus, EOL $8 (20,000 X) for X 20,000 $0 where X is sales in units. b. EOL KN(D) with K $8 10,000 60, 000 20, 000 D= =4 10, 000 and N(D) 0.000007145. for X 20,000 for X BE

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DECISION THEORY

AND THE

NORMAL DISTRIBUTION

Thus, EOL (8)(10,000)(0.000007145) $0.57160 c. EVPI $0.57160, since EOL EVPI 20, 000 60, 000 = 4 d. Z = 10, 000 standard deviations from A Z value for 4 is not found in the table, but we used 0.99997. Thus, P(prot) 0.99997 99.99% P(loss) M3-7. 0.00003 0.003% e. The rm should print the book

d. EVPI EOL EOL K N(D) K6 3,571 9, 000 6, 000 D= = 0.8401 3, 571 N(.84) .1120 Thus, EOL (6)(3571)(0.1120) $2,399.71, and Rudy should be willing to pay up to $2,399.71 for a marketing research study. M3-8. FC $24,000 VC/U $8 P/U $24
FC 24, 000 = = 1, 500 sets P / U VC / U 24 8 b. If D 2,000, True Lens should produce the lenses. The expected prot would be BE =

a.

Revenue (2,000 $24/set)


20% 6,000 20%

$48,000

= 9,000

12,000

Less expenses Fixed cost 24,000 Variable cost (2,000 $8/set) 16,000 Total expenses (40,000) Prot $8,000) M3-9. EMV ($28 $20)(35,000) $16,000 $264,000 No effect. M3-10. $10(30 x) for X 30 where X is actual sales a. OLF 0 otherwise

a.

Z=

(area to the left of 12,000 0.80; from Appendix A, Z value for 0.80 0.84)

Thus,

0.84 =

12, 000 9, 000

b.

D=

0.84 3,000 3,571 6, 000 9, 000 3, 000 = = 0.84 b. Z = 3, 571 3, 571 Using Appendix A gives Z(0.84) 0.79955 1 0.79955 0.20045 Thus, P(loss) 0.20045 20.045% P(prot) 0.79955 79.955% c. EMV (P/U VC/U)() FC ($10 $4)(9,000) $36,000 $54,000 $36,000 $18,000 Thus,

X 45 30 = 30
0.5N(D) N(0.5) 0.1978

EOL KN(D) $10 30 0.1978 $59.34 c. EVPI EOL $59.34 M3-11. EOL K N(D) K $8, $10, or $15 30

D=

45 30 = 0.5 30

N(D) 0.1978 EOL if K $8 (8)(30)(0.1978) $47.47 EOL if K $10 (10)(30)(0.1978) $59.34 EOL if K $15 (15)(30)(0.1978) $89.01 Thus, as the loss per lamp increases, the expected opportunity loss increases.

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DECISION THEORY

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NORMAL DISTRIBUTION

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M3-12. a. New EMV ($28 $19)(35,000) $32,000 $283,000. Go ahead with new process. b. New EMV ($32 $20)(26,000) $16,000 $296,000. Increase selling price. Xb 350 200 D= = =1 150 N(D) 0.0833 EVPI EOL KN(D) $80 150 0.0833 $999.60 The most Joe would be willing to pay is $999.60. M3-14. EVPI EOL K N(D) $500 $100 50 N(D) N(D) 0.1; from OL tables, D 0.9 X b 5, 000 X b D= = Xb 4,955 50 Break-even point is 4,955 pumps. M3-15. 700 M3-17. M3-18.

N(D) 0.08332 EVPI EOL K N(D) $15 200 0.08332 $249.96 M3-16. 750; still 200

D=

750 500 200

M3-13.

1.25; N(D) decreased to 0.05059 EOL $15 0.05059 200 $151.77 Fixed cost $4,000, Prot per job $40. Break even point 4,000/40 100 jobs. The EVPI is equal to the minimum EOL. We use the formula EOL K N(D); K 80; 15; BEP 100
D=

BEP 120 100 = = 1.33 15

N(1.33) 0.0427 EVPI EOL K N(D) $80 15 0.0427 51.24 M3-19. If the selling price increases to $150, the prot per job would increase to $70 and the break even point would be 4,000/70 57.14 units.

750 700 P ( X < 750) = P Z < = 0.60


= 750 700 = 200 0.25

D=

X b 700 500 = = 1.00 200