Operations and Supply Chain Management The Core

102 OPERATIONS AND SUPPLY CHAIN MANAGEMENT
expand could be reconsidered. Waiting longer than one year would allow competition to move in and
would make expansion no longer feasible.
The assumptions and conditions are as follows:
1. Strong growth as a result of the increased population of computer fanatics from the new electronics
firm has a 55 percent probability.
2. Strong growth with a new site would give annual returns of $195,000 per year. Weak growth
with a new site would mean annual returns of $115,000.
3. Strong growth with an expansion would give annual returns of $190,000 per year. Weak
growth with an expansion would mean annual returns of $100,000.
4. At the existing store with no changes, there would be returns of $170,000 per year if there is
strong growth and $105,000 per year if growth is weak.
5. Expansion at the current site would cost $87,000.
6. The move to the new site would cost $210,000.
7. If growth is strong and the existing site is enlarged during the second year, the cost would still
be $87,000.
8. Operating costs for all options are equal.
SOLUTION
We construct a decision tree to advise Hackers’ owner on the best action. Exhibit 4.3 shows the decision
tree for this problem. There are two decision points (shown with the square nodes) and three
chance occurrences (round nodes).
The values of each alternative outcome shown on the right of the diagram in Exhibit 4.4 are
calculated as follows:
ALTERNATIVE REVENUE COST VALUE
Excel:
Decision Trees
Move to new location, strong growth $195,000 × 5 yrs $210,000 $765,000
Move to new location, weak growth $115,000 × 5 yrs $210,000 $365,000
Expand store, strong growth $190,000 × 5 yrs $87,000 $863,000
Expand store, weak growth $100,000 × 5 yrs $87,000 $413,000
Do nothing now, strong growth, expand next year $170,000 × 1 yr + $87,000 $843,000
$190,000 × 4 yrs
Do nothing now, strong growth, do not expand next year $170,000 × 5 yrs $0 $850,000
Do nothing now, weak growth $105,000 × 5 yrs $0 $525,000
Working from the rightmost alternatives, which are associated with the decision of whether to
expand, we see that the alternative of doing nothing has a higher value than the expansion alternative.
We therefore eliminate the expansion in the second-year alternatives. What this means is that
if we do nothing in the first year and we experience strong growth, then in the second year it makes
no sense to expand.
Now we can calculate the expected values associated with our current decision alternatives. We
simply multiply the value of the alternative by its probability and sum the values. The expected value
for the alternative of moving now is $585,000. The expansion alternative has an expected value of
$660,500, and doing nothing now has an expected value of $703,750. Our analysis indicates that our
best decision is to do nothing (both now and next year)!
Due to the five-year time horizon, it may be useful to consider the time value of the
revenue and cost streams when solving this problem. If we assume a 16 percent interest rate,
the first alternative outcome (move now, strong growth) has a discounted revenue valued at