Smith industry observed a probable risk that a shortage of a certain input that will affect the
project objective. smith industry must decide whether to manufacture a new component at its
factory or purchase the components from supplier to mitigate the risk. if demand for the product
is high enough It will be more profitable to manufacture the component in-house rather than
purchase it. However, the make or buy decision must be made before the demand level is known.
The projected profit (in thousands of dollars) are given in the following payoff table
ANSWER
Based on the provided payoff table and the context, Smith Industry is trying to decide whether to
manufacture the new component or purchase it from a supplier. This decision must be made
before the demand level is known, but the company is aware of three potential demand scenarios:
high demand (H), medium demand (M), and low demand (L).
Payoff Table Overview:
Alternatives High Demand (H) Medium Demand (M) Low Demand (L)
Manufacture 200 60 -30
Purchase 140 80 20
Probability 0.3 0.4 0.3
The values represent projected profit (in thousands of dollars) for each decision under different
demand conditions. The probability for each demand level is also provided.
Decision-Making Strategies:
1. Maximax (Optimistic Approach):
The Maximax criterion assumes the decision-maker is highly optimistic and will focus on the
maximum possible payoff.
Manufacture: Best payoff = 200 (high demand)
Purchase: Best payoff = 140 (high demand)
Decision: According to the Maximax approach, Smith Industry should choose to Manufacture,
as the maximum possible payoff (200) is higher than the best payoff from purchasing (140).
2. Maximin (Pessimistic Approach):
The Maximin approach focuses on the worst-case scenario and suggests choosing the option
with the best of the worst outcomes.
Manufacture: Worst payoff = -30 (low demand)
Purchase: Worst payoff = 20 (low demand)
Decision: According to the Maximin approach, Smith Industry should choose to Purchase, as
the worst-case payoff (20) is better than the worst-case payoff for manufacturing (-30).
3. Hurwicz (Weighted Average Approach):
The Hurwicz criterion is a compromise between optimism and pessimism. It involves assigning
weights to the best and worst outcomes, usually based on the decision-maker’s level of
optimism.
Let’s assume the decision-maker is 70% optimistic (α = 0.7) and 30% pessimistic (1 - α = 0.3):
Manufacture: Expected payoff = 0.7(200)+0.3(−30)=140−9=1310.7(200) + 0.3(-30) =
140 - 9 = 1310.7(200)+0.3(−30)=140−9=131
Purchase: Expected payoff = 0.7(140)+0.3(20)=98+6=1040.7(140) + 0.3(20) = 98 + 6 =
1040.7(140)+0.3(20)=98+6=104
Decision: According to the Hurwicz approach, Smith Industry should choose to Manufacture,
as the expected payoff (131) is higher than purchasing (104).
4. Equal Likelihood (Laplace):
The Equal Likelihood approach assumes equal probabilities for each state of nature (high,
medium, and low demand) and calculates the average payoff for each alternative.
Manufacture: Expected payoff = 200+60−303=76.67\frac{200 + 60 - 30}{3} =
76.673200+60−30=76.67
Purchase: Expected payoff = 140+80+203=80\frac{140 + 80 + 20}{3} = 803140+80+20
=80
Decision: According to the Equal Likelihood approach, Smith Industry should choose to
Purchase, as the average payoff (80) is higher than manufacturing (76.67).
5. Expected Value of Perfect Information (EVPI):
This strategy helps determine whether it is worth investing in gathering additional information
about demand. If perfect information were available (knowing the exact demand level), the
company could choose the best option based on the actual demand.
For perfect information, the best possible outcomes would be:
o High Demand (H): Manufacture → 200
o Medium Demand (M): Purchase → 80
o Low Demand (L): Purchase → 20
To calculate the Expected Value of Perfect Information (EVPI):
EVPI = (0.3×200)+(0.4×80)+(0.3×20)=60+32+6=98(0.3 \times 200) + (0.4 \times 80) +
(0.3 \times 20) = 60 + 32 + 6 = 98(0.3×200)+(0.4×80)+(0.3×20)=60+32+6=98
Now, compare this to the expected value without perfect information:
Expected value without perfect information:
o (0.3×200)+(0.4×60)+(0.3×(−30))=60+24−9=75(0.3 \times 200) + (0.4 \times 60)
+ (0.3 \times (-30)) = 60 + 24 - 9 =
75(0.3×200)+(0.4×60)+(0.3×(−30))=60+24−9=75
EVPI = 98 (perfect information) - 75 (current decision) = 23
This means that if Smith Industry could know the demand in advance, they would gain an
additional $23,000 in profit.
Conclusion:
Maximax Approach: Manufacture (optimistic).
Maximin Approach: Purchase (pessimistic).
Hurwicz Approach: Manufacture (optimistic with 70% weight).
Equal Likelihood: Purchase (assume equal likelihood of demand scenarios).
Recommendation:
Given that manufacturing provides the highest possible payoff under the best-case scenario, and
assuming a moderately optimistic outlook, manufacture is the optimal decision for Smith
Industry. However, if the company is highly risk-averse, it might prefer to purchase, especially
considering the worst-case scenario or financial stability considerations.
Based on the provided payoff table and context for Smith Industry's decision, the company
needs to make a make-or-buy decision regarding whether to manufacture a new component in-
house or purchase it from a supplier. The decision is influenced by the probability of different
demand levels and the projected profits (in thousands of dollars) for each option.
Payoff Table Overview:
Alternatives High Demand (H) Medium Demand (M) Low Demand (L)
Manufacture 200 60 -30
Purchase 140 80 20
Probability 0.3 0.4 0.3
Key Factors:
High Demand (H): When demand for the product is high, manufacturing provides a
large profit of 200, compared to 140 for purchasing.
Medium Demand (M): When demand is moderate, purchasing yields a better return (80
vs. 60 for manufacturing).
Low Demand (L): When demand is low, purchasing results in a positive profit (20),
whereas manufacturing results in a loss (-30).
Probabilities:
High Demand: 0.3 (30% probability)
Medium Demand: 0.4 (40% probability)
Low Demand: 0.3 (30% probability)
Possible Decision-Making Strategies:
1. Maximax (Optimistic Approach):
The Maximax criterion focuses on the maximum possible payoff assuming the best case
will occur.
Manufacture: Best payoff = 200 (high demand)
Purchase: Best payoff = 140 (high demand)
Decision: According to the Maximax approach, Smith Industry should choose Manufacture, as
the maximum possible payoff (200) is higher than purchasing (140).
2. Maximin (Pessimistic Approach):
The Maximin strategy focuses on the worst-case scenario and chooses the option with the
best of the worst outcomes.
Manufacture: Worst payoff = -30 (low demand)
Purchase: Worst payoff = 20 (low demand)
Decision: According to the Maximin approach, Smith Industry should choose to Purchase, as
the worst-case payoff (20) is better than the worst-case payoff for manufacturing (-30).
3. Hurwicz (Weighted Average Approach):
The Hurwicz criterion balances optimism and pessimism by assigning weights to the best
and worst outcomes, based on the decision-maker's level of optimism.
Let’s assume a 70% optimistic (α = 0.7) approach.
Manufacture: Expected payoff = 0.7(200)+0.3(−30)=140−9=1310.7(200) + 0.3(-30) =
140 - 9 = 1310.7(200)+0.3(−30)=140−9=131
Purchase: Expected payoff = 0.7(140)+0.3(20)=98+6=1040.7(140) + 0.3(20) = 98 + 6 =
1040.7(140)+0.3(20)=98+6=104
Decision: According to the Hurwicz approach, Smith Industry should choose to Manufacture,
as the expected payoff (131) is higher than purchasing (104).
4. Equal Likelihood (Laplace):
The Equal Likelihood approach assumes that each state of nature (demand level) is
equally probable.
Manufacture: Expected payoff = 200+60−303=76.67\frac{200 + 60 - 30}{3} =
76.673200+60−30=76.67
Purchase: Expected payoff = 140+80+203=80\frac{140 + 80 + 20}{3} = 803140+80+20
=80
Decision: According to the Equal Likelihood approach, Smith Industry should choose to
Purchase, as the expected payoff (80) is higher than manufacturing (76.67).
5. Expected Value of Perfect Information (EVPI):
EVPI helps determine the value of having perfect knowledge of demand before making
the decision. It compares the expected value with and without perfect information.
For perfect information:
High Demand (H): Best option = Manufacture → 200
Medium Demand (M): Best option = Purchase → 80
Low Demand (L): Best option = Purchase → 20
Expected value with perfect information (EVPI):
EVPI = (0.3×200)+(0.4×80)+(0.3×20)=60+32+6=98(0.3 \times 200) + (0.4 \times
80) + (0.3 \times 20) = 60 + 32 + 6 =
98(0.3×200)+(0.4×80)+(0.3×20)=60+32+6=98
Expected value without perfect information:
(0.3×200)+(0.4×60)+(0.3×(−30))=60+24−9=75(0.3 \times 200) + (0.4 \times 60)
+ (0.3 \times (-30)) = 60 + 24 - 9 =
75(0.3×200)+(0.4×60)+(0.3×(−30))=60+24−9=75
EVPI = 98 (perfect information) - 75 (current decision) = 23
Conclusion:
Maximax: Manufacture (optimistic).
Maximin: Purchase (pessimistic).
Hurwicz: Manufacture (70% optimistic).
Equal Likelihood: Purchase (equal likelihood of demand scenarios).
Recommendation:
If Smith Industry is optimistic about demand or can handle the risks associated with
manufacturing, it should manufacture the component.
However, if Smith Industry is more risk-averse and prefers to avoid potential losses
(especially in the low demand scenario), purchasing the component might be a safer
choice.
In summary, manufacturing is generally the preferred decision unless Smith Industry values
stability and guaranteed returns, in which case purchasing might be the better option.