The Microflange Company is currently facing heavy demand for one of its flanges. The existing manufacturing facility is working at full capacity on normal shifts. The firm has two options to meet the current heavy demand: either instituting overtime, or installing new machinery. The choice between the options depends mainly on what happens to sales over the next two years. During the first year, management estimates that there is a 70 percent chance that sales will rise and a 30 percent chance that they will fall.
At the end of the first year, Microflange can make another round of decisions.
If sales rise in the first year, Microflange has the following options: If the initial choice was to install a new machine, the company could install a second machine or institute overtime. If the initial choice was to institute overtime, the company could install a machine or install a machine and use overtime.
If sales in the first year fall, Microflange has the following options: If the initial decision was to install a new machine, the company would continue to use the existing capacity of the machine added at the beginning of the first year. If the initial decision was to institute overtime, the company would continue to use overtime to meet demand.
In the second year, sales will either be high or low. Because management is unsure about sales beyond the first year, they have assigned equal probabilities to high and low sales. Based on the decision tree provided on the following page:
1) What is your recommendation to the Microflange Company? What is the expected payoff for this recommendation? You must include the EMV for each of the alternatives at the three numbered decision points on the decision tree.
2) At what probability of sales rising during the first year, will the Microflange be indifferent between installing a new machine and instituting overtime?