Case Scenario: LUMI's choice
LUMI, a manufacturer of electronic components, is trying to select a single supplier for the raw materials that go into its main product, Electrolytic Capacitor. This is a new capacitor that is used by cellular phone manufacturers to protect microprocessors from power spikes. Two companies can provide the necessary raw materials-Chemicom and Jianghai.
Chemicom has a solid reputation for its products and charges a higher price on account of its reliability of supply and delivery. Chemicom dedicates plant capacity to each customer, and therefore supply is ensured. This allows Chemicom to charge $1.20 for the raw materials used in each Electrolytic capacitor.
Jianghai is a small raw materials supplier that has limited capacity but charges only $0.90 for a unit's worth of raw materials. Its reliability of supply, however, is in question. Jianghai does not have enough capacity to supply all its customers all the time. This means that orders to Jianghai are not guaranteed. In a year of high demand for raw materials, J ianghai will have 90,000 units available for LUMI. In low-demand years, all product will be delivered.
If LUMI does not get raw materials from suppliers, it needs to buy them on the spot market to supply its customers. LUMI relies on one major cell phone manufacturer for the majority of its business. Failing to deliver could lead to losing this contract, essentially putting the firm at risk. Therefore, LUMI will buy raw material on the spot market to make up for any shortfall. Spot prices for single-lot purchases (such as LUMI would need) are $2.00 when raw materials demand is low and $4.00 when demand is high.
Demand in the raw materials market has a 75 percent chance of being high each of the next two years. LUMI sold 100,000 Electrolytic capacitors last year and expects to sell 110,000 this year. However, there is a 25 percent chance it will sell only 100,000. Next year, the demand has a 75 percent chance of rising 20 percent over this year and a 25 percent chance of falling 10 percent. LUMI uses a discount rate of 20 percent. Assume all costs are incurred at the beginning of each year (Year 1 costs are incurred now and Year 2 costs are incurred in a year) and that LUMI must make a decision with a two-year horizon. Only one supplier can be chosen, as these two suppliers refuse to supply someone who works with their competitor.
Q1. Which supplier should LUMI choose? Using the decision tree to do expected value calculation for each of the two options to support your choice.
Q2. What other information would you like to have to make this decision?