Delicious Foods Corporation
The Delicious Foods Corporation makes nutrition (candy) bars. Next month (January) the company plans to sell nearly 200,000 pounds of candy (although they don't call it candy because they extol its nutritional value), which will be packaged as 600,000 bars; the price Delicious Foods will receive is 28 cents ($0.28) for each bar. Production capacity for the plant is 640,000 bars per month. The cost estimates for next month are:
Fixed Costs (do not vary with number of bars made)
Fixed manufacturing costs (factory overhead) $ 21,500
Fixed administrative costs (office overhead) 11,500
Advertising 4,500
Interest 4,100
Variable Costs (each of these is a "per bar" cost)
Labor 4 cents per bar
Materials 8 cents per bar
The planning horizon for Delicious Foods is the next five months, January thru May. For January, the price will be $0.28 per bar; after that, the price will increase to $0.29 for two months, and then to $0.30 for two months. The number of bars made and sold is projected to begin at 600,000 bars, and then increase 2.5% each month until the capacity of 640,000 bars is reached. Because of the rapid growth, substantial increases in other costs are projected as follows:
Fixed manufacturing costs (factory overhead) increase 5% per month
Fixed administrative costs (office overhead) increase 7% per month
Advertising increase 8% per month
Interest will not change
Labor increase 10% per month
Materials increase 0.1 cents
($0.01) per bar each month
The General Manager (GM) is considering augmenting the advertising with a marketing cam¬paign designed to increase volume. This additional advertising would cost $7500 in January and $1500 in each of the remaining four months of the planning horizon. These campaign costs are in addition to the advertising costs already discussed. Once started, the marketing campaign must continue. The thrust of the campaign is to enhance the quantity of bars sold at the prices projected above. The GM believes that the campaign will either be a flop (leaving the quantity sold as projected), be moderately successful (bringing about an 8% monthly increase in quantity sold, instead of 2.5%), or be very successful (bring¬ing about a 15% monthly increase in quantity sold, instead of 2.5%). A decision to begin the campaign must be made within a day or two.
The campaign may not be a very good idea if the capacity limits (640,000 bars per month) are reached. Negotiations have taken place to obtain expanded facilities at the end of the first month, when it will be known if the advertising campaign is a flop, is moderately successful, or is very successful. The facilities expansion will cost $500 a month for the remaining four months, to increase capacity to 750,000 bars a month. Increasing the capacity to 1,000,000 bars a month would cost $1000 a month for the remaining four months. The capacity decision is made at the beginning of the second month; once made, it cannot be changed.
The probabilities of success for the campaign are flop, 0.1; moderate, 0.5; very successful, 0.4.
Analysis
What is the GM's primary issue at this point? The first decision that must be made is whether to undertake the advertising campaign. There is a secondary issue facing the GM: whether to expand the capacity of the factory. While it is known that there is enough capacity for January (planned production: 600,000 bars; capacity: 640,000 bars), it may be advantageous to obtain more capacity. If the campaign is started, the decision to obtain more capacity can be made after the first month's results are known. The GM believes that the growth rate in the first month will continue throughout the "planning horizon". (Oh, how wordy that has become!) The purpose of the wordiness is to demonstrate vividly the ability of a decision tree to communicate the sequence of acts and events. Develop such a decision tree for the GM.
The scenario has provided the probability values, so they present no difficulty. The terminal values for profit will require substantial computation, however. A spreadsheet model is a useful way to calculate these terminal values. The model should calculate the profit before tax for any combination of campaign decision, campaign event (bar growth rate), and capacity decision. Rather than attempt to develop one model to simultaneously evaluate all end points, you should try to build one model that can be used to evaluate each end point by changing the values in a few cells.
Activities:
Write a report for the GM (and be prepared to present it).
a. Construct a spreadsheet model using the data provided.
b. Use the model to find all terminal values in the decision tree.
c. Construct the decision tree, placing probabilities on appropriate branches.
d. Use the tree to recommend a course of action.
e. What would be the end result (net income) if the worst possible set of events occurred? Discuss.
f. What would be the end result (net income) if the best possible set of events occurred? Discuss.
g. Which would be worse, to have a very successful ad campaign and not expand production or to have a poor ad campaign and expand production? (Assume you don't know the result of the campaign before you have to decide on expansion.) Why. Explain in detail.
h. At what cost for expanded capacity would expansion become infeasible? Explain.