Issi 1

ENM 383.2: Strategic Decision and Risk Analysis

Integrated Siting Systems, Inc. Case Report

John – As you are aware, we have had little experience in the dense urban environments of Midwestern cities, and everything from the dimensions and configuration of the buildings to the characteristics of the trees could create interference with the line-of-sight reception of the satellite transmissions we need for our systems to function appropriately. I emphasized this difficulty to our Sales team prior to contract negotiations and suggested a stronger and more powerful system alternative than the standard package that we have installed elsewhere, unfortunately – fearing loss of the contract, Sales priced the package at $850,000. This amount does represent a small premium over the normal markup on a standard system (which, as you know, would cost $550,000 to deliver and install), but it is not a sufficient markup for the robust package ($700,000 to deliver and install) that I guarantee would work in this new environment. Current simulations indicate a 90% chance that the standard system will meet the performance requirements of the contract. Better estimates of the environmental

parameters that determine this factor could be obtained and a new series of simulations could be run for $50,000. The System Design team has determined that a standard system will work 96% of the time if it were to pass this new test and, even if it failed there would be a 72% chance that it would still work anyway. Contract terms stipulate that ISSI’s obligations should the system fail include pre-specified penalties for a delay in system launch time and pulling and replacing the units with more powerful processors and receivers, The complete and total incremental cost resulting from this in-field replacement project would be $400,000. However, this does not include any intangible costs of lost reputation resulting from our first major failure, negative media coverage, and any additional detracting factors. For the purposes of our discussion, allow me to introduce a variable, §, which is equal to the total cost of an infield replacement, including these intangible costs. I have incorporated the various alternatives and probabilities into a decision tree (which you can see in Figure 1) for purposes of analysis and decision making and have a set of recommendations for you moving forward. If you believe that § < $1,250,000, then we should not invest the $50,000 in the development of the new test. Furthermore, we should install a standard system and trust that it will work correctly. Somewhat similarly, if you think that § > $2,083,333.33, we should not pursue the new test, but we should install a robust system instead and have peace of

mind that it will work every time. However, if you are of the opinion that $1,250,000 < § < 2,083,333.33, then we must spend the $50,000 to create the new test. Given that a standard system passes our stronger evaluation, I suggest installing it (and do so with a high degree of confidence), but if it should fail, then going with the alternative robust design would be the wiser and more prudent choice. You can see the graphical interpretation of this § sensitivity analysis and the resultant decisions in Figure 2 (as well as the expected monetary value of the project corresponding to the optimal decision in each case in Figure 3). If we take the intangible cost of an in-field replacement to be $1.2 million, then § = $1,600,000. Without the test, my analysis concludes that we are better off going with a robust system and that we will make $150,000 from this project. According to my work however, we should develop the test, then act according to the results of a standard system (I have included the optimal decision tree for your reference in Figure 4), and I project that we have an expected monetary value (EMV) of $164,500, which is $14,500 more than if we hadn’t pursued the test. We can compare this number to the value of perfect information 1, with the understanding that perfect information tells us exactly whether a standard system is going to turn out good and perform according to the terms of the contract or not. Without this information, our decision is as before (to go with the robust design with 1

Please note that for the purposes of this analysis, I am pretending that the

information is free – a convention that allows us to compare different types of information more easily.

an EMV of $150,000). If we know that a standard system will work perfectly, then we obviously change our decision and install it instead of the robust design. This choice correlates with an EMV of $300,000 and a change in EMV of $150,000. If we know that a standard system will not work, then we do not change our decision, and therefore this information (albeit perfect) actually has no value, because information that does not change your decision inherently is of zero value. Multiplying the change in EMV associated with the perfect information that a standard system will work well times that very probability (90%) yields an expected value of perfect information of $135,000. Therefore, our value of sample information is roughly 11% of the potential value of perfect information. I have included additional information (including the risk profile, statistics, and a table for the decision where § = $1,600,000) for you in an appendix to this report should you wish to explore the situation in further granularity, and would ask that you please contact me immediately should you have any questions, concerns, or comments whatsoever. I’d be more than happy and capable to assist you in making the best decision for our company.

Best and thanks, Jordeen