Question

Suzy Jones is trying to decide whether to use one or two suppliers for the motors than go into the chain saws that her company produces. She wants to use local suppliers because her firm runs a JIT operation. Her factory is located in a coastal town that is prone to hurricanes. She estimates that the probability in any year of a "super-event" that might shut down all suppliers at the same time for at least two weeks is 5%. Such a total shutdown would cost the company approximately $100,000. She estimates the "unique-event" risk for any of the suppliers to be 10%. Assuming that the marginal cost of managing an additional supplier is $12,000 per year, should Suzy use one or two suppliers?

Answer 1

As per the Expected Monetary Value (EVM) or so called the cost of handling the two suppliers is computed to be more than one suppler. Therefore, the company should choose one supplier instead of two.

Step-by-step explanation:

We can compute the following equation which state the probability of a total disruption of n supplier instantaneously

P (n) = S + (1 – S) × Un

Where

S is the probability of supper occurrence where all suppliers will be disrupted = 5% or 0.05

U is the probability of exceptional event where only one supplier will be disrupted = 10% or 0.1

Now using it for 1 or 2 suppliers

P (1) = 0.05 + (1 - 0.05) × (0.10) ^1

P (1) = 0.05 + (0.95) × (0.10) = 0.145

And

P (2) = 0.05 + (1 - 0.05) × (0.10) ^2

P (2) = 0.05 + (0.95) × (0.01) = 0.0595

Expected Monetary Value (EVM) for supplier = (n×C) × (1- P) + (L+ n×C) × (P)

Where,

P is the probability of a total disruption (as calculated above)

n is the number of supplier

L is the financial all earned in a supply series if all suppliers will be disrupted = $100,000

C is the marginal cost of managing one supplier = $12,000

Therefore,

EMV for one supplier = 1 × $12,000 × (1 - 0.145) + ($100,000 + 1 × $12,000) × (0.145)

EMV for one supplier = $10,260 + $16,240 = $26,500

For Two Suppliers

EMV for two suppliers = 2 × $12,000 × (1 - 0.0595) + ($100,000 + 2 × $12,000) × (0.0595)

EMV for two suppliers = $24,000 *(1 - 0.0595) + $124,000 *(0.0595)

EMV for two suppliers = $22,572 + $7,378 = $29,950

The Expected Monetary Value (EVM) or cost of dealing two suppliers is more than the one suppler. Therefore company should choose one supplier.