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The Two Valleys Company 299
Fixed costs
Costs Revenue
Variable
costs
Open market
demand
Figure 11.1 – Sources of uncertainty at Two Valleys Company
Table 11.1 – Estimated values for uncertain factors
Location
Contract won?
Callum falls Littleton
Lowest Most Highest Lowest Most Highest
Factor likely likely
Annual fixed costs ($m) 6 7.5 9 2 4 6
Variable cost per unit ($) 2.7 3.0 3.3 3.2 3.5 3.8
Annual demand 1 4 7 (as for Callum Falls)
(units in millions)
p(contract won?) 0 0.6 1 (as for Callum Falls)
of financial return. This is shown in Figure 11.1. Table 11.1 shows the
estimated ranges of values of these factors and their most likely values.
Probabilities distributions were then estimated for the costs and level
of open-market demand. It was also estimated that there was a 0.6
probability that the contract would be signed. A risk-analysis simulation
model (see Chapter 7) was then used to generate cumulative probability
distributions for the annual profit of each site. These are shown in
Figure 11.2.
The simulation shows that Littleton exhibits first-order stochastic
dominance over Callum Falls. In addition, its expected annual profit is
$2.38 million as opposed to only $1.52 million for Callum Falls. However,
although Littleton is the preferred location, in terms of annual profit,
it is not a risk-free option. The simulation revealed that it has an 8%
probability of generating a loss and this could be as high as $2.8 million.