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The Two Valleys Company 301
annual profit and what would the probability distribution of profit now
look like? If we increase the probability of obtaining the contract to 1.0
and carry out a new simulation this reveals that the expected profit
associated with Littleton increases to $2.7 million – an increase of just
$320 000 on the current expected payoff. In addition, the risk of a loss
reduces from 5.7% to 2.9%. Littleton’s limited capacity means that its
dependence on winning the contract is relatively low.
We can carry out similar analyses on the other uncertain quantities,
changing each in turn to its most favorable value, while assuming the
other quantities cannot be controlled. What if the managers could take
actions to ensure that the fixed costs of Littleton were at their lowest
possible value of $2 million? What if they were able to ensure that openmarket
demand would be equivalent to the highest possible level of
demand that Littleton could cope with (5 million units, or 4 million units
if the contract is signed)? What if they could ensure that variable costs
will be at their lowest possible level? Table 11.2 summarizes the results
of simulations that were run to determine the effect of these actions.
The results suggest that trying to reduce fixed and variable costs or
increase demand has the greatest potential for increasing expected profit
and reducing the chances of incurring a loss. In contrast, looking into
ways that might increase the chances of the contract being accepted and
efforts to reduce variable costs are likely to be less productive.
Obtaining these results involves quite a lot of effort. Each action that
is being evaluated requires a new simulation run and in a complex
problem, involving a large number of uncertain quantities, this could
be extremely time consuming. A quicker method, which is available
on most risk-analysis packages, involves the generation of a tornado
diagram. As discussed in Chapter 7, this will show the effect on the
profit if each of the uncertain quantities in turn varies between its
lowest and highest possible values, while all of the other factors are
held at their most likely values. For example, if fixed costs are at their
Table 11.2 – Results of risk management actions
Action
Increase
in expected profit
Risk of a
loss
Lowest
possible profit
Do nothing $0.0 8.0% −$2.8m
Contract signed $0.32m 2.9% −$2.4m
Fixed costs at lowest $1.98m 0.2% −$1.8m
Highest possible demand $0.95m 0 $0.33m
Variable costs at lowest $1.22m 1.8% −$2.0m