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302 Risk and uncertainty management
lowest value of $2 million, but the other factors are at their most likely
values (variable costs per unit: $3.5, annual demand: 4 million units and
p(contract signed) = 0.6) then the annual profit can be found as follows:
Annual profit
= Demand(Price − Variable costs) + p(contract)
× Contract sales(Discounted price − Variable costs) − Fixed costs
= 4 000 000(5 − 3.5) + 0.6 × 1 000 000(4.8 − 3.5) − 2 000 000
= $4.78 million
Note that, in this calculation, we have used the expected sales that will be
achieved from the contract (0.6 × 1 million), rather than the most likely
sales level, which is of course 1 million. This is because the contract
sales will turn out to be one of two extremes, 0 or 1 million units. The
compromise value of 0.6 million is more appropriate, given that it is the
variation in fixed costs that we are investigating.
Figure 11.3 shows the tornado diagram for the Littleton site. Note
that the chart displays the lowest and highest possible values of each
factor at the ends of the bars. Although the diagram does not provide
as much information as Table 11.2, it conveys the same general message
and clearly indicates where the best opportunities for uncertainty
management are likely to be. For example, the variation in fixed costs
is associated with a major variation in profit and the same is true for
open-market demand. In contrast, a relatively small variation in profit is
associated with whether or not the contract is signed. Efforts to control
variable costs also appear to be less crucial.
2. Repeat the above process for the next best option
This is only worth considering if the next best option has performed
almost as well as that of the currently favored option in the initial risk
Demand
Fixed costs
Var. costs
p(contract)
1
6
3.8
−3 −2 −1 0 1 2 3 4 5 6
Profit $m
Figure 11.3 – Tornado diagram for Littleton
0
1
5
3.2
2