MGS 3100 Decision Analysis Exercise
THE SCENARIO
You work for PeachyKeen Software as Assistant Vice President for Long-Range Planning. PeachyKeen's business is based on the following sequence of events:
As you can see from this, PeachyKeen is not truly a software developer, but is a software publisher.
Your boss, Kay Sirrah, the VP of Long Range Planning, has just met with Ivan Werkin, who has developed a new speech processing package named Ear. With a cheap telephone handset or headset (not provided), Ear will perform most functions of a keyboard and mouse. Ear has passed all of PeachyKeen's tests with few glitches. Kay is excited about the prospects for Ear, and wants you to help her decide whether the company should publish Ear.
Kay and Ivan have worked out a tentative deal. If PeachyKeen publishes Ear, it will pay Ivan $200,000 plus 5% of gross sales. While a product like Ear will carry a $295 retail list price, PeachyKeen would actually sell it into its distribution channels at $50 per copy for large orders, with the buyer paying all freight costs. PeachyKeen would calculate Ivan's 5% based on the $50/unit actual revenue, not list price.
Kay's best estimate is that, after Ivan does a final cleanup of his software and manuals, it will cost PeachyKeen about $150,000 to edit the manuals, set type, create master installation disks, design packaging, advertise, and generally prepare the product for the manufacturing stage of publishing. If they cancel the deal now, of course, they avoid these costs.
PeachyKeen's manufacturing process is set up in such a way that there is always a manually produced test run of 100 copies first. After the test run, the process is set up for a run of any number of copies. All later batches of the software must be made in that number. Thus, if the first real run is a batch of 10,000 copies, all later runs are 10,000 copy runs. It costs $25,000 to set up a run (even the test run). For Ear, it appears that the incremental manufacturing cost would be very close to $10 per copy manufactured.
Although it is a great oversimplification, Kay is willing to make the decision based on the possibility that Ear will be a Dog, a Standard, or a Killer. A Dog usually loses money. A company usually hopes that most of its new products will prove to be Standards. A Killer application, if handled right, is cause for great celebration.
In this case, she defines a Dog as selling only 10,000 copies in the first year. A Standard would sell 50,000 copies. If it is a Killer application, Ear will sell 250,000 copies in the first year on the market. It is PeachyKeen Software's policy that they will meet demand. If they plan, for example, on a product being a Standard and it turns out to be a Killer, they will produce as many more batches as may be required to meet demand, even if the extra setup costs are painful.
They do not waste the copies made in the test run. PeachyKeen sends them to a variety of publications as review copies. In their experience, the reviews have a great deal to do with the sales volume a software publisher can expect to encounter in the first year of sales. Because things change so fast in the computer and software industries, PeachyKeen never counts on a product having a life of greater than a year; if a product sells for several more years, that is "gravy".
The Options
Since the possible outcomes appear to be a Dog, Standard, or Killer application, Kay thinks it only makes sense to consider batch sizes that correspond. Thus, the only alternatives they are considering at this time are:
Kay, after consideration, has assessed the probabilities that Ear might face a Dog, Standard, or Killer demand. She has also provided for you the track record of the magazine reviews in the past. Three hundred past reviews of products by the magazines are shown, with the breakdown of the demand level that actually occured for those products later on.
In considering the Ear decision, keep in mind that making 10,000, 50,000, or 250,000 copies per batch is a decision to which PeachyKeen must commit before they know whether the product will turn out to be a Dog, a Standard, or a Killer application (but after reading the reviews). Not only that, but the reviews do not determine the demand levels. They only improve your state of information about what demand level might materialize. Thus, no matter what kind of review the techie mags give, any production decision is worth evaluating and any demand level still has some chance of occurring.
THE PROBABILITIES
Kay's probabilities are as follows.
Prior Probabilities for States of Nature (Demand).
P (Dog) = .40
P (Standard) = .50
P (Killer) = .10
Past track record of the magazine reviews of 300
products, given a demand level that actually occurred for software products
afterwards.
Demand Level
|
|
Dog |
Standard |
Killer |
|
Poor Review |
80 |
30 |
10 |
|
Good Review |
10 |
50 |
20 |
|
Rave Review |
10 |
20 |
70 |
|
Total |
100 |
100 |
100 |
YOUR JOB
This is a task that calls for Decision Analysis. The easy way to handle this sort of Decision Analysis job is either with special purpose software (which we don't have) or a spreadsheet. So you are going to build Kay Sirrah a spreadsheet. It is critical that you follow the principles of effective spreadsheet development that we have stressed. She could change her mind about how many copies of a Dog, a Standard, or a Killer the company might sell. Or she might get new cost estimates, or negotiate a better deal with Ivan Werkin. She'll want to be able to change all of those kinds of things easily and still get meaningful results. She needs all the help you can give her by providing a well designed and executed spreadsheet.
Your spreadsheet should develop the costs involved with each combination of a choice (e.g., make 50,000/batch) and an outcome (e.g., product is a Killer application). It should also develop the revenues. That will allow you to construct the Payoff Table. Be sure to label the contents of your spreadsheet in such a way that Kay can understand what you are showing her.
Develop your probabilities on the spreadsheet, and show them in some reasonable tabular form in Kay's work area. In a real situation, they would be inputs that she could change.
Your spreadsheet should at least help answer these questions:
Give Kay a brief memorandum stating your recommendations. Since Expected Monetary Value does not necessarily address all of the issues, you are not required to base your advice on strict EMV reasoning, so long as you acknowledge what EMV has to say and provide cogent reasons for your own viewpoint.
Your report should thus include: