Sierra Mountainbikes, Inc. is developing a new order entry system to replace their awkward and faulty current system. They estimate it will take them 12 months and $1800K to achieve an Initial Operational Capability (IOC).
They also estimate that if Christmas demand for their bikes is light, that they will achieve a profit of $5000K for the first year. However, if Christmas demand is heavy and they do nothing about their equally awkward and faulty order fulfillment system, they will suffer the same fate as Toys "R" Us, with many late deliveries and angry customers at Christmas, reducing their profits to $1000K, making an unsatisfactory net operating loss for the year.
They have two options for reducing the risk of a losing outcome if demand is heavy (there is no difference in profit if demand is light): 1)Build an IOC-version order fulfillment system. This will cost $2100K, and actually increase their profits; 2)Build a smaller Core Capability version of the order fulfillment system. This will cost only $1000K, and will restore their profits back to $5000K.
Having the added order fulfillment capability thus reduces their
relative to having no new order fulfillment capability. The CCD version reduces Size(Loss) of reduced profits by $4000K. The IOC version reduces Size(Loss) by a larger amount, but costs more.
They would like to do a Risk Reduction Leverage analysis to determine which of the IOC or CC versions of an order fulfillment system is the better strategy, but they don't know the value of P(Loss), or of Size(Loss) for the IOC option.
You can help them by determining the breakeven point for P(Loss) or Size(Loss) savings-IOC (SLS-IOC): values of P(Loss) and SLS-IOC for which higher values of P(Loss) make IOC the better choice, and lower values make CC the better choice.
Do this by calculating the Risk Reduction Leverages (RRL's) for the IOC and CC decision options for the following combinations:
P(Loss) = 0.1, SLS-IOC = $7000K
P(Loss) = 0.3, SLS-IOC = $7000K
P(Loss) = 0.3, SLS-IOC = $10000K
Is the preferred decision between IOC and CC sensitive to P(Loss)? to SLS-IOC? For the decision-sensitive variable, determine its breakeven point: the value of the variable where the RRL values are equal.