Smith Brewery produces and sells nationally a popular premium beer and has enjoyed good profits for many years. In recent years, however, its sales volume has not grown with the general market. This lack of growth is due to the increasing popularity of light beer and the fact that Smith has not entered this market.
Smith is now developing its own light beer and is considering potential marketing strategies. Introducing the new light beer nationally will require a large commitment of resources for a full nationwide introduction because Smith is a late entry into the light beer market. Smith's advertising agency has helped assess the market risk and has convinced the Smith management that there are only two reasonable alternative strategies to pursue.
(a) Strategy 1 is to perform a test advertising and sales campaign in a limited number of states for a 6-month period. Smith would decide whether or not to introduce the light beer nationally and conduct a nationwide promotional campaign on the basis of the results of the test campaign.
(b) Strategy 2 is to conduct a nationwide promotion campaign and make the new light beer available in all 50 states immediately, without conducting any test campaign. The nationwide promotion and distribution campaign would be allowed to run for a full 2 years before a decision would be made to continue the light beer nationally.
Smith management believes that if strategy 2 is selected, there is only a 50% chance of its being successful. The introduction of light beer nationally will be considered a success if $40 million of revenue is generated, while $30 million of variable cost is being incurred during the 2-year period in which the nationwide promotion and distribution campaign is in effect. If the 2-year nationwide campaign is unsuccessful, revenue is expected to be $16 million and variable cost will be $12 million. Total fixed cost for the 2-year period will amount to $6 million, regardless of the result.
The advertising agency consultants believe that if strategy 1 is selected, there is a 20% chance that the test will indicate that Smith should conduct a nationwide promotion and distribution campaign when, in fact, a nationwide campaign would be unsuccessful. In addition, the consultants believe that there is a 20% chance that the test results will indicate Smith should not conduct a nationwide promotion and distribution when, in fact, a nationwide campaign would be successful. The cost of the test campaign is estimated to be $500,000, and the probability of a successful test is 50%.
Required:
(1) Prepare a decision tree representing Smith's decision problem, including all decision alternatives and possible outcomes with related expected values.
(2) Recommend the best strategy to Smith management, based on the results indicated by the decision tree analysis.
(3) Criticize the expected value decision criterion.