Advanced: Calculation of expected value of perfect and imperfect information Butterfield Ltd manufactures a single brand of dog- food called ‘Lots O’ Grissle’ (LOG). Sales have stabilized for several years at a level of £20 million per. annum at current prices. This level is not expected to change in the foreseeable future (except as indicated below). It is well below the capacity of the plant. The managing director, Mr Rover, is considering how to stimulate growth in the company’s turnover and profits. After rejecting all of the alternative possibilities that he can imagine, or that have been suggested to him, he is reviewing a proposal to introduce a new luxury dog-food product. It would be called ‘Before Eight Mince’ (BEM), and would have a recommended retail price of £0.50 per tin. It would require no new investment, and would incur no additional fixed costs.

Mr Rover has decided that he will undertake this new development only if he can anticipate that it will at least break even in the first year of opera¬ tion.

(a) Mr Rover estimates that BEM has a 75% chance of gaining acceptance in the market¬ place. His best estimate is that if the product gains acceptance it will have sales in the forthcoming year of £3.2 million at retail prices, given a contribution of £1 million after meeting the variable costs of manufac¬ ture and distribution. If, on the other hand, the product fails to gain acceptance, sales for the year will, he thinks, be only £800 000 at retail prices, and for various reasons there would be a negative contribution of £400000 in that year.

You are required to show whether, on the basis of these preliminary estimates, Mr Rover should give the BEM project further consid¬ eration. (4 marks)

(b) Mr Rover discusses- the new project infor¬ mally with his sales director, Mr Kfioo Chee Khoo, who suggests that some of the sales achieved for the new product would cause lost sales of LOG. In terms of retail values he estimates the likelihood of this as follows:

There is a 50% chance that sales of LOG will fall by half of the sales of BEM. There is a 25% chance that sales of LOG will fall by one-quarter of the sales of BEM.

There is a 25% chance that sales of LOG will fall by three-quarters of the sales ofBEM.

The contribution margin ratio of LOG is 25% at all relevant levels of sales and output. You are required to show whether, after accepting these further estimates, Mr Rover should give the BEM project further consid¬ eration. (5 marks)

(c) Mr Rover wonders also whether, before attempting to proceed any further, he should have some market research undertaken. He approaches Delphi Associates, a firm of market research consultants for whom he has a high regard. On previous occasions he has found them to be always right in their fore¬ casts, and he considers that their advice will give him as near perfect information as it is possible to get. He decides to ask Delphi to advise him only on whether or not BEM will gain acceptance in the marketplace in the sense in which he has defined it; he will back Mr Khoo Chee Khoo’s judgement about the effects of the introduction of BEM on the sales ofLOG. If Delphi advise him that the product will not be accepted he will not proceed further. Delphi have told him that their fee for this work would be £100000.

You are required to show whether Mr Rover should instruct Delphi Associates to carry out the market research proposals.

(5 marks)

(d) Preliminary discussions with Delphi suggest that Delphi’s forecast will not be entirely reliable. They believe that, if they indicate that BEM will gain acceptance, there is only a 90% chance that they will be right; and, if they indicate failure to gain acceptance, there is only a 70% chance that they will be right. This implies a 75% chance overall that Delphi will indicate acceptance, in line with Mr Rover’s estimate.

You are required to show the maximum amount that Mr Rover should be prepared to pay Delphi to undertake the market research, given the new estimates of the reliability of their advice. (5 marks)

(e) You are required to outline briefly the strengths and limitations of your methods of analysis in (a)-

(d) above.