option value of capacity Ralph' s Option finds Ralph the manager of a consulting company. At present, business is slow and Ralph has 1,200 hours of consultanCs time that are not committed to one job or another. Ralph's policy is to keep the consultants on the payroll (at a rate of 30 per hour) when times are slack. It is understood that, in good times, the consultants will work overtime and not receive additional compensation.

Ralph usually bilIs the consultants at 75 per hour to customers. Variable overhead averages about 15 per hour of consultant. Other, generally fixed, costs average about 22 per hour of consultant's time. Any additional direct costs, such as travel, subcontracting of highly technieal expertise and software purchases, are directly billed to the customer.

An astute customer has just asked Ralph for help in selecting and developing a new warehouse site. This job wilI take about 1,000 hours of consultants' time.

The customer insists he will pay no more than 35 per hour for the consulting team.

aJ Determine whether Ralph should accept this offer; be certain to indude an analysis of the costs and revenues.

bJ Suppose accepting this offer wiIl not allow the consulting firm to take on any new business for the remainder of the period; and any such new business cannot be deferred to a subsequent period; it is simply lost, with no iIl wilI. Let P be the probability a customer wiIl arrive and pay 75 per hour for the full 1,200 hours;

determine the maximum value of p such that Ralph would find the 35 per hour offer aUractive.

e J Determine a value of p such that insisting on a price at least equal to full product cost would be a reasonable pricing strategy.

dj Briefly discuss how the option value of idle capacity is reported in the typical accounting library.

AppendixLO1