Xiaotian Geng, president of Shanghai Manufacturing Corp., wants to create a portfolio of suppliers for the motors used in her company’s products that will represent a reasonable balance between costs and risks. While she knows that the single-supplier approach has many potential benefits with respect to quality management and just-in-time production, she also worries about the risk of fires, natural disasters, or other catastrophes at supplier plants disrupting her firm’s performance. Based on historical data and climate and geological forecasts, Xiaotian estimates the probability of a “super-event” that would negatively impact all suppliers simultaneously to be 0.5% (i.e., probability 5 0.005) during the supply cycle. She further estimates the “unique-event” risk for any of the potential suppliers to be 4% (probability 5 0.04). Assuming that the marginal cost of managing an additional supplier is $10,000, and the financial loss incurred if a disaster caused all suppliers to be down simultaneously is $10,000,000, how many suppliers should Xiaotian use? Assume that up to three nearly identical suppliers are available.

APPROACH c Use of a decision tree seems appropriate, as Shanghai Manufacturing Corp. has the basic data: a choice of decisions, probabilities, and payoffs (costs).