Project 1 - Decision Analysis

You work for PeachyPub Software Publishing as Assistant Vice President for Long-Range Planning. PeachyPub's business is based on the following sequence of events:

1. An independent developer creates an innovative new software package or other computer/internet related product.
2. The developer approaches PeachyPub to distribute the software.
3. PeachyPub does intial testing of the new software for bugs, user interface, usefulness, features, and other areas of concern. The testing costs about $50,000 for every potential product tested. They test ten to twenty possibilities in a typical year, and about 2 to 5 of them pass. For PeachyPub, this testing is just a routine cost of doing business.
4. If it passes PeachyPub's testing, PeachyPub and the developer negotiate.
5. If they strike a deal, then PeachyPub specifies final "polish" (including documentation), and arranges for distribution disks, manuals, packaging, and distribution.

Your boss, Kay Sirrah, the VP of Long Range Planning, has just met with Ivan Werkin, who has developed a new speech processing package named SpeakEZ. With a cheap telephone handset or headset (not provided), SpeakEZ will perform most functions of a keyboard and mouse. SpeakEZ has passed all of PeachyPub's intial tests with few glitches. Kay is excited about the prospects for SpeakEZ, and wants you to help her decide whether the company should publish SpeakEZ.

Kay and Ivan have worked out a tentative deal. If PeachyPub publishes SpeakEZ, it will pay Ivan $200,000 plus 5% of gross sales. While a product like SpeakEZ could carry a $295 retail list price, PeachyPub would actually sell it into its distribution channels at $50 per copy for large orders, with the buyer paying all freight costs. PeachyPub would calculate Ivan's 5% based on the $50/unit actual revenue, not list price.

Kay's best estimate is that, after Ivan does a final cleanup of his software and manuals, it will cost PeachyPub about $150,000 to edit the manuals, create master installation disks and website, design packaging, advertise, and generally prepare the product for the manufacturing stage of publishing. If they cancel the deal now, of course, they avoid these costs.

PeachyPub's manufacturing process is set up in such a way that there is always a test run of 100 copies produced first. After the test run, the process is set up for a run of any number of copies. All later batches of the software must be made in that number. Thus, if the first real production run is a batch of 10,000 copies, all later runs must also be of 10,000 copies. It costs $25,000 to set up a run (even the test run). For SpeakEZ, it appears that the incremental manufacturing cost would be very close to $10 per copy manufactured.

Although it is a great oversimplification, Kay is willing to make the decision based on the possibility that SpeakEZ will be either a Dog, a Standard, or a Killer Application. A Dog usually loses money. A company usually hopes that most of its new products will prove to be Standards. A Killer application, if handled right, is cause for great celebration.

In this case, she defines a Dog as selling only 10,000 copies. A Standard would be sales of 50,000 copies. If it is a Killer application, SpeakEZ will sell 250,000 copies. It is PeachyPub Software's policy that they will meet demand. If they plan, for example, on a product being a Standard and it turns out to be a Killer, they will produce as many more batches as may be required to meet demand, even if the extra setup costs are painful.

The Options

Since the possible outcomes appear to be a Dog, Standard, or Killer application, Kay thinks it only makes sense to consider batch sizes that correspond. Thus, the only alternatives they are considering at this time are:

1. Don't sign with Ivan.
2. Sign with Ivan, do the test run, check out the reviews, and then make a decision to either

1. Drop the product at that point,
2. Make SpeakEZ in batches of 10,000 copies,
3. Make SpeakEZ in batches of 50,000 copies, or
4. Make SpeakEZ in batches of 250,000 copies.

Kay, after consideration, has assessed the probabilities that SpeakEZ might face a Dog, Standard, or Killer demand. She has also provided for you the track record of the magazine reviews in the past. Three hundred past reviews of products by the magazines are shown, with the breakdown of the demand level that actually occurred for those products later on.

In considering the SpeakEZ decision, keep in mind that making 10,000, 50,000, or 250,000 copies per batch is a decision to which PeachyPub must commit before they know whether the product will turn out to be a Dog, a Standard, or a Killer application (but after reading the reviews). Not only that, but the reviews do not determine the demand levels. They only improve your state of information about what demand level might materialize. Thus, no matter what kind of review the techie magazines give, any production decision is worth evaluating and any demand level still has some chance of occurring.

THE PROBABILITIES

Kay's probabilities are as follows.
 
Prior Probabilities for States of Nature (Demand).

P (Dog) = .40
P (Standard) = .50
P (Killer)  = .10

Past track record of the magazine reviews of 300 products, given a demand level that actually occurred for software products afterwards.

                                                                 Demand Level

This is a task that calls for Decision Analysis. So you are going to build Kay Sirrah a spreadsheet. She could change her mind about how many copies of a Dog, a Standard, or a Killer the company might sell. Or she might get new cost estimates, or negotiate a better deal with Ivan Werkin. She'll want to be able to change all of those kinds of things easily and still get meaningful results. She needs all the help you can give her by providing a well designed and executed spreadsheet.

Your spreadsheet should develop the revenues and costs involved with each combination of a choice (e.g., make 50,000/batch) and an outcome (e.g., product is a Killer application). That will allow you to compute the Payoffs (profits) for each combination. Also compute the posterior probabilities – show the joint probability table first – in the spreadsheet.

Your spreadsheet should at least help answer these questions:

1. Should PeachyPub sign a contract with Ivan Werkin on his terms? Keep in mind that if you try to keep Ivan from earning a reasonable return for his efforts, he just might take SPEAKEZ to a competitor.
2. If the reviews are Poor, should we abandon the project? Produce 10,000? 50,000? 250,000? What about if the reviews are Good? Rave?
3. In each of those cases, what's the best course of action and the corresponding Expected Value?
4. What is the Expected Monetary value for the project as a whole?

Give Kay a report with your analysis and recommendations. Since Expected Value does not necessarily address all of the issues, you are not required to base your advice on strict EV reasoning, so long as you acknowledge what EV has to say and provide cogent reasons for your own viewpoint.

Your job for the Project

1. A spreadsheet that shows all the payoff computations and probabilities.
2. A decision tree that is neatly labeled - it must show all the Payoffs, Probabilities, Expected Values and the best decision at each decision node.
3. A report in Word that summarizes for Ms. Kay Sirrah your recommendations and the reasoning behind those recommendations. Write a report that shows your analysis and interpretation.  It must have the following sections:

a.       A cover page with title, names of all the team members, and a distribution of points for each member based on participation. If each person contributes equally, each is to be allocated 100 points. If in a team of 3, one person does less and another covers up for him/her, the points may look like this 120,100, 80 (or some other combination that the team decides on). These are peer review points, and I will use those to adjust individual grades on the project.

b.      Introduction: Begin with an introduction of what the report is about, why you are thinking of starting this business.

c.       Executive Summary of your findings – what was the breakeven? Is the business worth starting? What fees would you recommend charging based on your analysis?

d.      Assumptions in your model: What basic costs and revenues did you assume? Remember that all the numbers provided in this project (including the ones you made up) are assumptions in the model.  List every single one, appropriately labeled. You can discuss how the numbers were obtained, in order to lend credibility to them (you can make up a story here – “The professor gave me the numbers” is not an acceptable answer!). Think of how you might have got the numbers if you were to actually start such a business.

e.      Analysis: Show summaries (tables and charts) of your spreadsheet analyses. Do not include every single detail from the spreadsheet. Interpret what you see in the tables or charts.

f.        Conclusion/Limitations: Discuss the kinds of things that might occur to make your analysis results less reliable.  It is important to recognize limitations of your own analysis, so that you have a realistic view of what could happen in a business.

Deliverables

Turn in the Word file of the report and the Excel Spreadsheet (with one of the files also containing the influence diagram), by uploading to iCollege.