World Engines (WE) is one of the largest producers of aircraft and ship engines in the world. It has assets in excess of $600bn. It is currently considering improvements to its marine engine production facilities. These improvements include the introduction of specialist hardware and software engine testing technology. Two companies have been shortlisted for supplying this technology.
Amethyst is a well-established company whose product provides sophisticated testing facilities and costs $7m. The software that supports the product is written in a conventional programming language. The solution is widely used, but it is relatively inflexible and it has an out-of-date user interface. Amethyst has been trading profitably for 20 years and currently has an annual turnover of $960m.
Topaz is a relatively new company (formed three years ago) whose product is more expensive ($8m) but it offers significant advantages in high volume performance and stress testing. It has a modular software design that allows it to be easily maintained and upgraded. It is written in a relatively new powerful programming language and it also has an attractive and contemporary user interface. Topaz currently has a turnover of $24m per year. Some WE executives are concerned about purchasing from such a young, relatively small company, although externally commissioned credit reports show that Topaz is a profitable, liquid and lightly geared company.
On a recent evaluation visit to Amethyst, WE’s complete evaluation team of five people, including the financial specialist, were killed when their aircraft crashed on its approach to landing. It was a small, 12 seat commuter aircraft that was flying the WE team on a short 100 km flight from the international airport to a small rural airport close to Amethyst’s base. It later emerged that small commuter airlines and aircraft were subject to less stringent safety procedures than larger aircraft used by established airlines.
Later that year, one of the divisional directors of WE was given responsibility for picking up and running the testing technology evaluation project. He has found the following table (Figure 1) produced by the financial specialist in the evaluation team who was killed in the air crash. The divisional director recalls that these returns were based on ‘tangible benefits resulting from the two options. The returns reflect the characteristics of the two products. Topaz produces better returns if demand for testing is high, but is less effective in low demand circumstances. This is a reflection of the fact that the two solutions differ slightly in terms of their functional scope and power’.
The divisional director also recalls a workshop convened to consider future market demand.
‘Demand in the marine industry is currently affected by global economic uncertainty and it is increasingly difficult to predict demand. I remember that we were also asked to estimate demand for our marine products for the next six years. We eventually came up with the following figures, although it was relatively hard to get everyone to agree and debate at the workshop became a little heated’.
– High demand for six years: probability p = 0·4
– Low demand for six years: probability p = 0·4
– High demand for three years, followed by low demand for three years: probability p = 0·2
These figures are confirmed by a document also recovered from the air crash site. ‘As I recall’, said the divisional director, ‘the financial specialist intended to develop a decision tree to help us evaluate the Amethyst and Topaz alternatives. However, there is no evidence that he ever constructed it, which is a pity because we could have taken the procurement decision on the basis of that decision tree’.
Required:
(a) Develop a decision tree from the information given in the scenario and discuss its implications and shortcomings. Ignore the time value of money in your analysis. (9 marks)
(b) The divisional director suggests that the procurement decision could have been taken on the evidence of the decision tree. Discuss what other factors (not considered by the decision tree analysis) should also be taken into consideration when deciding which option to select. (6 marks)
(c) WE executives are concerned about the risk of Topaz, as a relatively new company, going out of business. They have also expressed concern about the loss of the evaluation team in a fatal accident and they believe that this should lead to a review of the risks associated with employee travel.
Discuss how EACH of the above risks (supplier business failure and employee travel) might be avoided or mitigated. (10 marks)