COLLEGUE OF LEADERSHIP AND GOVERNANCE
DEPARTMENT OF PROJECT LEADERSHIP AND MANAGEMENT
PROJECT RISK AND DECISION ANALYSIS
INDIVIDUAL ASSIGNMENT-2
TITTLE:
A case study involving a make-or-buy decision for Smith Industry
SUBMITTED BY
MIKIYAS DESSIE
ID No……………………………………ECSU 2301321
Submitted to: Meseret G. (PhD)
March 2025, Addis Ababa
CASE
Smith industry observed a probable risk that a shortage of a certain input that will affect the
project objective. smith industry must decide whether to manufacture a new component at its
factory or purchase the components from supplier to mitigate the risk. if demand for the product
is high enough It will be more profitable to manufacture the component in-house rather than
purchase it. However, the make or buy decision must be made before the demand level is known.
The projected profit (in thousands of dollars) are given in the following payoff table
ANSWER
To help you analyze the payoff table for the make-or-buy decision and guide you through
possible decision-making strategies, we’ll go through the steps needed for evaluating the risk and
potential outcomes. Here's how we can approach this:
Step 1: Understand the Case
In this scenario, Smith Industry needs to decide whether to manufacture a new component in-
house or purchase it from an external supplier. The decision must be made before the demand
level for the product is known, which means the company is facing uncertainty in its decision-
making process.
Based on the provided payoff table and the context, Smith Industry is trying to decide whether to
manufacture the new component or purchase it from a supplier. This decision must be made
before the demand level is known, but the company is aware of three potential demand scenarios:
high demand (H), medium demand (M), and low demand (L).
The decision will depend on two potential demand outcomes:
1. High Demand (more profitable to manufacture in-house)
2. Low Demand (more profitable to buy from the supplier)
1
The company must balance the risk of uncertain demand against the profit from each choice.
Step 2: Payoff Table
The payoff table is a table that displays the potential outcomes (profits) for each possible
decision under different scenarios of demand. Based on the case provided, the table might look
something like this (values are in thousands of dollars):
Alternatives High Demand (H) Medium Demand (M) Low Demand (L)
Manufacture 200 60 -30
Purchase 140 80 20
Probability 0.3 0.4 0.3
Important Key Factors
High Demand (H): When demand for the product is high, manufacturing provides a
large profit of 200, compared to 140 for purchasing.
Medium Demand (M): When demand is moderate, purchasing yields a better return (80
vs. 60 for manufacturing).
Low Demand (L): When demand is low, purchasing results in a positive profit (20),
whereas manufacturing results in a loss (-30).
Probabilities:
High Demand: 0.3 (30% probability)
Medium Demand: 0.4 (40% probability)
Low Demand: 0.3 (30% probability)
The values represent projected profit (in thousands of dollars) for each decision under different
demand conditions. The probability for each demand level is also provided.
Decision-Making Strategies
1. Maximax (Optimistic Approach):
The Maximax criterion assumes the decision-maker is highly optimistic and will focus on the
maximum possible payoff.
Manufacture: Best payoff = 200 (high demand)
Purchase: Best payoff = 140 (high demand)
2
Decision
According to the Maximax approach, Smith Industry should choose to Manufacture, as the
maximum possible payoff (200) is higher than the best payoff from purchasing (140).
2. Maximin (Pessimistic Approach):
The Maximin approach focuses on the worst-case scenario and suggests choosing the option with
the best of the worst outcomes.
Manufacture: Worst payoff = -30 (low demand)
Purchase: Worst payoff = 20 (low demand)
Decision: According to the Maximin approach, Smith Industry should choose to Purchase, as the
worst-case payoff (20) is better than the worst-case payoff for manufacturing (-30).
3. Hurwicz (Weighted Average Approach):
The Hurwicz criterion is a compromise between optimism and pessimism. It involves assigning
weights to the best and worst outcomes, usually based on the decision-maker’s level of
optimism.
Let’s assume the decision-maker is 70% optimistic (α = 0.7) and 30% pessimistic (1 - α = 0.3):
Manufacture: Expected payoff = 0.7(200) +0.3(−30)
=140 − 9=1310.7(200) + 0.3(-30)
= 140 - 9 = 1310.7(200) +0.3(−30)
=140 − 9
=131
Purchase: Expected payoff = 0.7(140) +0.3(20)
=98+6=1040.7(140) + 0.3(20)
= 98 + 6 = 1040.7(140) +0.3(20)
=98+6
=104
Decision
According to the Hurwicz approach, Smith Industry should choose Manufacture, as the expected
payoff (131) is higher than purchasing (104).
4. Equal Likelihood (Laplace):
The Equal Likelihood approach assumes equal probabilities for each state of nature (high,
medium, and low demand) and calculates the average payoff for each alternative.
Manufacture: Expected payoff = (200+60−30)/3
3
=76.67
Purchase: Expected payoff = (140+80+20)/3
=80
Decision
According to the Equal Likelihood approach, Smith Industry should choose to Purchase, as the
average payoff (80) is higher than manufacturing (76.67).
5. Expected Value of Perfect Information (EVPI):
This strategy helps determine whether it is worth investing in gathering additional information
about demand. If perfect information was available (knowing the exact demand level), the
company could choose the best option based on the actual demand.
For perfect information, the best possible outcomes would be:
High Demand (H): Manufacture → 200
Medium Demand (M): Purchase → 80
Low Demand (L): Purchase → 20
To calculate the Expected Value of Perfect Information (EVPI):
EVPI = (0.3×200) + (0.4× 80) + (0.3 ×20)
=60+32+6
=98
Now, compare this to the expected value without perfect information:
Expected value without perfect information:
EVPI = (0.3× 200) + (0.4 × 60) +(0.3× (−30))
=60+24 − 9
=75
EVPI = 98 (perfect information) - 75 (current decision) = 23 which is in thousands of
dollars.
This means that if Smith Industry could meet the demand in advance, they would gain an
additional $23,000 in profit.
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Conclusion:
Maximax Approach: Manufacture (optimistic).
Maximin Approach: Purchase (pessimistic).
Hurwicz Approach: Manufacture (optimistic with 70% weight).
Equal Likelihood: Purchase (assume equal likelihood of demand scenarios).
Recommendation:
Given that manufacturing provides the highest possible payoff under the best-case scenario, and
assuming a moderately optimistic outlook, manufacture is the optimal decision for Smith
Industry. However, if the company is highly risk-averse, it might prefer to purchase, especially
considering the worst-case scenario or financial stability considerations.
