Management Accounting- Probability and decision

As an appliance dealer, you are deciding how to service your one-year warranty on the 1,000 colour television sets you have just sold to a large local hotel.  You have three alternatives:

1.   A reputable service firm has offered to service the sets, including all parts and labour, for a flat fee of £18,000.

2.   For £15,000, another reputable service firm would furnish all necessary parts and provide up to 1,000 service calls at no charge.  Service calls in excess of that number would be £4 each.  The number of calls is likely to be:

      Event                              Chance                      Probability             Total Cost

                                       of Occurrence              of Occurrence                 £

1,000 calls or less                     50%                               0.5                       15,000

1,500 calls                                   20                                0.2                       17,000

2,000 calls                                   20                                0.2                       19,000

2,500 calls                                   10                                0.1                       21,000

                                                 100%                            1.0

                                                  ===                               ==

3.   You can hire your own labour and buy your own parts.  Your past experience with similar work has helped you to formulate the following probabilities and total cost:

      Event                              Chance                      Probability             Total Cost

                                       of Occurrence              of Occurrence                  £

Little trouble                           10%                                  0.1                         8,000

Medium trouble                          70                                 0.7                       10,000

Much trouble                              20                                 0.2                       30,000

                                               100%                              1.0

                                                 ==                                  ==

Required:

Using the expected monetary value approach, compare the three alternatives. 

Which plan do you favour? Why?

                                                                                                                    (25 Marks)

Alternative        (1)	Event          (2)	Cost        (3)	Probability        (4)	Expected Cost     (5) = (3) x (4)
Alternative 1: Service firm, flat fee	Any level of  demand	£18,000	1.0        ===	£18,000      ======
Alternative 2: Service firm fixed + variable fee	1,000 calls or less 1,500 calls 2,000 calls 2,500 calls	£15,000     17,000     19,000     21,000	0.5        0.2        0.2        0.1        1.0       ===	£75,000         3,400         3,800         2,100       16,800       =====
Alternative 3: Hire own labour + parts	Little trouble Medium trouble Much trouble	£8,000     10,000     30,000	0.1        0.7        0.2        1.0        ===	£     800         7,000         6,000       13,800        =====

Hiring your own labour and buying your own parts (Alternative 3) is the preferred alternative.  It gives a maximum expected monetary value (lowest expected cost) of the three alternatives.

Note that there is a 20% chance that the cost of Alternative 3 will soar to £30,000, but there is no uncertainty about Alternative 1.  Comparison of the £18,000, £16,800, and £13,800 costs, by themselves, is not as informative as having these figures plus some idea of the probability distributions they represent.  The accountant should explicitly indicate the degree of uncertainty accompanying the relevant cost estimates.