The previous post showed the connections between decisions concerning the market, the capacity profile and how to get good answers by checking certain options.
The example of last post had relatively little uncertainty around it. In most cases any action to enhance the demand is subject to high uncertainty. Other factors like the predicted capacity utilization are also impacted by uncertainty.
Let’s first remember the key question we need an answer to:
Considering the decision on the table would net profit (NP) go up or down?
This means we don’t have to know the exact impact on NP in order to make a sound decision! We need to find out the direction of the impact. We need also to validate that in the worst case the organization would be still viable – it should NOT kill the organization. The practical meaning is to establish a RED-LINE, defining the state the organization would not tolerate and thus no decision should bring the organization too close to that state!
Any prediction of the future is uncertain. However, the valuable intuition of the key executives and key professionals could carefully define the boundaries of what is highly unlikely. What should come out of these assessments is a range of likely results. My suggestion is to check the full ramifications of the two extreme values of the range, provided they are not exaggerated.
For example, suppose that the cost of materials went up by 20%, bringing the T-per-unit down from $20 to only $14 (70% of the original T). The financial people push to increase the selling price by 10% (from $50 to $55) to compensate for most of the increase in cost. The VP of Sales claims such a move would reduce the number of units sold by 20% at the very least, possibly by 50%. She also claims that if the price is not changed then sales would go up by 10-20% because some of the competitors are going to increase the price.
How would YOU handle the case, taking into account the intuition of Sales as there is no other reliable source of information?
My proposed suggestion is to create the reasonable pessimistic scenarios for both alternative decisions, and the optimistic scenarios for both.
Suppose the current T is NT. Let’s call the new total resulting T: RT
The pessimistic scenario of no change in price would come to: RT = (0.7*NT)*1.1 = 0.77NT.
The pessimistic scenario of increasing the price by 10% (bringing the T to about .95NT) RT = (0.95*NT)*0.5 = 0.475NT
The optimistic scenario and no change in price is: RT = (0.7*NT)*1.2 = 0.84*NT
The optimistic scenario and increasing the price by 10% is: RT = (0.95*NT)*0.8 = 0.76*NT
What should the decision be?
If the pessimistic case is closer to reality then we should not change the price.
If the optimistic case is closer to reality then we should not change the price.
So, the decision is clear.
If we would have conflicting results then the managerial judgment has to take into account the possible loss versus the possible gain. When you consider the loss you need to ensure it does not penetrate into the RED-LINE for the organization. If this happens – choose the other decision.
Note, we did not check the ramifications on capacity of 10-20% more sales. It could change the above results if, and only if, a penetration into the protective capacity of even one resource happens. My assumption is that the current sales are achieved by available capacity, maybe with some overtime that is fully covered by the current T. It might not be the case for 10-20% more sales. So, this part has to be checked, but this post has to be short and simple enough and thus I assume no lack of capacity even for 20% more sales.
Eli Schragenheim 