of Alternative COA Principles of Cost Analysis and Management 1 Ever had a vacation disaster Car trouble Lost luggage Missed flight Something worse How did that affect your vacation ID: 713852
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Slide1
Calculate Expected Valuesof Alternative COA
Principles of Cost Analysis and Management
1Slide2
Ever had a vacation disaster?
Car trouble? Lost luggage?
Missed flight?
Something worse?
How did that affect your vacation cash flows?
2Slide3
Terminal Learning Objective
Action: Calculate Expected Values of Alternative Courses of Action.
Condition:
FM Leaders in a classroom environment working individually and as a member of a small group, using doctrinal and administrative publications, self-study exercises, personal experiences, practical exercises, handouts, and discussion.
Standard: With at least 80% accuracy (70% for International learners):Define expected value calculation Determine cash flow value of each possible outcomeAnalyze probabilities to outcomes
3Slide4
What is Expected Value?
Recognizes that cash flows are frequently tied to uncertain outcomes.
Example:
It is difficult to plan for cost when different performance scenarios are possible and the cost of each is vastly different.
Expected Value represents a weighted average cash flow of the possible outcomes.
4Slide5
Applications for Expected Value
Deciding what cash flows to use in a Net Present Value calculation when actual cash flows are uncertain.Reducing multiple uncertain cash flow outcomes to a single dollar value for a “reality check.”
Example: cost of medical insurance
5Slide6
Expected Value Calculation
Expected Value =
Probability of Outcome1 * Dollar Value of Outcome1 +
Probability of Outcome2 * Dollar Value of Outcome2 + Probability of Outcome3 * Dollar Value of Outcome3 etc.Assumes probabilities and dollar value of outcomes are known or can be estimated.Probability of all outcomes must equal 100%
6Slide7
The local youth center is running the following fundraising promotion:Donors will roll a pair of dice, with the following outcomes:
A roll of 2 (snake-eyes): The donor pays $100
A roll of 12: The donor wins $100
3 and/or 11: The donor pays $50
All other rolls: The donor pays $25Task: You are considering rolling the dice. Calculate the expected value of your donation.
7
Expected Value ExampleSlide8
Expected Value Example
What are the possible outcomes?2, 12, 3, 11 and everything else
What are the cash flows associated with each outcome?
Outcome
Cash Flow
2-$100121003 and 11-50All else-25
8
What are the probabilities of each outcome?
Outcome
Probability
2
1/36
12
1/36
3 and 11
4/36
All else
30/36
Total
36/36
Calculate Expected Value:
Given this expected value, will you roll the dice?
Outcome
Probability
*
Cash Flow
=
Expected
Value
21/36*-$100=121/36*100=3 and 114/36*-50=All else30/36*-25=Total36/36
Calculate Expected Value:Given this expected value, will you roll the dice?
OutcomeProbability*Cash Flow=Expected Value21/36*-$100=-$2.78121/36*100=3 and 114/36*-50=All else30/36*-25=Total36/36
Calculate Expected Value:
Given this expected value, will you roll the dice?
OutcomeProbability*Cash Flow=Expected Value21/36*-$100=-$2.78121/36*100=2.783 and 114/36*-50=All else30/36*-25=Total36/36
Calculate Expected Value:
Given this expected value, will you roll the dice?
OutcomeProbability*Cash Flow=Expected Value21/36*-$100=-$2.78121/36*100=2.783 and 114/36*-50=-5.55All else30/36*-25=Total36/36
Outcome
Probability
*Cash Flow=Expected Value21/36*-$100=-$2.78121/36*100=2.783 and 114/36*-50=-5.55All else30/36*-25=-20.83Total36/36
Outcome
Probability*Cash Flow=Expected Value21/36*-$100=-$2.78121/36*100=2.783 and 114/36*-50=-5.55All else30/36*-25=-20.83Total36/36-$26.38
Given this expected value, will you roll the dice?Slide9
LSA #1 Check on Learning
Q1. What variables must be defined before calculating Expected Value?
Q2.
What does Expected Value represent?
9
A1.
A2
.Slide10
Demonstration Problem
Sheila is playing Let’s Make a Deal and just won $1000. She now has two alternative courses of action:
Keep the $1000
Trade the $1000 for a chance to choose between three curtains:
Behind one of the three curtains is a brand new car worth $40,000 (which will be taxed at 22.5%)
Behind each of the other two curtains there is a $100 billTask: Calculate the Expected Value of Sheila’s alternative courses of action.
10Slide11
Step 1: Define the outcomes
Step 2: Define the probabilities of each outcomeStep 3:
Define the cash flows associated with each outcome
Step 4:
Calculate Expected Value
11
Demonstration ProblemSlide12
Define the Outcomes
Course of Action 1:
Keep the $1,000
Course of Action 2:
Trade $1,000 for one of the curtains
Two possible outcomes:New car$100 bill
12Slide13
Define the Probabilities
Keep the $1,000
Sheila already has the $1,000 in hand.
This is a certain event
The probability of a certain event is 100%
Trade $1,000 for Curtain:OutcomeProbabilityCar$100Total
13
Outcome
Probability
Car
1/3 or 33.3%
$100
2/3 or 66.7%
Total
3/3 or 100%Slide14
Define the Cash Flows
Keep the $1,000
Cash flow is
$
1,000
14
Outcome
Cash Flow
Car
$100
Trade $1,000 for Curtain:
Cash flow is $1,000
Outcome
Cash Flow
Car
$40,000
- $1,000
- $9000
= +$30,000
$100
Value of the car = $40,000
Gives up $1,000 = -$1,000
Tax 22.5% on $40,000 = -$9,000
Outcome
Cash Flow
Car
$40,000 - $1,000 - $9000 = +$30,000
$100
$100 - $1,000 = -$900
Outcome%* CF= EVKeep $1000100%$1,000$1,000Outcome%* CF= EVCar33.3%$30,000$10,000$10066.7%-$900-$600Total100%$9,400
Which would you choose?
Calculate Expected ValueSlide15
Q1. How can Expected Value be used in comparing alternative Courses of Action?
15
LSA #2 Check on Learning
A1. Slide16
Expected Value Application
Your organization has submitted a proposal for a project. Probability of acceptance is 60%
If proposal is accepted you face two scenarios which are equally likely:
Scenario A: net increase in cash flows of $75,000.
Scenario B: net increase in cash flows of $10,000.
If proposal is not accepted you will experience no change in cash flows.Task: Calculate the Expected Value of the proposal.
16Slide17
17
Expected Value ApplicationSlide18
Expected Value and Planning
If you outsource the repair function, total cost will equal $750 per repair.
Historical data suggests the following scenarios:
25% probability of 100 repairs
60% probability of 300 repairs
15% probability of 500 repairsHow much should you plan to spend for repair cost if you outsource?
18Slide19
Expected Value of outsourcing:
19
Outcome
%
*
Cash Flow=EV
100 repairs
25%
*
100 *
$750 = $75,000
=
$18,750
300 repairs
60%
*
300 *
$750 = $225,000
=
$135,000
500 repairs
15%
*
500 *
$750 = $375,000
=
$56,250Total100%$210,000
Expected Value and PlanningSlide20
If you insource the repair function, total cost will equal $65,000 fixed costs plus variable cost of $300 per repair.How much should you plan to spend for repair cost if you insource?
Given these assumptions, which option is more attractive?
20
Expected Value and PlanningSlide21
Expected Value of insourcing:
Insourcing is more attractive:
Total cash flow is higher when repairs are few, but
Probabilities of more repairs and the savings when repairs are many justify insourcing
21
Outcome
%
*
Cash Flow
=
EV
100 repairs
25%
*
(100 *
$300) + $65,000 = $95,000
=
$23,750
300 repairs
60%
*
(300 *
$300) + $65,000 = $155,000
=
$93,000
500 repairs
15%*(500 * $300) + $65,000 = $215,000 =$32,250
Total100%$149,000
Expected Value and PlanningSlide22
Expected Value and NPV
Proposed project requires a $600,000 up-front investment.The discount rate is 12%
P
roject has a five year life with the following potential annual cash flows:
10% probability of $300,000 = $30,000
70% probability of $200,000 = $140,00020% Probability of $100,000 = $20,000What is the EV of the annual cash flow? $190,000How would this information be used to evaluate the project’s NPV?
22Slide23
Proposed project requires a $600,000 up-front investment.
Project has a five year life with the following potential annual cash flows:10% probability of $300,000 = $30,000
70% probability of $200,000 = $140,000
20% Probability of $100,000 = $20,000
What is the EV of the annual cash flow? $190,000.
How would this information be used to evaluate the project’s NPV?
23
Expected Value and NPVSlide24
Q1. How can expected value be used to plan for costs when level of activity is uncertain?
24
LSA #3 Check on Learning
A1. Slide25
25
LSA # 1-3 Summary
During
this lesson, we covered the following Learning Step Activities
:
Define expected value calculation
Determine cash flow value of each possible outcome
Analyze probabilities
to outcomes
What
are your questions?Slide26
TLO Check on Learning
Divide the learners into two groups
, have each group as a group write down one question from this lesson, give about
two
minutes. Once the groups have their question written, pass it to another group to answer it. Facilitate a discussion on each question.
26Slide27
TLO Summary
Action: Calculate Expected Values of Alternative Courses of Action.
Condition:
FM Leaders in a classroom environment working individually and as a member of a small group, using doctrinal and administrative publications, self-study exercises, personal experiences, practical exercises, handouts, and discussion.
Standard: With at least 80% accuracy (70% for International learners):Define expected value calculation Determine cash flow value of each possible outcomeAnalyze probabilities to outcomes
27Slide28
TLO Summary (Cont.)
What
are your questions?
27
Expected Value is a useful method for estimating cash flows under uncertain circumstances.
Expected value assumes probabilities and dollar value of outcomes are known or can be estimated
.
The probability of all outcomes must equal 100%. Expected value may be used to evaluate alternatives.
The
expected value of an uncertain outcome can be weighed against the value of a known (100% probable) outcome.
Expected
value is also useful in estimating cash flows when multiple cost scenarios are possible, such as the demand for services. Slide29
Practical Exercises
29Slide30
Expected Value Spreadsheet
30
Use to calculate single scenario expected values
Assures that sum of all probabilities equals 100%Slide31
© Dale R. Geiger 2011
31
Spreadsheet tool permits comparison of up to four courses of action
Uses color coding to rank options
Expected Value SpreadsheetSlide32
32
Practical Exercises