Management Accounting
Expected Value of Perfect Information
Perfect
information is knowledge about the future that would enable us to make the best
choice today for any possible situation in the future. If we know in advance
the future state of the economy, we could make a much more informed choice
between say, Project X and Project Y.
As we calculate
the expected value of perfect information (EVPI), we should keep in mind that
we do not know in advance what the perfect information will be. In other words,
we must determine what it would be worth to us to know this perfect information
before we know what we are buying and what amount of return we can expect from
the deal.
Companies can
sometimes obtain information that reduces or eliminates the uncertainty
associated with the different future events/states of nature of a problem. The
EVPI refers to the maximum amount a company would pay to obtain this
information.
Formula to calculate EVPI:
EVPI = EV of best alternative with perfect information – EV of best alternative without perfect information
Part B
Management Accounting
Expected Value of Perfect Information
Selected Problems and Solutions
Problem: 1
A company which produces cheese slices and other cheese related products has to decide about how much of sliced cheese to produce per week. The probability of sales in kgs is as follows:
|
Production
in kg (di) |
200 |
210 |
220 |
230 |
240 |
250 |
|
Probability
(pi) |
0.1 |
0.2 |
0.3 |
0.2 |
0.1 |
0.1 |
A kg of cheese
sells for Rs 100 in the market and has a cost of Rs 75. The company never sells
cheese that is more than a week old in the market. Any unsold cheese is sold to
a local restaurant for Rs 60 per kg.
Required:
1.
Construct
a pay-off table and use it to determine the optimal quantity of cheese to be
produced per week and also the expected profit; and
2.
Compute
the Expected Value of Perfect Information (EVPI).
Solution: 1
Problem: 2
Building Ltd. owns land in Noida and intends to build
a condominium development on the site. The company is deciding on whether to
build a small, medium or large development. Demand is uncertain and fluctuates;
demand could be low, medium or high. Management at Building Ltd. has determined
profit pay-offs as follows:
|
Building alternatives |
Demand (in Rs ’000) |
||
|
Low |
Medium |
High |
|
|
Small (d1) |
1,400 |
1,400 |
1,400 |
|
Medium (d2) |
1,100 |
1,600 |
1,600 |
|
Large (d3) |
(1,300) |
1,200 |
2,100 |
Management has determined the probabilities of demand
as follows:
|
Demand |
Probability |
|
Low |
0.20 |
|
Medium |
0.35 |
|
High |
0.45 |
Required:
1.
Determine
the optimal building alternative and the expected profit; and
2.
Compute
the Expected Value of Perfect Information (EVPI).
Solution: 2
