PROBLEM ON CAPACITY EXPANSION

1. A firm needs to decide on capacity expansion. It anticipates the increase in demand to follow
Uniform Distribution between [0, 4000] annually. The cost of building the capacity is given as
follows:

Capacity Built Cost

1000 $250000
2000 $450000
3000 $625000
4000 $800000

The capacity built will be written off in 3 years. The moment firm decides on some capacity
level, in the next 3 years, it cannot increase the capacity further. The demand will be realized
only after building the capacity will remain the same for the next five years. The contribution
margin from each unit sold is $300. What should be the firms optimal decision?
[Use straight line depreciation method]
SOL: When capacity size is 1000
Expected sales= 1000* P (Demand>=1000) + Expected Demand when Demand <1000
=1000*0.75+ 0.25*1000/2=875
Expected Profit= 875*300-250000/3=?
When capacity size = 2000
Expected sales= 2000* P (Demand>=2000) + Expected Demand when Demand <2000
=2000*0.5+0.5*2000/2=1500
Expected Profit= 1500*300-450000/3=?
When capacity size = 3000
Expected sales= 2000* P (Demand>=3000) + Expected Demand when Demand <3000
=3000*0.25+0.75*3000/2=1875
Expected Profit= 1875*300-625000/3=?
When capacity size = 4000
Expected sales= 4000* P (Demand>=4000) + Expected Demand when Demand <4000
=4000*0+1*4000/2=2000
Expected Profit= 2000*300-800000/3=?

2. A firm XYZ wishes to launch a new product in the market. Even though it is unaware of the
exact market condition, it is aware of the futures states of demand with known probability. XYZ
firm has decided to outsource the entire production process to some other firm ABC under some
contractual agreement which states that irrespective of the levels of production, the firm XYZ
requires to pay an upfront fee of $100000 to the firm ABC. The firm XYZ also has to commit on
a given production level at the start of the selling season to ABC. Apart from it, for every unit
procured, there will be a variable cost of $6 and the same product can be sold for a price of $15.
It is also to be noted that if the procured quantity exceeds that of the final demand, the remaining
items cannot be sold and there is no salvage value. The firm XYZ has to take a decision whether
to launch the product or not and if yes, then what level of production needed to be committed to
ABC. In case, the firm decides not to launch the product, there is neither any profit, nor any loss.
The future states of demand are as follows:
Demand 12000 15000 18000
Probability 0.25 0.45 0.3
Hint: Dont use breakeven analysis
Sol:
When order is 12000, whatever be the case all units can be sold. Expected profit is given as:
12000*(15-6)-100000=?
When order is 15000, once demand is >=15000, all units can be sold. And when demand is
12000 with a probability of 0.25, only 12000 can be sold and the remaining 3000 units will have
no monetary value and needs to be thrown away. Expected profit is
15000*(15-6)*0.75+(12000*(15-6)-3000*6)*0.25-100000=?
When order is 18000, once demand is >=18000, all units can be sold. And when demand is
12000 with a probability of 0.25, only 12000 can be sold and the remaining 6000 units will have
no monetary value and needs to be thrown away. When demand is 15000 with a probability of
0.45, only 15000 can be sold and the remaining 3000 units will have no monetary value and
needs to be thrown away. Expected profit is
18000*(15-6)*0.3+(12000*(15-6)-6000*6)*0.25+(15000*(15-6)-3000*6)*0.45-100000=?