Cost Management: A Strategic Emphasis 5th Edition by David Stout, Edward Blocher, Gary Cokins

Exercise 29

Risk Aversion and Decision Making John Smith is the production manager of Elmo’s Glue Company. Because of limited capacity, the company can produce only one of two possible products. The two products are:

a. A space-age bonding formula that has a 15 percent probability of making a profit of $1,000,000 for the company and an 85 percent chance of generating $200,000 in profit.

b. A reformulated household glue that has a 100 percent chance of making a profit of $310,000.

John gets a bonus of 20 percent of the profit from his department. John has the responsibility to choose between the two products. Assume John is more risk-averse than the top management of Elmo’s Glue Company.

Required

1. Which product will John choose? Why?

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2. Is this the product Elmo’s would choose? Why or why not? Assume the company is risk-neutral.

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3. How can Elmo’s change its reward system to have John consistently make decisions which are consistent with top management’s wishes?