Past experience indicates a 75% probability that a reported overhead cost varian

Question

Past experience indicates a 75% probability that a reported overhead cost variance is not due to a specific cause (i.e., is attributable to random fluctuations). Past experience also shows that the average cost to investigate the underlying cause of a variance is $1,200 and that the cost to correct an out-of-control process is, on average, $3,800. If the underlying variance is systematic and management decides not to investigate the cause of the variance, the costs are thought to be significant: $28,000. Required: 1. Given the preceding information, what is the expected value of investigating the reported variance? Expected value $ 2,150 2. Prepare a payoff table that summarizes the above information. (Hint: Your table should include cells for combinations of management actions (investigate vs. do not investigate) and states of nature (systematic cause vs. random event), plus cells to represent the expected cost of each management action. States of Nature (prob.) Systematic (25%) Management Action Investigate Don't Investigate Random (75%) Expected Value 2,150 7,000

Explanation / Answer

Solution:-

Random Probability = 75%

Non Random Prob = 25%

Cost to conduct investigation = (I) = 1200

Corrective action cost (C) =3800

Loss if do nothing (L) = 28000

(1200*75%) + (5000*25%) = 2150

Mgt Action

Random

Systematic

Expected value

Investigate

I

I+C

Do not investigate

none

L

Mgt Action

Random (75%)

Systematic (25%)

Expected value

Investigate

1200

5000

2150

Do not investigate

0

28000

7000

28000*25% = 7000

Mgt Action

Random

Systematic

Expected value

Investigate

I

I+C

Do not investigate

none

L

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