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John Hobson Company:

The company has been successful in its business undertaking in the last ten years but the in the last six months the situation has changed due to a decline in the demand for its services, the company has however cut down its operation costs in order to break even, the reduction in operation costs has been achieved by laying off workers, two office workers who left have not been replaced and the sale and parking of operation lorries, this has led to a reduction of costs by 20%.

The cutting down of operation costs is in line with the input output theory of the firm, The input output theory states that a firm can cut down its variable costs when the demand for its products or services decline, in our case the firm has experienced a decline in demand for its services and for this reason it has tried to cut down its variable costs which include reducing administration cost, the company however has not broken even and therefore it is experiencing losses in its operations, the break even point where the total costs are equal to total revenue has not been achieved and this is because the total revenue is less than total cost.

The three options give the company a chance to improve its business operation in order to achieve high profits; the options include option 1, 2 and 3. the first option requires the company to take over operations of a company that was previously undertaking transportation services, the services that this company undertook is similar to that of the Hobson company. Taking over these operations would mean that the company will increase its demand for services which was the main problem why the company is in present situation.

The second option is to undertake distribution at the final stage where the company requires buying smaller vehicles; this operation will require the company to buy smaller vehicles to

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undertake the final distribution undertaking. The third operation requires the company to import, transport and package refrigerated fish, this option will require that the company invert in refrigeration and packaging operation.

The third option is in line with the transaction cost theory that supports a company to produce other than buy, The transaction cost theory was introduced by Ronald Coarse and it states that a company will determine whether to outsource or to produce goods or services on their own, this theory in making decision on whether to buy or make products, according to this theory the market price are not important to a firm when making this decision and what is important is the transaction costs which include contract costs, search cost and coordinating costs. For this reason therefore the company is justified to undertake this operation because it reduces the transaction costs.

The third option is also supported by the evolutionary theory of the firm, this theory tends to advocate the possibility of transforming already existing organisation structure, this is because the existing organisation forms are seen as to have emerged from the already existing organisational structures this is for the purpose of resolving existing problems, the Hudson company by choosing the third option will mean that it will be transforming its operations from a mere transport company into an import, packaging and transportation company, this can be seen as a positive option of growth and diversity of operation.

2. Prepare a reasoned comparison of the three alternative options. This should include:

(i) A decision tree

The tree diagram below summarises the probability of achieving option one and its various

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possibilities

Option 1

probability

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0.65

profit of 210000

0.43875

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extend to 3rd year

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0.75

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0.35

profit falls to 150000

0.23625

success bid

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0.9

0.65

profit of 210000

0.14625

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0.25

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not extend to 3rd year

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profit falls to 150000

0.07875

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bid

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0.1

0.1

failure bid

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To summarise the above tree diagram it follows that option 1 has a 0.43 possibility that there will be a successful bid, and that a profit of 210,000 is achieved and the contract is extended to the third year, if it is not extended to the third year then the probability is 0.23. if the contract is picked by the company it will have to invest 480000 and the profit for the three years is 630000 with a 0.43 probability.

Option 2 tree diagram is as follows:

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profit

investment

2nd year

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95000

0.55

190000

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200000

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year 1

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0.45

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285000

200000

3rd year

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Option two the profit is guaranteed of 95000 each year with an investment of 200000, the probability that it will last 2 years is 0.55 meaning total profits will be 190,000, the probability that the contract will be extended for three years is 0.45 with a total profit of 285,000, Option 3 however has no probability provided since this is a new venture.

investment

profit

probability

option 1

480000

630000

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0.43875

480000

450000

0.23625

option 2

200000

285000

0.45

The table above summarises a three year contract comparison of option 1 and option two and the levels of investment and profit expected.

(ii) An assessment of the relative risk of the three alternatives

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Relative risk is a ratio of an event occurring versus control, relative risk is calculated by dividing the possibility of an event occurring over the possibility of occurrence of other events. It can be defined as the probability of exposed divided by probability of control.

relative risk for 3  year

probability

low growth

option 1

0.43875

2.925

option 2

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0.45

3

option 3

0.5

3.333333333

From the above chart we assume that the option 3 possibility of occurrence is 0.5 because we are not sure, next we consider the growth rate, medium, low and high growth rate possibility as our references, in this case our control possibility for our events is 0.15, therefore the table above represents the relative risks for the three options.

(iii) A sensitivity analysis focusing on

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(a) For Option 1, the probability of success of the proposal bid

The first problem with option is the bid which requires 30,000 which has a 0.1 possibility of failure; secondly the operation requires an investment of 450,000 which is funded by the bank at 7% interest rate per year. There is a 0.43 possibility of attaining a total of 630,000 and a 0.23 possibility of getting 450,000 as profit. Therefore there is a 0.23 possibility of breaking even and 0.43 possibility of attaining higher profits.

(b) For Option 2, the probability of an additional 2-year contract, making it three years in total,

This option requires investment in small vehicles which will require the company to invest 200,000, there is a 0.55 possibility that the investment will only be valid for 2 years and only a 0.45 possibility that the contract will last for 3 years, if the contract lasts for two years the profit level will be 190,000.

(c) For Option 3, the amount of the initial investment involved

For option three the investment required being 350,000 it is not clear what the profit level will be, this is a new venture and it requires the investment in refrigeration equipment and also start of a packaging operation in the company, the profit levels are not provided and therefore there is a high uncertainty that the firm will make a profit.

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4. What should Hobson’s choice be? Advise the company on which of the three mutually-exclusive options (1, 2 or 3) it should choose (if any). Give clear reasons for your answer, indicating what additional pieces of information (both quantitative and qualitative) you (and the company) would need to obtain to more effectively evaluate the three alternatives.

Given the probability of profit margins in the options given it would be better to i9nvest in option two, this is because the option requires less investment and that the first year at work is guaranteed, second the profit margin is 95,000 for the three years, also according to the table below this option has the highest possibility of occurrence. We discard investment of investment 1 because of its high investment level required bearing in mind that the funds are obtained from the banks, however option one is attractive because of its high profits margin, however there is a possibility of 0.23 that if the contract runs for the three year profits may fall to 150,000 meaning that this option has a high risk, therefore the best option will be option 2 which has guaranteed profits.

Three year

investment

profit

probability

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option 1

480000

630000

0.43875

480000

450000

0.23625

option 2

200000

285000

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0.45

For this reason therefore it is better to invest in the second option where the company will work with Jones and company where the company will be involved in final distribution process, this will increase the demand for its services which it has already specialised in and therefore the option will be easy to manage and also it will employ it drivers, there is also a possibility where the company will sell its parked lorries and buy smaller cars for the contract.

References:

Abraham Shuchman (1993) Scientific Decision Making in Business, Rinehart and Winston publishers, New York

C. Gilligan and B. Neale (1993) Business Decision Making, Prentice hall publishers, New York

D. Cooper and P. Schindler (2005) research methods in business, McGraw Hill publishers, UK

Donald Waters (2001) Quantitative Methods in Business, Prentice Hall publishers, New York

Gilbert Gordon (1998) Quantitative Decision Making for Business, Prentice Hall, New York

Harold Bier man (1997) Quantitative Analysis in Business Decisions, McGraw Hill publishers, UK

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Ian Hardwick (1996) Decision and Discrete Mathematics, Oxford University press, Oxford

John Gibbs (1993) Financial Decision Making in Business, Prentice Hall publishers, New York

John Hull (1990) The Evaluation of Risks in Business Investment, Prentice hall publishers, New York

Robert Koller (2000) Risk Modelling for Determining Value and Decision Making, McGraw Hill publishers, UK

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