Jon Jackson Manufacturing is searching for suppliers for its new line of equipment. Jon has narrowed his choices to two sets ofsuppliers. Believing in diversification of risk, Jon would select two suppliers under each choice. However, he is still concernedabout the risk of both suppliers failing at the same time. The “San Francisco option” uses both suppliers in San Francisco. Bothare stable, reliable, and profitable firms, so Jon calculates the “unique-event” risk for either of them to be 0.5%. However, becauseSan Francisco is in an earthquake zone, he estimates the probability of an event that would knock out both suppliers to be 2%.The “North American option” uses one supplier in Canada and another in Mexico. These are upstart firms; John calculates the“unique-event” risk for either of them to be 10%. But he estimates the “super-event” probability that would knock out both of thesesuppliers to be only 0.1%. Purchasing costs would be $500,000 per year using the San Francisco option and $510,000 per year usingthe North American option. A total disruption would create an annualized loss of $800,000. Which option seems best?
Jon Jackson Manufacturing is searching for suppliers for its new line of equipment. Jon has narrowed his choices to two sets of
suppliers. Believing in diversification of risk, Jon would select two suppliers under each choice. However, he is still concerned
about the risk of both suppliers failing at the same time. The “San Francisco option” uses both suppliers in San Francisco. Both
are stable, reliable, and profitable firms, so Jon calculates the “unique-event” risk for either of them to be 0.5%. However, because
San Francisco is in an earthquake zone, he estimates the probability of an event that would knock out both suppliers to be 2%.
The “North American option” uses one supplier in Canada and another in Mexico. These are upstart firms; John calculates the
“unique-event” risk for either of them to be 10%. But he estimates the “super-event” probability that would knock out both of these
suppliers to be only 0.1%. Purchasing costs would be $500,000 per year using the San Francisco option and $510,000 per year using
the North American option. A total disruption would create an annualized loss of $800,000. Which option seems best?
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