AE 123 MANAGEMENT SCIENCE

MODULE 1
Introduction to Management Science – Part 2

LEARNING OUTCOMES
At the end of this lesson, you will be able to:
1. Understand the nature of cost, volume, and profit;
2. Classify costs according to their relation to the production and operation;
3. Apply the break-even formula in computing target or budget sales;
4. Explore the break-even formula and its various applications;
5. Determine the different break-even model and computer solutions and
techniques used, and management science modeling techniques; and
6. Understand management science models in decision support system.

Model Building: Break-Even Analysis

The purpose of break-even analysis is to determine the number of units of a product
to sell or produce that will equate total revenue with total cost. The point where total
revenue equals total cost is called break-even point, and at this point profit is zero. The
1 break-even point gives a manager a point of reference in determining how many units will
be needed to ensure a profit.
Components of Break-Even Analysis
1. Volume – is the level of sales or production by a company. It can be expressed as
the number of units produced and sold, as the dollar volume of sales, or as
percentage of total capacity available.
2. Costs
a. Fixed Costs - independent of the volume of units produced and sold. Fixed
costs remain constant, regardless of how many units of product are produced
within a given range.
b. Variable Costs – determined on a per-unit basis. Total variable costs depend
on the number of units produced. Variable costs include such items as raw
materials and resources, direct labor, packaging, material handling, and
freight. Total variable costs are a function of the volume and the variable cost
per unit. This relationship can be expressed mathematically as

Total variable cost = vcv

where cv = variable cost per unit and v = volume (number of units) sold.

c. Total Costs (TC) equals the fixed cost (cf) plus the variable cost per unit (c v)
multiplied by volume (V). Where cf = fixed cost.
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As an example, consider Western Clothing Company, which products denim

jeans. The company incurs the following monthly costs to produce denim
jeans:
fixed cost = cf = $10,000
variable costs = cv = $8 per pair
if we arbitrarily let the monthly sales volume v, equal 400 pairs of denim
jeans, the total cost is
TC = cf + vcv = $10,000 + (400) (8) = $13,200
where p = price per unit.

3. Profit – is the difference between total revenue and total cost. Total revenue is
the volume multiplied by the price per unit. The formula is total revenue = vp,
wherein p = price per unit.

For clothing company example, if denim jeans sell for $23 per pair and we sell
400 pairs per month, then the total monthly revenue is total revenue = vp =
(400) (23) = $9,200.

Now that we have developed relationships for total revenue and total cost, profit
(Z) can be computed as follows:
total profit = total revenue – total cost
2
Z = vp – (Cf + vcv)
= vp – cf - vcv
Graphical Solution
Graphical models have the advantage of providing a ‘picture’ of the model that help
to understand the modeling process better than mathematics alone can. We can easily
graph the break-even model for our Western Clothing Company example because the
functions for total revenue are linear. That means we can graph each relationship as a
straight line on a set of coordinates, as shown in Figure 1.1.
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Figure 1.1: Break-Even Model

The fixed cost has a constant value of $10,000, regardless of the volume. The total
cost line, represents the sum of variable cost and fixed cost. The total cost line increases
because variable cost increases as the volume increases. The total revenue line also
increases as volume increases, but at a faster rate than total cost. The point where these
two lines intersect indicates that the total revenue equals total cost. The volume, that
corresponds to this point is the break-even volume. The break-even volume in Figure 1 is
666.7 pairs of denim jeans.
Sensitivity Analysis
Sensitivity Analysis sees how sensitive a management model is to change. It can be
performed on all management science models in one form or another. Companies develop
models for the primary purpose of experimentation to see how the model will react to
different changes the company is contemplating or that management might expect to occur
in the future. As a demonstration of how sensitivity analysis works, we will look at the
effects of some changes on our break-even model.
The first thing we will analyze is price. As an example, we will increase the price for
denim jeans from $23 to $30. As expected, this increases the total revenue, and it therefore
reduces the break-even point from 666.7 pairs of jeans to 454.5 pairs of jeans:

v= cf
3
p - cv
= 10,000
= 454.5 pairs of denim jeans
30 - 8
The effect of the price change on break-even volume is illustrated in Figure 1.2.

Figure 1.2. Break-even model with an increase in price

In general, an increase in price lowers the break-even point, all other things held
constant. A decision to increase price looks inviting from a strictly analytical point of view, it
must be remembered that the lower break-even volume and higher profit are possible but
not guaranteed.
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A higher price can make it more difficult to sell the product. Thus, a change in price often
must be accompanied by corresponding increase in costs, such as advertising, packaging,
and possibly production.
Figure 1.3 shows that the increase in variable costs will increase the break-even
point, all other things held constant, wherein the new break-even volume and the change in
the total cost line occurs as a result of the variable cost change.

Figure 1.3. Break-even model with an increase in variable cost

Moreover, an increase in advertising expenditures to offset the potential loss in sales

4 resulting from a price increase is the next to be considered. An increase in advertising
expenditures is an addition to fixed costs. Figure 1.4 shows that the increase in fixed costs
will increase the break-even point, all other things held constant. The break-even volume is
higher than the original volume of 666.7 pairs of jeans, as a result of the increased cost
necessary to offset the potential loss in sales. This indicates the necessity to analyze the
effect of a change in one of the break-even components on the whole break-even model.
Therefore, it is not sufficient to consider a change in one model component without
considering the overall effect.

Figure 1.4. Break-even model with a change in fixed cost

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Excel Spreadsheet
Spreadsheets are not always easy to use, and you cannot conveniently solve
every type of management science model. Spreadsheet have become almost
universally available to anyone who owns a computer. Spreadsheet have become
very popular as a teaching tool because they tend to guide the student through a
modeling procedure, and they can be interesting and fun to use.
To solve the break-even model using Excel, spreadsheet with headings must
be install to easily identify the models’ parameter and variables and then input the
appropriate mathematical formulas into the cells where you want to display the
solution.
Management Science Modeling Techniques
1. Linear Mathematical Programming Techniques. Linear programming models help
managers determine solution for problems that will achieve some objective in which
there are restrictions, such as limited resources or recipe or perhaps production
guidelines.
2. Probabilistic Techniques are distinguished from mathematical programming
techniques in that the results are probabilistic. Mathematical programming
techniques assume that all parameters in the models are known with certainty.
5 Therefore, the solution results are assumed to known with certainty, with no
probability. A deterministic technique assumes certainty in the solution.
3. Network Techniques consist of models that are represented as diagrams rather than
some strictly mathematical relationships. As such, these models offer a pictorial
representation of the system under analysis. These models represent either
probabilistic or deterministic systems. A network diagram can be drawn to help a
manager determine the shortest route among a number of different routes from a
source to a destination. In addition, network is drawn that shows the relationships of
all the tasks and activities for a project, such as building a house or developing a new
computer system. With this, managers can have the best plans to accomplish each of
the tasks in the project so that it will take the shortest amount of time possible.
Management Science Models in Decision Support System

 Decision Support System (DSS) is a computer-based system that helps decision

makers address complex problems that cut across different parts of an organization
and operations. It is normally interactive, combining various databases and different
management science models and solution techniques with user interface that
enables the decision maker to ask questions and receive answers. In its simplest
form any computer-based software program that helps a decision-maker make a
decision can be referred to as a DSS. Alternatively, enterprise-wide DSSs can
encompass many different types of models and large data warehouses, and they
can serve many decision makers in any organization. They can provide decision
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makers with interrelated information and analyses about almost anything in a

company as what Figure 1.5. illustrates.

Figure 1.5. Management Science Models in Decision Support System

Staff and management salaries Rent on plant and equipment Plant maintenance Advertising Heat
and light Insurance Depreci

Direct labor Raw materials and resources

ASSESTMENT 2: QUIZ 1
PROBLEMS: Given the following problems, answers the questions showing your solutions (if
6
needed).

1. The Window Furniture Company produces tables. The fixed monthly cost of
production is $8,000, and the variable cost per table is $65. The tables sell for $180
apiece.
a. For monthly volume of 300 tables, determine the total cost, total revenue,
and profit.
b. Determine the monthly break-even volume for the Window Furniture
Company.
2. Evergreen Fertilizer Company produces fertilizer. The company’s fixed monthly cost
is $25,000, and its variable cost per pound of fertilizer is $0.15. Evergreen sells the
fertilizer for $0.40 per pound. Determine the monthly break-even volume for the
company.
3. The College of Business at Tech is planning an online MBA program. The initial start-
up cost for computing equipment, facilities, course development, and staff
recruitment and development is $350,000. The college plans to charge tuition of
$18,000 per student per year. However, the university administration will charge the
college $12,000 per student for the first 100 students enrolled each year for
administrative costs and its share of the tuition payments.
a. How many students does the college need to enroll in the first year to break-
even?
b. If the college can enroll 75 students the first, how much profit will it make?
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c. The college believes it can increase tuition to $24,000, but doing wo would
reduce enrolment to 35. Should the college consider doing this?
4. The Star Youth Soccer Club helps to support its 20 boys’ and girls’ teams financially,
primarily through the payment of coaches. The club puts on a tournament each fall
to help pay its expenses. the cost of putting on the tournament is $8,000, mainly for
development, printing, and mailing of the tournament brochures. The tournament
entry fee is $400 per team. For every team that enters, it costs the club about $75 to
pay referees for the three-game minimum each team is guaranteed. If the club
needs to clear $60,000 from the tournament, how many teams should it invite?
5. The Easy Drive Car Rental Agency needs 500 new cars in its Nashville operation and
300 new cars in Jacksonville, and it currently has 400 new cars in both Atlanta and
Birmingham. It costs $30 to move a car from Atlanta to Nashville, $70 to move a car
from Atlanta to Jacksonville, $40 to move a car from Birmingham to the agencies in
Nashville and Jacksonville in order to meet demand while minimizing the transport
costs. Develop a mathematical model for this problem and use logic to determine a
solution.

ASSESSMENT 3: CASE PROBLEM

Constructing a Downtown Parking Lot in Draper

The town of Draper, with a population of 20,000, sits adjacent to State University,
7 which has an enrolment of 27,000 students. Downtown Draper merchant have long
complained about the lack of parking available to their customers. The local chamber of
commerce has finally convinced the town council to consider the construction of a new
multilevel indoor parking facility downtown. Kelly Mattingly, the town’s public works
director, has developed plans for a facility that would cost $4.5 million to construct. To pay
for the project, the town would sell municipal bonds with a duration of 30 years at 8%
interest. Kelly also estimates that five employees would be required to operate the lot on a
daily basis, at a total annual cost of $140,000. It is estimated that each car that enters the
lot would park for an average of 2.5 hours and pay an average fee of $3.20. further, it is
estimated that each car that parks in the lot would (on average) cost the town $0.60 in
annual maintenance for cleaning and repairs to the facility. Most of the downtown
businesses (which include a number of restaurant) are open 7 days per week.
a. Using a break-even analysis, determine the number of cars that would have park in
the lot on an annual basis to pay off the project in the 30-year time frame.
b. From the results in (A), determine the approximate number of cars that would have
to park in the lot on a daily basis. Does this size of the town and college population?
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Reference:
1. Taylor, B. (2013). Introduction to Management Science. 11 th edition. ISBN-13:978-0-
13-2751919-9