NOTRE DAME OF MIDSAYAP COLLEGE

Midsayap, Cotabato

College of Business and Accountancy

MANAGEMENT
SCIENCE

By: HAMOD M. GULIDTEM, CPA

 BRIEF TABLE OF CONTENTS

CHAPTER 1 Linear Programming: Graphical Method

CHAPTER 2 Linear Programming: Simplex Method
2(a) Dual Analysis
2(b) Sensitivity Analysis

CHAPTER 3 Transportation Model

3(a) North-West Corner Rule
3(b) Minimum Cost Cell Method
3(c) Stepping-Stone Method
3(d) Modified Distribution (MODI)

CHAPTER 4 Project Management

4(a) Critical Path Method
4(b) Program Evaluation and Review Technique
4(c) Cost Analysis

CHAPTER 5 Forecasting
5(a) Moving Average
5(b) Exponential Smoothing
5(c) Trend Projection
5(d) Measuring Forecast Accuracy
5(e) Regression Analysis

CHAPTER 6 Break-Even Analysis

CHAPTER 7 Decision Theory
7(a) Decision Criteria
7(b) Expected Value/Mathematical Expectations
7(c) Decision Tree
 CHAPTER 1
Linear Programming Model:
Graphical Method

LEARNING OBJECTIVES

After completing this chapter, students will be able to:

1. Understand the basic assumptions and properties of linear
programming (LP).

2. Graphically solve any LP problem that has only two variables

by both the corner point and isoprofit line methods.

3. Understand special issues in LP such as infeasibility,

unboundedness, redundancy, and alternative optimal solutions.

4. Understand the role of sensitivity analysis.

CHAPTER OUTLINE

1.1 Introduction

1.2 Requirements of a Linear Programming Problem

1.3 Formulating LP Problems

1.4 Graphical Solution to a LP Problem

1.5 Solving Minimization Problems

1.6 Four Special Cases in LP

1.7 Sensitivity Analysis Overview

 1.1 INTRODUCTION

Many management decisions involve making the most effective

use of an organization’s resources. Resources typically include
machinery, labor, money, time, warehouse space, and raw materials.
These resources may be used to make products or services. Linear
Programming (LP) is a widely used mathematical modeling technique
designed to help managers in planning and decision making relative
to resource allocation.
In the world of management science, programming refers to
modeling and solving a problem mathematically.

1.2 REQUIREMENTS OF A LINEAR

PROGRAMMING PROBLEM

All linear programming problems have four properties in common.

1. Problems seek to maximize or minimize an objective. (One
objective function)
2. Constraints limit the degree to which the objective can be
obtained. (One or more constraints)
3. There must be alternatives available. (Alternative courses of
action)
4. Mathematical relationships are linear. (Objective function
and constraints are linear)

The first property that LP problems have common is the problem

seeks to maximize or minimize some quantity, usually profit or
cost. We refer to this property as the objective function of a LP
problem. For instances, in the case of a typical manufacturer, the
major objective is to maximize dollar profits while in the case of
trucking or railroad distribution system the objective might be to
minimize shipping costs. In any event, this objective must be
stated clearly and defined mathematically.
The second property is the presence of restriction or
constraints that limit the degree to which we can pursue our
objective. For example, deciding how many units of each product in
a firm’s product line to manufacturer is restricted by available
personnel and machinery. Selection of an advertising policy or a
financial portfolio is limited by the amount of money available to
be spent or invested. We want, therefore, to maximize or minimize
a quantity (the objective function) subject to limited resources
(the constraints).
The third property is the alternative course of action. There
must be alternative courses of action to choose from. For example,
if a company produces three differential products, management may
use LP to decide how to allocate them its limited production
resources. Should it devote all manufacturing capacity to make
only the first product, should it produce equal amounts of each
product, or should it allocate the resources in some other ratio?
If there were no alternatives to select from, we would not need
LP.
The last property is the objective and constraints in LP
problems must be expressed in terms of linear equations or
inequalities. Linear mathematical relationships mean that all
terms used in the objective function and constraints are of the
first degree (i.e., not squared, or to the third or higher power,
or appearing more than once). For example, the equation 2A + 5B =
10 is an acceptable linear equation.

Basic Assumptions of Linear Programming

1. Certainty
2. Proportionality
3. Additivity
4. Divisibility
5. Nonnegative variables
We assume that conditions of certainty exist: that is, numbers
in the objective and constraints are known with certainty and do
not change during the period being studied.
We also assume that proportionality exists in the objective and
constraints. This means that if production of 1 unit of a product
uses 3 hours of a particular scarce resource, then making 10 units
of that product uses 30 hours of the resource.
The third technical assumption deals with the additivity,
meaning that the total of all activities equals the sum of the
individual activities. For example, if an objective is to maximize
profit = P8 per unit of first product made plus P3 per unit of
second product made and if 1 unit of each product is actually
produced, the profit contributions of P8 and P3 must add up to
produce a sum of P11.
 We make the divisibility assumption that solutions need not be
in whole numbers (integers). Instead, they are divisible and may
take any fractional value. In production problems, we often define
variables as the number of units produced per week or per month,
and a fractional value (e.g., 0.3 chairs)would simple mean that
there is work in process (something started in one week can be
finished in the next week). However, in other types of problem,
fractional values does not make sense. If a fraction of a product
cannot be purchased (for example, 1/3 of a submarine), an integer
programming exists.
Finally, we assume that all answers or variables are
nonnegative. Negative values of physical quantities are
impossible; you simply cannot produce a negative number of chairs,
shirts, lamps or computers.

1.3 FORMULATING LP PROBLEMS

Formulating a linear program involves determining a
mathematical model to represent the managerial problem. The steps
in formulating a linear program follow:
1. Complete understand the managerial problem being faced.
2. Identify the objective and the constraints.
3. Define the decision variables.
4. Use the decision variables to write mathematical expressions
for the objective function and the constraints.
One of the most common LP applications is the product mix
problem. Two or more products are usually produced using limited
resources such as personnel, machines, raw materials, and so on.
The profit that the firm seeks to maximize is based on the profit
contribution per unit of each product (selling price per unit minus
the variable cost per unit). The company would like to determine
how many units of each product it should produce so as to maximize
overall profit given its limited resources. A problem of this type
is formulated in the following example.

CBA GOLDEN FURNITURE COMPANY

CBA Golden Furniture Company produces inexpensive tables and
chairs. The production process for each is similar in that both
require a certain number of hours of carpentry work and a certain
number of labor hours in painting and varnishing department. Each
table takes 4 hours of carpentry and 2 hours in the painting and
varnishing shop. Each chair requires 3 hours in carpentry and 1
hour in painting and varnishing. During the current production
period, 240 hours of carpentry time are available and 100 hours in
painting and vanishing time are available. Each table sold yields
a profit of P70; each chair produced is sold for a P50 profit.
CBA Golden Furniture’s problem is to determine the best
possible combination of tables and chairs to manufacture in order
to reach the maximum profit. The firm would like this production
mix situation formulated as an LP problem.

HOURS REQUIRED TO AVAILABLE

DEPARTMENT PRODUCE 1 UNIT HOURS THIS WEEK
Tables (X) Chairs (Y) (constraints)
Carpentry 4 3 240
Painting and varnishing 2 1 100
Profit per unit P70 P50
Table 1.1 CBA Golden Furniture Company Data

We begin by summarizing the information needed to formulate and

solve this problem (see Table 1.1). Next we identify the objective
and constraints. The objective is MAXIMIZE PROFIT.
The constraints are:
1. The hours of carpentry time cannot exceed 240 hours per week.
2. The hours of painting and varnishing time used cannot exceed
100 hours per week.
The decision variables that represent the actual decisions we
will make defined as:
X = number of tables to be produced per week
Y = number of chairs to be produced per week

The objective function is Maximize profit = P70X + P50Y

Subject to the constraints:
a. Carpentry time used < carpentry time available
(4X + 3Y < 240)
b. Painting & varnishing time < painting & varnishing time
available
(2X + Y < 100)
c. The values for X and Y must be nonnegative numbers.
(X > 0) and (Y > 0)
 1.4 GRAPHICAL SOLUTION TO A
LINEAR PROGRAMMING PROBLEM
The easiest way to solve a small LP problem such as the CBA
Golden Furniture Company is with the graphical solution approach.
The graphical procedure is useful only when there are two decision
variables (such as the number of tables to produce (X) and number
of chairs to produce (Y) in the problem.

When there are more than two variables, it is not possible to

plot the solution on a two-dimensional graph and we must turn to
more complex approaches. But the graphical method is invaluable in
providing us with insights into how other approaches work.
 Graphical Representation of Feasible Solution Region for the
CBA Golden Furniture Company

Figure 1.1 Feasible Solution Region for the CBA

Golden Furniture Company

In LP problems we are interested in satisfying all constraints

at the same time. Hence, the constraints should be drawn on one
graph. This is shown in Figure 1.1

The shaded region now represents the area of solutions that

does not exceed either the two CBA Golden Furniture constraints.
It is known as by the term area of feasible solutions or, more
simply, the feasible region. The feasible region is the overlapping
area of constraints that satisfies all the restrictions on
resources. Any point in the region would be a feasible solution to
the CBA Golden Furniture problem; any point outside the shaded
area would represent an infeasible region.
 Hence it would be feasible to manufacture 30 tables and 40
chairs (30, 40) during a production period because both constraints
are observed:
Carpentry constraint: 4X + 3Y < 240 hours available
4(30) + 3(40) = 240 hours used (/)

Painting constraint: 2X + Y < 100 hours available

2(30) + (40) = 100 hours used (/)

However, it would violate both of the constraints to produce

70 tables and 40 chairs, as we see here mathematically:
Carpentry constraint: 4X + 3Y < 240 hours available
4(70) + 3(40) = 400 hours used (x)
Painting constraint: 2X + Y < 100 hours available
2(70) + (40) = 180 hours used (x)

Furthermore, it would also be infeasible to manufacture 50

tables and 5 chairs (50, 5). See computations below:
Carpentry constraint: 4X + 3Y < 240 hours available
4(50) + 3(5) = 215 hours used (/)
Painting constraint: 2X + Y < 100 hours available
2(50) + (5) = 105 hours used (x)

This possible solution falls within the time available in

carpentry but exceeds in time available in painting and varnishing
and thus fall outside the feasible region.
ISOPROFIT LINE METHOD

The isoprofit method is the one of the speediest method to

find the optimal solution. The optimal solution is the point lying
in the feasible region that produces the highest profit.

The method starts by letting profits equal some arbitrary but

small dollar amounts. For example, for the CBA Golden Furniture
Company we may choose a profit of P4,100. This is a profit level
that can be easily obtained without violating either of the two
constraints. The objective function can be written as 70X + 50Y =
P4,100. This expression is just the equation of a line called
isoprofit line. Iso means equal or similar. Thus, an isoprofit
line represents a line with all profits the same.

To easily find the optimal solution is to determine the point

that intersects the two constraint lines. As shown in the Figure
1.1, point (30,40) is the intersection of the two constraints lines
that would generate a profit of P4,100.

See the computation below for the point that intersects the
two constraint lines.
CORNER POINT SOLUTION METHOD

A second approach to solving LP problems employs the corner

point method. This technique is simpler conceptually than the
isoprofit line approach, but it involves looking at the profit at
every corner point of the feasible region.

The mathematical theory behind LP states that an optimal

solution to any problem (that is, the values of X, Y yield the
maximum profit) lie at a corner point, or extreme point, of the
feasible region. Hence, it is only necessary to find the values of
the variables at each corner; the maximum profit or optimal
solution will lie at one (or more of them).

Solving for corner point requires the use of simultaneous

equations, an algebraic technique (same with the solving of the
intersection of the two constraint lines).

Both isoprofit line method and corner point solution method

yield the same optimal solution by finding the points that
intersects the two constraints line. Thus, the corner point that
would yield the highest profit is point (30,40).

ISOPROFIT LINE METHOD

1. Graph all constraints and find the feasible region.
2. Select a specific profit (or cost) line and graph it to find the slope.
3. Move the objective function in the direction of the increasing profit (or decreasing cost) while
maintaining the slope. The last point it touches in the feasible region is the optimal solution.
4. Find the values of the decision variables at this point and compute the profit (or cost).
CORNER POINT METHOD
1. Graph all constraints and find the feasible region.
2. Find the corner points of the feasible region.
3. Compute the profit (or cost) at each of the feasible region.
4. Select the corner point with the best value of the objective function found in step 3. This is
the optimal solution.

Table 1.2 Summary of Graphical Solution Methods

 1.5 SOLVING MINIMIZATION PROBLEMS

Many LP problems involve minimizing an objective such as cost

instead of maximizing a profit function. A restaurant, for
example, may wish to develop a work schedule to meet staffing
needs while minimizing the total number of employees. A
manufacturer may seek to distribute its products from several
factories to its many reginal warehouses to minimize total
shipping costs.
Minimization problems can be solved graphically by first
setting up the feasible solution region and then using either
the corner point method or an isocost line approach (analogous
to the isoprofit approach in maximization problems).

CBA Meal Turkey Ranch

CBA Meal Turkey Ranch is considering buying two different
brands of turkey and blending them to provide a good, low-cost
diet for its turkeys. Each feed contains, in varying proportions,
some or all of the three nutritional ingredients essential for
fattening turkeys. Each pound of brand 1 purchased, for example,
contains 5 ounces of ingredient A, 4 ounces of ingredient B, and
0.5 ounces of ingredient C. Each pound of brand 2 contains 10
ounces of ingredient A, 3 ounces of ingredient B, but no ingredient
C. The brand 1 feed costs the ranch 2 cents a pound, while the
brand 2 feed costs 3 cents a pound. The owner of the ranch would
like to use LP to determine the lowest-cost diet that meets the
minimum monthly intake requirement for each nutritional
ingredient.

COMPOSITION OF EACH POUND

INGREDIENT OF FEED (OZ.) MINIMUM MONTHLY
Brand 1 Feed Brand 2 Feed REQUIREMENT PER TURLEY
(X) (Y) (OZ.)
A 5 10 90
B 4 3 48
C 0.5 0 1.5
Cost per pound 2 cents 3 cents
Table 1.3 CBA Meal Turkey Ranch Data
Let:
X = number of pounds of brand 1 feed purchased
Y = number of pounds of brand 2 feed purchased

Objective function:
Minimize cost = 2X + 3Y

Subject to constraints:
5X + 10Y > 90 (assumed) (ingredient A constraint)
4X + 3Y > 48 (assumed) (ingredient B constraint)
0.5X > 1.5(assumed) (ingredient C constraint)
X,Y > 0 (non-negativity constraints)

Note: Before solving the problem, take note of the three features
that affect the solution. First, the third constraints implies
that farmer must purchase enough brand 1 feed to meet the minimum
standards for the C nutritional ingredient. Buying only brand 2
would not be feasible because it lacks C. Second, we will be
solving for the blest blend of brands 1 and 2 to buy per turkey
per month. If the ranch houses 5,000 turkeys in a given month, it
need simply multiply the X and Y quantities by 5,000 to decide how
much feed to order overall. Third, we are dealing with a series of
greater than or equal to constraints. These cause the feasible
solution area to be above the constraints.

To simply find the optimal minimal cost solution using either

corner point method or isocost line method is to determine the
point that intersects the A constraint and B constraints. See the
computation below:
 1.6 FOUR SPECIAL CASES IN LP

Four special cases and difficulties arise at times when using

the graphical method to solve LP problems:
1. Infeasibility
2. Unboundedness
3. Redundancy
4. Alternative optimal solutions

No Feasible Region
When there is no solution to LP problem that satisfies all of
the constraints, then no feasible solution exists. Graphically, it
means that no feasible solution region exists, a situation that
might occur if the problem was formulated with conflicting
constraints. For example, if one constraints is supplied by the
marketing manager who states that at least 300 tables must be
produced (X > 300) to meet sales demand, and a second restriction
is supplied by the production manager, who insists that no more
than 220 tables be produced namely (X < 220) because of a lumber
shortage, no feasible solution region results.

Unboundedness
Unboundedness is a condition that exists when a solution
variable and the profit can be made infinite large without
violating any of the problem’s constraints in a maximization
process. It would indeed be wonderful for the company to be able
to produce an infinite number of units of product but obviously no
firm has infinite resource available or infinite product demand.

Redundancy
Redundancy is the presence of one or more constraints that
do not affect the feasible solution region.

Alternate Optimal Solutions

Alternate optimal solution is a situation in which more than
one optimal solution is possible. It arises when the slope of the
objective function is the same as the slope of a constraint.
 1.7 SENSITIVITY ANALYSIS

Sensitivity analysis refers to the study of how sensitive an

optimal solution model assumptions and to data changes. It is often
referred to as postoptimality analysis.

Postoptimality analysis means examining changes after the

optimal solution has been reached.

Sensitivity analysis also often involves a series of what-

if? questions. What if the profit on product 1 increases by 10%?
What if less money is available in the advertising budget
constraint? It’s like how sensitive is the optimal solution to
changes in profits, resources, or other input parameters.

There are two approaches to determine how sensitive an optimal

solution is to changes. The first is simply a trial and error
approach. This approach usually involves resolving the entire
problem and takes a long time to test a series of possible changes
in this approach.

The second approach (which is the preferably) is the analytic

postoptimality method. After LP problem has been solved, we attempt
to determine a range of changes in problem parameters that will
not affect the optimal solution or change the variables in the
solution. This is done without resolving the whole problem.
 CHAPTER 2
Linear Programming Model:
Simplex Method

LEARNING OBJECTIVES

After completing this chapter, students will be able to:

1. Completing LP constraints to equalities with slack, surplus,
and artificial variables.

2. Set up and solve LP problems with simplex tableaus.

3. Interpret the meaning of every number in a simplex tableau.

4. Recognize special cases such as infeasibility, unboundedness

and degeneracy.

CHAPTER OUTLINE

2.1 Introduction

2.2 Additional Variables used in Solving LPP

2.3 Maximization Case

2.4 Minimization LP Problems

2.5 Big M Method

2.6 Degeneracy in LP Problems

2.7 Unbounded Solutions in LPP

2.8 Multiple Solutions in LPP

2.9 Duality in LP Problems

2.10 Sensitivity Analysis

 2.1 INTRODUCTION

Recall that the theory of LP states that the optimal solution

will lie at a corner point of the feasible region. In large LP
problems, the feasible region cannot be graphed because it has
many dimensions, but the concept is the same.
The simplex method systematically examines corner points,
using algebraic steps, until and optimal solution is found. The
simplex method solves the linear programming problem in iterations
to improve the value of the objective function. The simplex
approach not only yields the optimal solution but also other
valuable information to perform economic and 'what if' analysis

2.2 ADDITIONAL VARIABLES USED IN

SOLVING LPP
2.3 MAXIMIZATION CASE
Continuation of the Problem:
2.4 MINIMIZATION LP PROBLEMS
2.5 BIG M METHOD
2.6 DEGENERACY IN LP PROBLEMS
2.7 UNBOUNDED SOLUTIONS IN LPP
2.8 MULTIPLE SOLUTIONS IN LPP

2.9 DUALITY IN LP PROBLEMS

2.10 SENSITIVITY ANALYSIS
 CHAPTER 3
Transportation Models

LEARNING OBJECTIVES

After completing this chapter, students will be able to:

1. Identify and explain transportation modeling.

2. Explain and able to use:

 Northwest-Corner Rule and Minimum Cost Cell Method

 Stepping-Stone Method
 Modified Distribution (MODI)

CHAPTER OUTLINE

3.1 Introduction

3.2 Transportation Modeling

3.3 Northwest-Corner Rule

3.4 Minimum Cost Cell Method

3.5 Stepping-Stone Method

3.6 Modified Distribution (MODI)

3.7 The Unbalanced Transportation Model

3.8 Degeneracy
 3.1
4 INTRODUCTION

Because location of a new factory, warehouse, or distribution

center is a strategic issue with substantial cost implications,
most companies consider and evaluate several locations. With a
wide variety of objective and subjective factors to be considered,
rational decisions are aided by a number of techniques. One of
those techniques is transportation modeling.

The transportation models described in this module prove

useful when considering alternative facility locations within the
framework of an existing distribution system. Each new potential
plant, warehouse, or distribution center will require a different
allocation of shipments, depending on its own production and
shipping costs and the costs of each existing facility. The choice
of a new location depends on which will yield the minimum cost for
the entire system.

3.2 TRANSPORATION MODELING

Transportation modeling is an iterative procedure for solving
problems that involves minimizing the cost of shipping products
from a series of sources to a series of destinations.

Transportation modeling finds the least-cost means of

shipping supplies from several origins to several destinations.
Origin points (or sources) can be factories, warehouses, car rental
agencies or any other points from which goods are shipped.
Destinations are any points that receive goods.

To use the transportation model, we need to know the

following:
1. The origin points and the capacity or supply per period at
each.
2. The destination points and the demand per period at each.
3. The cost of shipping one unit from each origin to each
destination.
 The following problem example is to be used to demonstrate
the formulation of the model.

CBA Golden Eagles harvested wheat in the Midwest and stored

in grain elevators in three different cities: Kansas City, Omaha,
and Des Moines. The grain elevators supply three flour mills,
located in Chicago, St. Louis, and Cincinnati. Grain is shipped to
the mills in railroad cars, each car capable of holding one ton of
wheat. Each grain elevator is able to supply the following number
of tons of wheat to the mills on a monthly basis.

Grain Elevator Supply

1. Kansas City 150
2. Omaha 175
3. Des Moines 275
Total 600 tons

Each mill demand the following number of tons of wheat per

month.

Mill Demand
A. Chicago 200
B. St. Louis 100
C. Cincinnati 300
Total 600 tons

The cost of transporting one ton of wheat from each grain

elevator (source) to each mill (destination) differs according to
the distance and rail system. The costs are shown in Table 4.1.
For example, the cost of shipping one ton of wheat from the grain
elevator at Omaha to the mill at Chicago is $7.

Mill
Grain Elevator Chicago St. Louis Cincinnati
Kansas City $6 $ 8 $10
Omaha 7 11 11
Des Moines 4 5 12

The problem is to determine how many tons of wheat to

transport from each grain elevator to each mill on a monthly basis
in order to minimize the total cost of transportation.
 Transportation problems are solved manually within a tableau
format, as in the simplex method. The tableau for CBA Golden Eagle
is shown below.

Table 3.2 CBA Golden Eagle Transportation Tableau

Each cell in the tableau represents the amount transported

from one source to one destination. Thus, the amount placed in
each cell is the value of a decision variable for that cell. The
smaller box within the cell contains the unit transportation costs
for that route. For example, in cell 1A the value, $6, is the cost
of transporting one ton of wheat from Kansas City to Chicago. Along
the outer rim of the tableau are the supply and demand constraints,
which referred to as rim requirements.

Transportation models do not start at the origin where all

decision variables equal zero; they must be given an initial
feasible region.

The two methods for solving a transportation model are the

stepping stone method and the modified distribution (MODI). The
initial solution for solving transportation problem is to
establish initial simplex tableau. In a transportation model, an
initial feasible solution can be found by several alternative
methods, including the northwest-corner method, minimum cell cost
method, and Vogel’s approximation model.
 3.3 NORTHWEST-CORNER RULE

Northwest-corner rule is procedure in the transportation

model where one starts at the upper left-hand cell of a table (the
northwest corner) and systematically allocates units to shipping
routes.
The northwest-corner rule requires that we start the largest
allocation in the upper left-hand cell (or northwest corner) of
the table and allocate units to shipping routes as follows:
1. Exhaust the supply capacity of each row (e.g., cell 1A
150) before moving down to the next row.
2. Exhaust the demand requirements of each column (e.g.,
Demand A: 200) before moving to the next column on the
right.
3. Check to ensure that all supplies and demands are met

Table 3.3 Initial NW Corner Solution

In our example, we first allocate as much as possible to cell

1A (the northwest corner). This is 150 tons, since that is the
maximum that can be supplied by grain elevator 1 at Kansas City,
even though 200 tons are demanded by mill A at Chicago.
We next allocate to a cell adjacent to cell 1A (either cell
2A or cell 1B). However, cell 1B is no longer represents a feasible
allocation, because the total tonnage of wheat available at source
has already been allocated. Thus, 2A represents the only feasible
alternative, and as much as possible is allocated to this cell.
Recall that 150 of 200 tons demanded at A already been supplied,
thus, 50 tons is the most constrained amount to be allocated to
cell 2A.
 The third allocation is made in the same way as the second
allocation. The only feasible cell adjacent to cell 2A is cell 2B.
The most that can be allocated is either 100 tons (demanded at
mill B) or 125 tons (175 tons minus 50 tons allocated to cell 2A).
The smaller (most constrained amount), 100 tons is allocated to
cell 2B.
The fourth allocation is 25 tons to cell 2C, and the fifth
allocation is 275 tons to cell 3C. Notice that all of the row and
allocations add up to the appropriate rim requirements. Thus, the
solution given is feasible because it satisfies all demand and
supply constraints.
The total cost of the transportation is $5,925. See Table
3.4.
Route Tons Shipped Cost Per unit Total Cost
From To
1 A 150 6 $ 900
2 A 50 7 350
2 B 100 11 1,100
2 C 25 11 275
3 12 275 12 3,300
Total 600 $5,925

Table 3.4 Computed Transportation Costs - NWC

Note: Northwest-corner rule is easy to use, but totally ignores
costs.

3.4 MINIMUM COST CELL METHOD

Minimum cost cell method is a cost-based approach to finding

an initial solution to a transportation problem.

This method makes initial allocations based on lowest cost.

This straightforward approach uses the following steps:
1. Identify the cell with the lowest cost. Break any ties for
the lowest cost arbitrarily.
2. Allocate as many units as possible to that cell without
exceeding the supply or demand. Then cross out that row or
column (or both) that is exhausted by this assignment.
3. Find the cell with the lowest cost from the remaining (not
crossed out) cells.
4. Repeat steps 2 and 3 until all units have been allocated
 Table 3.5 Initial Minimum Cost Cell Method Solution

The total cost of this initial solution is $4,550 (see Table

3.6), as compared to a total cost of $5,925 for the initial
northwest corner solution. Minimum cost cell method is lower than
northwest corner solution because it considers cost in the
allocation process.

Route Tons Shipped Cost Per unit Total Cost

From To
1 B 25 8 $ 200
1 C 125 10 1,250
2 C 175 11 1,925
3 A 200 4 800
3 B 75 5 375
Total 600 $4,550

Table 3.6 Computed Transportation Costs - MCCM

3.5 STEPPING-STONE METHOD

Stepping-stone method is an iterative technique for moving
from an initial feasible solution to an optimal solution in the
transportation method.

The stepping-stone method will help us move from an initial

feasible solution to an optimal solution. It is used to evaluate
the cost effectiveness of shipping goods via transportation routes
not currently in the solution. When applying it, we test each
unused cell, or square, in the transportation table by asking:
What would happen to total shipping costs if one unit of the
product (for example, one bathtub) was tentatively shipped on an
unused route? We conduct the test as follows:
1. Select any unused square to evaluate.
2. Trace a closed path back to the original square via squares
that are currently being used (only horizontal and vertical
moves are permissible). You may, however, step over either
an empty or an occupied square.
3. Beginning with a plus (+) sign at the unused square, place
alternating minus signs and plus signs on each corner
square of the closed path just traced.
4. Calculate an improvement index by first adding the unit-
cost figures found in each square containing a plus sign
and then by subtracting the unit costs in each square
containing a minus sign.
5. Repeat steps 1 through 4 until you have calculated an
improvement index for all unused squares. If all indices
computed are greater than or equal to zero, you have reached
an optimal solution. If not, the current solution can be
improved further to decrease total shipping costs.

Since the initial solution obtained by the minimum cell cost

method had the lowest total cost of the two initial solutions, we
will use it as the starting point.
The stepping-stone method determines if there is a cell with
no allocation that would reduce cost if used.
Adding 1 ton to cell 1A, subtraction of 1 ton to cell 1B,
adding 1 ton to 3B and subtraction of 1 ton to cell 3A results
to reduced cost by $1. Thus, it means the initial solution is
not optimal because a lower can be achieved by allocating tons
of wheat as shown in the table below.
 The following tables are additional testing for adding and
subtraction of ton (trial and error).

Notice that after all four unused routes are evaluated, there
is tie for the entering variables cells 1A and 2A. The tie can be
broken arbitrarily. We will select cell 1A to enter the solution
(because of low cost).
 Now we must check to see whether the solution shown in Table
B.19 is the optimal solution. We so this by plotting the paths for
the unused routes or empty cells (1B, 2A, 2B and 3C). If one of
the solutions is $0 reduced cost, it means the solution in Table
B-19, is the optimal cost solution.
 Therefore, the solution and the total minimum cost are shown
in the table below:
Route Tons Shipped Cost Per unit Total Cost
From To
1 A 25 6 $ 150
1 C 125 10 1,250
2 C 175 11 1,925
3 A 175 4 700
3 B 100 5 500
Total 600 $4,525

Table 3.7 Computed Transportation Costs – Stepping-Stone Optimal Solution

3.6 MODIFIED DISTRIBUTION (MODI)

Modified Distribution (MODI) is a modified version of the
stepping-stone method in which math equations replace the
stepping-stone paths.

To demonstrate MODI, we will use again the initial solution

obtained by the minimum cell cost method.
3.7 THE UNBALANCED TRANSPORTATION
MODEL
3.8 DEGENERACY
 CHAPTER 4
PROJECT MANAGEMENT

LEARNING OBJECTIVES

After completing this chapter, students will be able to:

1. Understand how to plan, monitor, and control projects with
the use of PERT and CPM.

2. Determine earliest start, earliest finish, later start,

latest finish, and slack times for each activity, along with
the total project completion time.

3. Reduce total project time at the least total cost by crashing

the network using manual or linear programming techniques.

CHAPTER OUTLINE

4.1 Introduction

4.2 PERT/CPM Components

4.3 Errors to be Avoided in Constructing a Network

4.4 Rules in Constructing a Network

4.5 Fulkerson’s Rule: Numbering the Events

4.6 Critical Path Analysis

4.7 Determination of Float and Slack Times

4.8 Program Evaluation and Review Technique

4.9 Cost Analysis

 4.1 INTRODUCTION

Any project involves planning, scheduling and controlling a

number of interrelated activities with use of limited resources,
namely, men, machines, materials, money and time. The projects may
be extremely large and complex such as construction of a power
plant, a highway, a shopping complex, ships and aircraft,
introduction of new products and research and development
projects. It is required that managers must have a dynamic planning
and scheduling system to produce the best possible results and
also to react immediately to the changing conditions and make
necessary changes in the plan and schedule. Project Management can
be used to manage complex projects. A convenient analytical and
visual technique of PERT and CPM prove extremely valuable in
assisting the managers in managing the projects.

Both the techniques use similar terminology and have the same
purpose. PERT stands for Project Evaluation and Review Technique
developed during 1950’s. The technique was developed and used in
conjunction with the planning and designing of the Polaris missile
project. CPM stands for Critical Path Method which was developed
by DuPont Company and applied first to the construction projects
in the chemical industry. Though both PERT and CPM techniques have
similarity in terms of concepts, the basic difference is, PERT is
used for analysis of project scheduling problems. CPM has single
time estimate and PERT has three time estimates for activities and
uses probability theory to find the chance of reaching the
scheduled time.

Project management generally consists of three phases.

1. Planning: Planning involves setting the objectives of the

project. Identifying various activities to be performed and
determining the requirement of resources such as men,
materials, machines, etc. The cost and time for all the
activities are estimated, and a network diagram is developed
showing sequential interrelationships (predecessor and
successor) between various activities during the planning
stage.

2. Scheduling: Based on the time estimates, the start and finish

times for each activity are worked out by applying forward
and backward pass techniques, critical path is identified,
along with the slack and float for the non-critical paths.
3. Controlling: Controlling refers to analyzing and evaluating
the actual progress against the plan. Reallocation of
resources, crashing and review of projects with periodical
reports are carried out.

4.2 PERT/CPM COMPONENTS

PERT / CPM networks contain two major components
i. Activities, and
ii. Events

Activity
An activity represents an action and consumption of resources
(time, money, energy) required to complete a portion of a
project. Activity is represented by an arrow, (Figure 4.1).

A
i j A is called an Activity.

Figure 4.1. An Activity

Event
An event (or node) will always occur at the beginning and end
of an activity. The event has no resources and is represented
by a circle. The ith event and jth event are the tail event
and head event respectively, (Figure 4.2).

A
i j

Tail Event Head Event

Figure 4.2. An Event

Figure 5.1 Figure 5.1 An

An Activity Activity
Merge and Burst Events
One or more activities can start and end simultaneously at an
event (Figure 4.3 a, b).

Figure 4.3 a, b. Merge and Burse Events

Preceding and Succeeding Activities

Activities performed before given events are known as
preceding activities (Figure 4.4), and activities performed
after a given event are known as succeeding activities.
Activities A and B precede activities C and D respectively.

Figure 4.4. Preceding and Succeeding Activities

Dummy Activity
An imaginary activity which does not consume any resource and
time is called a dummy activity. Dummy activities are simply
used to represent a connection between events in order to
maintain a logic in the network. It is represented by a dotted
line in a network, see Figure 4.5.

Figure 4.5. Dummy Activity

4.3 ERRORS TO BE AVIODED IN
CONSTRUCTING A NETWORK
a) Two activities starting from a tail event must not have a
same end event. To ensure this, it is absolutely necessary
to introduce a dummy activity, as shown in Figure 4.6.

Figure 4.6. Correct and Incorrect Activities

b) Looping error should not be formed in a network, as it

represents performance of activities repeatedly in a cyclic
manner, as shown below in Figure 4.7.

Figure 4.7. Looping Error

c) In a network, there should be only one start event and one

ending event as shown below, in Figure 4.8

Figure 4.8. Only one start and one end.

d) The direction of arrows should flow from left to right
avoiding mixing of direction as shown in Figure 4.9.

Figure 4.9. Wrong Direction of Arrows

4.4 RULES IN CONSTRUCTING A

NETWORK
1. No single activity can be represented more than once in a
network. The length of an arrow has no significance.

2. The event numbered 1 is the start event and an event with

highest number is the end event. Before an activity can be
undertaken, all activities preceding it must be completed.
That is, the activities must follow a logical sequence (or
– interrelationship) between activities.

3. In assigning numbers to events, there should not be any

duplication of event numbers in a network.

4. Dummy activities must be used only if it is necessary to

reduce the complexity of a network.

5. A network should have only one start event and one end event
 Some conventions of network diagram are shown in Figure 4.10
(a), (b), (c), (d) below:

Figure 5.10.Some Conventions followed in Making Network Diagrams.

4.5 PROCEDURE FOR NUMBERING THE

EVENTS USING FULKERSON’S RULE

Step 1:
Number the start or initial event as 1.

Step 2:
From event 1, strike off all outgoing activities.
This would have made one or more events as initial
events (event which do not have incoming
activities). Number that event as 2.

Step 3:
Repeat step 2 for event 2, event 3 and till the end
event. The end event must have the highest number
 4.6 CRITICAL PATH ANALYSIS

The critical path for any network is the longest path through
the entire network.

Since all activities must be completed to complete the entire

project, the length of the critical path is also the shortest time
allowable for completion of the project. Thus if the project is to
be completed in that shortest time, all activities on the critical
path must be started as soon as possible. These activities are
called critical activities.

If the project has to be completed ahead of the schedule,

then the time required for at least one of the critical activity
must be reduced. Further, any delay in completing the critical
activities will increase the project duration.

The activity, which does not lie on the critical path, is

called non-critical activity. These non-critical activities may
have some slack time.

The slack is the amount of time by which the start of an

activity may be delayed without affecting the overall completion
time of the project. But a critical activity has no slack.

To reduce the overall project time, it would require more

resources (at extra cost) to reduce the time taken by the critical
activities to complete.

Scheduling of Activities: Earliest Time and Latest Time

Before the critical path in a network is determined, it is

necessary to find the earliest and latest time of each event to
know the earliest expected time (TE) at which the activities
originating from the event can be started and to know the latest
allowable time (TL) at which activities terminating at the event
can be completed.
4.7 DETERMINATION OF FLOAT AND
SLACK TIMES
Example 5:
The following Table 8.7 gives the activities in construction
project and time duration.
 4.8 PROJECT EVALUATION REVIEW
TECHNIQUE (PERT)

A Program Evaluation and Review Technique chart is a visual

tool used for determining the length of time each step in a project
should take, as well as dependencies for those steps. It’s
especially useful for determining the duration of riskier
projects, as it accounts for milestones (also known as events or
steps) taking more time in a worst-case scenario.

In the critical path method, the time estimates are assumed

to be known with certainty. In certain projects like research and
development, new product introductions, it is difficult to
estimate the time of various activities. Hence PERT is used in
such projects with a probabilistic method using three time
estimates for an activity, rather than a single estimate, as shown
in Figure 8.22.
 4.9 COST ANALYSIS
The two important components of any activity are the cost and
time. Cost is directly proportional to time and vice versa. For
example, in constructing a shopping complex, the expected time of
completion can be calculated using be time estimates of various
activities. But if the construction has to the finished earlier,
it requires additional cost to Network Model complete the project.

We need to arrive at a time / cost trade-off between total

cost of project and total time required to complete it.

Normal time: Normal time is the time required to complete the

activity at normal conditions and cost.

Crash time: Crash time is the shortest possible activity time;

crashing more than the normal time will increase the direct cost
 CHAPTER 5
FORECASTING
LEARNING OBJECTIVES

After completing this chapter, students will be able to:

1. Understand and know when to use various families of
forecasting models.

2. Why BEP is important?

3. How is the BEP determined?

4. What methods are used to identify BEP?

CHAPTER OUTLINE

5.1 Introduction

5.2 Forecasting Fundamentals

5.3 Time-Series Models

5.4 Naïve Method

5.5 Mean (Simple Average) Method

5.6 Simple Moving Average

5.7 Weighted Average Method

5.8 Exponential Smoothing Method

5.9 Trend Projection

5.10 Stability vs. Responsiveness in Forecasting

5.11 Measuring Forecast Accuracy

5.12 Regression Analysis

 5.1 INTRODUCTION

Every day, managers make decisions without knowing what will

happen in the future. Inventory is ordered through no one knows
what sales will be, new equipment is purchased though no one knows
the demand for products, and investments are made though no one
knows what profits will be. Managers are always trying to reduce
this uncertainty and to make better estimates of what will happen
in the future. Accomplishing this is the main purpose of
forecasting.

There are many ways to forecast the future. In numerous firms,

the entire process is subjective, involving seat-of-the-plants
method, intuition, and years of experience. There are also many
quantitative forecasting methods, such as moving averages,
exponential smoothing, trend projections, and least squares
regression analysis.

Regardless of each method that is used to make the forecast,

the same eight overall procedures that follow are used.

1. Determine the use of the forecast.

2. Select the items or quantities that are to be forecasted.
3. Determine the time horizon of the forecast.
4. Select the forecasting model or models.
5. Gather the data needed to make the forecast.
6. Validate the forecasting model.
7. Make the forecast.
8. Implement the results.

5.2 FORECASTING FUNDAMENTALS

Forecast is a prediction, projection, or estimate of some future
activity, event, or occurrence. Types of Forecasts:
 Economic forecasts. Predict a variety of economic
indicators, like money supply, inflation rates, interest
rates, etc.
 Technological forecasts. Predict rates of technological
progress and innovation.
 Demand forecasts. Predict the future demand for a company’s
products or services.
 TYPES OF FORECASTING MODELS
Qualitative methods
These types of forecasting methods are based on judgments,
opinions, intuition, emotions, or personal experiences and are
subjective in nature. They do not rely on any rigorous mathematical
computations.

Quantitative methods
These types of forecasting methods are based on mathematical
(quantitative) models, and are objective in nature. They rely
heavily on mathematical computations.
 5.3 TIME-SERIES MODELS
Time-series models attempt to predict the future by using the
historical data. These models make the assumption that what happens
in the future is a function of what has happened in the past.

DECOMPOSITION OF A TIME SERIES

Patterns that may be present in a time series:
 Trend: Data exhibit a steady growth or decline over time.
 Seasonality: Data exhibit upward and downward swings in a
short to intermediate time frame (most notably during a
year).
 Cycles: Data exhibit upward and downward swings in over a
very long time frame.
 Random variations: Erratic and unpredictable variation in the
data over time with no discernable pattern.
5.4 NAÏVE METHOD
5.5 MEAN (SIMPLE AVERAGE) METHOD

5.6 SIMPLE MOVING AVERAGE METHOD

5.7 WEIGHRED MOVING AVERAGE
METHOD

5.8 EXPONENTIAL SMOOTHING METHOD

5.9 TREND PROJECTION
5.10 STABILITY vs RESPONSIVENESS
IN FORECASTING
5.11 MEASURING FORECAST ACCURACY
5.12 REGRESSION ANALYSIS
Another Example Regression Problems:
 CHAPTER 6
BREAK-EVEN ANALYSIS

LEARNING OBJECTIVES

After completing this chapter, students will be able to answer

the following questions:
1. What is the break-even point (BEP)?

2. Why BEP is important?

3. How is the BEP determined?

4. What methods are used to identify BEP?

CHAPTER OUTLINE

6.1 Introduction

6.2 Break-Even Point

6.3 Break-Even Formula Approach

6.4 Solving Break-Even Point Problem

 6.1 INTRODUCTION

Much of the information managers’ use to plan and control

reflects relationships among product cost, selling prices, and
sales volumes. Changing one of these essential components in the
mix will cause changes in other components.

This chapter focuses on understanding how costs, volumes, and

profits interact. Understanding these relationships helps in
predicting future conditions (planning) as well as explaining,
evaluating, and acting on past results (controlling). Also, it is
useful to management when it decides whether to introduce new
product lines, change sales prices on established products, or
enter new market areas.

6.2 BREAK-EVEN POINT

Break-even is defined as “having equal cost and income”.

Break-even point is the volume at which total revenues equal total
costs (both fixed and variable), thus, no profit. At this point
(sales volume) the company will realize no income but will suffer
no loss (No Gain/Loss). The process of finding the break-even point
is called break-even analysis.
Knowing the BEP, managers are better able to set sales goals
that should result in profits from operations rather than losses.

Several simplifying assumptions must be made concerning revenue

and cost functions:

a. Relevant range: The company is assumed to be operating

within the relevant range of activity specified in
determining the revenue and cost information used in the
BEP model;

b. Revenue: Total revenue fluctuates in direct proportion to

the level of activity or volume while revenue per unit is
assumed to remain constant, and fluctuations in per unit
revenue for factors such as quantity discounts are ignored;
 c. Variable costs: Total variable costs fluctuate in direct
proportion to the level of activity or volume. Variable
costs per unit are assumed to remain constant within the
relevant range. Variable production costs include direct
material, direct labor, and variable overhead; variable
selling costs include charges for items such as commissions
and shipping; variable administrative costs may exist in
areas such as purchasing but in the example administrative
costs are assumed to be fixed; and

d. Fixed costs: Total fixed costs are assumed to remain

constant within the relevant range. Fixed cost per unit
decreases as volume increases, and increases as volume
decreases. Fixed costs include both fixed manufacturing
overhead and fixed selling and administrative expenses.

6.3 BREAK-EVEN FORMULA APPROACH

Formula Approach to Breakeven
1. Algebraic equation. The formula approach uses an algebraic
equation to calculate the exact break-even point. Sales
activity, rather than production, is the focus for the
relevant range.

R(x) – VC(x) – FC = P

where R = revenue (selling price) per unit

x = number of units sold or to be sold
R(x) = total revenue
VC = variable cost per unit
VC(x) = total variable cost
FC = total fixed cost
P = profit

The equation represents an income statement, so P can be set

equal to zero for the formula to indicate a break-even
situation.
2. The break-even point can be expressed in either units or
dollars of revenue.
a. The break-even point in units can be found by solving the
equation for X:
X = FC ÷ (R – VC)

b. Break-even point volume is equal to total fixed cost

divided by the unit contribution margin (revenue per unit
minus the variable cost per unit):
X = FC ÷ CM, where CM = contribution margin per unit

c. The break-even point in sales dollars can be found by

multiplying the break-even point in units by the selling
price per unit.

3. The break-even point in sales dollars can also be computed.

a. Contribution margin (CM) ratio is the proportion of each

revenue dollar remaining after variable costs have been
covered; it is computed as contribution margin divided by
sales on a total or per unit basis.

b. The variable cost (VC) ratio represents the variable cost

proportion of each revenue dollar and is computed as
variable costs divided by sales or as (1 – contribution
margin ratio).

c. The BEP in dollars is found by dividing total fixed costs

by the contribution margin ratio.
Sales = FC ÷ (1 – VC%) or Sales = FC ÷ CM%

Where VC% = the percentage relationship of variable

cost to sales
CM% = the percentage relationship of contribution
margin to sales
 6.4 SOLVING BREAK-EVEN POINT
PROBLEMS
PROBLEM 1
CBA Golden Eagles Corporation manufactures and sells a single
product. The company’s sales and expenses for the recent month are
shown below:

Amount Per unit

Sales P 600,000 P 40
Variable Cost P 420,000 P 28
Fixed Cost P 150,000

Find the break-even point in units.

Solution:
In unit

BEP = 40Q - 28Q - 150,000

= 12Q – 150,000
Q = 150,000/12
Q = 12,500

PROBLEM 2
CITE Black Hawks Corporation sell a product for $79.99 that
costs $11.99 per unit to produce. The firm total fixed costs is
$27,336. Determine how many units must CITE Black Hawks to sell
to break even?

Solution:
Given:
P = 79.99
V = 11.99
FC = 27,336

x = FC / (P –V)
= 27,336 / (79.99 – 11.99)
= 402 units
PROBLEM 3
NDMC Kudos Corporation is a small but growing manufacturer of
telecommunications equipment. The company has no sales force of
its own; rather, it relies completely on independent sales agents
to market its products. These agents are paid a commission of 15%
of selling price for all items sold.

Noel Cacanindin, Kudos’s controller, has just prepared the

company’s budgeted income statement for next year. The statement
follows:
NDMC Kudos Corporation
Budgeted Income Statement
For the Year Ended December 31
Sales P16,000,000
Manufacturing costs:
Variable P7,200,000
Fixed overhead 2,340,000 9,540,000
Gross margin 6,460,000
Selling and administrative
costs:
Commissions to agents 2,400,000
Fixed marketing costs* 120,000
Fixed administrative costs 1,800,000 4,320,000
Net operating income 2,140,000
Less fixed interest cost 540,000
Income before income taxes 1,600,000
Less income tax (30%) 480,000
Net income P1,120,000

*Primarily depreciation on storage facilities

As Noel handed the statement to Ronniel Labio, Kudos’s president,

he commented, “I went ahead and used the agents’ 15% commission
rate in completing these statements, but we’ve just learned that
they refuse to handle our products next year unless we increase
the commission rate to 20%.”

“That’s the last straw,” Ronniel replied angrily. “Those agents

have been demanding more and more, and this time they’ve gone too
far. How can they possibly defend a 20% commission rate?”

“They claim that after paying for advertising, travel, and the
other costs of promotion, there’s nothing left over for profit,”
replied Noel.
“I say it’s just plain robbery,” retorted Ronniel. “And I also
say it’s time we dumped those guys and got our own sales force.
Can you get your people to work up some cost figures for us to
look at?”

“We’ve already worked them up,” said Noel. “Several companies we

know about pay a 7.5% commission to their own salespeople, along
with a small salary. Of course, we would have to handle all
promotion costs, too. We figure our fixed costs would increase by
P2,400,000 per year, but that would be more than offset by the
P3,200,000 (20% x P16,000,000) that we would avoid on agents’
commissions.”

The breakdown of the P2,400,000 cost figure follows:

Salaries:
Sales manager P 100,000
Salespersons 600,000
Travel and entertainment 400,000
Advertising 1,300,000
Total P2,400,000

“Super,” replied Ronniel. “And I note that the P2,400,000 is just

what we’re paying the agents under the old 15% commission rate.”

“It’s even better than that,” explained Noel. “We can actually
save P75,000 a year because that’s what we’re having to pay the
auditing firm now to check out the agents’ reports. So our overall
administrative costs would be less.”

“Pull all of these number together and we’ll show them to the
executive committee tomorrow,” said Ronniel. “With the approval
of the committee, we can move on the matter immediately.”

Requirements: Compute for the following

1. What is the breakeven point in pesos for next year assuming
that the agents’ commission rate remains unchanged at 15%?

2. What is the breakeven point in pesos for next year assuming

that the agents’ commission rate is increased to 20%?
3. What is the breakeven point in pesos for next if the company
employs its own sales force?

4. Assume that NDMC Kudos Corporation decides to continue

selling through agents and pays the 20% commission rate. The
volume of sales that would be required to generate the same
net income as contained in the budgeted income statement for
next year would be:
 5. The volume of sales at which net income would be equal
regardless of whether company sells through agents at a 20%
commission rate or employs its own sales force:

Solutions:

1. Fixed Costs:
Overhead 2,340,000
Marketing 120,000
Administrative 1,800,000
Interest 540,000
Total 4,800,000

Contribution margin ratio:

1 - [(7,200,000 + 2,400,000)/16M] = 40%

Breakeven next year with no change in commission:

4,800,000 ÷ 0.4 = P12,000,000

2. If the commission rate is increased by 5%, the contribution

margin is decreased by 5% or a new contribution margin ratio
of 35%.
Breakeven sales next year = 4,800,000 / 0.35 = P13,714,286

3. Fixed cost under 15% commission plan 4,800,000

Increase in Fixed cost 2,400,000
Decrease in audit fee ( 75,000)
Increased fixed costs 7,125,000

The commission rate of 7.5%, instead of 15% will raise the

contribution margin ratio to 47.5% (40% + 7.5%).
Revised breakeven sales 7,125,000 / .475 = P 15M

4. Required sales, with 20% commission and profit target of

P1,120,000:
(P4,800,000 + 1,600,000) ÷ .35 = 18,285,714

5. The question asked for is the indifference point. The peso sales
required to produce equal income can be easily calculated by
dividing the net increase in fixed costs by the increase in
contribution margin ratio:
Difference in CMR = 35% - 47.5 = 12.5%
Increase in fixed costs = 2,400,000 – 75,000 = P2,325,000
Indifference Point: 2,325,000 ÷ 0.125 = P18.6M
 CHAPTER 7
DECISION THEORY

LEARNING OBJECTIVES

After completing this chapter, students will be able to:

1. List the steps of the decision-making process.

2. Describe the types of decision making environments.

3. Make decisions under certainty.

4. Use probability values to make decisions under risk.

5. Develop accurate and useful decision trees.

CHAPTER OUTLINE

7.1 Introduction

7.2 The Six Steps in Decision Making

7.3 Types of Decision-Making Environments

7.4 Decision Making Under Certainty

7.5 Decision Making Under Uncertainty

7.6 Decision Making Under Risk

7.7 Expected Value With Perfect Information

7.8 Use of Subjective Probabilities in Decision Making

7.9 Use of Posterior Probabilities in Decision Making

7.10 Decision Trees

 7.1 INTRODUCTION

To a great extent, the successes or failures that a person

experiences in life depend on the decisions that he or she makes.
Decision theory is an analytical and systematic approach to
the study of decision making. In this chapter, we present the
mathematical models useful in helping managers make the best
possible decisions.

7.2 SIX STEPS IN DECISION MAKING

Whether you are deciding about getting a haircut today,

building a multimillion-dollar plant, or buying a new camera, the
steps in making a good decision are basically the same:
1. Clearly define the problem at hand.
2. List the possible alternatives.
3. Identify the possible outcomes or states of nature.
4. List the payoff or profit of each combination of
alternatives and outcomes.
5. Select one of the mathematical decision theory models.
6. Apply the model and make your decision.

7.3 TYPES OF DECISION-MAKING

ENVIRONMENTS
The types of decisions people make depend on how much
knowledge or information they have about the situation. There are
three decision-making environments:
Decision making under certainty
Decision making under uncertainty
Decision making under risk
 7.4 DECISION MAKING UNDER
CERTAINTY
Decision-making is needed whenever an individual or an
organization (private or public) is faced with a situation of
selecting an optimal (or best in view of certain objectives) course
of action from among several available alternatives. For example,
an individual may have to decide whether to build a house or to
purchase a flat or live in a rented accommodation; whether to join
a service or to start own business; which company's car should be
purchased, etc. Similarly, a business firm may have to decide the
type of technique to be used in production, what is the most
appropriate method of advertising its product, etc.

The decision analysis provides certain criteria for the

selection of a course of action such that the objective of the
decision-maker is satisfied. The course of action selected on the
basis of such criteria is termed as the optimal course of action.

Every decision problem has four basic features, mentioned

below:

1. Alternative Courses of Action or Acts: Every decision-maker

is faced with a set of several alternative courses of action
A1, A2, Am and he has to select one of them in view of the
objectives to be fulfilled.

2. States of Nature: The consequences of selection of a course

of action are dependent upon certain factors that are
beyond the control of the decision-maker. These factors are
known as states of nature or events. It is assumed that
the decision-maker is aware of the whole list of events S1,
S2 ... Sn and exactly one of them is bound to occur. In
other words, the events S1, S2, Sn are assumed to be mutually
exclusive and collective exhaustive.

3. Consequences: The results or outcomes of selection of a

particular course of action are termed as its consequences.
The consequence, measured in quantitative or value terms,
is called payoff of a course of action. It is assumed that
the payoffs of various courses of action are known to the
decision-maker.
 4. Decision Criterion: Given the payoffs of various
combinations of courses of action and the states of nature,
the decision-maker has to select an optimal course of
action. The criterion for such a selection, however,
depends upon the attitude of the decision-maker. If Xij
denotes the payoff corresponding to a combination of a
course of action and a state of nature, i.e., (A1, Sj), i
= 1 to m and j = 1 to n, the above elements of a decision
problem can be presented in a matrix form, popularly known
as the Payoff Matrix.

Given the payoff matrix for a decision problem, the process

of decision-making depends upon the situation under which
the decision is being made. These situations can be
classified into three broad categories:
a) Decision-making under certainty,
b) Decision -making under uncertainty and
c) Decision-making under risk.

The conditions of certainty are very rare particularly when

significant decisions are involved. Under conditions of certainty,
the decision-maker knows which particular state of nature will
occur or equivalently, he is aware of the consequences of each
course of action with certainty. Under such a situation, the
decision-maker should focus on the corresponding column in the
payoff table and choose a course of action with optimal payoff.
 7.5 DECISION MAKING UNDER
UNCERTAINTY
A situation of uncertainty arises when there can be more than
one possible consequences of selecting any course of action. In
terms of the payoff matrix, if the decision-maker selects A1, his
payoff can be X11, X12, X13, etc., depending upon which state of
nature S1, S2, S3, etc., is going to occur. A decision problem,
where a decision-maker is aware of various possible states of
nature but has insufficient information to assign any
probabilities of occurrence to them, is termed as decision-making
under uncertainty.
There are a variety of criteria that have been proposed for
the selection of an optimal course of action under the environment
of uncertainty. Each of these criteria make an assumption about
the attitude of the decision-maker.
1. Maximin Criterion: This criterion, also known as the
criterion of pessimism, is used when the decision-maker is
pessimistic about future. Maximin implies the maximization
of minimum payoff. The pessimistic decision-maker locates
the minimum payoff for each possible course of action. The
maximum of these minimum payoffs is identified and the
corresponding course of action is selected.
Example No.1:
Let there be a situation in which a decision-maker has
three possible alternatives A1, A2 and A3, where the outcome
of each of them can be affected by the occurrence of any
one of the four possible events S1, S2, S3 and S4. The
monetary payoffs of each combination of Ai and Sj are given
in the following table:

Solution: Since 17 is maximum out of the minimum payoff,

the optimal action is A2.
2. Maximax Criterion: This criterion, also known as the
criterion of optimism, is used when the decision-maker is
optimistic about future. Maximax implies the maximization
of maximum payoff. The optimistic decision-maker locates
the maximum payoff for each possible course of action. The
maximum of these payoffs is identified and the
corresponding course of action is selected. The optimal
course of action in the above example, based on this
criterion, is A3.

3. Regret Criterion: This criterion focuses upon the regret

that the decision-maker might have from selecting a
particular course of action. Regret is defined as the
difference between the best payoff we could have realized,
had we known which state of nature was going to occur and
the realized payoff. This difference, which measures the
magnitude of the loss incurred by not selecting the best
alternative, is also known as opportunity loss or the
opportunity cost.

From the payoff matrix (given in § 12.6), the payoffs

corresponding to the actions A1, A2, An under the state of
nature Sj are X1i, X2j, Xnj, respectively. Of these assume
that X2j is maximum. Then the regret in selecting Ai, to
be denoted by Rij is given by X2j – Xij, i = 1 to m. We note
that the regret in selecting A2 is zero. The regrets for
various actions under different states of nature can also
be computed in a similar way.

The regret criterion is based upon the minimax principle,

i.e., the decision-maker tries to minimize the maximum
regret. Thus, the decision-maker selects the maximum regret
for each of the actions and out of these the action which
corresponds to the minimum regret is regarded as optimal.

The regret matrix of example no.1 can be written as given

below:
4. Hurwicz Criterion.

The maximax and the maximin criteria, discussed above,

assumes that the decision-maker is either optimistic or
pessimistic.

A more realistic approach would, however, be to take into

account the degree or index of optimism or pessimism of
the decision-maker in the process of decision-making. If
a, a constant lying between 0 and 1, denotes the degree of
optimism, then the degree of pessimism will be 1 - a. Then
a weighted average of the maximum and minimum payoffs of
an action, with a and 1 - a as respective weights, is
computed. The action with highest average is regarded as
optimal.

We note that a nearer to unity indicates that the decision-

maker is optimistic while a value nearer to zero indicates
that he is pessimistic. If a = 0.5, the decisionmaker is
said to be neutralist.

We apply this criterion to the payoff matrix of example

no. 1. Assume that the index of optimism a = 0.7

5. Laplace Criterion: In the absence of any knowledge about

the probabilities of occurrence of various states of
nature, one possible way out is to assume that all of them
are equally likely to occur. Thus, if there are n states
of nature, each can be assigned a probability of occurrence
= 1/n.

Using these probabilities, we compute the expected payoff

for each course of action and the action with maximum
expected value is regarded as optimal.
7.6 DECISION MAKING UNDER RISK
In case of decision-making under uncertainty the
probabilities of occurrence of various states of nature are not
known. When these probabilities are known or can be estimated,
the choice of an optimal action, based on these probabilities,
is termed as decision making under risk.
The choice of an optimal action is based on The Bayesian
Decision Criterion according to which an action with maximum
Expected Monetary Value (EMV) or minimum Expected Opportunity
Loss (EOL) or Regret is regarded as optimal.
Example No. 2:
The payoffs (in Rs) of three Acts A1, A2 and A3 and the possible
states of nature S1, S2 and S3 are given below:
 7.7 EXPECTED VALUE WITH PERFECT
INFORMATION (EVPI)
The expected value with perfect information is the amount of
profit foregone due to uncertain conditions affecting the
selection of a course of action.

Given the perfect information, a decision-maker is supposed

to know which particular state of nature will be in effect. Thus,
the procedure for the selection of an optimal course of action,
for the decision problem given in example no. 2, will be as
follows:

If the decision-maker is certain that the state of nature S1

will be in effect, he would select the course of action A3, having
maximum payoff equal to Rs 200.

Similarly, if the decision-maker is certain that the state of

nature S2 will be in effect, his course of action would be A1 and
if he is certain that the state of nature S3 will be in effect,
his course of action would be A2. The maximum payoffs associated
with the actions are Rs 200 and Rs 600 respectively.

The weighted average of these payoffs with weights equal to the

probabilities of respective states of nature is termed as Expected
Payoff under Certainty (EPC). Thus, EPC = (200 x 0.3) + (200 x
0.4) + (600 x 0.3) = 320

The difference between EPC and EMV of optimal action is the

amount of profit foregone due to uncertainty and is equal to EVPI.
Thus, EVPI = EPC - EMV of optimal action = 320 - 194 = 126.

It is interesting to note that EVPI is also equal to EOL of the

optimal action.

Cost of Uncertainty. It is the difference between the EOL of

optimal action and the EOL under perfect information.

Given the perfect information, the decision-maker would select

an action with minimum opportunity loss under each state of nature.
Since minimum opportunity loss under each state of nature is zero,
therefore, EOL under certainty = (0 X 0.3) + (0 x 0.4) + (0 0.3)
= 0.

Thus, the cost of uncertainty = EOL of optimal action = EVPI.

Example No. 3:
A group of students raise money each year by selling souvenirs
outside the stadium of a cricket match between teams A and B. They
can buy any of three different types of souvenirs from a supplier.
Their sales are mostly dependent on which team wins the match. A
conditional payoff (in Rs.) table is as under:

Example No. 4:

The following is the information concerning a product X:

(i) Per unit profit is Rs 3.
(ii) Salvage loss per unit is Rs 2.
(iii) Demand recorded over 300 days is as under:

Find:
(i) EMV of optimal order.
(ii) Expected profit presuming certainty of demand.
 7.8 USE OF SUBJECTIVE
PROBABILITIES IN DECISION
MAKING
When the objective probabilities of the occurrence of various
states of nature are not known, the same can be assigned on the
basis of the expectations or the degree of belief of the decision-
maker. Such probabilities are known as subjective or personal
probabilities. It may be pointed out that different individuals
may assign different probability values to given states of nature.
This indicates that a decision problem under uncertainty can
always be converted into a decision problem under risk by the use
of subjective probabilities. Such an approach is also termed as
Subjectivists' Approach.

Example No. 5:
The conditional payoff (in Rs) for each action-event combination
are as under:
 7.9 USE OF POSTERIOR
PROBABILITIES IN DECISION
MAKING
The probability values of various states of nature, discussed
so far, were prior probabilities. Such probabilities are either
computed from the past data or assigned subjectively. It is
possible to revise these probabilities in the light of current
information available by using the Bayes' Theorem. The revised
probabilities are known as posterior probabilities.

Example No. 6:

A manufacturer of detergent soap must determine whether or

not to expand his productive capacity. His profit per month,
however, depend upon the potential demand for his product which
may turn out to be high or low. His payoff matrix is given below:

On the basis of past experience, he has estimated the

probability that demand for his product being high in future is
only 0.4

Before taking a decision, he also conducts a market survey.

From the past experience he knows that when the demand has been
high, such a survey had predicted it correctly only 60% of the
times and when the demand has been low, the survey predicted it
correctly only 80% of the times.

If the current survey predicts that the demand of his product

is going to be high in future, determine whether the manufacturer
should increase his production capacity or not? What would have
been his decision in the absence of survey?
 7.10 DECISION TREE APPROACH

The decision tree diagrams are often used to understand and

solve a decision problem. Using such diagrams, it is possible to
describe the sequence of actions and chance events. A decision
node is represented by a square and various action branches stem
from it. Similarly, a chance node is represented by a circle and
various event branches stem from it.

Various steps in the construction of a decision tree can be

summarized as follows:

I. Show the appropriate action-event sequence beginning from

left to right of the page.

II. Write the probabilities of various events along their

respective branches stemming from each chance node.

III. Write the payoffs at the end of each of the right-most

branch.

IV. Moving backward, from right to left, compute EMV of each

chance node, wherever encountered. Enter this EMV in the
chance node. When a decision node is encountered, choose
the action branch having the highest EMV. Enter this EMV
in the decision node and cutoff the other action
branches.

Following this approach, we can describe the decision problem

of the example No.6 as given below: