ACC 115| Management Science
Module #7 Teacher’s Guide
Lesson title: Simplex Method and Shadow Pricing Materials:
Learning Targets: Pen and non-scientific calculator
At the end of this module, you should be able to: Strategic Cost Management by
1. Familiarize the process of simplex method. Cabrera
2. Assess the usefulness of shadow pricing in
decision making. References:
www.researchgate.net
www.accountingtools.com
A. LESSON PREVIEW/REVIEW
Introduction
For linear programming problems involving two variables (x and y), the graphical solution method
is convenient. However, for problems involving more than two variables, we will use the ―Simplex
Method‖. Developed by George Dantzig in 1946, it provides us with a systematic way of examining
the vertices of the feasible region to determine the optimal value of the objective function.
B. MAIN LESSON
Content Notes and Skill Building
Lesson Objective 1
Simplex Method
Simplex Method - It is a repetitive optimizing technique or iterative process of solving a linear
programming problem that uses Gauss-Jordan row operations to determine the optimum basic solution.
Basic Solution - It is a solution of the basic variables of a simplex method obtained by solving the
equations. The basic solution of a simplex method corresponds to a corner point of the solution space
or feasible region in the graphical method.
Basic Variable - It refers to a nonzero variable in the simplex method. A zero variable is called a
nonbasic variable.
Slack Variable — It refers to a nonnegative variable that is added to the left side of a less than or
equar (s) constraint to convert the constraint into an equation. (Note: The difference between the right
side and the left side of the s constraint can be thought as the unused or slack amount of the resource;
the right side represents the limit on the availability of a resource while the left side represents the
usage of this limited resource by the activities (variables) of the linear program or model. For a
maximization problem, a slack variable is also added to the left side of an equality (=) constraint to
prevent the constraint from equating a constant to zero.
Surplus Variable — It refers to a nonnegative variable that is subtracted from the left side of a "greater
than or equar (2) constraint to convert the constraint into an equation, with the addition of an artificial
variable. (Note: A 2 constraint sets a lower limit on the activities (variables) of the linear program or
model, so that the amount by which the left side exceeds the minimum limit represents a surplus.)
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Artificial Variable — It refers to a nonnegative variable that is added to the left side of a 2 constraint
after a surplus variable has been subtracted to convert the constraint into an equation. It must have a
large value to prevent the surplus variable from becoming negative. For a minimization problem, an
artificial variable is also added to the left side of an equality (=) constraint to prevent the constraint from
equating a constant to zero.
Optimality Condition — It refers to the rule of selecting the entering variable that will give the optimum
contribution to the objective function.
Feasibility Condition - It refers to the rule of selecting the leaving variable by ratio computations or
ratio tests that will guarantee the feasibility of a new solution.
Minimum Ratio Test — It is the division of each of the solution coefficient by their corresponding
positive pivot column coefficient to find the least quotient or minimum ratio. The zero and negative pivot
column coefficients are excluded from the test.
Pivot Column (or Optimum Column) - It is the column where the variable that gives the optimum
contribution to the objective function is located. The pivot column is also the entering variable row.
Pivot Row - It is the row where the solution coefficient and the positive pivot column coefficient, which
gives the minimum ratio, are located. This pivot row is also the leaving variable row.
Pivot Element (or Pivot Number) - It is the coefficient that belongs to both the pivot column and the
pivot row; the 'intersection" of pivot column and pivot row.
Entering Variable - It refers to the variable of the pivot column that will enter the basic solution in the
next iteration.
Leaving Variable - It refers to the variable of the pivot row that will leave the basic solution in the next
iteration.
Gauss-Jordan Row Operation - It is the process of computing the coefficients of the entering row
variable and the new coefficients of the remaining row variables, which is done by the application of the
following formulas:
entering row coefficient = leaving row coefficient
pivot element
for entering row coefficients, and
new row coefficient = old row coefficient - (pivot column old row coefficient x entering
row coefficient)
for new coefficients of the remaining rows.
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Optimum Table (or Final Table) - It refers to the simplex table where it is no longer possible to
determine the pivot column and its entering variable and where the optimum basic solution can be
found.
Steps in Solving LP Maximization Problem by Simplex Method
1. Base on the original linear program (which is either already given or formulated from a problem),
formulate a new linear program with slack variables by using the rules on converting the explicit
inequality constraints into equations.
2. Construct the initial (or first) simplex table with appropriate variables and coefficients. The
simplex method for maximization starts with the unknown (or decision) variables equal to the
lowest possible value usually zero, and hence, the initial basic variables (product or Prod
column) are the nonzero slack variables in the constraints. With this, the initial Zi row
coefficients are also all zeros and the Ci-Zi entries are the same as the initial Ci row coefficients.
(Note: C stands for contribution to profit or cost while Z is the variable to be optimized.)
3. Determine the pivot column (or optimal column). The pivot column is the column where the
highest positive Ci-Zi value belongs. The variable in the pivot column will be the entering
variable.
4. Determine the pivot row by minimum ratio test (MRT) i.e., by dividing each of the solution
(quantity or Qty column) coefficients by their corresponding positive pivot column coefficient.
Ignore or exclude from the test those with negative or zero pivot column coefficient. The row
that gives the minimum ratio is the pivot row. The variable in the pivot row will be the leaving
variable. The value or coefficient that belongs to both the pivot column and the pivot row is
called pivot element or pivot number.
5. Construct a new simplex table with the new coefficients determined as follows:
For entering row coefficients:
entering row coefficient = leaving row coefficient
pivot element
For new coefficients of remaining rows:
new row coefficient = old row coefficient - (pivot column old row coefficient x entering
row coefficient)
For Zi row coefficients:
Zi row coefficient = summation of (Ci column coefficient x row coefficient)
For Ci-Zi row coefficients:
Ci-Zi row coefficient = Ci row coefficient - Zi row coefficient
6. Repeat steps 3 to 5 until an optimum table is constructed. The table is optimum when there is
already no positive value in the Ci-Zi row.
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7. State the decision. The value of the decision variables and the maximum Z are in the solution or
quantity column.
Rules in Converting Inequality Constraints into Equations for Maximization Problem
Constraints involving/containing: Rule:
≤ Add a slack variable
= Add a slack variable
≥ Multiply both sides by -1 and then
add a slack variable
Illustration:
Note: The following computations are just for illustration of the simplex method and no similar problems
that will require to perform all the following calculations will be given for assessments.
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Optimal Solution
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Summary of the Simplex Method
The simplex method is an iterative, stepwise process which approaches an optimum solution in order to
reach an objective function of maximization and minimization. Each iteration or pivot involves the
removal of one old variable from the product mix (the basis) and the addition of one new variable to find
an improved solution – that is higher profit for maximization problems or lower cost for minimization
problems. This process is continuously applied until the optimal solution is reached.
Lesson Objective 2
Shadow Pricing
Shadow pricing has two definitions, which are as follows:
The assignment of a price to an intangible item for which there is no ready market from which to
derive a price. Shadow prices are most commonly used in cost-benefit analyses where some
elements of the analyses cannot be quantified by reference to a market price or a cost.
The maximum price that a business should be willing to pay for one additional unit of some type
of resource. This definition relates to the perceived benefit that management believes it can
obtain from the additional unit. An example of this definition is the cost of paying overtime to
employees to stay on the job and operate a production line for one more hour. Thus, if the result
of keeping the production line running longer (the shadow price) exceeds the cost required to
run the line, management should do so. The contribution margin that a business will lose if it
does not engage in the specific activity can also be considered the shadow price
Examples of Shadow Pricing
1. ABC International is considering turning over some of its excess property to the local city
government, to be converted into a park. The alternative choice for ABC is selling the property to a
developer who will convert it into an office parking space. ABC can assign a shadow price to the
usefulness (intangible item) that city residents will gain from use of the park, and compare it to the
proceeds that the company could achieve from selling to the developer.
2. DEF Company is considering paying its truck driver to work late in order to deliver a shipment to a
customer early. Doing so may qualify the company for more business with the customer. DEF assigns a
shadow price of ₱5,000 as the benefit of this improved relationship with the customer. Therefore, DEF
should be willing to pay up to ₱5,000 to the truck driver to make the delivery.
Advantage of Shadow Pricing
Shadow pricing is useful for incremental decisions, when management needs to know the benefit
associated with the cost of extending the usage of a resource.
Disadvantage of Shadow Pricing
A shadow price is frequently a guess estimate for which there is little proof, especially when it is applied
to intangible items. In this case, a range of estimates can be used, with probabilities assigned to the
most likely outcomes in the range. Even using a range analysis, there is a good chance that any
estimates proposed will be incorrect, and possibly by substantial amounts.
Illustration
A furniture dealer deals in only two items–tables and chairs. He has ₱50,000 to invest and has storage
space of at most 60 pieces. A table costs ₱2,500 and a chair costs ₱500. He estimates that from the
sale of one table, he can make a profit of ₱250 and that from the sale of one chair a profit of ₱75. He
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wants to know how many tables and chairs he should buy from the available money so as to maximize
his total profit, assuming that he can sell all the items which he buys.
Let x be the number of tables and y be the number of chairs that the dealer buys.
The objective function for the problem:
P = 250x + 75y
Subject to: ... (1)
... (2)
... (3)
... (4)
The maximum profit for this combination is ₱6,250.
Required: Compute the shadow price of constraint (3).
Step 1: Add one unit to the constraint under consideration.
Constraint (3) is under consideration, so
Step 2: Resolve the problem and find the maximum profit. Let us use the algebraic approach to
compute find the maximum profit.
( )
( ) ( )
Step 3: Compute the shadow price by finding the difference between the new profit and the optimum
profit.
New profit 6,293.75
Optimum profit 6,250.00
Shadow price 43.75
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Skill-building Activities
A final tableau for a linear programming profit maximization problem is shown below:
x1 x2 x3 s1 s2
x1 1 0 4 3 -7 50
x2 0 1 -2 -6 2 60
0 0 5 1 9 1,200
Additional information:
If x1, x2, and x3 represents products, s1 refer to square feet (in thousands) of warehouse capacity, and s2
refers to labor hours (in hundreds).
Required:
1. The number of x1 that should be produced to maximize profit would be
2. The contribution to profit of an additional 100 hours of labor would be
3. What would be the effect of additional 1,000 square feet of warehouse space on x1 and x2.
Check your answers against the Key to Corrections found at the end of this SAS. Be sure to complete
each activity before looking. Write your score on your paper.
Check for Understanding
A linear programming problem shows an objective function of:
P = 250x + 75y
Subject to constraints:
... (1)
... (2)
The maximum profit for this combination is ₱6,250.
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Required: Compute the shadow price of constraint (2).
C. LESSON WRAP-UP
Thinking about Learning (5 mins)
How do you feel today?
I feel (unsatisfactory/satisfactory/excellent) because_________________________________________
__________________________________________________________________________________
What are your challenges in learning the concepts in this module? If you do not have challenges, what
is your best learning for today?
__________________________________________________________________________________
_______________________________________________________________________________
What are the questions/thoughts you want to share to your teacher today?
__________________________________________________________________________________
_______________________________________________________________________________
ANSWER KEY
Skill Building Activity
1.
x1 x2 x3 s1 s2
x1 1 0 4 3 -7 50
x2 0 1 -2 -6 2 60
0 0 5 1 9 1,200
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2. Since s2 = labor hours (in hundred), the shadow price of resource s2 is the coefficient of s2 in the
objective function row of the final tableau: 9
3. s1= square feet of warehouse space (in thousands). One additional unit of s1 (1,000 square feet) will
affect the basic variables as indicated in the s1 column: x1 would increase by 3, x2 would decrease by
6, and profits would increase by 1.
Check for Understanding
( )
New profit 6,406.25
Optimum profit 6,250.00
Shadow price 156.25
ADDITIONAL NOTES FOR TEACHERS
In this portion, you may include:
● Additional exercises that teachers may give to students during face-to-face classes or
during remote coaching sessions
● Additional reading materials or references that teachers may use
● Instructions for activities during face-to-face classes
● Answer Keys for quizzes and exams
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