DECISION MAKING

MODELS
Dr.M.MutasimBillah
Example A1
• A hospital is considering a new procedure to be offered at $200 per
patient. The fixed cost per year would be $100,000, with total variable
costs of $100 per patient. What is the break-even quantity for this
service? Use both algebraic and graphic approaches to get the
answer.

To Accompany Krajewski & Ritzman Operations Management:

Strategy and Analysis, Seventh Edition © 2004 Prentice Hall,
Inc. All rights reserved.
Break-Even Analysis
 Break-Even Analysis
400 –

Dollars (in thousands)

300 –

200 –

100 –

| | | |
0– 500 1000 1500 2000
Example A.1 – page 33 Patients (Q)
 Break-Even Analysis
Quantity Total Annual Total Annual
(patients) Cost ($) Revenue ($)
(Q) (100,000 + 100Q) (200Q)
400 –
0 100,000 0
2000 300,000 400,000

Dollars (in thousands)

300 –

200 –

100 –

| | | |
0– 500 1000 1500 2000
Example A.1 Patients (Q)
 Break-Even Analysis
Quantity Total Annual Total Annual
(patients) Cost ($) Revenue ($)
(Q) (100,000 + 100Q) (200Q) (2000, 400)
0 400100,000
– 0
2000 300,000 400,000

Dollars (in thousands)

300 – Total annual revenues

200 –

100 –

| | | |
0– 500 1000 1500 2000
Example A.1 Patients (Q)
 Break-Even Analysis
Quantity Total Annual Total Annual
(patients) Cost ($) Revenue ($)
(Q) (100,000 + 100Q) (200Q)
(2000, 400)
0 400100,000
– 0
2000 300,000 400,000

Dollars (in thousands)

300 – Total annual revenues (2000, 300)

Total annual costs

200 –

100 – Fixed costs

| | | |
0– 500 1000 1500 2000
Example A.1 Patients (Q)
 Break-Even Analysis
Quantity Total Annual Total Annual
(patients) Cost ($) Revenue ($)
(Q) (100,000 + 100Q) (200Q)
(2000, 400)
0 400100,000
– 0
2000 300,000 400,000
Profits

Dollars (in thousands)

300 – Total annual revenues (2000, 300)

Total annual costs

200 – Break-even quantity

100 – Fixed costs

Loss

| | | |
0– 500 1000 1500 2000
Example A.1 Patients (Q)
 Break-Even Analysis
(2000, 400)
400 –

Profits

Dollars (in thousands)

300 – Total annual revenues (2000, 300)

Total annual costs

200 – Break-even quantity

100 – Fixed costs

Loss

| | | |
0– 500 1000 1500 2000
Figure A.1 Patients (Q)
Example A2
Sensitivity Analysis of Sales Forecast

• If the most pessimistic sales forecast for the proposed

service in Figure A.1 were 1,500 patients, what would
be the procedure’s total contribution to profit and
overhead per year?

To Accompany Krajewski & Ritzman Operations Management:

Strategy and Analysis, Seventh Edition © 2004 Prentice Hall,
Inc. All rights reserved.
 Sensitivity Analysis
400 –

Profits

Dollars (in thousands)

300 – Total annual revenues

Total annual costs

200 –

100 – Fixed costs

Loss

| | | |
0– 500 1000 1500 2000
Example A.2 – page 34 Patients (Q)
 Sensitivity Analysis
400 –

Profits

Dollars (in thousands)

300 – Total annual revenues

Total annual costs

200 – Forecast = 1,500

100 – Fixed costs

Loss

| | | |
0– 500 1000 1500 2000
Example A.2 Patients (Q)
 Sensitivity Analysis
pQ – (F + cQ)
400 –

Profits

Dollars (in thousands)

300 – Total annual revenues

Total annual costs

200 – Forecast = 1,500

100 – Fixed costs

Loss

| | | |
0– 500 1000 1500 2000
Example A.2 Patients (Q)
 Sensitivity Analysis
pQ – (F + cQ)
200(1500) –400[100,000
–
+ 100(1500)]
$50,000 Profits

Dollars (in thousands)

300 – Total annual revenues

Total annual costs

200 – Forecast = 1,500

100 – Fixed costs

Loss

| | | |
0– 500 1000 1500 2000
Example A.2 Patients (Q)
 Problem 1 class practice

• 1. Mary Williams, owner of Williams Products, is evaluating whether to introduce

a new product line. After thinking through the production process and the costs of
raw materials and new equipment, Williams estimates the variable costs of each
unit produced and sold at $6 and the fixed costs per year at $60,000.
• a. If the selling price is set at $18 each, how many units must be produced and sold
for Williams to break even? Use both graphic and algebraic approaches to get your
answer.
• b. Williams forecasts sales of 10,000 units for the first year if the selling price is set
at $14 each. What would be the total contribution to profits from this new product
during the first year?
• c. If the selling price is set at $12.50, Williams forecasts that first-year sales would
increase to 15,000 units. Which pricing strategy ($14.00 or $12.50) would result in
the greater total contribution to profits?
• d. What other considerations would be crucial to the final decision about making
and marketing the new product?
Class Practice
• The owner of a small manufacturing business has patented a new device
for washing dishes and cleaning dirty kitchen sinks. Before trying to
commercialize the device and add it to his or her existing product line, the
owner wants reasonable assurance of success. Variable costs are
estimated at $7 per unit produced and sold. Fixed costs are about
$56,000 per year.
• a. If the selling price is set at $25, how many units must be produced and
sold to break even? Use both algebraic and graphic approaches.
• b. Forecasted sales for the first year are 10,000 units if the price is
reduced to $15. With this pricing strategy, what would be the product’s
total contribution to profits in the first year?
 Make or Buy

• The manager of a fast-food restaurant featuring hamburgers is adding

salads to the menu. For each of the two new options, the price to the
customer will be the same. The make option is to install a salad bar stocked
with vegetables, fruits, and toppings and let the customer assemble the
salad. The salad bar would have to be leased and a part-time employee
hired. The manager estimates the fixed costs at $12,000 and variable costs
totaling $1.50 per salad. The buy option is to have preassembled salads
available for sale. They would be purchased from a local supplier at $2.00
per salad. Offering preassembled salads would require installation and
operation of additional refrigeration, with an annual fixed cost of $2,400.
The manager expects to sell 25,000 salads per year. What is the make-or-
buy quantity?
Make-or-Buy Decisions
 Make-or-Buy Decisions

Figure A.2
 Make-or-Buy Decisions

Fm – Fb
Q=
cb – cm
12,000 – 2,400
Q=
Example A.3 2.0 – 1.5
 Make-or-Buy Decisions

Fm – Fb
Q=
c b – cm

Example A.3
Q = 19,200 salads
Problem 6
• A news clipping service is considering modernization. Rather than manually clipping and
photocopying articles of interest and mailing them to its clients, employees electronically
input stories from most widely circulated publications into a database. Each new issue is
searched for key words, such as a client’s company name, competitors’ names, type of
business, and the company’s products, services, and officers. When matches occur,
affected clients are instantly notified via an online network. If the story is of interest, it is
electronically transmitted, so the client often has the story and can prepare comments for
follow-up interviews before the publication hits the street. The manual process has fixed
costs of $400,000 per year and variable costs of $6.20 per clipping mailed. The price
charged the client is $8.00 per clipping. The computerized process has fixed costs of
$1,300,000 per year and variable costs of $2.25 per story electronically transmitted to the
client.
• a. If the same price is charged for either process, what is the annual volume beyond which
the automated process is more attractive?
• b. The present volume of business is 225,000 clippings per year. Many of the clippings sent
with the current process are not of interest to the client or are multiple copies of the same
story appearing in several publications. The news clipping service believes that by
improving service and by lowering the price to $4.00 per story, modernization will increase
volume to 900,000 stories transmitted per year. Should the clipping service modernize?
Break Even Solved Problem 1
• The owner of a small manufacturing business has patented a new device for
washing dishes and cleaning dirty kitchen sinks. Before trying to
commercialize the device and add it to his or her existing product line, the
owner wants reasonable assurance of success. Variable costs are estimated
at $7 per unit produced and sold. Fixed costs are about $56,000 per year.
• a. If the selling price is set at $25, how many units must be produced and
sold to break even? Use both algebraic and graphic approaches.
• b. Forecasted sales for the first year are 10,000 units if the price is reduced
to $15. With this pricing strategy, what would be the product’s total
contribution to profits in the first year?
Q= Fm – Fa
Ca - Cm
Solved Problem 1
250 –

200 –
Total revenues
Dollars (in thousands)
150 –
Break-even
quantity
100 –
$77.7
Total costs
50 – 3.1

| | | | | | | |
0–
1 2 3 4 5 6 7 8
Figure A.7
Units (in thousands)
Jennings Company
• 2. A product at the Jennings Company enjoyed reasonable sales
volumes, but its contributions to profits were disappointing. Last year,
17,500 units were produced and sold. The selling price is $22 per unit,
the variable cost is $18 per unit, and the fixed cost is $80,000.
• a. What is the break-even quantity for this product? Use both graphic
and algebraic approaches to get your answer.
• b. If sales were not expected to increase, by how much would
Jennings have to reduce their variable cost to break even?
• c. Jennings believes that a $1 reduction in price will increase sales by
50 percent. Is this enough for Jennings to break even? If not, by how
much would sales have to increase?