Table of Contents

Chapter 1 (Introduction)

Special Products Break-Even Analysis (Section 1.2)

1.2 – 1.6

Advertising Problem (UW Lecture)

1.8 – 1.21
An illustration of the management science approach to a problem. At the University of
Washington, this is the very first lecture in the core MBA class on management science. While it
includes some advanced topics (Solver, nonlinear objectives, etc.) it can be taught entirely on the
spreadsheet in a very intuitive way, and has proven to be a good introduction to the power of
Solver. The next several lectures then would need to “back up” and cover more of the
fundamentals of linear programming, modeling, the Solver, etc.

McGraw-Hill/Irwin 1.1 © The McGraw-Hill Companies, Inc., 2008

 Special Products Break-Even Analysis

• The Special Products Company produces expensive and unusual gifts.

• The latest new-product proposal is a limited edition grandfather clock.

• Data:
– If they go ahead with this product, a fixed cost of $50,000 is incurred.
– The variable cost is $400 per clock produced.
– Each clock sold would generate $900 in revenue.
– A sales forecast will be obtained.

Question: Should they produce the clocks, and if so, how many?

McGraw-Hill/Irwin 1.2 © The McGraw-Hill Companies, Inc., 2008

 Expressing the Problem Mathematically

• Decision variable:
– Q = Number of grandfather clocks to produce

• Costs:
– Fixed Cost = $50,000 (if Q > 0)
– Variable Cost = $400 Q
– Total Cost =
• 0, if Q = 0
• $50,000 + $400 Q, if Q > 0

• Profit:
– Profit = Total revenue – Total cost
• Profit = 0, if Q = 0
• Profit = $900Q – ($50,000 + $400Q) = –$50,000 + $500Q, if Q > 0

McGraw-Hill/Irwin 1.3 © The McGraw-Hill Companies, Inc., 2008

 Special Products Co. Spreadsheet

B C D E F
3 Data Results
4 Unit Revenue $900 Total Revenue $180,000
5 Fixed Cost $50,000 Total Fixed Cost $50,000
6 Marginal Cost $400 Total Variable Cost $80,000
7 Sales Forecast 300 Profit (Loss) $50,000
8 Range Name Cell
9 Production Quantity 200 FixedCost C5
MarginalCost C6
ProductionQuantity C9
Profit F7
SalesForecast C7
E F TotalFixedCost F5
3 Results TotalRevenue F4
4 Total Revenue =UnitRevenue*MIN(SalesForecast,ProductionQuantity) TotalVariableCost F6
UnitRevenue C4
5 Total Fixed Cost =IF(ProductionQuantity>0,FixedCost,0)
6 Total Variable Cost =MarginalCost*ProductionQuantity
7 Profit (Loss) =TotalRevenue-(TotalFixedCost+TotalVariableCost)

McGraw-Hill/Irwin 1.4 © The McGraw-Hill Companies, Inc., 2008

 Analysis of the Problem

$200,000

$160,000
Revenue = $900 x
Profit

$120,000

Fixed cost Cost = $50,000 + $400 x

$80,000

Loss
$40,000

0 40 80 120 160 200 x

Break-even point = 100 units

McGraw-Hill/Irwin 1.5 © The McGraw-Hill Companies, Inc., 2008

 Management Science Interactive Modules

• Sensitivity analysis can be performed using the Break-Even module in the Interactive
Management Science Modules (available on your MS Courseware CD packaged with
the text).
– Here we see the impact of changing the fixed cost to $75,000.

McGraw-Hill/Irwin 1.6 © The McGraw-Hill Companies, Inc., 2008

 Special Products Co. Spreadsheet

B C D E F
3 Data Results
4 Unit Revenue $900 Total Revenue $270,000
5 Fixed Cost $50,000 Total Fixed Cost $50,000
6 Marginal Cost $400 Total Variable Cost $120,000
7 Sales Forecast 300 Profit (Loss) $100,000
8 Range Name Cell
9 Production Quantity 300 Break-Even Point 100 FixedCost C5
MarginalCost C6
ProductionQuantity C9
E F Profit F7
SalesForecast C7
3 Results
TotalFixedCost F5
4 Total Revenue =UnitRevenue*MIN(SalesForecast,ProductionQuantity) TotalRevenue F4
5 Total Fixed Cost =IF(ProductionQuantity>0,FixedCost,0) TotalVariableCost F6
6 Total Variable Cost =MarginalCost*ProductionQuantity UnitRevenue C4

7 Profit (Loss) =TotalRevenue-(TotalFixedCost+TotalVariableCost)

8
9 Break-Even Point =FixedCost/(UnitRevenue-MarginalCost)

McGraw-Hill/Irwin 1.7 © The McGraw-Hill Companies, Inc., 2008

 An Advertising Problem

• Parker Mothers is a manufacturer of children’s toys and games. One of their hottest
selling toys is an interactive electronic Harry Potter doll.

• Some data:
– Unit Variable Cost: $48
– Unit Selling Price: $65
– Fixed Overhead: $42,000

• Parker Mothers has analyzed past data for the Harry Potter doll (and other similar toys),
and determined that sales are affected by a number of factors:
– the season (e.g., more at Christmas, more when a new Harry Potter book or movie is released,
etc.),
– the size of the sales force devoted to the product,
– the level of advertising.

Question: What should the advertising budget for the Harry Potter doll be? (Proposal:
$50,000)

McGraw-Hill/Irwin 1.8 © The McGraw-Hill Companies, Inc., 2008

 Predicting the Sales Level

• After performing a statistical regression analysis, they estimate that sales for the quarter will be approximately
related to the season and advertising budget, as follows:

Sales  (Seasonality Factor)  2000+35 $Advertising 

• Seasonality Factors:
– Q1: 1.2 (publication of new Harry Potter book)
– Q2: 0.7
– Q3: 0.8
– Q4: 1.3 (Christmas and expected release of new Harry Potter movie)

• Effect of Advertising:

Sales

Advertising + (Sales Force/2)

McGraw-Hill/Irwin 1.9 © The McGraw-Hill Companies, Inc., 2008

 Spreadsheet for Quarter 1

B C
3 Parameters:
4 Unit Variable Cost $48
5 Unit Price $65
6 Fixed Overhead $42,000
7 Seasonality 1.2
8
9 Decision Variable:
10 Advertising $50,000
11
12 Quarter Q1 B C
13 Expected Units Sold 11,791 12 Quarter Q1
14 13 Expected Units Sold =C7*(2000+35*SQRT(C10))
15 Sales Revenue $766,447 14
16 Cost of Sales $565,991 15 Sales Revenue =C13*$C$5
17 Gross Margin $200,455 16 Cost of Sales =C13*$C$4
18 17 Gross Margin =C15-C16
18
19 Advertising Cost $50,000 19 Advertising Cost =C10
20 Fixed Overhead $42,000 20 Fixed Overhead =$C$6
21 21
22 Profit $108,455 22 Profit =C17-C19-C20

McGraw-Hill/Irwin 1.10 © The McGraw-Hill Companies, Inc., 2008

 3 Parameters:
B C
Trial Solutions
4 Unit Variable Cost $48
5 Unit Price $65
6 Fixed Overhead $42,000
7 Seasonality 1.2
8
9 Decision Variable: C C C
10 Advertising $50,000 10 $100,000 10 $150,000 10 $200,000
11 11 11 11
12 Quarter Q1 12 Q1 12 Q1 12 Q1
13 Expected Units Sold 11,791 13 15,682 13 18,667 13 21,183
14 14 14 14
15 Sales Revenue $766,447 15 $1,019,302 15 $1,213,324 15 $1,376,893
16 Cost of Sales $565,991 16 $752,715 16 $895,993 16 $1,016,783
17 Gross Margin $200,455 17 $266,587 17 $317,331 17 $360,111
18 18 18 18
19 Advertising Cost $50,000 19 $100,000 19 $150,000 19 $200,000
20 Fixed Overhead $42,000 20 $42,000 20 $42,000 20 $42,000
21 21 21 21
22 Profit $108,455 22 $124,587 22 $125,331 22 $118,111

B C
9 Decision Variable:
10 Advertising $125,000
11
12 Quarter Q1
13 Expected Units Sold 17,249
14
15 Sales Revenue $1,121,201
16 Cost of Sales $827,964
17 Gross Margin $293,237
18
19 Advertising Cost $125,000
20 Fixed Overhead $42,000
21
22 Profit $126,237

McGraw-Hill/Irwin 1.11 © The McGraw-Hill Companies, Inc., 2008

 The Excel Solver

B C
3 Parameters:
4 Unit Variable Cost $48
5 Unit Price $65
6 Fixed Overhead $42,000
7 Seasonality 1.2
8
9 Decision Variable:
10 Advertising $50,000
11
12 Quarter Q1
13 Expected Units Sold 11,791
14
15 Sales Revenue $766,447
16 Cost of Sales $565,991
17 Gross Margin $200,455
18
19 Advertising Cost $50,000
20 Fixed Overhead $42,000
21
22 Profit $108,455

McGraw-Hill/Irwin 1.12 © The McGraw-Hill Companies, Inc., 2008

 The Optimized Solution

B C
3 Parameters:
4 Unit Variable Cost $48
5 Unit Price $65
6 Fixed Overhead $42,000
7 Seasonality 1.2
8
9 Decision Variable:
10 Advertising $127,449
11
12 Quarter Q1
13 Expected Units Sold 17,394
14
15 Sales Revenue $1,130,610
16 Cost of Sales $834,912
17 Gross Margin $295,698
18
19 Advertising Cost $127,449
20 Fixed Overhead $42,000
21
22 Profit $126,249

McGraw-Hill/Irwin 1.13 © The McGraw-Hill Companies, Inc., 2008

 Four Quarters Spreadsheet

B C D E F G
3 Parameters:
4 Unit Variable Cost $48
5 Unit Price $65
6 Fixed Overhead $42,000
7 Seasonality 1.2 0.7 0.8 1.3
8
9 Total
10 Decision Variables: Advertising
11 Advertising $50,000 $50,000 $50,000 $50,000 $200,000
12
13 Quarter Q1 Q2 Q3 Q4 Total
14 Expected Units Sold 11,791 6,878 7,861 12,774 39,305
15
16 Sales Revenue $766,447 $447,094 $510,964 $830,317 $2,554,822
17 Cost of Sales $565,991 $330,162 $377,328 $613,157 $1,886,638
18 Gross Margin $200,455 $116,932 $133,637 $217,160 $668,184
19
20 Advertising Cost $50,000 $50,000 $50,000 $50,000 $200,000
21 Fixed Overhead $42,000 $42,000 $42,000 $42,000 $168,000
22
23 Profit $108,455 $24,932 $41,637 $125,160 $300,184

McGraw-Hill/Irwin 1.14 © The McGraw-Hill Companies, Inc., 2008

 Four Quarters Solver Optimized

B C D E F G
3 Parameters:
4 Unit Variable Cost $48
5 Unit Price $65
6 Fixed Overhead $42,000
7 Seasonality 1.2 0.7 0.8 1.3
8
9 Total
10 Decision Variables: Advertising
11 Advertising $127,449 $43,368 $56,644 $149,576 $377,036
12
13 Quarter Q1 Q2 Q3 Q4 Total
14 Expected Units Sold 17,394 6,502 8,264 20,197 52,357
15
16 Sales Revenue $1,130,610 $422,638 $537,160 $1,312,813 $3,403,221
17 Cost of Sales $834,912 $312,102 $396,672 $969,462 $2,513,148
18 Gross Margin $295,698 $110,536 $140,488 $343,351 $890,073
19
20 Advertising Cost $127,449 $43,368 $56,644 $149,576 $377,036
21 Fixed Overhead $42,000 $42,000 $42,000 $42,000 $168,000
22
23 Profit $126,249 $25,168 $41,844 $151,776 $345,037

McGraw-Hill/Irwin 1.15 © The McGraw-Hill Companies, Inc., 2008

 Residual Effect
B C D E F G
3 Parameters:
4 Unit Variable Cost $48
5 Unit Price $65
6 Fixed Overhead $42,000
7 Seasonality 1.2 0.7 0.8 1.3
8 Advertising Previous Q4 $50,000
9 Total
10 Decision Variables: Advertising
11 Advertising $127,449 $43,368 $56,644 $149,576 $377,036
12
13 Quarter Q1 Q2 Q3 Q4 Total
14 Expected Units Sold 15,959 7,817 8,025 18,473 50,273
15
16 Sales Revenue $1,037,305 $508,078 $521,654 $1,200,723 $3,267,760
17 Cost of Sales $766,010 $375,196 $385,221 $886,688 $2,413,115
18 Gross Margin $271,295 $132,882 $136,433 $314,035 $854,645
19
20 Advertising Cost $127,449 $43,368 $56,644 $149,576 $377,036
21 Fixed Overhead $42,000 $42,000 $42,000 $42,000 $168,000
22
23 Profit $101,846 $47,514 $37,789 $122,460 $309,608
B C D
7 Seasonality 1.2 0.7
8 Advertising Previous Q4 50000
13 Quarter Q1 Q2
14 Expected Units Sold =C7*(2000+35*SQRT(0.7*C11+0.3*C8)) =D7*(2000+35*SQRT(0.7*D11+0.3*C11))
E F G
13 Q3 Q4 Total
14 =E7*(2000+35*SQRT(0.7*E11+0.3*D11)) =F7*(2000+35*SQRT(0.7*F11+0.3*E11)) =SUM(C14:F14)

McGraw-Hill/Irwin 1.16 © The McGraw-Hill Companies, Inc., 2008

 Residual Effect (Solver Optimized)

B C D E F G
3 Parameters:
4 Unit Variable Cost $48
5 Unit Price $65
6 Fixed Overhead $42,000
7 Seasonality 1.2 0.7 0.8 1.3
8 Advertising Previous Q4 $50,000
9 Total
10 Decision Variables: Advertising
11 Advertising $173,577 -$21,148 $130,494 $48,777 $331,700
12
13 Quarter Q1 Q2 Q3 Q4 Total
14 Expected Units Sold 17,917 6,130 9,763 14,918 48,729
15
16 Sales Revenue $1,164,637 $398,437 $634,621 $969,669 $3,167,364
17 Cost of Sales $860,040 $294,231 $468,643 $716,063 $2,338,977
18 Gross Margin $304,597 $104,207 $165,978 $253,606 $828,388
19
20 Advertising Cost $173,577 -$21,148 $130,494 $48,777 $331,700
21 Fixed Overhead $42,000 $42,000 $42,000 $42,000 $168,000
22
23 Profit $89,021 $83,354 -$6,516 $162,829 $328,688

McGraw-Hill/Irwin 1.17 © The McGraw-Hill Companies, Inc., 2008

 Solver Options

McGraw-Hill/Irwin 1.18 © The McGraw-Hill Companies, Inc., 2008

 Residual Effect (Solver Re-Optimized)

B C D E F G
3 Parameters:
4 Unit Variable Cost $48
5 Unit Price $65
6 Fixed Overhead $42,000
7 Seasonality 1.2 0.7 0.8 1.3
8 Advertising Previous Q4 $50,000
9 Total
10 Decision Variables: Advertising
11 Advertising $155,280 $0 $121,431 $52,661 $329,371
12
13 Quarter Q1 Q2 Q3 Q4 Total
14 Expected Units Sold 17,172 6,688 9,763 14,918 48,541
15
16 Sales Revenue $1,116,152 $434,714 $634,621 $969,669 $3,155,157
17 Cost of Sales $824,236 $321,020 $468,643 $716,063 $2,329,962
18 Gross Margin $291,917 $113,694 $165,978 $253,606 $825,195
19
20 Advertising Cost $155,280 $0 $121,431 $52,661 $329,371
21 Fixed Overhead $42,000 $42,000 $42,000 $42,000 $168,000
22
23 Profit $94,637 $71,694 $2,547 $158,945 $327,823

McGraw-Hill/Irwin 1.19 © The McGraw-Hill Companies, Inc., 2008

 Residual Effect with Budget (Optimized)

B C D E F G H I
3 Parameters:
4 Unit Variable Cost $48
5 Unit Price $65
6 Fixed Overhead $42,000
7 Seasonality 1.2 0.7 0.8 1.3
8 Advertising Previous Q4 $50,000
9 Total
10 Decision Variables: Advertising
11 Advertising $91,433 $0 $75,727 $32,841 $200,000 <= $200,000
12
13 Quarter Q1 Q2 Q3 Q4 Total
14 Expected Units Sold 14,205 5,458 8,047 12,327 40,037
15
16 Sales Revenue $923,334 $354,749 $523,030 $801,286 $2,602,398
17 Cost of Sales $681,846 $261,969 $386,237 $591,719 $1,921,771
18 Gross Margin $241,487 $92,781 $136,792 $209,567 $680,627
19
20 Advertising Cost $91,433 $0 $75,727 $32,841 $200,000
21 Fixed Overhead $42,000 $42,000 $42,000 $42,000 $168,000
22
23 Profit $108,055 $50,781 $19,066 $134,726 $312,627

McGraw-Hill/Irwin 1.20 © The McGraw-Hill Companies, Inc., 2008

 Adding a Constraint in Solver

McGraw-Hill/Irwin 1.21 © The McGraw-Hill Companies, Inc., 2008