Decision Making Tools

Break-even analysis
Analysis to compare processes by finding the volume at
which two different processes have equal total costs.

Break-even quantity
The volume at which total revenues equal total costs.
 Evaluating Service or Products
Variable cost (c)
The portion of the total cost that varies directly with
volume of output.
Fixed cost (F)
The portion of the total cost that remains constant
regardless of changes in levels of output.
Quantity (Q)
The number of customers served or units produced per
year.
Evaluating Services or Products

Total cost = F + cQ
Total revenue = pQ

By setting revenue equal to total cost

pQ = F + cQ

F
Q=
p-c
 Example A.1
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.
The formula for the break-even quantity yields

F 100,000
Q= = = 1,000 patients
pc 200 100
 Example A.1
The following table shows the results for Q = 0 and Q = 2,000

Quantity
Total Annual Cost ($) Total Annual Revenue ($)
(patients)
(100,000 + 100Q) (200Q)
(Q)
0 100,000 0
2,000 300,000 400,000
 Example A.1
400 (2000, 400)

Total annual revenues Profits

Dollars (in thousands)

300
(2000, 300)
Total annual costs
200
Break-even quantity The two lines
intersect at
100 1,000
Loss Fixed costs patients, the
| | | |
break-even
0
500 1000 1500 2000 quantity
Patients (Q)

Figure A.1
 Application A.1
The Denver Zoo must decide whether to move twin polar bears to Sea
World or build a special exhibit for them and the zoo. The expected
increase in attendance is 200,000 patrons. The data are:
Revenues per Patron for Exhibit
Gate receipts $4
Concessions $5
Is the predicted
Licensed apparel $15
increase in
attendance
Estimated Fixed Costs
sufficient to
Exhibit construction $2,400,000
break even?
Salaries $220,000
Food $30,000

Estimated Variable Costs per Person

Concessions $2
Licensed apparel $9
 Application A.1
Q TR = pQ TC = F + cQ Where
0 $0 $2,650,000 p = 4 + 5 + 15 = $24
F = 2,400,000 + 220,000 + 30,000
250,000 $6,000,000 $5,400,000 = $2,650,000
7 c = 2 + 9 = $11
6
(millions of dollars)
Cost and revenue

0 | | | | | |
50 100 150 200 250
Q (thousands of patrons)
 Application A.1
Where
Q TR = pQ TC = F + cQ
p = 4 + 5 + 15 = $24
F = 2,400,000 + 220,000 + 30,000
0 $0 $2,650,000 = $2,650,000
250,000 $6,000,000 $5,400,000 c = 2 + 9 = $11

Algebraic solution of Denver Zoo problem

pQ = F + cQ
24Q = 2,650,000 + 11Q
13Q = 2,650,000
Q = 203,846
 Example A.2
If the most pessimistic sales forecast for the proposed
service from Figure A.1 was 1,500 patients, what would be
the procedures total contribution to profit and overhead per
year?

pQ (F + cQ) = 200(1,500) [100,000 + 100(1,500)]

= $50,000
 Evaluating Processes
Fb
The fixed cost (per year) of the buy option
Fm
The fixed cost of the make option
cb
The variable cost (per unit) of the buy option
cm
The variable cost of the make option
 Evaluating Processes
Total cost to buy
Fb + cbQ
Total cost to make
Fm + cmQ

Fb + cbQ = Fm + cmQ

Fm Fb
Q= c c
b m
 Example A.3
A fast-food restaurant featuring hamburgers is adding
salads to the menu
The price to the customer will be the same
Fixed costs are estimated at $12,000 and variable costs
totaling $1.50 per salad
Preassembled salads could be purchased from a local
supplier at $2.00 per salad
Preassembled salads would require additional
refrigeration with an annual fixed cost of $2,400
Expected demand is 25,000 salads per year
What is the break-even quantity?
 Example A.3
The formula for the break-even quantity yields the
following:
Fm Fb
Q= c c
b m

12,000 2,400
= = 19,200 salads
2.0 1.5
 Application A.2
At what volume should the Denver Zoo be
indifferent between buying special sweatshirts from
a supplier or have zoo employees make them?
Buy Make
Fixed costs $0 $300,000
Variable costs $9 $7

Fm Fb 300,000 0
Q= c c Q= Q = 150,000
b m 97
 Decision Making Under Risk

Use the expected value rule

Weigh each payoff with associated probability

and add the weighted payoff scores.

Choose the alternative with the best expected

value.
 Decision Trees
Decision Tree
A schematic model of alternatives available to
the decision maker along with their possible
consequences.
 Decision Trees
E1 [P(E1)]
Payoff 1
E2 [P(E2)]
Payoff 2
E3 [P(E3)]
Payoff 3

Alternative 3
Payoff 1
Alternative 4
1 2 Payoff 2
Alternative 5
1st Payoff 3
Possible
decision
2nd decision

= Event node E2 [P(E2)]

Payoff 1
= Decision node E3 [P(E3)]
Payoff 2
Ei = Event i
P(Ei) = Probability of event i
Figure A.4
 Example A.8
A retailer will build a small or a large facility at a new location
Demand can be either small or large, with probabilities
estimated to be 0.4 and 0.6, respectively
For a small facility and high demand, not expanding will have a
payoff of $223,000 and a payoff of $270,000 with expansion
For a small facility and low demand the payoff is $200,000
For a large facility and low demand, doing nothing has a payoff
of $40,000
The response to advertising may be either modest or sizable,
with their probabilities estimated to be 0.3 and 0.7, respectively
For a modest response the payoff is $20,000 and $220,000 if the
response is sizable
For a large facility and high demand the payoff is $800,000
 Example A.8
Low demand [0.4] $200

Dont expand
$223

2
Expand $270
1 Do nothing
$40
Modest response [0.3]
3 $20
Advertise

Sizable response [0.7]

$220

High demand [0.6]

$800
 Example A.8
Low demand [0.4] $200

Dont expand
$223

2
Expand
$270
1 Do nothing 0.3 x $20 = $6
$40
Modest response [0.3]
3 $20
Advertise

Sizable response [0.7]

$6 + $154 = $160 $220

0.7 x $220 = $154

High demand [0.6]
$800
 Example A.8
Low demand [0.4] $200

Dont expand
$223

2
Expand $270
1 Do nothing
$40
Modest response [0.3]
3 $20
Advertise
$160
Sizable response [0.7]
$160 $220

High demand [0.6]

$800
 Example A.8
Low demand [0.4] $200

Dont expand
$223

2
Expand $270
1 $270
Do nothing
$40
Modest response [0.3]
3 $20
Advertise
$160
Sizable response [0.7]
$160 $220

High demand [0.6]

$800
 Example A.8
Low demand [0.4] $200 x 0.4 = $80
$80 + $162 = $242

Dont expand
$223

2
Expand
$270 x 0.6 = $162
$270
1 Do nothing
$40
Modest response [0.3]
3 $20
Advertise
$160
Sizable response [0.7]
$160 $220

High demand [0.6]

$800
 Example A.8
Low demand [0.4] $200
$242

Dont expand
$223

2
Expand $270
$270
1 Do nothing
$40
Modest response [0.3]
3 $20
Advertise
$160
Sizable response [0.7]
$160 $220
0.4 x $160 = $64

$544 High demand [0.6]

$800 x 0.6 = $480
 Example A.8
Low demand [0.4] $200
$242

Dont expand
$223

2
Expand $270
$270
1 Do nothing
$40
$544 Modest response [0.3]
3 $20
Advertise
$160
Sizable response [0.7]
$160 $220

$544 High demand [0.6]

$800
 Application A.6
a. Draw the decision tree for the Fletcher, Cooper, and
Wainwright
b. What is the expected payoff for the best alternative
in the decision tree below?

Land routes, Land Routes,

Sea routes, Only
Alternative No Treaty Treaty Only
(0.20)
(0.50) (0.30)

Arrows 840,000 440,000 190,000

Barrels 370,000 220,000 670,000

Wagons 25,000 1,150,000 -25,000

Application A.6
 Solved Problem 1
A small manufacturing business has patented a new
device for washing dishes and cleaning dirty kitchen sinks
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 products total contribution to profits in the
first year?
 Solved Problem 1
a. Beginning with the algebraic approach, we get

F 56,000
Q= pc =
25 7
= 3,111 units

Using the graphic approach, shown in Figure A.6, we first draw

two lines:
Total revenue = 25Q
Total cost = 56,000 + 7Q

The two lines intersect at Q = 3,111 units, the break-even

quantity
 Solved Problem 1
250

200
Total revenues
Dollars (in thousands)

150

Break-even
100 quantity
$77.7
Total costs
50
3.1

| | | | | | | |
0
1 2 3 4 5 6 7 8
Units (in thousands)
 Solved Problem 1
b. Total profit contribution = Total revenue Total cost
= pQ (F + cQ)

= 15(10,000) [56,000 + 7(10,000)]

= $24,000
 Solved Problem 4
White Valley Ski Resort is planning the ski lift operation for its
new ski resort and wants to determine if one or two lifts will
be necessary. Each lift can accommodate 250 people per day
and skiing occurs 7 days per week in the 14-week season and
lift tickets cost $20 per customer per day. The table below
shows all the costs and probabilities for each alternative and
condition. Should the resort purchase one lift or two?
Alternatives Conditions Utilization Installation Operation
One lift Bad times (0.3) 0.9 $50,000 $200,000
Normal times (0.5) 1.0 $50,000 $200,000
Good times (0.2) 1.0 $50,000 $200,000
Two lifts Bad times (0.3) 0.9 $90,000 $200,000
Normal times (0.5) 1.5 $90,000 $400,000
Good times (0.2) 1.9 $90,000 $400,000
 Solved Problem 4
The decision tree is shown on the following slide. The payoff
($000) for each alternative-event branch is shown in the
following table. The total revenues from one lift operating at
100 percent capacity are $490,000 (or 250 customers 98 days
$20/customer-day).
Alternatives Economic Conditions Payoff Calculation (Revenue Cost)
One lift Bad times 0.9(490) (50 + 200) = 191
Normal times 1.0(490) (50 + 200) = 240
Good times 1.0(490) (50 + 200) = 240
Two lifts Bad times 0.9(490) (90 + 200) = 151
Normal times 1.5(490) (90 + 400) = 245
Good times 1.9(490) (90 + 400) = 441
 Solved Problem 4
Bad times [0.3]
0.3(191) + 0.5(240) + $191
0.2(240) = 225.3
Normal times [0.5]
$240
One lift
$225.3
Good times [0.2]
$240
$256.0
Bad times [0.3]
$151

Two lifts Normal times [0.5]

$245

$256.0
Good times [0.2]
0.3(151) + 0.5(245) + $441
0.2(441) = 256.0