CHAPTER 1: INTRODUCTION TO MANAGEMENT SCIENCE

Learning Objectives
After completing this chapter, the students will be able to:
 Discuss the term Management Science
 Describe the nature of Management Science
 Explain what a mathematical model is
 Use a mathematical model to perform break-even analysis
 Gain an appreciation the relevance of Management Science
 Learn and recognize when Management Science can be fruitfully applied
 Learn how to apply the major techniques of Management Science to analyze a
variety of managerial problems
 Develop an understanding of how to interpret the result of a Management
Science study

Management Science
Management science is a scientific approach to solving management problems.
Management science can be used in a variety of organizations to solve many different
types of problems. It encompasses a logical approach to problem solving

The Management Science Approach to Problem Solving

Management science uses an objective (logical, scientific and mathematical)
approach to solve management problems. It is used in a variety of organizations to
solve many different types of problems. Investment, resource allocation, production
mix, marketing, multi-period scheduling etc.

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 Figure 1.1 The Management Science Process

The Steps of Scientific Methods

Observation
The first step in the management science process is the identification of a problem that
exists in the system (organization). The system must be continuously and closely
observed so that problems can be identified as soon as they occur or are anticipated.
Problems are not always the result of a crisis that must be reacted to but, instead,
frequently involve an anticipatory or planning situation. The person who normally
identifies a problem is the manager because managers work in places where problems
might occur. However, problems can often be identified by a management scientist, a
person skilled in the techniques of management science and trained to identify problems,
who has been hired specifically to solve problems using management science
techniques.

Definition of the Problem

Once it has been determined that a problem exists, the problem must be clearly and
concisely defined. Improperly defining a problem can easily result in no solution or an
inappropriate solution. Therefore, the limits of the problem and the degree to which it
pervades other units of the organization must be included in the problem definition.
Because the existence of a problem implies that the objectives of the firm are not being
met in some way, the goals (or objectives) of the organization must also be clearly
defined. A stated objective helps to focus attention on what the problem is.

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Model Construction
A management science model is an abstract representation of an existing problem
situation. It can be in the form of a graph or chart, but most frequently a management
science model consists of a set of mathematical relationships. These mathematical
relationships are made up of numbers and symbols. In model construction, equation is
composed of a variable and parameter.

❖ Variable. It is a symbol used to represent an item that can take on any value.
The number of units sold, x, and the profit, Z, can be any amount (within limits);
they can vary. These two variables can be further distinguished. Z is a dependent
variable because its value is dependent on the number of units sold; x is an
independent variable because the number of units sold is not dependent on
anything else.
❖ Parameters. It is the constant values that are generally coefficients of the
variables (symbols) in an equation. Parameters usually remain constant during the
process of solving a specific problem. The parameter values are derived from data
(i.e., pieces of information) from the problem environment. Sometimes the data are
readily available and quite accurate. For example, presumably the selling price of
Php200 and product cost of Php50 could be obtained from the firm’s accounting
department and would be very accurate. However, sometimes data are not as
readily available to the manager or firm, and the parameters must be either
estimated or based on a combination of the available data and estimates. In such
cases, the model is only as accurate as the data used in constructing the model.

The equation is known as a functional relationship (also called function and relationship).
The term is derived from the fact that profit, Z, is a function of the number of units sold, x,
and the equation relates profit to units sold. Because only one functional relationship
exists in this example, it is also the model. In this case the relationship is a model of the
determination of profit for the firm. However, this model does not really replicate a
problem.

Example of Model Construction Problem Definition

Information and Data:

A bakery makes and sells birthday cakes (Cake A and Cake B). Cake A costs $100 to
produce, Cake B costs $120. Cake A sells for $200 while Cake B sells for $250. Cakes
A and B require 0.5 and 0.8 pounds of double cream to make, respectively. The bakery
has 20 pounds of double cream for each day.

Business problem: Assuming all cakes produced can be sold out, determine the
numbers of different cakes to produce to make the most profit given the limited amount
of double cream available.

Decision Variable: x = number of Cake A to produce

y = number of Cake B to produce
Z = total profit

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Model: Z = $200x +$250y- $100x - $120y (objective function)
0.5x +0.8y <= 20 lb of double cream (resource constraint)
Parameters: $200, $100, 0.5 lb, 20 lbs (known values)

Formal specification of model:

maximize Z = $200x + $250y - $100x - $120y
subject to 0.5x +0.8y <= 20
x >= 0, y>= 0
Model Solution
Once models have been constructed in management science, they are solved using the
management science techniques presented in the next chapter. A management science
solution technique usually applies to a specific type of model. Thus, the model type and
solution method are both part of the management science technique. We are able to say
that a model is solved because the model represents a problem. When we refer to model
solution, we also mean problem solution

Model Implementation
The final step in the management science process for problem solving described in Figure
1.1 is implementation. Implementation is the actual use of the model once it has been
developed or the solution to the problem the model was developed to solve. This is a
critical but often overlooked step in the process. It is not always a given that once a model
is developed or a solution found, it is automatically used. Frequently the person
responsible for putting the model or solution to use is not the same person who developed
the model, and thus the user may not fully understand how the model works or exactly
what it is supposed to do. Individuals are also sometimes hesitant to change the normal
way they do things or to try new things. In this situation the model and solution may get
pushed to the side or ignored altogether if they are not carefully explained and their benefit
fully demonstrated. If the management science model and solution are not implemented,
then the effort and resources used in their development have been wasted

Applications of Management Science in Business: Opening a Fairwood Fast Food

Restaurant
Business questions:
1. Is it worth doing?
(Break-even analysis, Forecasting)
2. What seating capacity should we build?
(Decision analysis)
3. How much food material to prepare?
(Forecasting)
4. How to schedule the staff to ensure a certain customer service level?
(Linear programming, Waiting line management

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Model Building: Break-even Analysis
Break-even analysis is an important type of cost-volume analysis, which focuses on
relationships between cost, revenue, and volume of output. One purpose of break-
even analysis is to estimate the income of an organization under different operating
conditions. It is a key component of most business plans and is especially important
for starting-up companies seeking financing or investors. Performing a break-even
analysis is a simple way to determine price levels and to estimate whether an
expansion or cost saving project makes good business sense. The goal of a break-
even analysis is to determine when sales revenue equals total expenses; in simple
terms, when a business or operation "breaks even." The real value lies in helping you
determine the relationships between revenue, fixed costs, and variable costs.
Changing one variable changes the results and allows you to model a variety of
potential scenarios and make better business decisions.
You can use a break-even analysis to:
 Make pricing decisions
 Determine the feasibility of selling new products
 Evaluate a project
Break-even analysis is used to determine the break-even point: the number of units
of a product to sell or produce (i.e. volume) that will equate total revenue with total
cost.
The Break-Even Point
The break-even point is the point in the volume of activity where the organization’s
revenues and expenses are equal.

Sales $ 250,000
Less: variable expenses 150,000
Contribution margin 100,000
Less: fixed expenses 100,000
Net income $ -

Components of Break-Even Analysis

1. Cost – typically incurred in the production of a product
2 Types of Cost
 Fixed costs - are independent of volume and remain constant. Fixed
costs can include such items as rent on plant and equipment, taxes,
staff and management salaries, insurance, advertising, depreciation,
heat and light, and plant maintenance.
 Variable costs - depend on the number of items produced. Variable
costs include such items as raw materials and resources, direct
labor, packaging, material handling, and freight.

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 2. Volume - is the level of sales or production by a company. It can be expressed
as the number of units (i.e., quantity) produced and sold, as the dollar volume of
sales, or as a percentage of total capacity available.
3. Profit - is the difference between total revenue (volume multiplied by price) and
total cost

Equation Approach

Contribution – Margin Approach

Consider the following information developed by the accountant at Curl, Inc.:

Total Per Unit Percent

Sales (500 surf boards) $ 250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $ 100,000 $ 200 40%
Less: fixed expenses 80,000
Net income $ 20,000

For each additional surf board sold, Curl

generates $200 in contribution margin.

𝐹𝑖𝑥𝑒𝑑 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠
= 𝐵𝑟𝑒𝑎𝑘 − 𝑒𝑣𝑒𝑛 𝑝𝑜𝑖𝑛𝑡 (𝑖𝑛 𝑢𝑛𝑖𝑡𝑠)
𝑈𝑛𝑖𝑡 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛

80,000
= 400 𝑠𝑢𝑟𝑓 𝑏𝑜𝑎𝑟𝑑𝑠
200

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Contribution Margin Ratio
Calculate the break-even point in sales dollars rather than units by using the
contribution margin ratio.

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛
= 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 𝑅𝑎𝑡𝑖𝑜
𝑆𝑎𝑙𝑒𝑠

𝐹𝑖𝑥𝑒𝑑 𝐸𝑥𝑝𝑒𝑛𝑠𝑒
= 𝐵𝑟𝑒𝑎𝑘 − 𝑒𝑣𝑒𝑛 𝑝𝑜𝑖𝑛𝑡 (𝑖𝑛 𝑠𝑎𝑙𝑒𝑠 𝑑𝑜𝑙𝑙𝑎𝑟𝑠/𝑝𝑒𝑠𝑜)
𝐶𝑀 𝑅𝑎𝑡𝑖𝑜

Total Per Unit Percent

Sales (400 surf boards) $ 200,000 $ 500 100%
Less: variable expenses 120,000 300 60%
Contribution margin $ 80,000 $ 200 40%
Less: fixed expenses 80,000
Net income $ -

80,000
= $200,000 𝑠𝑎𝑙𝑒𝑠
40%

Target Net Profit

We can determine the number of surfboards that curl must sell to earn a profit of $
100,000 using the contribution margin approach.

𝐹𝑖𝑥𝑒𝑑 𝐸𝑥𝑝𝑒𝑛𝑠𝑒 + 𝑇𝑎𝑟𝑔𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡

= 𝑈𝑛𝑖𝑡 𝑠𝑜𝑙𝑑 𝑡𝑜 𝑒𝑎𝑟𝑛 𝑡𝑎𝑟𝑔𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡
𝑈𝑛𝑖𝑡 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛

80,000 + 100, 000

= 900 𝑠𝑢𝑟𝑓𝑏𝑜𝑎𝑟𝑑𝑠
200

Equation Approach:
𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠 − 𝐹𝑖𝑥𝑒𝑑 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠 = 𝑃𝑟𝑜𝑓𝑖𝑡
$500 𝑥 X − $300 𝑥 X − $80,000 = 100,000
200 X = 180,000
X = 900 surfboards

Applying CVP Analysis

Safety Margin - The difference between budgeted sales revenue and break-even
sales revenue. The amount by which sales can drop before losses begin to be
incurred.

Curl, Inc. has a break-even point of $200,000. If actual sales are $250,000, the safety
margin is $50,000 or 100 surf boards.

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Changes in Fixed Costs
Curl is currently selling 500 surfboards per year. The owner believes that an increase
of $10,000 in the annual advertising budget, would increase sales to 540 units. Should
the company increase the advertising budget?

Proposed
Current Sales Sales
(500 Boards) (540 Boards)
Sales $ 250,000 $ 270,000
Less: variable expenses 150,000 162,000
Contribution margin $ 100,000 $ 108,000 Sales will increase by
Less: fixed expenses 80,000 90,000 $20,000, but net income
Net income $ 20,000 $ 18,000 decreased by $2,000.

540 units × $500 per unit = $270,000

$80,000 + $10,000 advertising = $90,000

Changes in Unit Contribution Margin

Because of increases in cost of raw materials, Curl’s variable cost per unit has
increased from $300 to $310 per surfboard. With no change in selling price per unit,
what will be the new break-even point?

($500 𝑥 X) − ($310 𝑥 X) − $80,000 = 0

X = 422 units (rounded)

Suppose Curl, Inc. increases the price of each surfboard to $550. With no change in
variable cost per unit, what will be the new break-even point?

($550 𝑥 X) − ($300 𝑥 X) − $80,000 = 0

X = 320 units

Predicting Profit Given Expected Volume

In the coming year, Curl’s owner expects to sell 525 surfboards. The unit contribution
margin is expected to be $190, and fixed costs are expected to increase to $90,000.

𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 − 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 = 𝑃𝑟𝑜𝑓𝑖𝑡

($190 𝑥 525) − $90,000 = 𝑋
𝑋 = $99,750 − $90,000
𝑋 = $9,750 𝑝𝑟𝑜𝑓𝑖𝑡

Assumptions Underlying Break-Even Analysis

1. Selling price is constant throughout the entire relevant range.
2. Costs are linear over the relevant range.
3. In manufacturing firms, inventories do not change (units produced = units sold).

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Management Science Modeling Techniques

Figure 1.2 Classification of Management Science Techniques

Characteristics of Modeling Techniques

• Linear mathematical programming: clear objective; restrictions on resources
and requirements; parameters known with certainty.
• Probabilistic techniques: results contain uncertainty.
• Network techniques: model often formulated as diagram; deterministic or
probabilistic.
• Forecasting and inventory analysis techniques: probabilistic and deterministic
methods in demand forecasting and inventory control.
• Other techniques: variety of deterministic and probabilistic methods for specific
types of problems.

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