Model Development

Mathematical models – representations of a problem by a

system of symbols and mathemeatical relationships or
expressions
Model Development
Uncontrollable Inputs – environmental factors w/c affect
both objective function and constraints

Controllable Inputs – completely controlled or determined by

the decision maker

Output – projection of what would happen

Deterministic vs Probabilistic

Deterministic Model – all uncontrollable inputs to

the model are known and cannot vary

Stochastic (or Probabilistic) Model – any

uncontrollable inputs are uncertain and subject to
variation
Models of Cost, Revenue and Profit

Fixed Cost – does not depend on production volume

Variable Cost – dependent on production volume

Marginal Cost – rate of change of the total cost

with respect to production volume
Cost-Volume-Profit (CVP) Analysis

Significance: helps managers understand the

interrelationship between cost, volume, and profit
5 Elements:
1. Prices of product
2. Volume or level of activity w/in relevant range
3. Variable cost per unit
4. Total fixed costs
5. Mix of products sold
Relationships that may be established
1. Contribution Margin per unit – excess of unit selling price over unit
variable costs

CM per unit = unit selling price – unit variable cost

2. Contribution Margin Ratio – percentage of total contribution margin to

total sales

CM ratio = Contribution Margin / Sales

CVP Analysis for Breakeven Planning
1. Break-even Point (units)
BEP = Total Fixed Costs ÷ CM per unit
2. Break-even Point (pesos)
BEP = Total Fixed Costs ÷ [1 – (VC/Sales)]
CVP Analysis for Revenue and Cost Planning

1. Sales (units) = (FC + desired profit) ÷ CM per unit

2. Sales (P) = (FC + desired profit) ÷ CM ratio

Illustrative Problem
The Income Statement for ABC Company’s Administrative Expenses:
product shows:
V 500
Sales (100 units @100/unit) 10,000
F 1,000
Cost of Goods Sold:
Operating Income 2,500
DL 1,500
Required:
DM 1,400
1. Compute the Break-even Point in Units
Variable FOH 1,000
2. If sales increase by 25%, how much will be
Fixed FOH 500 the new operating income?
Gross Profit 5,600 3. Compute the new break-even point in
pesos if fixed factory overhead will
Marketing Expenses: increase by 1,700.
V 600
F 1,000
Illustrative Problem
1. Compute the Break-even Point in Units
BEP = Total Fixed Costs ÷ CM per unit
BEP = (500 + 1,000 + 1,000) ÷ 50

2. If sales increase by 25%, how much will be the new operating income?
Current Net Income 2,500
Add: Incremental CM (25 units x 50) 1,250
Operating Income 3,750

3. Compute the new break-even point in pesos if fixed factory overhead will
increase by 1,700.
BEP = Total Fixed Costs ÷ CM ratio
BEP = 2,500 + 1,700
50%
BEP = 8,400
Break-even sales for multi-products firm
1. Break-even Point (combined units)
BEP = Total Fixed Costs ÷ Weighted Average CM per unit

Weighted Average CM per unit = (Unit CM x No. of Units) + (Unit CM x No. of Units)
Total number of units per sales mix
2. Break-even Point (combined pesos)
BEP = Total Fixed Costs ÷ Weighted CM ratio

Weighted CM ratio = Total Weighted CM ÷ Total Weighted Sales

Sensitivity Analysis for CVP Results
Measures used to examine sensitivity of profits to changes in sales:
Margin of Safety – measures potential effect of the risk that sales will fall
short of planned levels

Margin of Safety = Budgeted Sales – Break-even Sales

Margin of Safety Ratio = Margin of Safety ÷ Budgeted Sales

Operating Leverage – potential effect of risk that sales will fall short of
planned levels
Operating Leverage = Contribution Margin ÷ Profit