16.

Business Modeling

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16. Business Modeling
Spreadsheet-based business modeling techniques are particularly useful for
solving problems in business and economics.

Some applications of spreadsheet modeling include:

• Determining product mix
• Identifying how much to produce
• Finding the right mix of inputs (capital and labour)
• Routing and logistics
• Financial planning such as portfolio mix
• Investment decisions
We are going to look at a number of examples of spreadsheet models.

By the end, you will get an idea of the range of problems for which
spreadsheet models can be useful.
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16.1. Spreadsheet Models

Example 1:

• Suppose consulting to a South Melbourne pizza restaurant.

• The restaurant rents premises on Clarendon Street, it employs workers

to make the pizzas and also buys ingredients.

• There are a number of business decisions to make on a day-to-day

basis for the owner.

• We will focus on one issue in particular; how much to spend on

advertising.

• The main way the pizza company advertises at the moment is via
pamphlet drops in the local area.

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16.1.1. How Much Should Be Spent on Advertising?
Let’s write out the relationship between advertising and weekly
profitability, as well as all the other variables going into generating profit:

Profit = Price × Quantity − Total Cost

Total Cost = Variable Cost + Fixed Cost
Fixed Cost = 700 + Pamphlet Price × Number of Pamphlets
 
Wage
Variable Cost = + Cost of Ingredients × Quantity
5
Quantity = 120 + 0.2 × Number of Pamphlets
− 0.0003 × Number of Pamphlets2
Price = 25
Wage = 20
Pamphlet Price = 2
Cost of Ingredients = 3

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16.1.1. How Much Should Be Spent on Advertising?
Profit is simply revenue minus total cost.
There are fixed and variable costs.
The most interesting and important equation is that for the quantity
of pizzas demanded.
The figure below shows how quantity changes as the number of
pamphlets dropped changes.
Figure: Quantity of Pizzas Demanded as a Result of Advertising

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16.1.1. How Much Should Be Spent on Advertising?

We have enough information to

Figure: Profit Calculation Using
calculate profit. We need to Multiple Equations
construct a spreadsheet in which all
the pieces fit together.
Profit is a function of revenue
and total cost, total cost is a
function of fixed and variable
cost and so forth.
We have initially considered the
case of 100 pamphlets and
profit is $1,566 per week.
This is a multi-tiered calculation.
How to go about it is illustrated in
the figure.

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16.1.1. How Much Should Be Spent on Advertising?
We can explore how profit changes as the number of pamphlets dropped
changes using Excel’s ‘Data Table’ function.

Let us extend the analysis a bit and also consider changes over a second
dimension; the pamphlet price. Set up the sheet as follows.
Figure: Setup for Data Table in Excel

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16.1.1. How Much Should Be Spent on Advertising?
The ‘Data Table’ function is under the ‘Data’ tab in ‘What-if Analysis’.
A dialog box will open. You need to tell Excel what the numbers
down the left hand side in rows and along the top columns represent.
The ‘Row Input Cell’ is the pamphlet price and the ‘Column Input
Cell’ is the number of pamphlets.
Figure: Creating the Data Table in Excel

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16.1.1. How Much Should Be Spent on Advertising?

Figure: The Final Data Table in Excel

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16.1.1. How Much Should Be Spent on Advertising?

In the final table we have the profit for each pair of pamphlet price and
number of pamphlets.

• For a pamphlet price of $2 the profit maximizing number of pamphlets

seems to be around 150 but could be as low as 100 or as high as 200.
• When pamphlet price is lower profit is quite a bit higher. This is the
result of a double-whammy.
• A lower pamphlet price means lower costs on a fixed number of
pamphlets.
• It also means we should drop more pamphlets which means higher
profits.
• With a pamphlet price of $0.5 the optimal number of pamphlets is
around 300.

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16.2.1. Optimal Advertising

Let us continue with Example 1 and try to work out exactly how much
advertising the restaurant should employ. But let’s extend it a bit.

• Suppose the restaurant can also advertise on Facebook as well as

using pamphlets.

• Facebook is a new means of advertising which is a bit more expensive

but also a bit more effective.
The amended problem, with the new equations, is shown below.
Fixed Cost = 700 + Pamphlet Price × Number of Pamphlets +
Facebook Price × Number of Facebook Ads
Quantity = 120 + 0.2 × Number of Pamphlets − 0.0003 × Number of Pamphlets2
+ 0.3 × Number of Facebook Ads − 0.0003 × Number of Facebook Ads2
Facebook Price = 5

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16.2.1. Optimal Advertising
Of particular note is the effect of Facebook ads on pizza demand.
Clearly Facebook is more effective than pamphlet drops but it is also
more expensive.
Figure: Quantity of Pizzas Demanded as a Result of Pamphlets and Facebook
Advertising

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16.2.1. Optimal Advertising

The pizza restaurant owner is wondering whether they should abandon

pamphlet advertising altogether and just use Facebook, or a bit of both, or
perhaps the higher cost of Facebook means that it is not cost effective.

• Problems of this sort are very common in business and are called
optimisation problems.

• Excel’s ‘Solver’ function can be used to solve these sorts of problems.

• Solver is a particularly powerful part of the suite of Excel tools.

• It allows maximisation/minimisation subject to certain constraints on

the variables chosen—for example, these constraints might be that
they are positive or are integers.

First we set up the revised profit calculation that reflects the possibility of
advertising on Facebook as well as using pamphlets.
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16.2.1. Optimal Advertising
The Excel Solver add-in appears under the ‘Data’ tab in ‘Analysis’.
In the ‘Set Objective’ box select the cell that calculates profit.
We want to maximize profit so make sure ‘Max’ is checked.
In the ‘By Changing Variable Cells’ enter the location of the cells
where we have the number of pamphlets and Facebook ads.
Figure: Dialog Box for Excel Solver

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16.2.1. Optimal Advertising
After clicking ‘Solve’ make sure you get the message, “Solver found a
solution. All constraints and optimality conditions are satisfied.”
This means the optimisation has been successful.
Select ‘Answer’ in ‘Reports’.
Figure: Dialog Box for Excel Solver Results

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16.2.1. Optimal Advertising
The sheet ‘Answer Report 1’ gives details of the optimal values found.
The optimal number of pamphlets is 148 and the optimal number of
Facebook ads is 37.
With no advertising (the original value) we make a profit of $1,460.
With optimal advertising spending we make a profit of $1,586.
Figure: Results for Excel Solver

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16.2.1. Optimal Advertising
But there is a fair amount of work in setting up a contract, should we
bother engaging in Facebook advertising at all?
This is like the previous problem but we have a constraint.
The constraint is that the number of Facebook ads is zero.
To solve these problems we proceed as before but use ‘Add’
constraint.
Figure: Dialog Box for Solver and Adding Constraints

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16.2.1. Optimal Advertising

We go through the same process as before and obtain the ‘Answer Report’
sheet.

• This tells us that the maximum profit with no Facebook advertising is

$1,579.

• This is not much below the profit with optimal Facebook advertising
($1,586).

• Maybe we shouldn’t bother with Facebook advertising at all.

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16.2.2. An Investment Decision and Net Present Value
Example 2: A Melbourne cafe is being considered for purchase.
You have projections of the expected profit (net cashflow) each year
for the next 10 years—and will sell it after this
Table: Projected Cashflow of Cafe
Year Cashflow
0 -$650,000
1 $40,000
2 $41,600
3 $43,264
4 $44,995
5 $46,794
6 $48,666
7 $50,613
8 $52,637
9 $54,743
10 $800,000

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16.2.2. An Investment Decision and Net Present Value

• In year 0 the cafe is purchased. It is currently being offered for sale at

$650,000 and you have to pay it so there is a negative sign in front of
this amount—this is your investment.
• In the first year of operation you estimate that the profit will be
around $40,000 and it will increase by 4% per year after that.
• In year 10 you will sell the cafe and estimate that you’ll be able to sell
if for around $800,000.
The vital question is, given this set of cashflows, is this a good investment
or a lemon?
• We answer this question by looking at the net present value (NPV)
and internal rate of return (IRR) of these cashflows.
• This enables us to compare this investment with other investments.

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16.2.2. Net Present Value
To answer this question we need to understand the time value of money.
• A $100 note in your pocket now does not have the same value as
$100 in 10 years time.
• This is because of inflation but also because of the lost opportunity.
• If you give me $100 now I could invest it and make it into more than
this by the time 10 years is up.
• We use the concept of the net present value (NPV) of money—the
discounted value of money back to some base period.

For our case let Ct denote the cashflow in period t then the NPV of this
flow of payments is:
X
10
Ct
NPV =
(1 + r )t
t=0
With r = 7% our NPV is positive indicating a return greater than 7%.
• To calculate this we use the function: NPV(Interest Rate,
Cashflows). e.g. in our case we have, 53984=NPV(0.07,B2:B12).
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16.2.2. The Internal Rate of Return
The most interesting case is if we ask the question, what is r if NPV = 0.

To see what r represents in this case consider a simple example.

• Suppose we put $100 in the bank and receive 10% interest per year
paid each year for 3 years then at the end we get the money back.
• This has the cashflow; −$100, $10, $10, $110(= $100 + $10).
• Suppose that we want to find the r such that the NPV of this
investment is 0. What is the r ?
• It is 10%, the interest rate!
• This is called the internal rate of return (IRR). It is the average return
generated by the set of cashflows.

Returning to our case, there is a special Excel function that can be used to
calculate this called IRR.
• It requires just one input: IRR(Cashflows).
• The output is the interest that sets NPV to zero.
• In our case we have, 0.0818=IRR(B2:B12), the IRR is 8.18%.
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16.2.2. Optimal Buying Price

The IRR of 8.18% might be too low for an investor.

• They might be considering another investment opportunity which has

an IRR of 9%.

The purchase price of $650,000 might be negotiable.

• In this case we can ask; what is the purchase price which would yield
an IRR of at least 9%?

To answer this question we will use the Excel function ‘Goal Seek’.
• Goal seek is like Solver but a bit simpler.

• We want to find the price such that r = 9% and NPV = 0.

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16.2.2. Optimal Buying Price

Figure: What is the Optimal Price for an IRR of 9%?

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16.2.2. Optimal Buying Price

The process in Goal Seek is:

• Setup the cashflow and calculate the NPV based on an interest rate
of 9%. Open the Goal Seek dialog box.

• The first part of the box will ask us ‘Set Cell’. Here we want to set
the NPV cell to zero.

• In the second box, ‘To Value’, put zero.

• In the third box ‘By Changing Cell’ put the cell reference to the initial
price of −$650, 000.

Goal Seek will change −$650, 000 to −$613, 663.

• What we have found is that if the price of the cafe drops to
−$613, 663 then the investment will have an IRR of 9%.

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16.3.1. The Distribution of the Internal Rate of Return

For the cafe, we have presumed that

we know the cashflows with Table: Projected Profit of Cafe
(Baseline Case)
certainty.
This is a pretty heroic Year Cashflow
assumption. 0 -$650,000
1 $40,000
We would like to know, along with
2 $41,600
the estimate of the IRR, what is the
3 $43,264
likely level of variability in the IRR?
4 $44,995
To do this we can undertake a 5 $46,794
simulation. 6 $48,666
This involves incorporating a 7 $50,613
degree of uncertainty and 8 $52,637
creating individual realisations 9 $54,743
of the cashflows reflecting this 10 $800,000
uncertainty.
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16.3.1. The Distribution of the Internal Rate of Return

Table: Sensitivity Analysis Assumptions

Purchase Price:
We reflect our uncertainty about the Mean $650,000
assumptions we have made by Standard Deviation $0
supposing they have a standard Cashflow in Year 1:
deviation. Mean $40,000
e.g. The mean cashflow in year 1 is Standard Deviation $3,000
likely to be $40,000 but this Growth in Cashflow:
estimate is not certain and has Mean 4.0%
an standard deviation of Standard Deviation 2.0%
$3,000. Selling Price:
Mean $800,000
Standard Deviation $100,000

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16.3.1. The Distribution of the Internal Rate of Return

To incorporate uncertainty into our calculations of the IRR we will use two
functions; NORM.INV and RAND.

• NORM.INV(probability, mean, standard deviation) takes as

inputs a probability, a mean and a standard deviation and gives the X
value which is at that point in the cumulative normal distribution.

• RAND() (it has no arguments) will generate a random number

between 0 and 1.

Combining these two we can generate random variables from the normal
distribution.
• For example, let us generate a random number from the normal
distribution with mean 0 and standard deviation 1 by entering,
NORM.INV(RAND(),0,1).

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16.3.1. The Distribution of the Internal Rate of Return
Using our estimates of uncertainty we generate a simulation of the possible
cashflows.
This depends on Excel’s random number generator so will change
every time it is implemented.

Figure: Excel Simulation of Internal Rate of Return—Formulas

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16.3.1. The Distribution of the Internal Rate of Return
The values for the first 5 simulations are shown below.
The important thing to note is that in each of the simulations of the
cashflow the values are different from the other simulations and from
the baseline case.

Figure: Excel Simulation of Internal Rate of Return—Values

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16.3.1. The Distribution of the Internal Rate of Return

When we calculate the IRR for each of these simulated cashflows we get a
different number.

• The first entry is a IRR of 10.81%, the second 9.22% and so forth.

We can get an idea of the uncertainty about the returns by undertaking a

large number of simulations.
• We undertook 100. But it is straightforward to undertake 200, 1000
or even 10000. It’s just a matter of dragging the formulas rightwards.

• We then plot the distribution of IRR using a histogram.

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16.3.1. The Distribution of the Internal Rate of Return
Figure: Histogram of Simulated Internal Rate of Return

It is clear from the histogram that a fair amount of uncertainty exists

around our central estimate of the IRR of 8.18%.
There is around a 12-in-100 chance of a IRR equal to 7% or less.
The possibility of such downside risk might turn off investors some
cafe.
This emphasises that this sort of simulation and sensitivity analysis of
the assumptions used is very important in business decision making.
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