Chapter 1: Introduction to Management
Science
Chapter 1: Introduction to Management
Science
1.1 - Problem Solving and Decision Making
1.2 - Quantitative Analysis and Decision
Making
1.3 - Quantitative Analysis
1.4 - Models of Cost, Revenue, and Profit
1.5 - Management Science Techniques
Introduction
The body of knowledge involving
quantitative approaches to decision making
is referred to as
● Management Science
● Operations Research
● Decision Science
It had its early roots in World War II
and is flourishing in business and industry
due, in part, to:
● Numerous methodological
developments (e.g. simplex method
for solving linear programming
problems)
● A virtual explosion in computing
power
Problem Solving and Decision Making
7 Steps of Problem Solving
(First 5 steps are the process of decision
making)
1. Define the problem.
2. Determine the set of alternative
solutions.
3. Determine the criteria for evaluating
alternatives.
4. Evaluate the alternatives.
5. Choose an alternative (make a
decision).
6. Implement the selected alternative.
7. Evaluate the results.
Quantitative Analysis and Decision
Making
Decision-Making Process
● Problems in which the objectives is
to find the best solution with respect
to one criterion are referred to as
single-criterion decision
problems.
● Problems that involve more than one
criterion are referred to as
multicriteria decision problems.
Quantitative Analysis
Analysis Phase of Decision-Making Process
Quanlitative Analysis
● based largely on the manager’s
judgement and experience
● includes the manager’s intuitive
“feel” for the problem
● is more of an art than a science
Quanlitative Analysis
● analyst will concentrate on the
quantitative facts or data associated
with the problem
● analyst will develop mathematical
expressions that describe the
objectives, constraints, and other
relationships that exist in the
problem
● analyst will use one or more
quantitative methods to make a
recommendation
Potential Reasons for a Quantitative
Analysis Approach to Decision Making
● The problem is complex.
● The problem is very important.
● The problem is new.
● The problem is repetitive.
Quantitative Analysis Process
● Model Development
● Data Preparation
● Model Solution
● Report Generation
Model Development
Models are representations of real
objects or situations.
Three forms of models are:
● Iconic models - physical replicas
(scalar representations) or real
objects
● Analog models - physical in form,
but do not physically resemble the
object being modeled
● Mathematical models - represent
real world problems through a
system of mathematical formulas
and expressions based on key
assumptions, estimates, or statistical
analyses
Generally, experimenting with
models (compared to experimenting with
the real situation):
● requires less time
● is less expensive
● involves less risk
The more closely the model
represents the real situation, the more
accurate the conclusions and predictions
will be.
Mathematical models
Objective Function - a mathematical
expression that describes the problem’s
objective, such as maximizing profit or
minimizing cost.
● Consider a simple production
problem. Suppose x denotes the
number of units produced and sold
each week, and the firm’s objective
is to maximize total weekly profit.
With a profit of $10 per unit, the
objective function is 10x.
Constraints - a set of restrictions or
limitations, such as production capacities.
● To continue our example, a
production capacity constraint would
be necessary if , for instance, 5
hours are required to produce each
unit and only 40 hours are available
per week. The production capacity
constraint is given 5x < 40.
● The value of 5x is the total time
required to produce x units; the
symbol indicates that the production
time required must be less than or
equal to the 40 hours available.
Uncontrollable Inputs - environmental
factors that are not under the control of the
decision maker.
● In the preceding mathematical
model, the profit per unit ($10), the
production time per unit (5 hours),
and the production capacity (40
hours) are environmental factors not
under the control of the manager or
decision maker.
Decision Variables - controllable inputs;
decision alternatives specified by the
decision maker, such as the number of units
of a product to produce.
● In the preceding mathematical
model, the production quantity x is
the controllable input to the model.

A complete mathematical model for
our simple production problem is:
The second constraint reflects the
fact that it is not possible to manufacture a
negative number of units.
Deterministic Model - if all uncontrollable
inputs to the model are known and cannot
vary.
Stochastic (or Probabilistic) Model - if
any uncontrollable are uncertain and subject
to variation.
● Stochastic models are often more
difficult to analyze.
● In our simple production example, if
the number of hours of production
time per unit could vary from 3 to 6
hours depending on the quality of
the raw material, the model would be
stochastic.
Data preparation is not a trivial step,
due to the time required and the possibility
of data collection errors.
● A model with 50 decision variables
and 25 constraints could have over
1300 data elements.
● Often, a fairly large database is
needed.
● Information systems specialists
might be needed.
Model Solution
The analyst attempts to identify the
alternative (the set of decision variable
values) that provides the “best” output for
the model.
● The “best” output is the optimal
solution.
● If the alternative does not satisfy all
of the model constraints, it is
rejected as being infeasible,
regardless of the objective function
value.
● If the alternative satisfies all of the
model constraints, it is feasible and
a candidate for the “best” solution.
Trial-and-Error Solution for
Production Problem
Model Testing and Validation
Often, goodness/accuracy of
a model cannot be assessed until
solutions are generated.
● Small test problems having
known, or at least expected,
solutions can be used for
model testing and validation.
● If the model generates
expected solutions, use the
model on the full-scale
problem.
 ● If inaccuracies or potential
shortcomings inherent in the
model are identified, take
corrective action such as:
● Collection of
more-accurate input
data
● Modification of the
model
Report Generation
A managerial report, based on the
results of the model, should be prepared.
● The report should be easily
understood by the decision maker.
● The report should include:
● the recommended decision
● Other pertinent information
about the results (for
example, how sensitive the
model solution is to the
assumptions and data used
in the model)
Models of Cost, Revenue, and Profit
Some of the most basic quantitative
models arising in business and economic
applications are those involving the
relationship between a volume variable -
such as production volume or sales volume
- and cost, revenue, and profit.
Through the use of these models, a
manager can determine the projected cost,
revenue, and/or profit associated with an
established production quantity or a
forecasted sales volume.
The cost of manufacturing or
producing a product is a function of the
volume produced. This cost can usually be
defined as a sum of two costs: fixed cost
and variable cost.
● Fixed cost is the portion of the total
cost that does not depend on the
production volume; this cost remains
the same no matter how much is
produced.
● Variable cost on the other hand, is
the portion of the total cost that is
dependent on and varies with the
production volume.
Nowlin Plastics produces a line of
cell phone covers. Nowlin’s best-selling
cover is its Viper model, a slim but very
durable black and gray plastic cover.
Several products are produced on
the same manufacturing line, and a setup
cost is incurred each time a changeover is
made for a new product.
● Suppose that the setup cost for the
Viper is $3000. This setup cost is a
fixed cost that is incurred regardless
of the number of units eventually
produced.
● In addition, suppose that variable
labor and material costs are $2 for
each unit produced.
The cost-volume model for producing x
units of the Viper can be written as
Marginal cost is defined as the rate of
change of the total cost with respect to
production volume. That is, it is the cost
increase associated with a one-unit
increase in the production volume.
In the cost model of equation (1.3),
we see that the total cost C(x) will increase
by $2 for each unit increase in the
production volume. Thus, the marginal cost
is $2.
Suppose that each Viper cover sells
for $5. The model for total revenue can be
written as

Marginal revenue is defined as the rate of
change of total revenue with respect to
sales volume. That is, it is the increase in
total revenue resulting from a one-unit
increase in sales volume. In the model of
the equation above, we see that the
marginal revenue is $5.
Total profit, denoted P(x), is total
revenue minus total cost; therefore, the
following model provides the total profit
associated with producing and selling x
units:
Using this equation, we can now
determine the total profit associated with
any production volume x.
The volume that results in total
revenue equals total cost (providing $0
profit) is called breakeven point.
The breakeven point can be found
by setting the total profit expression equal to
zero and solving for the production volume.
Using equation (1.5), we have
With this information, we know that
production and sales of the product must be
greater than 1000 units before a profit can
be expected.
Management Science Techniques
● Linear Programming
● Integer Linear Programming
● Nonlinear Programming
● PERT/CPM
● Inventory Models
● Walking Line Models
● Simulation
● Decision Analysis
● Goal Programming
● Analytic Hierarchy Process
● Forecasting
● Markov-Process Models
● Linear programming is a
problem-solving approach
developed for situations involving
maximizing or minimizing a linear
function subject to linear constraints
that limit the degree to which the
objective can be pursued.
● Integer linear programming is an
approach used for problems that can
be set up as linear programs with
the additional requirement that some
or all of the decision
recommendations be integer values.
● Network models are specialized
solution procedures for problems in
transportation system design,
information system design, project
scheduling,....
● Project scheduling: PERT of subjective factors in arriving at a
(Program Evaluation and Review recommended decision.
Technique) and CPM (Critical Path ● Markov-process models are useful
Method) help managers responsible in studying the evolution of certain
for planning, scheduling, and systems over repeated trials (such
controlling projects that consist of as describing the probability that a
numerous separate jobs or tasks machine, functioning in one period,
performed by a variety of will function or break down in
departments, individuals, and so another period).
forth. Methods Used Most Frequently
● Inventory models are used by ● Linear programming
managers faced with the dual ● Integer programming
problems of maintaining sufficient ● Network models (such as
inventories to meet demand for transportation and transshipment
goods and, at the same time, models)
incurring the lowest possible ● Simulation
inventory holding costs.
● Waiting line (or queuing) models
help managers understand and
make better decisions concerning
the operation of systems involving
waiting lines.
● Simulation is a technique used to
model the operation of a system.
This technique employs a computer
program to model the operation and
perform simulation computations.
● Decision analysis can be used to
determine optimal strategies in
situations involving several decision
alternatives and an uncertain pattern
of future events.
● Forecasting methods are
techniques that can be used to
predict future aspects of a business
operation.
● Goal programming is a technique
for solving multi-criteria decision
problems, usually within the
framework of linear programming.
● Analytic hierarchy process is a
multi-criteria decision-making
technique that permits the inclusion
Chapter 2: Decision Analysis
13.1 - Problem Formulation
13.2 - Decision Making without Probabilities
13.3 - Decision Making with Probabilities
13.4 - Risk Analysis and Sensitivity Analysis
13.5 - Decision Analysis with Sample
Information
13.6 - Computing Branch Probabilities with
Bayes’ Theorem
13.7 - Utility Theory
Decision Analysis
● Decision analysis can be used to
develop an optimal strategy when a
decision maker is faced with several
decision alternatives and an
uncertain or risk-filled pattern of
future events.
● Even when a careful decision
analysis has been conducted, the
uncertain future events make the
final consequence uncertain.
● The risk associated with any
decision alternative is a direct result
of the uncertainty associated with
the final consequence.
● Good decision analysis includes risk
analysis that provides probability
information about the favorable as
well as the unfavorable
consequences that may occur.
Problem Formulation
● A decision problem is characterized
by decision alternatives, states of
nature, and resulting payoffs.
● The decision alternatives are the
different possible strategies the
decision maker can employ.
● The states of nature refer to future
events, not under the control of the
decision maker, which may occur.
States of nature should be defined
so that they are mutually exclusive
and collectively exhaustive.
Example: Pittsburgh Development Corp.
Pittsburgh Development Corporation
(PDC) purchased land that will be the site of
a new luxury condominium complex. PDC
commissioned preliminary architectural
drawings for three different projects: one
with 30, one with 60, and one with 90
condominiums.
The financial success of the project
depends upon the size of the condominium
complex and the chance event concerning
the demand for the condominiums. The
statement of the PDC decision problem is to
select the size of the new complex that will
lead to the largest profit given the
uncertainty concerning the demand for the
condominiums.
Influence Diagrams
● An influence diagram is a graphical
device showing the relationships
among the decisions, the chance
events, and the consequences.
● Squares or rectangles depict
decision nodes.
● Circles or ovals depict chance
nodes.
● Diamonds depict consequence
nodes.
● Lines or arcs connecting the nodes
show the direction of influence.
Payoff Tables
● The consequence resulting from a
specific combination of a decision
alternative and a state of nature is a
payoff.
● A table showing payoffs for all
combination of decision alternatives
and states of nature is a payoff
table.
● Payoffs can be expressed in terms
of profit, cost, time, distance or any
other appropriate measure.
Example: Pittsburgh Development Corp.
Consider the following problem with
three decision alternatives and two states of
nature with the following payoff table
representing profits:
Decision Making without Probabilities
Three commonly used criteria for
decision making when probability
information regarding the likelihood of the
states of nature is unavailable are:
● the optimistic approach - the
decision with the largest payoff or
lowest cost is chosen.
● the conservative approach - for each
decision the minimum payoff is listed
and the decision corresponding to
the maximum of these payoffs is
selected. Or the maximum costs are
determined and the minimum of
those is selected.
● the minimax regret approach.
Example: Optimistic Approach
An optimistic decision maker would
use the optimistic (maximax) approach. We
choose the decision that has the largest
single value in the payoff table.
Example: Conservative Approach
A conservative decision maker
would use the conservative (maximin)
approach. List the minimum payoff for each
decision. Choose the decision with the
maximum of these minimum payoffs.
Minimax Regret Approach
● The minimax regret approach
requires the construction of a regret
table or an opportunity loss table.
● This is done by calculating for each
state of nature the difference
between each payoff and the largest
payoff for that state of nature.
● Then, using this regret table, the
maximum regret for each possible
decision is listed.
● The decision chosen is the one
corresponding to the minimum of the
maximum regrets.
Example: Minimax Regret Approach
For the minimax regret approach,
first compute a regret table by subtracting
each payoff in a column from the largest
payoff in that column. In this example, in the
first column subtract 8, 14, and 20 from 20;
etc.
For each decision list the maximum
regret. Choose the decision with the
minimum of these values.
Decision Making with Probabilities each square node represent the
Expected Value Approach different decision alternatives.
● If probabilistic information regarding ● At the end of each limb of a tree are
the states of nature is available, one the payoffs attained from the series
may use the expected value (EV) of branches making up that limb.
approach.
● Here the expected return for each
decision is calculated by summing
the products of the payoff under
each state of nature and the
probability of the respective state of
nature occurring.
● The decision yielding the best
expected return is chosen.

Expected Value of a Decision Alternative

● The expected value of a decision
alternative is the sum of weighted
payoffs for the decision alternative.
● The expected value (EV) of decision
alternative di

Expected Value for Each Decision

Decision Tree
● A decision tree is a chronological
representation of the decision
problem.
● Each decision tree has two types of
nodes: round nodes correspond to
the states of nature while square
nodes correspond to the decision
alternatives.
● The branches leaving each round
node represent the different states of
nature while the branches leaving
Choose the decision alternative with
the largest EV. Build the large complex.
Expected Value of Perfect Information
● Frequently information is available
which can improve the probability
estimates for the states of nature.
● The expected value of perfect
information is the increase in the
 expected profit that would result if
one knew with certainty which state
of nature would occur.
● The EVPI provides an upper bound
on the expected value of any sample
or survey information.
Decision Analysis with Sample
Information
Risk Analysis
● Risk analysis helps the decision
maker recognize the difference
between:
● The expected value of a
decision alternative, and
● The payoff that might actually
occur.
● The risk profile for a decision
alternative shows the possible
payoffs for the decision alternative
along with their associated
probabilities.
Risk Profile
Example: Pittsburgh Development Corp.
Sensitivity Analysis
● Sensitivity analysis can be used to
determine how changes to the
following inputs affect the
recommended decision alternative:
● probabilities for the states of
nature
● values of the payoffs
● If a small change in the value of one
of the inputs causes a change in the
recommended decision alternative,
extra effort and care should be taken
in estimating the input value.
● Frequently, decision makers have
preliminary or prior probability
assessments for the states of nature
that are the best probability values
available at that time.
● To make the best possible decision,
the decision maker may want to
seek additional information about the
states of nature.
● This new information, often obtained
through sampling, can be used to
revise the prior probabilities so that
the final decision is based on more
accurate probabilities for the states
of nature.
● These revised probabilities are
called posterior probabilities.
● Let us return to the PDC problem
and assume that management is
considering a 6-month market
research study designed to learn
more about potential market
acceptance of the PDC
condominium project. Management
anticipates that the market research
study will provide one of the
following two results:
 1. Favorable report: A If the market research study is not
significant number of the undertaken, the prior probabilities are
individuals contacted express applicable:
interest in purchasing a PDC
condominium.
2. Unfavorable report: Very few
of the individuals contacted Decision Tree 1
express interest in
purchasing a PDC
condominium.

Influence Diagram

Sample Information
PDC has developed the following branch
probabilities.

If the market research study is

undertaken:

If the market research report is

favorable:

Decision Strategy
❖ A decision strategy is a sequence of
If the market research report is decisions and chance outcomes
unfavorable: where the decisions chosen depend
on the yet-to-be-determined
outcomes of chance events.
❖ The approach used to determine the
optimal decision strategy is based
on a backward pass through the
 decision tree using the following
steps:
● At chance nodes, compute
the expected value by
multiplying the payoff at the
end of each branch by the
corresponding branch
probabilities.
● At decision nodes, select the
decision branch that leads to
the best expected value. This
expected value becomes the
expected value at the
decision node.
Decision Tree 2
PDC’s Decision Strategy
PDC’s optimal decision strategy is:
● Conduct the market research study.
● If the market research report is
favorable, construct the large
condominium complex.
● If the market research report is
unfavorable, construct the medium
condominium complex.
Risk Profile
Expected Value of Sample Information
● The expected value of sample
information (EVSI) is the additional
expected profit possible through
knowledge of the sample or survey
information.
● The expected value associated with
the market research study is $15.93.
● The best expected value if the
market research study is not
undertaken is $14.20.
● We can conclude that the difference,
$15.93 - $14.20 = $1.73, is the
expected value of sample
information.
● Conducting the market research
study adds $1.73 million to the PDC
expected value.
Efficiency of Sample Information
● Efficiency of sample information is
the ratio of EVSI to EVPI.
● As the EVPI provides an upper
bound for the EVSI, efficiency is
always a number between 0 and 1.
The efficiency of the survey:
E = (EVSI/EVPI) X 100
= [($1.73 mil)/($3.20 mil)] X 100
= 54.1%
The information from the market
research study is 54.1% as efficient
as perfect information.
Computing Branch Probabilities
Bayes’ Theorem and Posterior
Probabilities
● Knowledge of sample (survey)
information can be used to revise
the probability estimates for the
states of nature.
● Prior to obtaining this information,
the probability estimates for the
states of nature are called prior
probabilities.
● With knowledge of conditional
probabilities for the outcomes or
indicators of the sample or survey
information, these prior probabilities
can be revised by employing Bayes’
Theorem.
● The outcomes of this analysis are
called posterior probabilities or
branch probabilities for decision
trees.

Posterior Probabilities

Branch (Posterior) Probabilities Calculation

● Step 1:
For each state of nature, multiply
the prior probability by its conditional
probability for the indicator - this
gives the joint probabilities for the
states and indicator.
● Step 2:
Sum these joint probabilities over
all states - this gives the marginal
probability for the indicator.
● Step 3:
For each state, divide its joint
probability by the marginal
probability for the indicator - this
gives the posterior probability
distribution.
Chapter 3. Risk and Rates of Return and
Portfolio Management
3.1 - Stand-alone Risk
3.2 - Portfolio Risk
3.3 - Risk and Return: CAPM/SML
The Required Rate of Return
The required rate of return is the
nominal rate of return that an investor needs
in order to make an investment worthwhile.
This return varies over time and is
comprised of the following:
● Real risk-free rate
● Inflation premium
● Risk premium
Real risk-free rate of return
The real risk-free rate of return (Rn)
is the minimum return an investor requires.
This rate does not take into account
expected inflation and the capital market
environment.
Example: Real risk-free rate of return
Determine the real risk-free rate if the
nominal risk-free rate is 8% and the inflation
rate is 3%.
Answer:
Nominal risk-free rate of return (Rnominal)
This is simply the real risk-free rate
of return adjusted for inflation.
Nominal risk-free rate = (1 + risk-free rate) x
(1 + rate of inflation) -1
Example: Nominal risk-free rate of return
Determine the nominal risk-free rate of
return if the risk-free rate is 3% and the rate
of inflation is 3%.
In an investment setting, an investor
sets his required rate of return as the base
return he requires from an investment.
However, given the usual uncertainty in the
market, it is difficult to meet the required
rate of return exactly. As such, an investor
would set his return above his required rate
of return to diminish the risk that his
required rate of return will not be met. The
excess return above the investor’s required
rate of return is known as the risk premium.
The fundamental sources of risk that
contribute to the need for the risk premium.
The fundamental sources of risk that
contribute to the need for the risk
premium,such as:
1. Business risk
2. Financial risk
3. Liquidity risk
4. Exchange rate risk
5. Political risk
These risks comprise systematic
risk, and cannot be avoided through
diversification since they affect the entire
market.
1. Business Risk : Business risk is the
risk that a business’ cash flow will
not meet its needs due to
uncertainty in the company’s
business lines.
2. Financial Risk : Financial risk is the
risk to equity holders as a company
increases its debt load. As debt load
increases, interest expense also
increases, leading to less income to
be paid out to investors.
3. Liquidity Risk : Liquidity risk is the
uncertainty around the ability to sell
an investment. The more liquid an
investment is, the easier it is to sell.
4. Exchange-Rate Risk :
Exchange-rate risk is the risk a
company faces when it has
businesses in other countries. When
 a company is in the business of
producing or buying products in a
country other than its own, a
company can face exchange-rate
risk when in the process when it
needs to exchange currency to
transact business as a part of its
normal business routine.
5. Political Risk : Political risk is the
risk of changes in the political
environment of a country in which
company transacts its businesses.
The risk could be caused by
changes in laws relating to a specific
business or even more serious as a
country revolution that would cause
disruption in a company’s
operations.
The security market line (SML) is the
line that reflects an investment’s risk versus
its return, or the return on a given
investment in relation to risk. The measure
of risk used for the security market line is
beta.
The line begins with the risk-free
rate (with zero risk) and moves upward and
to the right. As the risk of an investment
increases, it is expected that the return on
an investment would increase. An investor
with a low risk profile would choose an
investment at the beginning of the security
market line. An investor with a highest risk
profile would thus choose an investment
higher along the security market line.
Security Market Line
Given the SML reflects the return on
a given investment in relation to risk, a
change in the slope of the SML could be
caused by the risk premium of the
investments. Recall that the risk premium of
an investment is the excess return required
by an investor to help ensure a required rate
of return is met. If the risk premium required
by investors was to change, the slope of the
SML would change as well.
When a shift in the SML occurs, a
change that affects all investments’ risk
versus return profile has occurred. A shift of
the SML can occur with changes in the
following:
1. Expected real growth in the
economy.
2. Capital market conditions.
3. Expected inflation rate.
The portfolio management process
is the process an investor takes to aid him
in meeting his investment goals.
The procedure is as follows:
1. Create a Policy Statement - A
policy statement is the statement
that contains the investor’s goals
and constraints as it relates to his
investments.
2. Develop an Investment Strategy -
This entails creating a strategy that
combines the investor’s goals and
objectives with current financial
market and economic conditions.
3. Implement the Plan Created - This
entails putting the investment
strategy to work, investing in a
portfolio that meets the client’s goals
and constraint requirements.
4. Monitor and Update the Plan -
Both markets and investors’ needs
change as time changes. As such, it
is important to monitor for these
changes as they occur and to
 update the plan to adjust for the
changes that have occurred.
Policy Statement
A policy statement is the statement
that contains the investor’s goals and
constraints as it relates to his investments.
This could be considered to be the most
important of all the steps in the portfolio
management process. The statement
requires the investor to consider his true
financial needs, both in the short run and
the long run. It helps to guide the
investment portfolio manager in meeting the
investor’s needs. When there is market
uncertainty or the investor’s needs change,
the policy statement will help to guide the
investor in making the necessary
adjustments to the portfolio in a disciplined
manner.
Expressing Investment Objectives in
Terms of Risk and Return
Return objectives are important to
determine. They help to focus an investor
on meeting his financial goals and
objectives. However, risk must be
considered as well. An investor may require
a high rate of return. A high rate of return is
typically accompanied by a higher risk.
Despite the need for a high return, an
investor may be uncomfortable with the risk
that is attached to that higher return
portfolio. As such, it is important to consider
not only return, but the risk of the investor in
a policy statement.
Factors Affecting Risk Tolerance
An investor’s risk tolerance can be affected
by many factors:
● Age - an investor may have lower
risk tolerance as they get older and
financial constraints are more
prevalent.
● Family situation - an investor may
have higher income needs if they
are supporting a child in college or
an elderly relative.
● Wealth and income - an investor
may have a greater ability to invest
in a portfolio if he or she has existing
wealth or high income.
● Psychological - an investor may
simply have a lower tolerance for
risk based on his personality.
Return objectives can be divided into the
following needs:
1. Capital Preservation - Capital
preservation is the need to maintain
capital. To accomplish this objective,
the return objective should, at a
minimum, be equal to the inflation
rate. In other words, the nominal rate
of return would equal the inflation
rate. With this objective, an investor
simply wants to preserve his existing
capital.
2. Capital Appreciation - Capital
appreciation is the need to grow,
rather than simply preserve, capital.
To accomplish this objective, the
return objective should be equal to a
return that exceeds the expected
inflation. With this objective, an
investor’s intention is to grow his
existing capital base.
3. Current Income - Current income is
the need to create income from the
investor’s capital base. With this
objective, an investor needs to
generate income from his
investments. This is frequently seen
with retired investors who no longer
have income from work and need to
generate income off of their
investments to meet living expenses
and other spending needs.
 4. Total Return - Total return is the
need to grow the capital base
through both capital appreciation
and reinvestment of that
appreciation.
Investment Constraints
When creating a policy statement, it
is important to consider an investor’s
constraint. There are five types of
constraints that need to be considered when
creating a policy statement. They are as
follows:
1. Liquidity Constraints - Liquidity
constraints identify an investor’s
need for liquidity, or cash. For
example, within the next year, an
investor needs $50,000 for the
purchase of a new home. The
$50,000 would be considered a
liquidity constraint because it needs
to be set aside (be liquid) for the
investor.
2. Time Horizon - A time horizon
constraint develops a timeline of an
investor’s various financial needs.
The time horizon also affects an
investor’s ability to accept risk. If an
investor has a long time horizon, the
investor may have a greater ability to
accept risk because he would have
a longer time period to recoup any
losses. This is unlike an investor
with a shorter time horizon whose
ability to accept risk may be lower
because he would not have the
ability to recoup any losses.
3. Tax Concerns - After-tax returns are
the returns investors are focused on
when creating an investment
portfolio. If an investor is currently in
a high tax bracket as a result of his
income, it may be important to focus
on investments that would not make
the investor’s situation worse, like
investing more heavily in
tax-deferred investments.
4. Legal and Regulatory - Legal and
regulatory factors can act as an
investment constraint and must be
considered. An example of this
would occur in a trust. A trust could
require that no more than 10% of the
trust be distributed each year. Legal
and regulatory constraints such as
this one often can’t be changed and
must not be overlooked.
5. Unique Circumstances - Any
special needs or constraints not
recognized in any of the constraints
listed above would fall in this
category. An example of a unique
circumstance would be the
constraint an investor might place on
investing in any company that is not
socially responsible, such as
tobacco company.
The Importance of Asset Allocation
Asset Allocation is the process of
dividing a portfolio among major asset
categories such as bonds, stocks or cash.
The purpose of asset allocation is to reduce
risk by diversifying the portfolio.
The ideal asset allocation differs
based on the risk tolerance of the investor.
For example, a young executive might have
an asset allocation of 80% equity, 20% fixed
income, while a retiree would be more likely
to have 80% in fixed income and 20%
equities.
Citizens in other countries around
the world would have different asset
allocation strategies depending on the types
and risks of securities available for
placement in their portfolio. For example, a
retiree located in the United States would
mostly likely have a large portion of his
portfolio allocated to U.S. treasuries, since
the U.S Government is considered to have
an extremely low risk of default. On the
other hand, a retiree in a country with
political unrest would most likely have a
large portion of their portfolio allocated to
foreign treasury securities, such as that of
the U.S.
Risk Aversion
Risk aversion is an investor’s
general desire to avoid participation in
“risky” behavior or, in this case, risky
investments. Investors typically wish to
maximize their return with the least amount
of risk possible. When faced with two
investment opportunities with similar
returns, a good investor will always choose
the investment with the least risk as there is
no benefit to choosing a higher level of risk
unless there is also an increased level of
return.
Insurance is a great example of
investors’ risk aversion. Given the potential
for a car accident, an investor would rather
pay for insurance and minimize the risk of a
huge outlay in the event of an accident.
Markowitz Portfolio Theory
Harry Markowitz developed the
portfolio model. This model includes not
only expected return, but also includes the
level of risk for a particular return. Markowitz
assumed the following about an individual’s
investment behavior.
● Given the same level of expected
return, an investor will choose the
investment with the lowest amount
risk.
● Investors measure risk in terms of
an investment's variance or standard
deviation.
● For each investment, the investor
can quantify the investment’s
expected return and the probability
of those returns over a specified
time horizon.
● Investors seek to maximize their
utility.
● Investors make decisions based on
an investment’s risk and return,
therefore, an investor’s utility curve
is based on risk and return.
The Efficient Frontier
Markowitz’ work on an individual’s
investment behavior is important not only
when looking at individual investment, but
also in the context of a portfolio. The risk of
a portfolio takes into account each
investment’s risk and return as well as the
investment’s correlation with other
investments in the portfolio.
Risk of a portfolio is affected by the
risk of each investment in the portfolio
relative to its return, as well as each
investment’s correlation with the other
investments in the portfolio.
A portfolio is considered efficient if it
gives the investors a higher expected return
with the same or lower level of risk as
compared to another investment. The
efficient frontier is simply a plot of those
efficient portfolios, ad illustrated below:
Efficient Frontier
 While an efficient frontier illustrates
each of the efficient portfolios relative to risk
and return levels, each of the efficient
portfolios may not be appropriate for every
investor. Recall that when creating an
investment policy, return and risk were the
key objectives. An investor’s risk profile is
illustrated with indifference curves. The
optimal portfolio, then, is the point on the
efficient frontier that is tangential to the
investor’s highest indifference curve.
The optimal portfolio for a
risk-averse investor will not be as risky as
the optimal portfolio of an investor who is
willing to accept more risk.
Individual Investment: The expected
return for an individual investment is simply
the sum of the probabilities of the possible
expected returns for the investment.
Example:
For Newco’s stock, assume the following
potential returns.
Expected returns for Newco’s stock price in
the various states.
Given the above assumptions, determine
the expected return for Newco’s stock.
Answer:
E(R) = (0.10)(10%) + (0.80)(14%) +
(0.10)(18%)
E(R) = 14.0%
The expected return for Newco’s stock is
14%.
Portfolio
To determine the expected return on a
portfolio, the weighted average expected
return of the assets that comprise the
portfolio is taken.
Example:
Assume an investment manager has
created a portfolio with Stock A and Stock
B. Stock A has an expected return of 20%
and a weight of 30% in the portfolio. Stock B
has an expected return of 15% and a weight
of 70%. What is the expected return of the
portfolio?
Answer:
E(R) = (0.30)(20%) + (0.70)(15%)
= 6% + 10.5% = 16.5%
The expected return of the portfolio is
16.5%
Computing Variance and Standard
Deviation for an Individual
To measure the risk of an investment, both
the variance and standard deviation for that
investment can be calculated.
Example: Variance and Standard Deviation
of an Investment
Given the following data for Newco’s stock,
calculate the stock’s variance and standard
deviation. The expected return based on the
data is 14%.
Expected return for Newco in various states
Answer:
The variance for Newco’s stick is 0.0003.
Given that the standard deviation of
Newco’s stock is simply the square root of
the variance, the standard deviation is
0.0179 or 1.79%.
Covariance
The covariance is the measure of
how two assets relate (move) together. If
the covariance of the two assets is positive,
the assets move in the same direction. For
example, if two assets have a covariance of
0.50, then the assets move in the same
direction. If however the two assets have a
negative covariance, the assets move in
opposite directions. If the covariance of the
two assets is zero, they have no
relationship.
Example: Calculate the covariance between
two assets
Assume the mean return on Asset A is 10%
and the mean return on Asset B is 15%.
Given the following returns over the past 5
periods, calculate the covariance for Asset
A as it relates to Asset B.
Correlation
The correlation coefficient is the relative
measure of the relationship between two
assets. It is between +1 and -1, with a +1
indicating that the two assets move
completely together and a -1 indicating that
the two assets move in opposite directions
from each other.
Example: Calculate the correlation of Asset
A with Asset B
Given our covariance of 18 in the example
above, what is the correlation coefficient for
Asset A relative to Asset B if Asset A has a
standard deviation of 4 and Asset B has a
standard deviation of 8.
Answer:
Correlation coefficient = 18/(4)(8) = 0.563
Components of the Portfolio Standard
Deviation Formula
Remember that when calculating the
expected return of a portfolio, it is simply the
sum of the weighted returns of each asset in
the portfolio. Unfortunately, determining the
standard deviation of a portfolio is not that
simple. Not only are the weights of the
assets in the portfolio and the standard
deviation for each asset in the portfolio
needed, the correlation of the assets in the
portfolio is also required to determine the
portfolio standard deviation.
The equation for the standard deviation for
a two asset portfolio is as follows:
The capital market theory builds upon the
Markowitz portfolio model. The main
assumptions of the capital market theory
are as follows:
 1. All Investors are Efficient
Investors - Investors follow
Markowitz idea of the efficient
frontier and choose to invest in
portfolios along the frontier.
2. Investors Borrow/Lend Money at
the Risk-Free Rate - This rate
remains static for any amount of
money.
3. The Time Horizon is equal for All
Investors - When choosing
investments, investors have equal
time horizons for the chosen
investments.
4. All Assets are Infinitely Divisible -
This indicates that fractional shares
can be purchased and the stocks
can be infinitely divisible.
5. No Taxes and Transaction Costs -
assume that investors’ results are
not affected by taxes and transaction
costs.
6. All Investors Have the Same
Probability for Outcomes - When
determining the expected return,
assume that all investors have the
same probability for outcomes.
7. No Inflation Exists - Returns are
not affected by the inflation rate in a
capital market as none exists in
capital market theory.
8. There is No Mispricing Within the
Capital Markets - Assume the
markets are efficient and that no
mospricings within the market exist.
What happens when a risk-free asset is
added to a portfolio of risky assets?
To begin, the risk-free asset has a standard
deviation/variance equal to zero for its given
level of return, hence the “risk-free” label.
● Expected Return - When the
Risk-Free Asset is Added
Given its lower level of return and its
lower level of risk, adding the
risk-free asset to a portfolio acts to
reduce the overall return of the
portfolio.
Example: Risk-Free Asset and Expected
Return
Assume an investor’s portfolio consists
entirely of risky assets with an expected
return of 16% and a standard deviation of
0.10. The investor would like to reduce the
level of risk in the portfolio and decides to
transfer 10% of his existing portfolio into the
risk-free rate with an expected return of 4%.
What is the expected return of the new
portfolio and how was the portfolio’s
expected return affected given the addition
of the risk-free asset?
Answer:
The expected return of the new portfolio is:
(0.9)(16%) + (0.1)(4%) = 14.4%
With the addition of the risk-free asset, the
expected value of the investor’s portfolio
was decreased to 14.4% from 16%.
● Standard Deviation - When
the Risk-Free Asset is Added
As we have seen, the
addition of the risk-free asset
to the portfolio of risky assets
reduces an investor’s
expected return. Given there
is no risk with a risk-free
asset, the standard deviation
of a portfolio is altered when
a risk-free asset is added.
Example: Risk-free Asset and Standard
Deviation
Assume an investor’s portfolio consists
entirely of risky assets with an expected
return of 16% and a standard deviation of
0.10. The investor would like to reduce the
level of risk in the portfolio and decides to
transfer 10% of his existing portfolio into the
risk-free rate with an expected return of 4%.
What is the standard deviation of the new
portfolio and how was the portfolio’s
standard deviation affected given the
addition of the risk-free asset?
Answer:
The standard deviation equation for a
portfolio of two assets is rather long,
however, given the standard deviation of the
risk-free asset is zero, the equation is
simplified quite nicely. The standard
deviation of the two-asset portfolio with a
risky asset is the weight of the risky assets
in the portfolio multiplied by the standard
deviation of the portfolio.
Standard deviation of the portfolio is:
(0.9)(0.1) = 0.09
Similar to the affect the risk-free asset had
on the expected return, the risk-free asset
also has the effect of reducing standard
deviation, risk, in the portfolio.
As seen previously, adjusting for the
risk of an asset using the risk-free rate, an
investor can easily alter his risk profile.
Keeping that in mind, in the context of the
capital market line (CML), the market
portfolio consists of the combination of all
risky assets and the risk-free asset, using
market value of the assets to determine the
weights. The CML line is derived by the
CAPM, solving for expected return at
various levels of risk.
Markowitz’ idea of the efficient
frontier, however, did not take into account
the risk-free asset. The CML does and, as
such, the frontier is extended to the risk-free
rate as illustrated below:
Systematic and Unsystematic Risk
Total risk to a stock not only is a
function of the risk inherent within the stock
itself, but is also a function of the risk in the
overall market. Systematic risk is the risk
associated with the market. When analyzing
the risk of an investment, the systematic risk
is the risk that cannot be diversified away.
Unsystematic risk is the risk inherent
to a stock. This risk is the aspect of total risk
that can be diversified away when building a
portfolio.
When building a portfolio, a key
concept is to gain the greatest return with
the least amount of risk. However, it is
important to note that additional return is not
guaranteed for an increased level of risk.
With risk, reward can come, but losses can
be magnified as well.
The capital asset pricing model is a
model that calculates expected return based
on expected rate of return on the market,
the risk-free rate and the beta coefficient of
the stock.
Example: CAPM model
Determine the expected return on Newco’s
stock using the capital asset pricing model.
Newco’s beta is 1.2. Assume the expected
return on the market is 12% and the
risk-free rate is 4%.
Answer:
E(R) = 4% + 1.2(12% - 4%) = 13.6%
Using the capital asset pricing model, the
expected return on Newco’s stock is 13.6%.
The Security Market Line (SML)
Similar to the CML, the SML is
derived from the CAPM, solving for
expected return. However, the level of risk
used is the Beta, the slope of the SML.
The SML is illustrated below:
Beta
Beta is the measure of a stock’s sensitivity
of returns to changes in the market. It is a
measure of systematic risk.
Example: Beta
Assume the covariance between Newco’s
stock and the market is 0.001 and the
variance of the market is 0.0008. What is
the beta of Newco’s stock?
Answer:
Determining Whether a Security is
Under-, Over- or Properly Valued
As discussed, the SML line can be
derived using CAPM, solving for the
expected return using beta as the measure
of risk. Given that interpretation and a beta
value for a specific security, we can then
determine the expected return of the
security with the CAPM. Then, using the
expected return for a security derived from
the CAPM, an investor can determine
whether a security is undervalued,
overvalued or properly valued.
Example: Calculate the expected return on
a security and evaluate whether the security
is undervalued, overvalued or properly
valued.
An investor anticipates Newco’s
security will reach $30 by the end of one
year. Newco’s beta is 1.3. Assume the
return on the market is expected to be 16%
and the risk-free rate is 4%. Calculate the
expected return of Newco’s stock in one
year and determine whether the stock is
undervalued, overvalued or properly valued
with a current value of $25.
Answer:
Given the expected return of
Newco’s stock using CAPM is 20% and the
investor anticipates a 20% return, the
security would be properly valued.
● If the expected return using the
CAPM is higher than the investor’s
required return, the security is
undervalued and the investor should
buy it.
● If the expected return using the
CAPM is lower than the investor’s
required return, the security is
overvalued and should be sold.
The Characteristic Line
The characteristic line is the line that
occurs when an individual asset or portfolio
is regressed to the market. The beta is the
slope coefficient for the characteristic line
and is thus the measure of systematic risk
for the asset or portfolio. Recall, a beta is
the measure of a stock’s sensitivity of
returns to changes in the market. It is a
measure of systematic risk.
 SUPPLEMENTARY:
Covariance
Covariance is a measure of the
relationship between two random variables,
designed to show the degree of
co-movement between them. Covariance is
calculated based on the
probability-weighted average of the cross-
products of each random variable’s
deviation from its own expected value. A
positive number indicates co-movement (i.e.
the variables tend to move in the same
direction); a value of 0 indicates no
relationship, and a negative covariance
shows that the variables move in the
opposite direction.
Correlation
Correlation is a concept related to
covariance, as it also gives an indication of
the degree to which two random variables
are related, and (like covariance) the sign
shows the direction of this relationship
(positive (+) means that the variables move
together; negative (-) means they are
inversely related). Correlation of 0 means
that there is no linear relationship one way
or the other, and the two variables are said
to be unrelated.
A correlation number is much easier
to interpret than covariance because a
correlation value will always be between -1
and +1.
● -1 indicates a perfectly inverse
relationship (a unit change in one
means that the other will have a unit
change in the opposite direction)
● +1 means a perfectly positive linear
relationship (unit changes in one
always bring the same unit changes
in the other).
Moreover, there is a uniform scale
from -1 to +1 so that as correlation values
move closer to 1, the two variables are
more closely related. By contrast, a
covariance value between two variables
could be very large and indicate little actual
relationship, or look very small when there
is actually a strong linear correlation.
Correlation is defined as the ratio of
the covariance between two random
variables and the products of their two
standard deviations, as presented in the
following formula:
As a result: Covariance (A,B) = Correlation
(A,B) *Standard Deviation (A) *Standard
Deviation (B)
Both correlation and covariance with
these formulas are likely to be required in a
calculation in which the other terms are
provided. Such an exercise simply requires
remembering the relationship, and
substituting the terms provided. For
example, if a covariance between two
numbers of 30 is given, and standard
deviation are 5 and 15, the correlation
would be 30/(5)*(15) = 0.40. If you are given
a correlation of 0.40 and standard
deviations of 5 and 15, the covariance
would be (0.4)*(5)*(15), or 30.
Expected Return, Variance and Standard
Deviation of a Portfolio
Expected return is calculated as the
weighted average of the expected returns of
the assets in the portfolio, weighted by the
expected return of each asset class. For a
simple portfolio of two mutual funds, one
investing in stocks and the other in bonds, if
we expect the stock fund to return 10% and
the bond fund to return 6%, and our
allocation is 50% to each asset class, we
have:
Expected return (portfolio) = (0.1)*(0.5) +
(0.06)*(0.5) = 0.08, or 8%
Variance is computed by finding the
probability-weighted average of squared
deviations from the expected value.
Example: Variance
In our previous example on making
a sales forecast, we found that the expected
value was $14.2 million. Calculating
variance starts by computing the deviations
from $14.2 million, then squaring:
Answer:
Variance weights each squared deviation by
its probability: (0.1)*(3.24) + (0.3)*(0.64) +
(0.3)*(0.04) + (0.3)*(1.44) = 0.96
The variance of return is a function of the
variance of the component assets as well as
the covariance between each of them. In
modern portfolio theory, a low or negative
correlation between asset classes will
reduce overall portfolio variance. The
formula for portfolio variance in the simple
case of a two- asset portfolio is given by:
Portfolio Variance = wo(R.)+w, o'(R)+
2*(w)*(w,)*Cov(R,, R) Where: w, and w, are
portfolio weights, (R) and (R) are variances
and Cov(R, R) is the covariance
Example: Portfolio Variance
Data on both variance and covariance may
be displayed in a covariance matrix.
Assume the following covariance matrix for
our two-asset case:
From this matrix, we know that the variance
on stocks is 350 (the covariance of any
asset to itself equals its variance), the
variance on bonds is 150 and the
covariance between stocks and bonds is 80.
Given our portfolio weights of 0.5 for both
stocks and bonds, we have all the terms
needed to solve for portfolio variance
Answer:
Portfolio variance = wo(R.) wa*o*(Rs) +
2*(W)*(W)*Cov(R. Rs) (0.5)*(350) +
(0.5)*(150) + 2*(0.5)* (0.5)*(80)
87.5+37.5+40=165.
Standard Deviation (6), as was defined
carlier when we discuss statistics, is the
positive square root of the variance. In our
example, o= (0.96), or $0.978 million.
Standard deviation is found by taking the
square root of variance: (165)=12.85%
A two-asset portfolio was used to illustrate
this principle; most portfolios contain far
more than two assets, and the formula for
variance becomes more complicated for
multi-asset portfolios (all terms in a
covariance matrix need to be added to the
calculation).
Correlation and Regression:
Financial variables are often
analyzed for their correlation to other
variables and/or market averages. The
relative degree of co-movement can serve
as a powerful predictor of future behavior of
that variable. A sample covariance and
correlation coefficient are tools used to
indicate relation, while a linear regression is
a technique designed both to quantify a
positive relationship between random
variables, and prove that one variable is
dependent on another variable. When you
are analyzing a security, if returns are found
to be significantly dependent on a market
index or some other independent source,
then both return and risk can be better
explained and understood.
Scatter Plots
A scatter plot is designed to show a
relationship between two variables by
graphing a series of observations on a
two-dimensional graph- one variable on the
X-axis, the other on the Y-axis.
Scatter Plot
Sample Covariance
To quantify a linear relationship
between two variables, we start by finding
the covariance of a sample of paired
observations. A sample covariance between
two random variables X and Y is the
average value of the cross-product of all
observed deviations from each respective
sample mean. A cross- product, for the ith
observation in a sample, is found by this
calculation: (ith observation of X - sample
mean of X)" (ith observation of Y-sample
mean of Y). The covariance is the sum of all
cross-products, divided by (n-1).
To illustrate, take a sample of live paired
observations of annual returns for two
mutual funds, which we will label X and Y
Average X and Y retums were found by
dividing the sum by n or 5, while the
average of the cross- products is computed
by dividing the sum by n 1, or 4. The use of
n - 1 for covariance is done by statisticians
to ensure an unbiased estimate. Interpreting
a covariance number is difficult for those
who are not statistical experts. The 99.64
we computed for this example has a sign of
"returns squared" since the numbers were
percentage returns, and a return squared is
not an intuitive concept. The fact that
Cov(X,Y) of 99.64 was greater than 0 does
indicate a positive or linear relationship
between X and Y. Had the covariance been
a negative number, it would imply an
inverse relationship, while 0 means no
relationship. Thus 99.64 indicates that the
returns have positive co-movement (when
one moves higher so does the other), but
doesn't offer any information on the extent
of the co-movement.
Sample Correlation Coefficient
By calculating a correlation coefficient, we
essentially convert a raw covariance
number into a standard format that can be
more easily interpreted to determine the
extent of the relationship between two
variables. The formula for calculating a
sample correlation coefficient (r) between
two random variables
X and Y is the following:
r-(covariance between X, Y)/(sample
standard deviation of X)* (sample std. dev.
of Y).

Example: Correlation Coefficient

Return to our example from the previous

section, where covariance was found to be
99.64. To find the correlation coefficient, we
must compute the sample variances, a
process illustrated in the table below.

Answer:

As with sample covariance, we use (n - 1)

as the denominator in calculating sample
variance (sum of squared deviations as the
mumerator) - thus in the above example,
each sum was divided by 4 to find the
variance. Standard deviation is the positive
square root of variance: in this example,
sample standard deviation of X is (136.06),
or 11.66; sample standard deviation of Y is
(99.14), or 9.96.

Therefore, the correlation coefficient is

(99.64)/11.66*9.96-0.858. A correlation
coefficient is a value between -1 (perfect
inverse relationship) and 1 (perfect linear
relationship) the closer it is to 1, the
stronger the relationship. This example
computed a number of 0.858, which would
suggest a strong linear relationship.
Chapter 4. Correlation and Regression Scatter Plots of Data with Various
Analysis Correlation Coefficients
Recall: Covariance

Interpreting Covariance

Linear Correlation

Correlation coefficient
■ Pearson's Correlation Coefficient is
standardized covariance (unitless):

Correlation
● Measures the relative strength of the
linear relationship between two
variables
● Unit-less
● Ranges between -1 and 1
● The closer to -1, the stronger the
negative linear relationship
● The closer to 1, the stronger the
positive linear relationship
● The closer to 0, the weaker any
positive linear relationship
Calculating by hand… Regression Analysis
● A set of statistical methods used to
estimate the relationships between a
dependent variable and one or more
independent variables.
● It can be used to assess the strength
of the relationship between variables
and for modeling the future
relationship between them.
Simpler calculation formula…
Variations of Regression Analysis:
● Simple Linear Regression
● Multiple Linear Regression
● Nonlinear Regression

Simple Linear Regression

Simple linear regression is a model that
assesses the relationship between a
dependent variable and an independent
variable. The simple linear model is
expressed using the following equation:
Distribution of the correlation coefficient:
Where:
Y = a + bx +€

Y-Dependent variable
X-Independent (explanatory) variable
a - Intercept
b-Slope
e-Residual (error)
The sample correlation coefficient follows a
T-distribution with n- 2 degrees of freedom Fundamental Assumptions of Multiple
(since you have to estimate the standard Linear Regression Analysis
error). ● The dependent and independent
variables show a linear relationship
*note, like a proportion, the variance of the between the slope and the intercept.
correlation coefficient depends on the ● The independent variable is not
correlation coefficient itself substitute in random.
estimated r ● The value of the residual (error) is
zero.
● The value of the residual (error) is
constant across all observations.
 ● The value of the residual (error) is ● Forecasting Revenues and
not correlated across all Expenses
observations.
● The residual (error) values follow the
normal distribution.
● Non-collinearity: Independent
variables should show a minimum of
correlation with each other. If the
independent variables are highly
correlated with each other, it will be
difficult to assess the true
relationships between the dependent
and independent variables.

Nonlinear Regression
● Nonlinear regression analysis is
commonly used for more
complicated data sets in which the
dependent and independent
variables show a nonlinear
relationship Chapter 5. Learning Curve Analysis
Chapter 5
Examples of Applications of Regression
Analysis in Finance
● Beta and CAPM.
Chapter 6. Linear Programming
Chapter 2
2.1 - A Simple Maximization Problem
2.2 - Graphical Solution Procedure
2.3 - Extreme Points and the Optimal
Solution
2.4 - Computer Solution of the Par, Inc.,
Problem
2.5 - A Simple Minimization Problem
2.6 - Special Cases
2.7 - General Linear Programming Notation
Linear Programming
● Linear programming has nothing to
do with computer programming.
● The use of the word “programming”
here means “choosing a course of
action.”
● Linear programming involves
choosing a course of action when
the mathematical model of the
problem contains only linear
functions.
● The maximization or minimization of
some quantity is the objective in all
linear programming problems.
● All LP problems have constraints
that limit the degree to which the
objective can be pursued.
● A feasible solution satisfies all the
problem’s constraints.
● An optimal solution is a feasible
solution that results in the largest
possible objective function value
when maximizing (or smallest when
minimizing).
● A graphical solution method can be
used to solve a linear program with
two variables.
Guidelines for Model Formulation
Problem formulation or modeling is the
process of translating a verbal statement of
a problem into a mathematical statement.
● Understand the problem thoroughly.
● Describe the objective.
● Describe each constraint.
● Define the decision variables.
● Write the objective in terms of the
decision variables.
● Write the constraints in terms of the
decision variables.
A Simple Maximization Problem
Par, Inc. is a small manufacturer of golf
equipment and supplies whose
management has decided to move into the
market for medium- and high-priced golf
bags. Par, Inc.’s distributor has agreed to
buy all the golf bags Par, Inc., produces
over the next three months.
Each golf bag produces will require the
following operations:
1. Cutting and dyeing the material
2. Sewing
3. Finishing (inserting umbrella holder,
club separators, etc.)
4. Inspection and packaging
This production information is summarized
in this table:
● Par, Inc.’s production is constrained
by a limited number of hours
available in each department. The
director of manufacturing estimates
that 630 hours for cutting and
dyeing, 600 hours for ewing, 708
 hours for finishing, and 135 hours for We continue by identifying the solution
inspection and packaging will be points satisfying each of the other three
available for the production of golf constraints.
bags during the next three months.
● The accounting department
analyzed the production data and
arrived at prices for both bags that
will result in a profit contribution 1 of
$10 for every standard bag and $9
for every deluxe bag produced.
The complete model for the Par, Inc., The graph shown identifies the feasible
problem is as follows: region:

Graphical Solution Procedure

Earlier, we saw that the inequality The optimal solution point is at the
representing the cutting and dyeing intersection of the cutting and dyeing and
constraint is: the finishing constraint lines.

To show all solution points that satisfy this

relationship, we start by graphing the
solution points satisfying the constraints as
an equality.
The optimal values of the decision variables
S and D must satisfy dyeing and the
finishing constraints simultaneously.
This system of equations can be solved
using substitution.
The exact location of the optimal solution
point is S =540 and D= 252. The optimal
production quantities for Par, Inc. are 540
standard bags and 252 deluxe bags, with a
resulting profit contribution of
10(540) + 9(252) = $7,668.
Summary of the Graphical Solution
Procedure for Maximization Problems
1. Prepare a graph of the feasible
solutions for each of the constraints.
2. Determine the feasible region that
satisfies all the constraints
simultaneously.
3. Draw an objective function line.
4. Move parallel objective function lines
toward larger objective function
values without entirely leaving the
feasible region.
5. Any feasible solution on the
objective function line with the
largest value is an optimal solution.
Slack and Surplus Variables
● A linear program in which all the
variables are non-negative and all
the constraints are equalities is said
to be in standard form.
● Standard form is attained by adding
slack variables to “less than or equal
to” constraints, and by subtracting
surplus variables from “greater than
or equal to” constraints.
● Slack and surplus variables
represent the difference between the
left and right sides of the constraints.
● Slack and surplus variables have
objective function coefficients equal
to 0.
The complete solution tells management
that the production of 540 standard bags
and 252 deluxe bags will require all
available cutting and dyeing time (630
hours) and all available finishing time (708
hours), while 600 - 480 = 120 hours of
sewing time and 135-117 = 18 hours of
inspection and packaging time will remain
unused. The 120 hours of unused sewing
time and 18 hours of unused inspection and
packaging time are referred to as slack for
the two departments.
Often slack variables are added to the
formulation of a linear programming
problem to represent the slack, or idle
capacity. Unused capacity makes no
contribution to profit; thus, slack variables
have coefficients of zero in the objective
function. After , the addition of four slack
variables, denoted as S1, S2, S3, and S4, the
mathematical model of the Par, Inc.,
problem becomes
Referring to the standard form of the Par,
Inc., problem, we see that at the optimal
solution (S = 540 and D = 252), the values
for the slack variables are
On the other hand, the sewing and the
inspection and packaging constraints are
not binding the feasible region to the optimal
solution, which means we can expect some
unused time or slack for these two
operations.
Extreme Points and the Optimal Solution
● The corners or vertices of the
feasible region are referred to as the
extreme points.
● An optimal solution to an LP problem
can be found at an extreme point of
the feasible region.
● When looking for the optimal
solution, you do not have to evaluate
all feasible solution points.
● You have to consider only the
extreme points of the feasible
region.
Here are the 5 extreme points of the
feasible region for the Par, Inc., Problem:
Computer Solutions
● LP problems involving 1000s of
variables and 1000s of constraints
are now routinely solved with
computer packages.
● Linear programming solvers are now
part of many spreadsheet packages,
such as Microsoft Excel.
● Leading packages include CPLEX,
LINGO, MOSEK, Xpress-MP, and
Premium Solver for Excel.
Here is a computer solution to the Par, Inc.,
Problem.
1. Prepare a graph of the feasible
solutions for each of the constraints.
2. Determine the feasible region that
satisfies all the constraints
simultaneously.
3. Draw an objective function line.
4. Move parallel objective function lines
toward smaller objective function
values without entirely leaving the
feasible region.
5. Any feasible solution on the
objective function line with the
smallest value is an optimal solution.
A Simple Minimization Problem
M&D Chemicals produces two products that
are sold as raw materials to companies
manufacturing bath soaps and laundry
detergents.
 ● M&D's management specified that
the combined production for
products A and B must total at least
350 gallons.
● A customer ordered 125 gallons of
product A.
● Product A requires 2 hours of time
per gallon.
● Product B requires 1 hour of
processing time per gallon.
● 600 hours of processing time are
available.
● M&D's objective is to satisfy these
requirements at a minimum total
production cost.
● Production costs are $2 per gallon
for product A and $3 per gallon for
product B.
After adding the nonnegativity constraints
(A, B > 0), we arrive at the following linear
program for the M&D Chemicals problem:
Here is the feasible region for the M&D
Chemicals problem:
Note that the objective function 2A + 3B =
800 intersects the feasible region at the
extreme point A= 250, B =100.
The optimal solution to the M&D Chemicals
problem shows that the desired total
production of A + B = 350 gallons is
achieved by using all processing time: 2A+
1B = 2(250) + 1(100) 600 hours.
Note that the constraint requiring that
product A demand be met has been
satisfied with A= 250 gallons. In fact, the
production of product A exceeds its
minimum level by 250- 125 125 gallons. =
This excess production for product A is
referred to as surplus.
Including two surplus variables, S1 and S2
for the > constraints and one slack variable,
S3 prime for the < constraint, the linear
programming model of the M&D Chemicals
problem becomes
All the constraints are now equalities.
At the optimal solution of A = 250 and B =
100, the values of the surplus and slack
variables are as follows:
Computer Solution
Feasible Region
● The feasible region for a
two-variable LP problem can be
nonexistent, a single point, a line, a
polygon, or an unbounded area.
● Any linear program falls in one of
four categories:
● is infeasible
● has a unique optimal solution
● has alternative optimal
solutions
● has an objective function that
can be increased without
bound
● A feasible region may be unbounded
and yet there may be optimal
solutions. This is common in
minimization problems and is
possible in maximization problems.
Special Cases
Alternative Optimal Solutions
In the graphical method, if the
objective function line is parallel to a
boundary constraint in the direction of
optimization, there are alternate optimal
solutions, with all points on this line
segment being optimal.
Let's return to the Par, Inc., problem.
However, now assume that the profit for the
standard golf bag (S) has decreased to
$6.30. The revised objective function
becomes 6.3S+9D.
The objective function values at these two
extreme points are identical:
6.3S+9D = 6.3(300)+9(420)=5670
and
6.3S+9D = 6.3(540)+9(252)=5670
Furthermore, any point on the line
connecting the two optimal extreme points
also provides an optimal solution.
For example, the solution point (S= 420,
D=336), which is halfway between the two
extreme points, also provides the optimal
objective function value of 6.3S+ 9D =
6.3(420) + 9(336) = 5670.
A linear programming problem with
alternative optimal solutions is generally a
good situation for the manager or decision
maker. It means that several combinations
of the decision variables are optimal and
that the manager can select the most
desirable optimal solution.
Infeasibility
● No solution to the LP problem
satisfies all the constraints, including
the non-negativity conditions.
● Graphically, this means a feasible
region does not exist.
● Causes include:
● A formulation error has been
made.
● Management's expectations
are too high.
● Too many restrictions have
been placed on the problem
(i.e. the problem is
over-constrained).
Unbounded
● The solution to a maximization LP
problem is unbounded if the value of
the solution may be made
indefinitely large without violating
any of the constraints.
● For real problems, this is the result
of improper formulation. (Quite likely,
a constraint has been inadvertently
omitted.)
General Linear Programming Notation
We selected decision-variable names of S
and D in the Par, Inc., problem and A and B
in the M&D Chemicals problem to make it
easier to recall what these decisions were.
variables represented in the problem.
Although this approach works well for linear
programs involving a small number of
decision variables, it can become difficult
when dealing with problems involving a
large number of decision variables.
A more general notation that is often used
for linear programs uses the letter x with a
subscript.
In the Par, Inc., problem, we could have
defined the decision variables:
X = number of standard bags
X2 = number of deluxe bags
In the M&D Chemicals problem, the same
variable names would be used, but their
definitions would change:
X1 = number of gallons of product A
X2 = number of gallons of product B
A disadvantage of using general notation for
decision variables is that we are no longer
able to easily identify what the decision
variables actually represent in the
mathematical model.
The advantage of general notation is that
formulating a mathematical model for a
problem that involves a large number of
decision variables is much easier.
Chapter 4
4.1 - Marketing Applications
4.2 - Financial Applications
4.3 - Operations Management Applications
Marketing Applications
Media Selection
● One application of linear
programming in marketing is media
selection.
● LP can be used to help marketing
managers allocate a fixed budget to
various advertising media.
● The objective is to maximize reach,
frequency, and quality of exposure.
● Restrictions on the allowable
allocation usually arise during
consideration of company policy,
contract requirements, and media
availability.
Relax-and-Enjoy Lake Development
Corporation is developing a lakeside
community at a privately owned lake.
The primary market for the lakeside lots and
homes includes all middle- and
upper-income families within approximately
100 miles of the development.
Relax-and-Enjoy employed the advertising
firm of Boone, Phillips, and Jackson (BP&J)
to design the promotional campaign.
BP&J collected data on the number of
potential customers reached, the cost per
advertisement, the maximum number of
times each medium is available, and the
exposure quality rating for each of the five
media.
The quality rating is measured in terms of
an exposure quality unit, a measure of the
relative value of one advertisement in each
of the media. This measure, based on
BP&J's experience in the advertising
business, takes into account factors such as
audience demographics (age, income, and
education of the audience reached), image
presented, and quality of the advertisement.
Advertising media alternatives for the
Relax-and-Enjoy Lake Development
Corporation:
With the objective of maximizing the total
exposure quality units for the overall media
selection plan, the objective function
becomes
Max 65DTV+90ETV+40DN +60SN+20R
Exposure quality
We now formulate the constraints for the
model from the information given:

The decision to be made is how many times The optimal solution to this five-variable,
to use each medium. We begin by defining nice-constraint linear programming model is
the decision variables: shown here.

DTV = number of times daytime TV is used

ETV = number of times evening TV is used
DN = number of times daily newspaper is
used
SN = number of times Sunday newspaper is
used
R= number of times radio is used

Each daytime TV (DTV) advertisement is

rated at 65 exposure quality units. Evening
TV (ETV) is rated at 90 exposure quality
units, daily newspaper (DN) rated at 40
exposure quality units, Sunday newspaper
(SN) rated at 60 exposure quality units, and
radio (R) rated at 20 exposure quality units.
The optimal solution calls for
advertisements to be distributed among
daytime TV, daily newspaper, Sunday
newspaper, and radio. The maximum
number of exposure quality units is 2370,
and the total number of customers reached
is 61,500.00.

Marketing Research
● A firm conducts marketing research
to learn about consumer
characteristics, attitudes, and
preferences.
● Marketing research services include
designing the study, conducting
surveys, analyzing data collected,
and providing recommendations for
the client.
● In the research design phase,
targets or quotas may be
established for the number and
types of respondents to be
surveyed.
● The marketing research firm's
objective is to conduct the survey so
as to meet the client's needs at a
minimum cost.
Marketing Research
Market Survey, Inc. (MSI) specializes in
evaluating consumer reaction to new
products, services, and advertising
campaigns. A client firm requested MSI's
assistance in ascertaining consumer
reaction to a recently marketed household
product.
During meetings with the client, MSI agreed
to conduct door-to-door personal interviews
to obtain responses from households with
children and households without children. In
addition, MSI agreed to conduct both day
and evening interviews.
The client's contract called for MSI to
conduct 1000 interviews under the following
quota guidelines:
1. Interview at least 400 households
with children.
2. Interview at least 400 households
without children.
3. The total number of households
interviewed during the evening must
be at least as great as the number of
households interviewed during the
day.
4. At least 40% of the interviews for
households with children must be
conducted during the evening.
5. At least 60% of the interviews for
households without children must be
conducted during the evening.
Because the interviews for households with
children take additional interviewer time and
because evening interviewers are paid more
than daytime interviewers, the cost varies
with the type of interview. Based on
previous research studies, estimates of the
interview costs are as follows:
Interview Cost
Household Day Evening
Children $20 $25
No children $18 $20
In formulating the linear programming model
for the MSI problem, we utilize the following
decision-variable notation:
DC= the number of daytime interviews of
households with children
EC = the number of evening interviews of
households with children
DNC = the number of daytime interviews of
households without children
ENC = the number of evening interviews of
households without children
The objective function:
Min 20DC + 25EC + 18DNC + 20ENC
The constraint requiring a total of 1000
interviews is:
DC + EC + DNC + ENC = 1000
The specifications concerning the types of
interviews:
Households with children:+DC + EC >= 400
Households without children:
DC + ENC > 400
At least as many evening interviews as day
interviews
EC + ENC >= DC + DNC or
- D * C + EC - DNC + ENC >= 0
The specifications concerning the types of
interviews:
● At least 40% of interviews of
households with children during the
evening:
EC204(DC+EC) or -0.4DC +0.6EC
20
● At least 60% of interviews of
households without children during
the evening:
ENC≥0.6(DC+ENC) or
-0.6DC+0.4ENC≥0
● The non-negativity requirements:
DC, EC, DNC, ENC > 0
The 4-variable, 6-constraint LP problem
formulation is:
Optimal Solution: Minimum total cost
= $20,320
Number of Interviews
Household Day Evening Totals
Children 240 160 400
No children 240 360 600
Totals 480 520 1000
Financial Applications
● LP can be used in financial
decision-making that involves capital
budgeting, make-or-buy, asset
allocation, portfolio selection,
financial planning, and more.
● Portfolio selection problems involve
choosing specific investments-for
example, stocks and bonds-from a
variety of investment alternatives.
● This type of problem is faced by
managers of banks, mutual funds,
and insurance companies.
● The objective function usually is
maximization of expected return or
minimization of risk.
● Portfolio selection problems involve
situations in which a financial
manager must select specific
investments-for example, stocks and
bonds-from a variety of investment
alternatives.
● The objective function for portfolio
selection problems usually is
maximization of expected return or
minimization of risk.
● The constraints usually take the form
of restrictions on the type of
permissible investments, state laws,
company policy, maximum
permissible risk, and so on.
Consider Welte Mutual Funds, Inc., located The complete linear programming model for
in New York City. Welte just obtained the Welte Mutual Funds investment
$100,000 and is looking for investment problem:
opportunities for these funds. Based on
Welte's current investments, the firm's top
financial analyst recommends that all new
investments be made in the oil industry,
steel industry, or in government bonds.
Specifically, the analyst identified five
investment opportunities and projected their
annual rates of return.

Here is the computer solution to the linear

programming model for the Welte Mutual
Funds investment problem:

Management of Welte imposed the

following guidelines:
1. Neither industry (oil or steel) should
receive more than $50,000.
2. Government bonds should be at
least 25% of the steel industry
investments.
3. The investment in Pacific Oil, the
high-return but high-risk investment,
cannot be more than 60% of the
total oil industry investment.
The optimal solution to the linear
What portfolio
programming model for the Welte Mutual
recommendations-investments and
Funds investment problem is:
amounts-should be made for the available
$100,000?

Let:

A = dollars invested in Atlantic Oil

P = dollars invested in Pacific Oil
M = dollars invested in Midwest Steel
H = dollars invested in Huber Steel
G = dollars invested in government bonds

The objective function for maximizing the

total return for the portfolio is
Max 0.073A + 0.103P + 0.064M
+ 0.075H + 0.045G
Financial Planning
Hewlitt Corporation established an early
retirement program as part of its corporate
restructuring. At the close of the voluntary
sign-up period, 68 employees had elected
early retirement. As a result of these early
retirements, the company incurs the
following obligations over the next eight
years:
The cash requirements (in thousands of
dollars) are due at the beginning of each
year.
The corporate treasurer must determine
how much money must be set aside today
to meet the eight yearly financial obligations
as they come due. The financing plan for
the retirement program includes
investments in government bonds as well as
savings. The investments in government
bonds are limited to three choices:
The government bonds have a par value of
$1000, which means that even with different
prices each bond pays $1000 at maturity.
The rates shown are based on the par
value. For purposes of planning, the
treasurer assumed that any funds not
invested in bonds will be placed in savings
and earn interest at an annual rate of 4%.
Define the Decision Variables
F= total dollars required to meet the
retirement plan's eight-year obligation
B1 = units of bond 1 purchased at the
beginning of year 1
B2 = units of bond 2 purchased at the
beginning of year 1
B3 = units of bond 3 purchased at the
beginning of year 1
S = amount placed in savings at the
beginning of year i
for i = 1,...,8
Define the Objective Function
The objective function is to minimize the
total dollars needed to meet the retirement
plan's eight-year obligation:
Min F
Define the Constraints
A key feature of this type of financial
planning problem is that a constraint must
be formulated for each year of the planning
horizon. It's form is: I
(Funds available at the beginning of the
year)
- (Funds invested in bonds and placed in
savings)
=(Cash obligation for the current year)
Define the Constraints
A constraint must be formulated for each
year of the planning horizon in the following
form:
Optimal solution to the 12-variable,
8-constraint LP problem:
Minimum total obligation - $1,728,729
Operations Management Applications
● LP can be used in operations
management to aid in
decision-making about product mix,
production scheduling, staffing,
inventory control, capacity planning,
and other issues.
● An important application of LP is
multi-period planning such as
production scheduling.
● Usually the objective is to establish
an efficient, low-cost production
schedule for one or more products
over several time periods.
● Typical constraints include
limitations on production capacity,
labor capacity, storage space, and
more.
The Janders Company markets various
business and engineering products.
Currently, Janders is preparing to introduce
two new calculators: one for the business
market called the Financial Manager and
one for the engineering market called the
Technician.
Each calculator has three components: a
base, an electronic cartridge, and a
faceplate or top. The same base is used for
both calculators, but the cartridges and tops
are different. All components can be
manufactured by the company or purchased
from outside suppliers.
Here are the manufacturing costs and
purchase prices for Janders calculator
components:
Company forecasters indicate that 3000
Financial Manager calculators and 2000
Technician calculates will be needed.
However, manufacturing capacity is limited.
The company has 200 hours of regular
manufacturing time and 50 hours of
overtime that can be scheduled for the
calculators. Overtime involves a premium at
the additional cost of $9 per hour.
The problem for Janders is to determine
how many units of each component to
manufacture and how many units of each
component to purchase. We define the
decision variables as follows:
BM = number of bases manufactured
BP = number of bases purchased
FCM = number of Financial cartridges
manufactured.
An additional decision variable is needed to
determine the hours of overtime that must
be scheduled.
The complete formulation of the Janders
make-or-buy problem with all decision
variables greater than or equal to zero is
The optimal solution of the Janders
make-or-buy problem is
The optimal solution of the Janders make-or
buy problem is
Chapter 17
17.1 - An Algebraic Overview of the
Simplex Method
17.2 - Tableau Form
17.3 - Setting Up the Initial Simplex
Tableaus
17.4 - Improving the Solution
17.5 - Calculating the Next Tableau
17.6 - Tableau Form: The General Case
17.7 - Solving a Minimization Problem
17.8 - Special Cases
An Algebraic Overview of the Simplex
Method
Let us introduce the problem we will use to
demonstrate the simplex method.
HighTech Industries imports electronic
components that are used to assemble two
different models of personal computers.
One model is called the Deskpro, and the
other model is called the Portable.
HighTech’s management is currently
interested in developing a weekly
production schedule for both products.
● The Deskpro generates a profit
contribution of $50 per unit, and the
Portable generates a profit
contribution of $40 per unit.
● A maximum of 150 hours of
assembly time is available.
● Each unit of the Deskpro requires 3
hours of assembly time. Each unit of
the Portable requires 5 hours of
assembly time.
● HighTech currently has only 20
Portable display components in
inventory; thus, no more than 20
units of the Portable may be
assembled.
● Only 300 square feet of warehouse
space can be made available for
new production. Assembly of each
Deskpro requires 8 square feet of
warehouse space; similarly, each
Portable requires 5 square feet.
To develop a linear programming model for
the HighTech problem, we will use the
following decision variables:
X1 = number of units of the Deskpro
X2 = number of units of the Portable
The complete mathematical model for this
problem is presented here.
Adding a slack variable to each of the
constraints permits us to write the problem
in standard form.
The simplex method finds solutions for
these equations by assigning zero values to
two of the variables and then solving for the
values of the remaining three variables. For
example, if we set x2 = 0 and s1 = 0, the
system of constraint equations becomes
constraint equations reduce to s1 = 150, s2 =
20, s3 = 300.
The complete solution would be
The following graph shows all the constraint
equations and basic solutions for the
HighTech problem. Circled points 1-5 are
basic feasible solutions; circled points 6-9
are basic solutions that are not feasible.

Thus, we obtain the following solution to the

three-equation, five-variable set of linear
equations:

This solution is referred to as a basic

solution.

Basic Solution
To determine a basic solution, set n - m of
the variables equal to zero, and solve the m
linear constraint equations for the remaining
Tableau Form
m variables.
A basic feasible solution to the system of m
We shall refer to the n 2 m variables set
linear constraint equations and n variables
equal to zero as the nonbasic variables and
is required as a starting point for the simplex
the remaining m variables as the basic
method. The purpose of tableau form is to
variables. Thus, in the preceding example,
provide an initial basic feasible solution.
x2 and s1 are the nonbasic variables, and x1,
Recall that for the HighTech problem, the
s2, and s3 are the basic variables.
standard-form representation is

A basic solution can be either feasible or

infeasible.
A basic feasible solution is a basic solution
that also satisfies the nonnegativity
conditions. The basic solution found by
setting x2 and s1 equal to zero and then
solving for x1, s2, and s3 is not a basic
feasible solution because s3 = -100.
However, suppose that we had chosen to
make x1 and x2 nonbasic variables by
setting x1 = 0 and x2 = 0. Solving for the
corresponding basic solution is easy
because with x1 = x2 = 0, the three
We can identify two properties that make it
possible to find an initial basic feasible
solution. The first property requires that the
following conditions be satisfied:
a. For each constraint equation, the
coefficient of one of the m basic
variables in that equation must be 1,
and the coefficients for all the
remaining basic variables in that
equation must be 0.
b. The coefficient for each basic
variable must be 1 in only one
constraint equation.
When these conditions are satisfied, exactly
one basic variable with a coefficient of 1 is
associated with each constraint equation,
and for each of the m constraint equations,
it is a different basic variable. Thus, if the
n-m nonbasic variables are set equal to
zero, the values of the basic variables are
the values of the right-hand sides of the
constraint equations.
The second property that enables us to find
a basic feasible solution requires the values
of the right-hand sides of the constraint
equations be nonnegative. This
nonnegativity ensures that the basic
solution obtained by setting the basic
variables equal to the values of the
righthand sides will be feasible.
If a linear programming problem satisfies
these two properties, it is said to be in
tableau form.
Thus, we see that the standard-form
representation of the HighTech problem is
already in tableau form.
In fact, standard form and tableau form for
linear programs that have all
less-than-or-equal-to constraints and
nonnegative right-hand-side values are the
same.
To summarize, the following three steps are
necessary to prepare a linear programming
problem for solution using the simplex
method:
Step 1. Formulate the problem.
Step 2. Set up the standard form by adding
slack and/or subtracting
surplus variables.
Step 3. Set up the tableau form.
Setting Up The Initial Simplex Tableau
After a linear programming problem has
been converted to tableau form, we have an
initial basic feasible solution that can be
used to begin the simplex method.
To provide a convenient means for
performing the calculations required by the
simplex method, we will first develop what is
referred to as the initial simplex tableau.
Part of the initial simplex tableau is a table
containing all the coefficients shown in the
tableau form of a linear program. If we
adopt the general notation
cj =objective function coefficient for variable j
bj=right-hand-side value for constraint j
aij=coefficient associated with variable j in
constraint / we can show this portion of the
initial simplex tableau as follows:
Thus, for the HighTech problem we obtain
the following partial initial simplex tableau:
Let:
c row = row of objective function coefficients
b column = column of right-hand-side
values of the constraint equations
A = m rows and n columns of coefficients of
the variables in the constraint equations
Using this notation, we can show these
portions of the initial simplex tableau as
follows:
To help us recall that each of the columns
contains the coefficients for one of the
variables, we write the variable associated
with each column directly above the column.
By adding the variables we obtain
This portion of the initial simplex tableau
contains the tableau-form representation of
the problem; thus, it is easy to identify the
initial basic feasible solution. First, we note
that for each basic variable, a
corresponding column has a 1 in the only
nonzero position. Such columns are known
as unit columns or unit vectors.
Second, a row of the tableau is associated
with each basic variable. This row has a 1 in
the unit column corresponding to the basic
variable. The value of each basic vanable is
then given by the bi value in the row
associated with the basic variable. In the
example, row 1 is associated with basic
variables, because this row has a 1 in the
unit column corresponding to s1. Thus, the
value of s1 is given by the right-hand-side
value b1: s1 = b1 = 150. In a similar fashion,
s2 = b2 = 20, and s3 = b3 = 300.
To move from an initial basic feasible
solution to a better basic feasible solution,
the simplex method must generate a new
basic feasible solution that yields a better
value for the objective function.
To do so requires changing the set of basic
variables: we select one of the current
nonbasic variables to be made basic and
one of the current basic variables to be
made nonbasic.
For computational convenience, we will add
two new columns to the simplex tableau.
One column is labeled "Basis" and the other
column is labeled “cB.” In the Basis column,
we list the current basic variables, and in
the cB column, we list the corresponding
objective function coefficient for each of the
basic variables. For the HighTech problem,
this results in the following:
Note that in the column labeled Basis, s1 is
listed as the first basic variable because its
value is given by the right-hand-side value
for the first equation. With s2 listed second
and s3 listed third, the Basis column and
right-hand-side values show the initial basic
feasible solution has s1 = 150 , s2 = 20 , and
s3 = 300.
Can we improve the value of the objective
function by moving to a new basic feasible
solution?
To find out whether it is possible, we add
two rows to the bottom of the tableau. The
first row, labeled zj represents the decrease
in the value of the objective function that will
result if one unit of the variable
corresponding to the jth column of the A
matrix is brought into the basis. The second
row, labeled cj - zj represents the net
change in the value of the objective function
if one unit of the variable corresponding to
the jth column of the A matrix is brought into
the solution. We refer to the cj - zj row as the
net evaluation row.
Let us first see how the entries in the zj row
are computed. Suppose that we consider
increasing the value of the nonbasic
variable x1 by one unit-that is, from x1 = 0 to
x1 = 1.
In order to make this change and at the
same time continue to satisfy the constraint
equations, the values of some of the other
variables will have to be changed.
As we will show, the simplex method
requires that the necessary changes be
made to basic variables only. For example,
in the first constraint we have
3x1 + 5x2 + 1s1 = 150
The current basic variable in this constraint
equation is s1. Assuming that x2 remains a
nonbasic variable with a value of 0, if x1 is
increased in value by 1, then s1 must be
decreased by 3 for the constraint to be
satisfied.
Similarly, if we were to increase the value of
x1 by 1 (and keep x2 =0), we can see from
the second and third equations that
although s2 would not decrease, s3 would
decrease by 8.
Recall that the values in the cB column of
the simplex tableau are the objective
function coefficients for the current basic
variables.
Hence, to compute the values in the zj row
(the decrease in value of the objective
function when xj is increased by one), we
form the sum of the products obtained by
multiplying the elements in the cB column by
the corresponding elements in the jth column
of the A matrix. Doing these calculations we
obtain
Because the objective function coefficient of
x1 is c1 = 50, the value of c1 - z1 is 50-0 = 50.
Then the net result of bringing one unit of x1
into the current basis will be an increase in
profit of $50. Hence, in the net evaluation
row corresponding to x1, we enter 50. In the
same manner, we can calculate the cj - zj
values for the remaining variables. The
result is the following initial simplex tableau:
The initial simplex tableau is now complete.
The initial basic feasible solution (x1 = 0, x2
= 0, s1 150, s2= 20, and s3 = 300) has an
objective function value, or profit, of $0.
Also, the cj - zj or net evaluation row has
values that will guide us in improving the
solution by moving to a better basic feasible
solution.
Improving the Solution
We must next determine which of the
current basic variables to make nonbasic.
Notice that each of the coefficients in the x1
column indicates the amount of decrease in
the corresponding basic variable that would
result from increasing x1 by one unit.
Considering the first row, we see that every
unit of the Deskpro produced will use 3
hours of assembly time, reducing s1 by 3. In
the current solution, s1 = 150 and x1 = 0.
Thus-considering this row only-the
maximum possible value of x1 can be
calculated by solving
3x1 = 150
x1 = 50
Finally, with 8 as the coefficient of x1 in the
third row, every unit that we increase x1 will
cause a decrease of eight units in s3.
Because the value of s3 is currently 300, we
can solve
8x1 = 300
to find the maximum possible increase in x1
before s3 will become nonbasic at a value of
zero; thus, we see that x1 cannot be any
larger than 300 / 8 = 37.5.
Considering the three rows (constraints)
simultaneously, we see that row 3 is the
most restrictive. That is, producing 37.5
units of the Deskpro will force the
corresponding slack variable to become
nonbasic at a value of s3 = 0.
In making the decision to produce as many
Deskpro units as possible, we must change
the set of variables in the basic feasible
solution, which means obtaining a new
basis. The simplex method moves from one
basic feasible solution to another by
selecting a nonbasic variable to replace one
of the current basic variables.
This process of moving from one basic
feasible solution to another is called an
iteration.
Criterion for Entering a New Variable into
the Basis
Look at the net evaluation row (cj - zj) ,and
select the variable to enter the basis that will
cause the largest per-unit improvement in
the value of the objective function. In the
case of a tie, follow the convention of
selecting the variable to enter the basis that
corresponds to the leftmost of the columns.
To illustrate the computations involved, we
add an extra column to the right of the
tableau showing the bi I aij ratios.
We see that c1 - z1 = 50 is the largest
positive value in the cj - zj row. Hence, x1 is
selected to become the new basic variable.
Checking the ratios b1 / ai1 for values of ai1
greater than zero, we see that
b3 / a31 = 300 / 8 = 37.5 is the minimum of
these ratios.
Thus, the current basic variable associated
with row 3 (s3) is the variable selected to
leave the basis. In the tableau we have
circled a31 = 8 to indicate that the variable
corresponding to the first column is to enter
the basis and that the basic variable
corresponding to the third row is to leave
the basis.
Adopting the usual linear programming
terminology, we refer to this circled element
as the pivot element. The column and the
row containing the pivot element are called
the pivot column and the pivot row,
respectively.
To improve the current solution of x1 = 0,
x2 = 0, s1 = 150 , s2 = 20 , and s3 = 300 , we
should increase X_{1} to 37.5. The
production of 37.5 units of the Deskpro
results in a profit of 50(37.5) = 1875. In
producing 37.5 units of the Deskpro, s3 will
be reduced to zero.
Hence, x1 will become the new basic
variable, replacing s3 in the previous basis.
Calculating the Next Tableau
We now want to update the simplex tableau
in such a fashion that the column
associated with the new basic variable is a
unit column; in this way its value will be
given by the right hand-side value of the
corresponding row.
We would like the column in the new
tableau corresponding to x1 to look just like
the column corresponding to s, in the
original s3 tableau, so our goal is to make
the column in the A matrix corresponding to
x1 appear as
0
0
1
The way in which we transform the simplex
tableau so that it still represents an
equivalent system of constraint equations is
to use the following elementary row
operations.
Elementary Row Operations
1. Multiply any row (equation) by a
nonzero number.
2. Replace any row (equation) by the
result of adding or subtracting a
multiple of another row (equation) to
it.
Summary of the Simplex Method
Let us now summarize the steps followed to
solve a linear program using the simplex
method. We assume that the problem has
all less-than-or-equal-to constraints and
involves maximization.
Step 1. Formulate a linear programming
model of the problem.
Step 2. Add slack variables to each
constraint to obtain standard form.
This also provides the tableau form
necessary to identify an initial basic
feasible solution for problems
involving all less-than-or-equal-to
constraints with nonnegative
right-hand-side values.
Step 3. Set up the initial simplex tableau.
Step 4. Choose the nonbasic variable with
the largest entry in the net
evaluation row to bring into the
 basis. This variable identifies the
pivot column: the column associated
with the incoming variable.
Step 5. Choose as the pivot row that row
with the smallest ratio of bi I aij > for
a>0 where j is the pivot column. This
pivot row is the row of the variable
leaving the basis when variable
j enters.
Step 6. Perform the necessary elementary
row operations to convert the
column for the incoming variable to a
unit column with a 1 in the pivot row.
a. Divide each element of the pivot row
by the pivot element (the element in
the pivot row and pivot column).
b. Obtain zeroes in all other positions
of the pivot column by adding or
subtracting an appropriate multiple
of the new pivot row. Once the row
operations have been. completed,
the value of the new basic feasible
solution can be read from the b
column of the tableau.
Step 7. Test for optimality. If cj - zj < 50 for
all columns, the solution is optimal. If
not, return to step 4.
Chapter 7: Distribution and Network
Models
7.1 - Supply Chain Models
7.1.1 - Transportation Problem
7.1.2 - Transshipment Problem
7.2 - Assignment Problem
7.3 - Shortest-Route Problem
7.4 - Maximal Flow Problem
7.5 - A Production and Inventory Application
Transportation, Transshipment, and
Assignment Problems
The models discussed in this
chapter belong to a special class of linear
programming problems called network flow
problems.
Examples: Supply chains,
transportation and transshipment problems,
assignment problems, shortest-route
problems, and maximal flow problems.
In each case, we present a graphical
representation of the problem in the form of
a network. We then show how the program
can be formulated and solved as a linear
program.
Supply Chain Models
● A supply chain describes the set of
all interconnected resources
involved in producing and
distributing a product.
● In general, supply chains are
designed to satisfy customer
demand for a product at minimum
cost.
● Those that control the supply chain
must make decisions such as where
to produce a product, how much
should be produced, and where it
should be sent.
Transportation Problem
● The transportation problem arises
frequently in planning for the
distribution of goods and services
from several supply locations to
several demand locations.
● Typically, the quantity of goods
available at each supply location
(origin) is limited, and the quantity of
goods needed at each of several
demand locations (destinations) is
known.
● The usual objective in a
transportation problem is to minimize
the cost of shipping goods from the
origins to the destinations.
Let us consider a transportation
problem faced by Foster Generators. This
problem involves the transportation of a
production from three plants to four
distribution centers. Foster Generators
operates plants in Cleveland, Ohio; Bedford,
Indiana; and York, Pennsylvania.
Production capacities over the next
three-month planning period for one
particular type of generator are as follows:
The firm distributes its generators
through four regional distribution centers
located in Boston, Chicago, Stl. Louis, and
Lexington; the three-month forecast of
demand for the distribution centers is as
follows:
 Management would like to determine X13 = the number of units shipped
how much of its production should be from origin 1 (Cleveland) to destination 3
shipped from each plant to each distribution (St. Louis)
center. X14 = the number of units shipped
from origin 1 (Cleveland) to destination 4
Here is a graph showing the 12 (Lexington)
distribution routes Foster can use. X21 = the number of units shipped
● Such a graph is called a network. from origin 2 (Bedford) to destination 1
● The circles are referred to as nodes (Boston)
and the lines connecting the nodes
as arcs.
● Note that the direction of flow (from
origin to destination) is indicated by
the arrows.
● Each origin and destination is
represented by a node, and each
possible shipping route is
represented by an arc.
● The amount of the supply is written
next to each origin node, and the
amount of the demand is written
next to each destination node.
● The goods shipped from the origins
to the destinations represent the flow
in the network.

The objective is to determine the

routes to be used and the quantity to be
shipped via each route that will provide the
minimum total transportation cost.
The cost for each unit shipped on
each route is shown on each arc.
A linear programming model can be
used to solve this transportation problem.
We use double-subscripted decision
variables, with
X11 = the number of units shipped
from origin 1 (Cleveland) to destination 1
(Boston)
X12 = the number of units shipped
from origin 1 (Cleveland) to destination 2
(Chicago),
X22 = the number of units shipped
from origin 2 (Bedford) to destination
2 (Chicago)
X23 = the number of units shipped
from origin 2 (Bedford) to destination
3 (St. Louis)
X24 = the number of units shipped
from origin 2 (Bedford) to destination
4 (Lexington)
X31 = the number of units shipped
from origin 3 (York) to destination 1
(Boston)
 X32 = the number of units shipped
from origin 3 (York) to destination 2
(Chicago)
X33 = the number of units shipped
from origin 3 (York) to destination 3
(St. Louis)
X34 = the number of units shipped
from origin 3 (York) to destination 4
(Lexington)
In general, the decision variables for
a transportation problem having m origins
and n destinations are written as follows:
Xi = number of units shipped from
origin i to destination j where i = 1,2,...m and
j = 1,2,...,n
Cleveland supply x11 + x12 + x13 + x14 <
5,000
Bedford supply x21 + x22 + x23 + x24 <
6,000
York supply x31 + x32 + x33 + x34 <
2,500
With the four distribution centers as
the destinations, four demand constraints
are needed:
Boston demand x11 + x21 + x31 = 6,000
Chicago demand x12 + x22 + x32 = 4,000
St. Louis demand x13 + x23 + x33 = 2,000
Lexington demand x14 + x24 + x34 = 1,500
Here is the optimal solution for the
Foster Generators Transportation Problem:

Because the objective of the

transportation problem is to minimize the
total transportation cost, we develop the
following cost expressions:
Transportation costs for units
shipped from Cleveland
= 3x11 + 2x12 + 7x13 +
6x14
Transportation costs for units
shipped from Bedford
= 7x21 + 5x22 + 2x23 +
3x24
Transportation costs for units
shipped from York
= 2x31 + 5x32 + 4x33 + The minimal cost transportation
5x34 schedule is:
The sum of these expressions
provides the objective function showing the
total transportation cost for Foster
Generators.

Transportation problems need

constraints because each origin has a
limited supply and each destination has a
demand.
The constraints for the total number
of units shipped are:
And the network diagram for the
optimal solution is:
For example, 3,500 units should be
shipped from Cleveland to Boston, and
1,500 units should be shipped from
Cleveland to Chicago.
Transshipment Problem
The transshipment problem is an
extension of the transportation problem in
which intermediate nodes, referred to as
transshipment nodes, are added to account
for locations such as warehouses.
● In this general type of distribution
problem, shipments may be made
between any pair of the three
general types of nodes: origin
nodes, transshipment nodes, and
destination nodes.
● As was true for the transportation
problem, the supply available at
each origin is limited, and the
demand at each destination is
specified.
● The objective in the transshipment
problem is to determine how many
units should be shipped over each
arc in the network so that all
destination demands are satisfied
with the minimum possible
transportation cost.
Consider the transshipment problem
faced by Ryan Electronics. Ryan is an
electronics company with production
facilities in Denver and Atlanta.
Components produced at either facility may
be shipped to either facility may be shipped
to either of the firm’s regional warehouses,
which are located in Kansas City and
Louisville. From the regional warehouses,
the firm supplies retail outlets in Detroit,
Miami, Dallas, and New Orleans.
We need a constraint for each node and
a variable for each arc. Let xij denote the
number of units shipped from node i to node
j.
For example, x13 denotes the number of
units shipped from the Denver plant to the
Kansas City warehouse, x14 denotes the
number of units shipped from the Denver
plant to the Louisville warehouse, and so
on.
Because the supply at the Denver plant
is 600 units, the amount shipped from the
Denver plant must be less than or equal to
600. Mathematically, we write this supply
constraint as
x13 + x14 < 600.
Similarly, for the Atlanta plant we have
x23 + x24 < 400.
We now consider how to write the
constraints corresponding to the two
transshipment nodes.
For node 3 (the Kansas City
warehouse), we must guarantee that the
number of units shipped out must equal the
number of units shipped into the
warehouse. If the number of units shipped
out of node 3 equals x35 + x36 + x37 + x38
And the number of units shipped into
node 3 equals x13 + x23 we obtain
x35 + x36 + x37 + x38 = x13 + x23
Placing all the variables on the
left-hand side provides the constraint
corresponding to node 3 as -x13 -x23 + x35 +
x36 + x37 + x38 = 0
Similarly, the constraint
corresponding to node 4 is -x14 -x24 + x45 +
x46 + x47 + x48 = 0

The optimal solution for the Ryan

Electronics Transshipment problem is
shown here.
The optimal solution for the Ryan
Electronics Transshipment problem is
shown here.

To develop the constraints

associated with the destination nodes, we
recognize that for each node the amount
shipped to the destination must equal the
demand.
For example, to satisfy the demand For an illustration of a more general
for 200 units at node 5 (the Detroit retail type of transshipment problem, let us modify
outlet), we write x35 + x45 = 200. the Ryan Electronics problem.
Similarly, for nodes 6,7, and 8, we Suppose that it is possible to ship
have directly from Atlanta to New Orleans at $4
x36 + x46 = 150 per unit and from Dallas to New Orleans at
x37 + x47 = 350 $1 per unit.
x38 + x48 = 300
As usual, the objective function
reflects the total shipping cost over the 12
shipping routes.

Combining the objective function

and constraints leads to a 12-variable,
8-constraint linear programming model of
the Ryan Electronics transshipment
problem.
 The new variables x28 and x78 appear
in the objective function and in the
constraints corresponding to the nodes to
which the new arcs are connected.
The value of the optimal solution has
been reduced by $600 by allowing these
additional shipping routes. The value of x28
= 300 indicates that 300 units are being
shipped directly from Atlanta to New
Orleans. The value of x78 = 0 indicates that
no units are shipped from Dallas to New
Orleans in this solution.
As with transportation problems,
transshipment problems may be formulated
with several variations, including
1. Total supply not equal to total
demand
2. Maximization objective function
3. Route capacities or route minimums
4. Unacceptable routes
The linear programming model
modifications required to accommodate
these variations are identical to the
modifications required for the transportation
problem. When we add one or more
constraints of the form xij < Lij to show that
the route from node i to node j has capacity
Lij, we refer to the transshipment problem as
a capacitated transshipment problem.
Assignment Problem
The assignment problem arises in a
variety of decision-making situations; typical
assignment problems involve assigning jobs
to machines, agents to tasks, sales
personnel to sales territories, contracts to
bidders, and so on.
● A distinguishing feature of the
assignment problem is that one
agent is assigned to one and only
one task.
● Specifically, we look for the set of
assignments that will optimize a
stated objective, such as minimize
cost, minimize time, or maximize
profits.
Let’s consider the case of Fowl
Marketing Research, which has received
requests for market research studies from 3
new clients.
● The company faces the task of
assigning a project leader (agent) to
each client (task).
● Three individuals have no other
commitments and are available for
the project leader assignments.
● The time required to complete each
study will depend on the experience
and ability of the project leader
assigned.
● The three projects have
approximately the same priority, and
management wants to assign project
leaders to minimize the total number
of days required to complete all
three projects.
● A project leader is to be assigned to
one client only.
 Fowle’s management must first The constraints reflect the condition
consider all possible project leader-client that each project leader can be assigned to
assignments and then estimate the at most one client and each client must
corresponding project completion times. have one assigned project leader. These
With three project leaders and three clients, constraints are:
nine assignment alternatives are possible.
Here are the estimated project
completion times (days) for each possible
project leader-client assignment:

Note the similarity between the Combining the objective function

network models of the assignment problem and constraints into one model provides the
and the transportation problem. following nine-variable, six-constraint linear
programming model:
The assignment problem is a special
case of the transportation problem in which
all supply and demand values equal 1, and
the amount shipped over each arc is either
0 or 1.
● If x11 = 1, we interpret this as “project
leader 1 (Terry) is assigned to client The optimal solution is:
1.”
● If x11 = 0, we interpret this as “project
leader 1 (Terry) is not assigned to
client 1.”
Using this notation and the
completion time data, we develop
completion time expressions:
Days required for Terry’s assignment
= 10x11 + 15x12 + 9x13
Days required for Carle’s assignment
= 9x21 + 18x22 + 5x23
Days required for McClymonds’s
assignment = 6x31 + 14x32 + 3x33

The sum of the completion times for
the 3 project leaders provide the total days
required to complete the three assignments.
Thus, the objective function is
MIN 10x11 + 15x12 + 9x13 + 18x22 +
5x23 + 6x31 + 14x32 + 3x33
Because the assignment problem
can be viewed as a special case of the
transportation problem, the problem
variations that may arise in an assignment
problem parallel those for the transportation
problem.
Specifically, we can handle
1. Total number of agents (supply) not
equal to the total number of tasks
(demand)
2. A maximization objective function
3. Unacceptable assignments
If the total number of agents (supply)
are not equal to the total number of tasks
(demand):
● This is analogous to total supply not
equaling total demand in a
transportation problem.
● The extra agents simply remain
unassigned in the linear
programming solution.
● If the number of tasks exceeds the
number of agents, the linear
programming model will not have a
feasible solution. By adding two
dummy project leaders, we can
create a new assignment problem
with the number of project leaders
equal to the number of clients. The
objective function coefficients for the
assignment of dummy project
leaders would be zero so that the
value of the optimal solution would
represent the total number of days
required by the assignments actually
made.
If the assignment alternatives are
evaluated in terms of revenue or profit
rather than time or cost, the linear
programming formulation can be solved as
a maximization rather than a minimization
problem.
If one or more assignments are
unacceptable, the corresponding decision
variable can be removed from the linear
programming formulation. This situation
could happen if an agent did not have the
experience necessary for one or more of the
tasks.
Shortest-Route Problem
The shortest-route problem is
concerned with finding the shortest path in a
network from one node (or set of nodes) to
another node (or set of nodes).
● If all arcs in the network have
nonnegativity values then a labeling
algorithm can be used to find the
shortest paths from a particular node
to all other nodes in the network.
● The criterion to be minimized in the
shortest-route problem is not limited
to distance even though the term
“shortest” is used in describing the
procedure. Other criteria include
time and cost. (Neither time nor cost
are necessarily linearly related to
distance.)
Maximal Flow Problem
The objective in a maximal flow
problem is to determine the maximum
amount of flow (vehicles, messages, fluid,
etc.) that can enter and exit a network
system in a given period of time.
● In this problem, we attempt to
transmit flow through all arcs of the
network as efficiently as possible.
● The amount of flow is limited due to
capacity restrictions on the various
arcs of the network. For example,
highway types limit vehicle flow in a
transportation system, while pipe
sizes limit oil flow in an oil
distribution system.
● The maximum or upper limit on the
flow in an arc is referred to as the
flow capacity of the arc.
● Even though we do not specify
capacities for the nodes, we do
 assume that the flow out of a node is
equal to the flow into the node.

A Production and Inventory Application

● Transportation and transshipment
models can be developed for
applications that have nothing to do
with the physical movement of
goods from origins to destinations.
● A transshipment model can be used
to solve a production and inventory
problem.

Example: Contois Carpets is a small

manufacturer of carpeting for home and
office installations. Production capacity,
demand, production cost per square yard,
and inventory holding cost per square yard
for the next four quarters are determined.
Production capacity, demand, and
production costs vary by quarter, whereas
the cost of carrying inventory from one
quarter to the next is constant at $0.25 per
yard. Contois wants to determine how many
yards of carpeting to manufacture each
quarter to minimize the total production and
inventory cost for the four-quarter period.
Chapter 8: Project Scheduling
GANTT CHART
Project Scheduling
● A project is a collection of tasks that
must be completed in minimum time
or at a minimal cost.
● Steps in Project Scheduling:
● Establishing objectives
● Determining available
resources
● Sequencing activities
● Identifying precedence
relationships
● Determining activity times
and costs
● Estimating material and
worker requirements
● Determining critical activities
Objectives of Project Scheduling
● Completing a project as early as
possible by determining the earliest
start and finish of each activity.
● Calculating the likelihood that a
project will be completed within a
certain time period.
● Finding the minimum cost schedule
needed to complete the project by a
certain date.
● Investigating the results of possible
delays in activity's completion time.
● Progress control.
● Smoothing out resource allocation
over the duration of the project.
Project Scheduling: Designating Tasks
● Tasks are called activities.
● Estimated completion time
(and sometimes costs) are
associated with each activity.
● Activity completion time is
related to the amount of
resources committed to it.
● The degree of activity details
depend on the application
and the level of specificity of
data.
● To determine the optimal schedules,
we need to:
● Identify all the project's
activities.
● Determine the precedence
relations among activities.
Example: Klone Computers
● Klone Computers manufactures
personal computers
● It is about to design, manufacture,
and market the Klonepalm 2000
palmbook computer.
● Tasks to perform
● Manufacture the new
computer.
● Train the staff and vendor
representatives.
● Advertise the new
● Klone needs to develop a
precedence relations chart which
gives a concise set of tasks and their
immediate predecessors.
Klone Computers Activities
 Klone Computers
Precedence Relationships Chart
Project Scheduling Techniques:
● Gantt Chart
● Critical Path Method (CPM)
● Program (or Project) Evaluation and
Review Technique (PERT)
Gantt Chart
● First devised in the mid 1890s by
Karol Adamiecki, a Polish engineer
who ran a steelworks in southern
Poland and had become interested
in management ideas and
techniques.
● Further developed and popularized
by Henry Laurence Gantt, an
American engineer and project
management consultant around
1910- 1915. The Gantt Chart is
named after him.
● It is also known as "Harmonogram"
● A type of bar chart that illustrates a
project schedule.
● Each bar is a project activity
● The horizontal axis
corresponds to time (usually
in weeks or months)
● Length of each bar indicates
time allocated to each activity
● Positioning of each bar
indicates timing-start and end
times for the activity.
● In an earliest Gantt Chart,
each bar begins and ends at
the earliest start/finish the
activity can take place.
● Gantt charts can be broken down
into sub-activities. But the more you
get, the more crowded and useless
the chart becomes.
● Additional details can be added into
Gantt charts:
● Colors might indicate the
owner of the activity (who
performs it)
● Shading (or space for
shading) might indicate
percentage of completion.
● Gantt Charts can be prepared in the
Computer using Microsoft Excel, but
can be prepared more appropriately
using Microsoft Visio.
● Gantt Charts allow you to see:
● What the various activities
are
● When each activity begins
and ends
● How long each activity is
scheduled to last
● Where activities overlap with
other activities, and by how
much
● The start and end date of the
whole project
A Simple Gantt Chart
A Complex Gantt Chart

Advantages and Disadvantages:

● Advantages:
● Easy to construct.
● Gives the earliest completion
date.
● Provides a schedule of
earliest possible start and
finish times of activities.
● Disadvantages:
● Gives only one possible
schedule (the earliest).
● Does not show whether the
project is behind schedule.
● Does not demonstrate the
effects of the delays in any
one activity on the start of
another activity, thus on the
project completion time.
PERT/CPM
9.1-Project Scheduling Based on Expected
Activity Times
9.2-Project Scheduling Considering
Uncertain Activity Times
9.3-Considering Time-Cost Trade-Offs
PERT/CPM
PERT - Program Evaluation and Review
Technique
● Developed by U.S. Navy for Polaris
missile project
● Developed to handle uncertain
activity times
CPM - Critical Path Method
● Developed by DuPont & Remington
Rand
● Developed for industrial projects for
which activity times generally were
known
Today's project management software
packages have combined the best features
of both approaches.
PERT and CPM have been used to plan,
schedule, and control a wide variety of
projects:
● R&D of new products and
processes
● Construction of buildings and
highways
● Maintenance of large and
complex equipment
● Design and installation of
new systems
● PERT/CPM is used to plan the
scheduling of individual activities
that make up a project.
● Projects may have as many as
several thousand activities.
● A complicating factor in carrying out
the activities is that some activities
depend on the completion of other
activities before they can be started.
Project managers rely on PERT/CPM to
help them answer questions such as:
● What is the total time to complete
the project?
● What are the scheduled start and
finish dates for each specific
activity?
● Which activities are critical and must
be completed exactly as scheduled
to keep the project on schedule?
● How long can noncritical activities be
delayed before they cause an
increase in the project completion
time?
Project Scheduling Based on Expected
Activity Times
● A project network can be
constructed to model the
precedence of the activities.
● The nodes of the network represent
the activities.
● The arcs of the network reflect the
precedence relationships of the
activities.
● A critical path for the network is a
path consisting of activities with zero
slack.
The owner of the Western Hills Shopping
Center plans to modernize and expand the
current 32-business shopping center
complex. The project is expected to provide
room for 8 to 10 new businesses. Financing
has been arranged through a private
investor. All that remains is for the owner of
the shopping center to plan, schedule, and
complete the expansion project.
Let us show how PERT/CPM can help.
The first step in the PERT/CPM scheduling
process is to develop a list of the activities
that make up the project.
The immediate predecessor column
identifies the activities that must be
completed immediately prior to the start of
that activity.
Using the activity information, we can
construct a graphical representation of the
project, or the project network.
A path is a sequence of connected nodes
that leads from the Start node to the Finish
node. For instance, one path for the network
is defined by the sequence of nodes
A-E-F-G-I.
To facilitate the PERT/CPM computations,
we modified the project network. The upper
left-hand corner of each node contains the
corresponding activity letter. The activity
time appears immediately below the letter.
All paths in the network must be traversed
in order to complete the project, so we will
look for the path that requires the greatest
time. Because all other paths are shorter in
duration, this longest path determines the
total time required to complete the project. If
activities on the longest path are delayed,
the entire project will be delayed. Thus, the
longest path is the critical path. Activities on
the critical path are referred to as the
critical activities for the project.
We begin by finding the earliest start time
and the latest start time for all activities in
the network. Let
ES = earliest start time for an activity
EF = earliest finish time for an
activity
t = expected activity time
The earliest finish time for any activity is
EF=ES+ t
Activity A can start as soon as the project
starts, so we set the earliest start time for
activity A equal to 0. With an expected
activity time of 5 weeks, the earliest time for
activity A is EF ES+1=0+5=5.
We will write the earliest start and earliest
finish times in the node to the right of the
activity letter. Using activity A as an
example, we have
Because an activity cannot be started until
all immediately preceding activities have
been finished, the following rule can be
used to determine the earliest start time for
each activity:
The earliest start time for an activity is equal
to the largest (i.e.. latest) of the earliest
finish times for all its immediate
predecessors.
Let us apply the earliest start time rule to
the portion of the network involving nodes
A, B, and C. With an earliest start time of 0
and an activity time of 6 for activity B, we
show ES = 0 and EF = 6 in the node is the
only immediate for activity B. Activity A
Predecessor for activity C. EF for activity A
is 5, so ES for activity C must be 5. Thus,
with An activity time of 4, the earliest finish
time for activity C is EF = 9.
With activities B and C as immediate
predecessors, the earliest start time for
activity H must be equal to the largest of the
earliest finish times for activities B and C.
Thus, with EF = 6 for activity B and EF=9 for
activity C, 9 is the earliest start time for
activity H (ES=9). With an activity time of 12
as shown in the node for activity H, the
earliest finish time is EF = 21.
Continuing with this forward pass through
the network, we can establish the earliest
start time and the earliest finish time for
each activity in the network. Therefore, we
now know that the expected completion
time for the entire project is 26 weeks.
We now continue finding the critical path by
making a backward pass through the
network. Because the expected completion
time for the entire project is 26 weeks, we
begin the backward pass with a latest
finish time of 26 for activity I.
Once the latest finish time for an activity is
known, the latest start time for an activity
can be computed as follows. Let
LS=latest start time for an activity
LF = latest finish time for an activity
Then
LS =LF- t
Beginning the backward pass with activity I,
we know that the latest finish time is LF = 26
and that the activity time is t = 2.
Thus, the latest start time for activity is LS=
24. We will write the LS and LF values in
the node directly below the earliest start
(ES) and earliest finish (EF) times. Thus, for
node I, we have
The following rule can be used to determine
the latest finish time for each activity in the
network:
The latest finish time for an activity is the
smallest (earliest) of the latest start times for
all activities that immediately follow the
activity.
After we complete the forward and
backward passes, we can determine the
amount of slack associated with each
activity.
Slack is the length of time an activity can be
delayed without increasing the project
completion time.
The amount of slack for an activity is
computed as follows:
Slack = LS - ES = LF - EF
The slack associated with activity C is
LS - ES = 8 - 5 = 3 weeks. Hence, activity C
can be delayed up to 3 weeks, and the
entire project can still be completed in 26
weeks. In this sense, activity C is not critical
to the completion of the entire project in 26
weeks.
Putting this information in tabular form
provides the activity schedule shown
We previously stated that project managers
look for procedures that will help answer
important questions regarding the planning.
scheduling, and controlling of projects. Here
are the answers:
1. How long will the project take to
complete?
Answer: The project can be
completed in 26 weeks if each
activity is completed on schedule.
2. What are the scheduled start and
completion times for each activity?
Answer: The activity schedule shows
the earliest start, latest start, earliest
finish, and latest finish times for
each activity.
3. Which activities are critical and must
be completed exactly as scheduled
to keep the project on schedule?
Answer: A, E, F, G, and I are the
critical activities.
4. How long can noncritical activities be
delayed before they cause an
increase in the completion time for
the project?
Answer: The activity schedule shows
the slack associated with each
activity.
Summary of the PERT/CPM Critical Path
Procedure
Step 1. Develop a list of the activities that
make up the project.
Step 2. Determine the immediate
predecessor(s) for each activity in
the project.
Step 3. Estimate the completion time for
each activity.
Step 4. Draw a project network depicting the
activities and immediate
predecessors listed in steps 1 and 2.
Critical Path Procedure
Step 5. Use the project network and the
activity time estimates to determine
the earliest start and the earliest
finish time for each activity by
making a forward pass through the
network. The earliest finish time for
the last activity in the project
identifies the total time required to
complete the project.
Step 6. Use the project completion time
identified in Step 5 as the latest
finish time for the last activity and
make a backward pass through the
network to identify the latest start
and latest finish time for each
activity.
Step 7. Use the difference between the
latest start time and the earliest start
time for each activity to determine
the slack for each activity.
Step 8. Find the activities with zero slack;
these are the critical activities.
Step 9. Use the information from steps 5
and 6 to develop the activity
schedule for the project.
Project Scheduling Considering
Uncertain Activity Times
In the three-time estimate approach, the
time to complete an activity is assumed to
follow a Beta distribution,
An activity's mean completion time is:
t = (a + 4m+b) / 6
a = the optimistic completion time estimate
b= the pessimistic completion time estimate
m = the most likely completion time
Estimate
Uncertain Activity Times
An activity's completion time variance is:
a = the optimistic completion time estimate
b = the pessimistic completion time estimate
In the three-time estimate approach, the
critical path is determined as if the mean
times for the activities were fixed times.
The overall project completion time is
assumed to have a normal distribution with
mean equal to the sum of the means along
the critical path and variance equal to the
sum of the variances along the critical path.
Crashing Activity Times
To determine just where and how much to
crash activity times, we need information on
how much each activity can be crashed and
how much the crashing process costs.
Hence, we must ask for the following
information:
● Activity cost under the normal or
expected activity time
● Time to complete the activity under
maximum crashing (i.e., the shortest
possible activity time)
● Activity cost under maximum
crashing
● When determining the time
estimates for activities in a project,
the project manager bases these
estimates on the amount of
resources (workers, equipment, etc.)
that will be assigned to an activity.
● The original developers of CPM
provided the project manager with
the option of adding resources to
selected activities to reduce project
completion time.
 ● Added resources (such as more
workers, overtime, and so on)
generally increase project costs, so
the decision to reduce activity times
must take into consideration the
additional cost involved.
● In effect, the project manager must
make a decision that involves
trading additional project costs for
reduced activity time.
Considering Time-Cost Trade-offs
The table shown defines a two-machine
maintenance project consisting of five
activities. Management has substantial
experience with similar projects and the
times for maintenance activities have very
little variability; hence, a single time
estimate is given for each activity.
The project network is shown here:
The length of the critical path, and thus the
total time required to complete the project,
is 12 days.
Crashing Activity Times
In the Critical Path Method (CPM) approach
to project scheduling, it is assumed that the
normal time to complete an activity, ri, which
can be met at a normal cost, ci
can be crashed to a reduced time, ri
prime under maximum crashing for an
increased cost, ci
Using CPM, activity is maximum time
reduction,
may be calculated by: Mi = ri - ri
It is assumed that its cost per unit reduction,
Ki
is linear and can be calculated by:
Ki = (Ci - Ci) I Mi.
For example, if the normal or expected time
for activity A is 7 days at a cost of CA = $500
and the time under maximum crashing is 4
days at a cost of CA = $800, the previous
equations show that the maximum possible
reduction in time for activity A is
MA = 7 - 4 - 3 days with a crashing cost of
We make the assumption that any portion or
fraction of the activity crash time can be
achieved for a corresponding portion of the
activity crashing cost. For example, if we
decided to crash activity A by only 1.5 days,
the added cost would be 1.5 ($100)= $150,
which results in a total activity cost of $500+
$150 = $650.
The complete normal and crash activity data
for the two-machine maintenance project
are given here:

Which activities should be crashed-and by

how much-to meet the 10-day project
completion deadline at minimum cost?

Your first reaction to this question may be to

consider crashing the critical activities-A, B,
or E. Activity A has the lowest crashing cost
per day of the three, and crashing this
activity by 2 days will reduce the A-B-E path
to the desired 10 days.

Keep in mind, however, that as you crash

the current critical activities, other paths
may become critical.

Thus, you will need to check the critical path

in the revised network and perhaps either
identify additional activities to crash or
modify your initial crashing decision.

For a small network, this trial-and-error

approach can be used to make crashing
decisions; in larger networks, however, a
mathematical procedure is required to
determine the optimal crashing decisions.