Basic Profit Models

Chapter 3

Part 1 Influence Diagram

1
In building spreadsheets for deterministic
models, we will look at:
ways to translate the black box representation
into a spreadsheet model.

recommendations for good spreadsheet model

design and layout

suggestions for documenting your models

useful features of Excel for modeling and

analysis 2
 Example 1: Simon Pie

Two ingredients combine to make Apple Pies:

Fruit and frozen dough

The Pies are then processed and sold to local grocery

stores in order to generate a profit.

Follow the three steps of model building.

Step 1: Study the Environment and Frame the
Situation
Critical Decision: Setting the wholesale pie price

Decision Variable: Price of the apple pies 3

(this plus cost parameters will determine profits)
 Step 2: Formulation
Using Black Box diagram, specify cost parameters
Pie Price
Unit Cost, Filling
Unit Cost, Dough Model profit
Unit Pie Processing Cost
Fixed Cost

The next step is to develop the relationships inside

the black box. A good way to approach this is to create an
Influence Diagram.

An Influence Diagram pictures the connections between the

models exogenous variables and a performance measure4
(e.g., profit).
To create an Influence Diagram:
start with a performance measure variable.

Decompose this variable into two or more intermediate

variables that combine mathematically to define the
value of the performance measure.

Further decompose each of the intermediate variables

into more related intermediate variables.

Continue this process until an exogenous variable is

defined (i.e., until you define an input decision variable
or a parameter). 5
 Profit performance
Start here: measure
variable

Decompose this variable into the intermediate variables

Revenue and Total Cost

6
 Profit

Revenue Total Cost

Now, further decompose each of these intermediate

variables into more related intermediate variables ...

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 Profit

Revenue Total Cost

Processing Ingredient
Cost Cost

Required
Ingredient
Quantities
Pies Demanded

Unit Pie Unit Cost Unit Cost

Pie Price Processing Cost Filling Dough Fixed Cost

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Step 3: Model Construction
Based on the previous Influence Diagram, create the
equations relating the variables to be specified in the
spreadsheet.

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 Profit

Revenue Total Cost

Profit = Revenue Total Cost

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 Profit

Revenue

Revenue = Pie Price * Pies Demanded

Pies Demanded

Pie Price

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 Profit
Total Cost

Processing Ingredient
Cost Cost

Total Cost =
Processing Cost + Ingredients Cost + Fixed Cost

Fixed Cost

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 Profit
Total Cost

Processing
Cost

Processing Cost =
Pies Demanded *
Pies Demanded Unit Pie Processing Cost

Unit Pie
Processing Cost
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 Profit
Total Cost
Ingredients Cost =
Qty Filling * Unit Cost Filling + Ingredient
Cost
Qty Dough * Unit Cost Dough
Required
Ingredient
Quantities

Unit Cost Unit Cost

Filling Dough
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 Simons Initial Model Input Values
Pie Price $8.00
Pies Demanded and sold 16
Unit Pie Processing Cost ($ per pie) $2.05
Unit Cost, Fruit Filling ($ per pie) $3.48
Unit Cost, Dough ($ per pie) $0.30
Fixed Cost ($000s per week) $12

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 Chapter 3
Part 2

Break-Even and Cross-Over

Analysis
MGS 3100

16
 Background
The Generalized Profit Model:
A decision-maker will break-even when profit
is zero.
Set the generalized profit model equal to zero,
and then solve for the quantity (Q).
For simplicity, assume that the quantity
produced is equal to the quantity sold. This
assumption will be relaxed in the module on
decision analysis.
17
 Basic Relationships
Profit () = Revenue (R) - Cost (C)

Revenue (R) = Selling price (SP) x Quantity

(Q)

Cost (C) = [Variable cost (VC) x Quantity (Q)]

+ Fixed Cost (FC)

Remember quantity produced = quantity sold

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 Basic Relationships cont
By substitution:
= (SP x Q) ((VC x Q) + FC)

= SP*Q - VC*Q FC Notice sign reversal

when parentheses are
removed!

= (SP-VC)*Q - FC
Just a bit of algebraic
reorganization

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 Contribution Margin

If Contribution Margin (CM) = SP-VC,

then by substitution
= CM*Q FC

In case you want to figure the quantity at

break-even, you just need to rearrange

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 Break-Even Quantity
= CM*Q FC
+ FC = CM*Q
( + FC)/CM = (CM*Q)/CM
( + FC)/CM = Q
Q = ( + FC)/CM
In the case of break-even, where =0, the
formula boils down to:
Q = FC/CM
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 Quantity and Profit Example
Again, Q = (FC + )/CM
If fixed cost is $150,000 per year, selling price
per unit (SP) is $400, and variable cost per unit
(VC) is $250, what quantity (Q) will produce a
profit of $300,000?
Q = ($150,000+$300,000)/($400-$250)
Q = $450,000/$150
Q = 3000

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 Cross-Over Point
The cross-over point (or indifference point)
is found when we are indifferent between
two plans.
In other words, the quantity when profit is
the same for each of two plans.

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 Cross-Over Point, cont
To find the cross-over point for Plan A and
B, set the profit formulas for each plan
equal to each other:
planA = planB, so
(CM*Q FC) planA = (CM*Q FC)planB

QAtoB = (FCA - FCB)/(CMA CMB)

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 Cross-Over Point, cont
So all you need are the fixed costs and
contribution margins (selling price and variable
cost) to solve.
For example, here are three plans
Plan A Plan B Plan C
FC 150,000 450,000 2,850,000
VC 250 150 100
SP 400 } 150 }
400 250 }
400 300

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 Cross-Over Point, cont
Breakeven Points for each plan are:

Plan A Plan B Plan C

QBE = 150,000/(400-250) 450,000/(400-150) 2,850,000/(400-100)

= 1000 units = 1800 units = 9500 units

What is the profit at each of these points?

Cross-Over Points
A to B B to C
QCO (150,000-450,000)/(150-250) (450,000-2,850,000)/(250-300)
= 3000 units = 48,000 units 26
 Calculating Profit at the Cross-Over
After calculating cross-over, we have a quantity
that can be plugged back into the formula to find
profit at the cross-over point

A = CMA*Q FCA B = CMB*Q - FCB

= 150(3000) - 150,000 = 250(48,000) - 450,000

= $300,000, or = $11,550,000, or

B = 250(3000) - 450,000 C = 300(48,000) - 2,850,000

= $300,000 = $11,550,000

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