Optimal Decisions Using Marginal Analysis

OPTIMAL DECISIONS USING
MARGINAL ANALYSIS
2
INTENDED LEARNING OUTCOMES
1. Define the simple model of the firm.

2. State the concept of marginalism and its use in managerial decision-making.
3. Apply the principle of marginalism to inventory management and break-even point analysis.
This module introduces the analysis of managerial decision making that will occupy us for the
remainder of this course. The module is devoted to two main topics. The first is a simple economic model
(i.e., a description) of the private, profit-maximizing firm. The second is an introduction to marginal
analysis, an important tool for arriving at optimal decisions. This optimal decision-making will be
explained thru economic order quantity and break-even point analysis.
A SIMPLE MODEL OF THE FIRM
The decision setting we will investigate can be described as follows:

1. A firm produces a single good or service for a single market with the objective of maximizing profit.
2. Its task is to determine the quantity of the good to produce and sell and to set a sales price.
3. The firm can predict the revenue and cost consequences of its price and output decisions with
certainty.
Together the above three statements fulfill the first four fundamental decision making steps
described in Module 1. Statement 1 specifies the setting and objective, statement 2 the firm’s possible
decision alternatives, and statement 3 (along with some specific quantitative information supplied
shortly) the link between actions and the ultimate objective, namely, profit. It remains for the firm’s
manager to “solve” and explore this decision problem using marginal analysis (steps 5 and 6).
Profitability
• Not considered really as a corporate objective.
• Only a requirement for the attainment of objectives.
• By way of formula:
Profit = Total Revenue – Total Cost
Accounting versus Economic Costs

• Economic cost are forward looking cost, meaning, economists are in tune with future cost
because these costs have major representation on the potential profitability of the firm.
• Economists are also giving emphasis on the so-called opportunity cost, or cost that are incurred
by not putting the resources to optimum use.
• If opportunity cost are measurable, it should be included in the decision making process, even
though it is expensive to do so.
• But there are some costs that should not be used in decision making such as sunk costs,
because these are costs that are irretrievable due to the fact that these are already incurred and
do not affect a firm’s decision.
• Accounting costs tend to be reflective; they recognized costs only when these are made and
properly recorded. They do not adjust these costs even if opportunity costs change.
• Therefore, the difference between economic costs and accounting costs is the opportunity
cost.
3 possible ways of increasing profit

1. With TC constant, increase TR
2. With TR constant, decrease TC
3. Increase TR, and decrease TC
But how do firms usually attain a preferred level of profit?
This can be done by computing Price per unit = Average cost + Mark up.
However, the general rule of the thumb is OPTIMIZATION or finding the best output to produce.
This can be achieve when MR = MC. Recall that MR (Marginal revenue) is the additional revenue per
additional unit of output produced and MC (Marginal Cost) is the additional cost per additional unit of
output produced.
MAXIMUM PROFIT IS NOT ALWAYS THE PRIMARY GOAL!
Some of the firms might aim to;

1. Attain a certain profit considered reasonable in an industry
2. Expanding sales so as to maintain control of the market
3. Provide substantial outlays in research in order to be in the forefront of innovation
In the Philippines, some firms might aim to have:

• Prestige and popularity
• Family control
• Social consciousness
MARGINAL ANALYSIS
Marginal analysis plays a crucial role in managerial economics, the study and application of
economic concepts, to guide in making managerial decisions. The idea is to predict and measure the
impact of per unit changes of an organization's goals, ultimately identifying the optimal resource
allocation given the constraints of the business.
Thus, this is a process of considering small changes in a decision and determining whether a given
change will improve the ultimate objective. As an example of this, consider the table below. If the main
objective of the firm is to maximize profit, what level of output will achieve this in our hypothetical
example below? Notice that increasing output also leads to increasing total costs (TC) and as well as
increasing total revenue (TR). At the initial level of production (when output is 100), MC is greater than
that of additional revenue (MR). However, increasing production by 100 every time results to declining
marginal cost after which MC rises again behaving like a U shaped curve. MR on the other hand is
constant regardless of output. If we are only concerned about hitting maximum profit, then we can
produce either 600 or 700 units. But producing at 600 with MR > MC is not optimal. What then is the
optimum level of production? Rightly so, it is when MR = MC! The formula is given below for MR and MC.
∆TC Change in Total Cost

MC = =
∆Q Change in Output
∆TC Change in Total Cost

MC = =
∆Q Change in Output
Table 2.1 Hypothetical table showing different levels of output.
How can the decision maker use profit changes as signposts pointing toward the optimal
output level? The answer is found by applying the maxim of marginal analysis:
“Make a small change in the level of output if and only if this generates an increase in profit. Keep moving,
always in the direction of increased profits, and stop when no further output change will help.”
APPLICATION OF MARGINAL ANALYSIS
A. Break-Even point Analysis
In the table above, we notice a point when TR=TC, profit is zero. The break-even point in
economics, business—and specifically cost accounting—is the point at which total cost and total revenue
are equal, i.e. "even". There is no net loss or gain, and one has "broken even", though opportunity costs
have been paid and capital has received the risk-adjusted, expected return.
The main purpose of break-even analysis is to determine the minimum output that must be
exceeded for a business to profit. It also is a rough indicator of the earnings impact of a marketing activity.
A firm can analyze ideal output levels to be knowledgeable on the amount of sales and revenue that
would meet and surpass the break-even point. If a business doesn't meet this level, it often becomes
difficult to continue operation.
• Important formulas to remember in BEP analysis:

1. Total Revenue (TR) = selling price x volume sold
2. Total Cost (TC)= Total Fixed Cost (TFC) + Total Variable Cost (TVC)
3. Profit = TR – TC
4. Break point : TR = TC
Other ways to solve for break even:
Total Fixed Cost

Break Even Volume =
Unit Selling Price − Unit Variable Cost
Fixed Cost + Variable Cost

Break − Even Price =
No. of Units Produced
Total Fixed Cost

Break − Even Area =
Sales Variable Cost
−
Unit Area Unit Area
B. Economic Order Quantity (EOQ)

• Important issue here: What level of inventory to keep during any given period?
The problem is we face 2 conflicting objectives!

1. Carrying a small inventory
2. Carrying a large amount of inventory
Advantages of carrying a small inventory

• Small storage and security cost
• Small amount of money tied up in inventory
• Small insurance cost
• Small handling and transfer costs
Advantages of carrying a large inventory

• Fewer number of reorders, therefore, less bookkeeping, typing, telephoning and messengerial
costs
• Bigger quantity per order, therefore, discounts could be availed
• Possibility of stock-out or running out of goods is very small, therefore customer goodwill is
maintained
Example Problem
• Suppose a merchandiser is confident of selling 100 units of certain commodity in one year.
Suppose also that carrying cost is P10/unit while ordering cost is P50/order.
We can try this equation to compute total inventory cost:
𝒄𝑫 𝒂𝑺
• I= +
𝟐 𝑫
• Where:
• I = total inventory costs
• D= size of the delivery
𝒄𝑫
• = total carrying costs for the entire year
𝟐
• c = inventory cost/unit
𝒂𝑺
• = total reordering costs for the year
𝑫
• a = ordering cost/unit
Simplifying, then we will have:
𝟏𝟎𝑫 𝟏𝟎𝟎
• I= + 50 x
𝟐 𝑫
= 5D + 5000/D
• By assigning different values to D, we can get different values of I.
• Try D = 10;
𝟓𝟎𝟎𝟎
• I = 5x10 + = 550
𝟏𝟎
• Summarizing the values we assign to D, we have a table below:
Table 2.2 Different sizes of Inventory and its relationship to total inventory cost.
Figure 2.1. Graphical Illustration of Economic Order Quantity.
What then is the optimum size of delivery based on the table and the graphical illustration above?
It should be the size of delivery where total inventory cost will be minimized. Or the point where the
reordering cost curve and the carrying cost curve intersects at the lowest level of the total inventory cost
curve.
Solving the exact amount of D, we can use the following formula:
D = √2aS/c
Thus,
D = √2(50)(100)/10
𝐃 = 𝟑𝟐
Using the Quantitative Management for windows software to generate the results, we confirmed
the optimal size of D that minimizes total inventory cost for the merchandiser as follows:
Figure 2.2 Economic Order Quantity Results using QM software
REFERENCES
Samuelson, W. & S. Marks, 2010. Managerial Economics. 2nd edition.
Villegas, B.M. 1999. Managerial Economics; Text and Case Studies. 3 rd ed.

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OPTIMAL DECISIONS USING

1. Define the simple model of the firm.

A SIMPLE MODEL OF THE FIRM

The decision setting we will investigate can be described as follows:

Profit = Total Revenue – Total Cost

Accounting versus Economic Costs

3 possible ways of increasing profit

But how do firms usually attain a preferred level of profit?

MAXIMUM PROFIT IS NOT ALWAYS THE PRIMARY GOAL!

Some of the firms might aim to;

In the Philippines, some firms might aim to have:

∆TC Change in Total Cost

∆TC Change in Total Cost

Table 2.1 Hypothetical table showing different levels of output.

APPLICATION OF MARGINAL ANALYSIS

A. Break-Even point Analysis

• Important formulas to remember in BEP analysis:

Other ways to solve for break even:

Total Fixed Cost

Fixed Cost + Variable Cost

Total Fixed Cost

B. Economic Order Quantity (EOQ)

The problem is we face 2 conflicting objectives!

Advantages of carrying a small inventory

Advantages of carrying a large inventory

Figure 2.1. Graphical Illustration of Economic Order Quantity.

Figure 2.2 Economic Order Quantity Results using QM software

Samuelson, W. & S. Marks, 2010. Managerial Economics. 2nd edition.

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