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MODELS OF COST, REVENUE AND PROFIT 15

MANAGEMENT SCIENCE IN ACTION

Models in Federal Express*
oday, Federal Express (FedEx), is an acknowl- started in March 1973 between 11 cities. It was
T edged leader in delivery services worldwide hardly an auspicious start – only six packages
with an annual revenue of over $30 billion and needed delivery and the next couple of days
1
around / 4 million employees and contractors. It proved no better. The company stopped its air
has the largest civil aviation fleet in the world. Its delivery service. Fortunately Smith brought in col-
founder and CEO, Frederick W. Smith acknowl- leagues who had an analytical and modelling back-
edges the role that models and management sci- ground. An initial model was developed looking at
ence have played in the company’s success. improving the origin-destination network that had
Indeed, if it hadn’t been for this FedEx might not originally been set up across 11 cities by taking a
be here today! Smith started FedEx in 1973 offer- more analytical approach looking at the types of
ing an overnight package delivery service between business in each city (FedEx’s potential customers),
11 cities in the south and southeast of the US. competition, likely market share. As a result a new
The innovative service operated on a hub-and- 26 city network was proposed and two months later,
spoke system (named after an old fashioned in April 1973, FedEx reopened its air delivery service
wagon wheel, where the hub is the centre part to great success. Additional models were developed
of the wheel and the spokes radiate out from the not long after, helping the business grow and suc-
centre to the edge of the wheel). Smith’s idea ceed: a flight scheduling and resourcing model and
was to use a fleet of aeroplanes to transport all a financial planning model allowing FedEx to assess
packages from their origin, to a central hub the financial implications of alternative routes and
facility (in Memphis). Then all the packages flying schedules. Unsurprisingly, CEO Fred Smith
would be sorted and flown back out across the has become a strong supporter of management
spokes to the city of destination. Many people science modelling.
commented at the time that this was a crazy
*Source: FedEx website and on Absolutely, Positively Operations
idea and would never work. They were almost
Research: the Federal Express Story, R.O. Mason, J.L. McKenney,
right. FedEx had acquired a fleet of 22 executive W. Carlson and D. Copeland in Interfaces 27:2 March-April 1997
jets to use as cargo planes and the service pp 17–36

1.6 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. Financial planning, production planning, sales quotas
and other areas of decision making can benefit from such cost, revenue and
profit models.

Cost and Volume Models

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

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