CHAPTER I

Linear equations and their

applications

1.1 Introduction

Mathematicians, economists, statisticians and others have applied their

skills to management problems for many years; but the first concentrated
effort in this area occurred during WWII, when these specialists were formed
in to operations Analysis group to assist in the planning of military
operations. The analysts used mathematics and statistics extensively in their
studies, and the resulting recommendations were an important contribution
to the war effort. Following the war, some analysts, soon joined by others,
turned their attention to problems of management operations and
accomplished major improvements in inventory control, quality control,
warehouse location, oil industry operations, agriculture, purchasing
decisions, scheduling of complex tasks such as building a shopping center,
and a variety of other areas. Mathematics, old and newly created, coupled
with innovative applications of the rapidly evolving electronic computer and
directed toward management problems resulted in a new field of study called
Quantitative Methods (or Management science or operations Research),
which has become part of the curriculum of colleges of business. The
importance of quantitative approaches to management problems is now
widely accepted, and a course in mathematics, with management applications
is included in the core subjects studied by almost all management students.

This material develops mathematics in the applied context required for an

understanding of the quantitative approach to management problems.

In this material one major area of study is that of linear Mathematics. This
chapter is the first of five chapters which focus up on linear mathematics and
its applications. Linear Mathematics is significant for a number of reasons.

1. Many of the real world phenomena which we might be interested in

representing mathematically either are linear or can be approximated
reasonably well using linear relationships. As a result linear
mathematics is widely applied.
2. The analysis of linear relationships is generally easier than that of non
linear relationships.
3. Some methods used in non linear mathematics are similar to or
extensions of those used in linear mathematics. Consequently having a

1
 good understanding of linear mathematics is prerequisite to the study
of non linear mathematics

Definitions and Characteristics of Linear Equations

Introduction

Linear equations are equations whose terms (parts separated by plus,

minus, and equal signs) are a constant or a constant times one variable to
the first degree. Linear equations are mathematical statements that
indicate two algebraic equations which are equal. Algebraic equations are
those that are linked by mathematical operations (+, - , X, or ÷). Linear
equation is an equation with one degree and whose graph is straight line
and whose slope is constant through the line

General Form of Linear Equations

Linear equation with two variables

A linear equation involving two variables X and Y has the standard form:
ax + by = c - - - - - - - - - - - - - - - (1.1)
Where a, b and c are real numbers and a and b cannot both equal zero

Notice that linear equations are first degree equations. Each variable in the
equation is raised (implicitly) to the first power. The presence of terms having
exponents other than 1(for example, x2) would exclude an equation from
being considered linear. The presence of terms involving a product of the two
variables (for example, 2xy) would also exclude an equation from being
considered linear.

The following are all examples of linear Equations involving two

variables:

1. 2x + 5y = -5 1
4. 2s – 4t = -
2
2. –x + ½ y = 0
5. 2 k + 2 = 5n
x
3. = 25 y + 30
3 6. 3 5m −2 7 p = −5

2
 The following are examples of equations which are not linear:

1. 2x + 3xy = 7
3. U + V = −10
2. x + Y + 3x = 16
2
4. 2x + 3xy – 4y = 10
In attempting to identify the form of an equation (linear versus nonlinear), an
equation is linear if it can be written in the form of eq. (1.1). A quick glance at the
5 x − 24
equation 2 x = + 10 might lead to the false conclusion that it is not linear.
4
However, multiplying both sides of the equation by 4 and moving all variables to the
left-hand side yields: 3 x + 2 y = 40 , which is in the form of eq. (1.1).

Linear Equation with n variables

Linear equation involving n variables X1, X2, X3 … Xn has the general form:

a 1 x 1 + a 2 x 2 + a 3 x 3 + . . . + a n x n = b . . . ……………………. (1.2)

Where a 1 , a 2 , a 3 . . . a n and b are real numbers and not all a 1 , a 2 , a 3 . . . a n equal

zero. And this is called standard form of a line .

Each of the following is an example of a linear equation involving more

than two variables:

1. 3x1 – 2x1 + 5x3 = 0

2. –x1 + 3x2 – 4x3 + 5x4 – x5 + 2x6 = -80
3. 5x1 – x2 + 4x3 + x4 – 3x5 + x6 – 3x7 + 10x8 – 12x9 = 1250

Characteristics of linear equations

1. Linear equations have variables with only one degree (power).

2. The product of two variables should not avail in the linear equation.
3. The graphs of linear equations are straight linear
4. The coefficients of the linear equations all should be different from zero.

Remark: A linear equation involving only two variables can also be denoted in
general as:

3
Y = m x + b………………………………………………. (1_3)
And this is called slope intercept form of a line .

∆y y 2 − y1
Where, m – slope = = , x 2 ≠ x1
∆x x2 − x1
b- Y – intercept (x = 0)

x- Independent variable

y- Dependent variable

1. Dependent and Independent variable

The relationship between y and x expressed by y = mx + b is called a functional

relationship, because for each value of x, there is one and only one corresponding
value for y. Notice that the expression states that y is in terms of x and we connote
this by saying y is a function of x. If we write; y is equal to an expression involving x
and constants, then x is called the independent variable and is plotted on the
horizontal axis. The value of y depends upon what value we assign to x, and so y is
called the dependent variable, which is plotted on the vertical axis. Thus, when
we plot points, the values of x can be chosen independently, but the corresponding
values of y depend on the values chosen for x. For example, Anbessa Shoes
manufacturing Company produces shoes using inputs such as leathers, labors,
etc. Therefore, the firm incurs costs which are varying with the level of shoes
produced.
Dependent variable: Total production cost because it is increasing with number of
shoes produced.
Independent variable: number of shoes produced

2. slope

The steepness of a ski slope, the pitch of a roof and the steepness of the glide path of a
descending airplane all are associated with the mathematical concept of the slope of a
straight line or line segment. Slope is defined as the rate of change in the dependent
variable for a unit change in the independent variable. Any straight line, with the
exception of vertical lines, can be characterized by its slope. Numerically, the slope of
a straight line is the ratio of the rise (or fall) to the run between two points on the
line, where rise or fall is the vertical separation and the run is the horizontal
separation of the two points.

4
Given any two points which lie on a (non vertical) straight line, the slope can be
computed as a ratio of the change in the value of y while moving form one point to
the other divided by the corresponding change in the value of x or

Difference ofy ' s changeiny

Slope = m = Difference ofx ' s = changeinx

∆y y 2 − y1
m= = ………………………………………… (1_4)
∆x x 2 − x1

Where ∆ (delta) means “change in”. Thus ∆y denotes “the change in the value of y”
and ∆x “the change in the value of x.”

Example:
Compute the slope of a line connecting points located at (2, 4) and (5, 12).
Solution
Arbitrarily identify one point as (x1, y1) and the other as (x2, y2). Given the location of
the two points (5, 12) as (x1, y1) and (2, 4) as (x2, y2), in moving from (5, 12) to (2, 4)
∆y = y2 – y1 = 4 – 12 = -8 and

∆x = x2 – x1 = 2 – 5 = -3

∆y − 8 8
Hence, m= = =
∆x − 3 3

Example:
Compute the slope of a line segment connecting two points: (5, 8) and
(10, -12).

Solution

Assume, (x1, y1) as (5, 8) and (10, -12) be (x2, y2)

∆y y 2 − y1 − 12 − 8 − 20
m= = = = = −4
∆x x 2 − x1 10 − 5 5

The slope of a line is quantified by a real number. The sign of the slope (number)
indicates whether the line is rising or falling. The magnitude (absolute value) of the
slope indicates the relative steepness of the line. The slope tells us the rate at which
the value of y changes relative to changes in the value of x. the larger the absolute
value of the slope, the steeper the angle at which the line rises or falls. For example
observe the following line segments.

5
Figure 1-2: Slope of different straight lines

Y
D (4, 10)

B (8, 6)

E (1, 8)

A (1, 2)
C (2, 1)

F (6, 3)

∆y 6 − 2 4
m AB = = = = 0.57
∆x 8 − 1 7

∆y 10 − 1 9
mCD = = = = 4.5
∆x 4 − 2 2

∆y 8 − 3 5
m EF = = = = −1
∆x 1 − 6 − 5

In fig 1.2, lines AB and CD both have positive slopes, but the slope of CD is larger
than that for AB . Similarly, line EF has the larger slope in absolute value sense.
Therefore, line CD is the steepest line where as EF is steeper than AB .

Example: Determine the y-intercept and x-intercept of the following equations:

a. Y = 2 x + 10
b. 2y = 8x – 20

6
Solution:
a. Y – Intercept is the value of y when x = 0.
For the line y = 2x + 10, x = 0
Y = 2(0) + 10
Y = 10
y- Intercept = y=10
∴The line y = 2x + 10 intersects the y-axis at a point (0, 10).
x- Intercept is the value of x when y = 0
y = 2x + 10
0 = 2x + 10
X-intercept = x = -5
∴ The line y = 2x + 10 intersects the x – axis at a point (-5, 0).

b. y- intercept is the value of y when x equals o.

Hence, 2y = 8(0) -20
2y = -20
y = -10 ⇒ y – intercept

This means the line 2y =8x -20 intersects the y- axis at a point (0, 10).
x- Intercept means the value of x when y equals 0.
Hence, 2(0) = 8x -20
0 = 8x – 20
20 5
x= = = x − int ercept
8 2
∴ The line 2y = 8x – 20 intersects the x –axis and the y-axis, respectively, at points
(5/2, 0) and (0, -10).

Exercises:
1. Discuss the difference between linear equations and non linear equations.
2. Define slope of a line and discuss the four natures of slope of a line
3. What is the difference between horizontal lines and vertical lines and lines
passing through the origin?
4. Determine the slope, x intercept and y intercept of the following linear
equations.
1
a. x + y = 20
2

b. 5 y = 8 x +16

c. − 2 x + 8 y = 0

5. Which of the following pair lines are parallel or perpendicular

7
 1
1 x + y = 20
A. x + y = 20 B. 2
2
x + 2Y = −20
− 2 x + y = 40

5 x − 24
2x = +10
C. x + 2 y = −30 D. 4
5 y = 8 x +16
x + 3 y = −20

6. Which of the following line is horizontal, vertical or neither of the two?

a. y = 2 x
b. y= −
1
20
c. x − 200 = 200

7. Which of the following line is negatively sloped, positively sloped, or line with
undefined slope or with zero slope?

A. y − 2 x = 0

B. x + 2 y = 40 − 2 x

C. x = 400

D. y = −20

E. y + 2 x = 0

Evaluating linear Equations

Introduction

1. Solution sets

Given a linear equation having the form Y = mx + b, the solution set for the equation
is the set of all ordered pairs (x, y) which satisfy the equation. Using set notation the
solution set S can be specified as:

S= { ( x, y ) / y = mx + b} ………………………………………… (1_5)

8
Verbally this notation states that the solution set S consists of elements (x, y) such
that the equation Y = mx + b is satisfied. For any linear equation, S consists of an
infinite number of pairs of values (x, y) which satisfy any linear equation involving
two variables.

Example:

Given the equation 4y = -2x + 16

a. Find any point of values which satisfies the equation.

b. Determine the pair of values which satisfies the equation when x = -2.
c. Determine the pair of values which satisfies the equation when y = 0.

Solution
(a) Arbitrary take x = 4, substituting x = 4 in to the equation we have

4y = -2(4) +16
4y = -8 + 16
4y = 8
y=2

Thus, (4, 2) is one of the points of values satisfying 4y = -2x +16.

Again assume x =5 and substituting in to the equation we have

4y = -2(5) + 16
4y = -10 + 16
4y = 6
3
y= .
2
 3
Thus,  5,  is one of the solution sets.
 2

  3 
Therefore, S = ( 4,2 ),  5, ....( x, y ) / 4 y = −2 x + 16  .
  2 

(b) Substituting x = -2 in to the equation we have

4y = -2 (-2) + 16
4y = 4 + 16
4y = 20
y=5

9
 Therefore, when x = -2, the pair of values satisfying the equation is x = -2 and y =
5 or (-2, 5).

(c) Substituting y = 0 in to the equation gives

4(0) = -2x + 16
0 = -2x + 16
x=8

Hence, when y = 0, the pair of values satisfying the equation is (8, 0).

Generalizing for n variable linear equations

Given a linear equation involving n variables, the solution set S can be specified
as:

S= { ( x1 , x2 , x3 ...xn ) / a1 x1 + a2 x2 + a3 x3 + ... + a n xn = b} …………………. (1_6)

As with the two variable cases, there are an infinite number of elements in the
solution set. An element in S is represented by a collection of values (x 1, x2, x3 . . .
xn), one for each of the n variables in the equation. One way of identifying specific
elements in S is to assume values for n-1 of the variables, substitute these in to
the equation, and solve for the value of the remaining variable.

Example:
Given the equation 2x1 + 3x2 – x3 + x4 = 16, what values satisfy the equation when
x1 = 2, x2 = -1 and x3 = 0?

Solution:
Substituting the given values for x1, x2 and x3 in to the equation yields:
2(2) +3 (-1) – (0) + x4 =16
x4 = 15.

The corresponding element of the solution set is (2, -1, 0, 15).

2. Graphing two variable Equations

A linear equation involving two variables has a graph which is a straight line in two
dimensions. In order to graph this type of linear equation, you only need to:
(1) Identify the coordinates of any two points which lie on the line,
(2) Connect the two points with a straight line, and
(3) Extend the straight line in both directions as far as necessary or desirable for
your purposes. The coordinates of the two points are found by identifying any two

10
members of the solution set. The location of this point is described by coordinates (x,
y) where x and y are the respective values of the two variables. For example if the
values of x =1 and y =3 satisfy an equation, the graphical representation of this
member of the solution set is a point located at (1, 3).

Example:
The graph of the equation 4y = -2x + 16 is found by first identifying any two pairs of
values for x and y which satisfy the equation.

Letting x = 0 the corresponding value for y is 4 and letting y = 0 results in

x = 8. Thus, (0, 4) and (8, 0) are two members of the solution set and their graphical
representation is indicate by the two points in Fig 1.1. The two points have been
connected by a straight line, and the line has been extended in both directions. Just
as (0, 4) and (8, 0) are members of the solution set for the equation 4y = -2x + 16, the
coordinates of every point lying on the line represent other members of the solution
set. There are an infinite number of pairs of values for x and y which satisfy any
linear equation. In summery, if there are any pairs of values (x, y) that satisfy an
equation, they can be identified by the coordinates of points lying on the line
representing the equation. In fig 1.1, the coordinates of any point not lying on the line
will not satisfy the equation.

Y Fig. 1.1: Graph of linear equation 4y = -2x + 16

(0, 4)

4y=-2x+16

(8, 0)
X

Example:

Graph the linear equation 4x – 7y = 0

11
Solution:

This equation is an example of the situation where two points will not be found by
setting each variable equal to 0 and solving for the remaining variable. Watch what
happens! If x = 0
4(0) – 74 = 0 or y = 0
4x – 7(0) = 0 or x = 0

Both cases have yielded the same point (0, 0). Therefore another value must be
assumed for one of the variables.
If we let x = 7, then we have
4 (7) – 7y = 0
y=4

Fig 1.2: Graph of the linear equation 4x – 7y = 0.

10

(0, 0)
-10 5 5 10
5
10

Two members of the solution set are, then (0, 0) and (7, 4).

Note: Any two variable linear equation having the form y = mx graphs as a
straight line which passes through the origin.
Exercises:
1
1. Given the equation − 2 y = x −
2
a. Find any point of values which satisfies the equation
b. Determine the pair of values which satisfies the equation when x = -2
c. Determine the pair of values which satisfies the equation when y = 0
2. Given the equation 2x1 +5x2 + x3 + x4 = 20, what values satisfy the equation
when x1 = 2, x2 = -1 and x3 = 0?

12
 3. Graph the linear equation 4x – 2y = 20.
4. Graph the linear equation 2x +y = 0.

Determining the Equation of a straight line

1. Slope and intercept

The easiest situations one in which you know the slope m and y intercept (0, k) of
the line representing an equation. To determine the linear equation in this almost
trivial case, simply substitute m and k into the slope intercept form, Eq. (1, 3). If
you are interested in stating the equation in the standard form of Eq. (1.1), simply
rearrange the terms in the slope intercept equation.

Example

Determine the equation of the straight line which has a slope of -5 and a y intercept
of (0, 15).

Solution

Substituting values of m = -5 and k =15 into Eq. (1.3) gives

Y = -5x + 15
Restated in the form of Eq. (1.1), an equivalent form of this equation is

5x + y = 15

Example
1
Determine the equation of the straight line which has a slope of + and a y
2
intercept at (0, 0).

Solution
1
Substituting m = and k = 0 in to Eq. (1.12) gives
2
1
Y = x +0
2

1
Y= x
2
1
Verify that the equation can be stated in the form of Eq. (1.1) as x - y = 0, or as x –
2
2y = 0.

13
Check Point
1
Is the equation y - x = 0 an equivalent form of the equation in the last example?
2
Why? Graph the two to see if they are the same
2. Slope and one point

Another possibility for a line is that you may know the slope and also one member of
the solution set (i.e., the coordinates of one point on the line). If you consider the slope
intercept form [Eq. (1. 3)], any member of the solution set should satisfy the equation.
That is we can define the values of x and y which satisfy an equation by the solution
set S, where S = {(x, y)/y = mx + k}.

Now follow this carefully! In the last section we said that knowing the slope and the y
intercept of an equation allows you to write out the lope-intercept form directly. In
this section we talk of knowing the slope and one point-but not the y intercept. From
Eq. (1.5), any point which lies on a line should satisfy the slope intercept equation. If
we substitute the known slope m and the coordinates of the point into Eq. (1.3) we
can solve for k. At this stage we would have m, the slope, and k, the y coordinate of
the y intercept; the equation of the line would follow directly. Let’s illustrate this with
a few examples.

Example

Given that the slope of a straight line is -2 and one point lying on the line is (2, 8), we
can substitute these values into Eq. (1. 3), yielding

8 = (-2) (2) + k
12 = k

Knowing that m = -2 and k = 12 leads directly to the slope intercept equation

y = -2x + 12.
And, as before, we can rewrite this equation in the equivalent form
2x + y = 12.

Example
If the slope a straight line is zero and one point lying on the line is (5, -30) the
equation of the line can be found by first substituting the zero slope and coordinates
(5, -30) into Eq. (1.3)
-30 = (0) (5) + k
-30 = k

14
Since we know that m = 0 and k = -30 the slope intercept equation is
y = 0x + (-30)
y = -30

Example

Considering the linear equation 3x – 6y = 24,

(a) What is the slope of the line represented by the given equation?
(b) What is the slope of any line parallel to the given line?
(c) What is the slope of any line perpendicular to the given line?
(d) How many different lines are perpendicular to this line?
(e) Fined the equation of the line which is perpendicular to the given line and
which passes through the point (2, 5).

Solution

(a) The given equation can be restated in slop-intercept form as

-6y = 24 – 3x
1
y = -4 + x
2

From the equation the slope can be seen to equal + ½

To lines are parallel if they have the same slope

1
(b) Since the slope of the given line equals + , any parallel line will have a slope
2
1
of + .
2

If a line has a slope m1 (m1 ≠ 0) the slope of any line which is perpendicular to the
given line has a slope equal to the negative reciprocal of the given line, or m2 =
-1/m1.

1
(c) since m1 = the slope of any line perpendicular to the line 3x – 6y = 24 is
2
1
m2 =
1
2

= -2

15
(d) Because there is an infinite set of lines with m = -2 an infinite number of lines
are perpendicular to this line.
(e) The line we are interested in has a slope equal to -2 and one point on the line
is (2, 5). Substituting these three values into Eq. (1.3) yields
5 = (-2) (2) + k
9=k

Therefore the equation of the line is

y = -2x + 9.
Or alternatively
2x + y = 9.

3. Two points

A more likely situation is that some data points have been gathered which lie on a
line and we wish to determine the equation of the line. Assume that we are given
the coordinates of two points which lie on a straight line. We can determine the
slope of the line by using the two point formula [Eq. (1.4)]. As soon as we know the
slope the y intercept can be determined by using either of the two data points, and
proceeding as we did in the last section.

Example

To determine the equation of the straight line which passes through (-4, 2) and the
origin, we substitute the coordinates in to the two-point formula, resulting in
0 −2
m=
0 − (−4)

−2 1
= =−
4 2

1
Substituting m = - and the coordinated (-4, 2) into Eq. (1.3) yields
2
 1
2 =  − ( − 4) + k
 2
2=2+k
0=k
Thus, the slope-intercept form of the equation is
1
y =− x
2

16
 Check point
In this last example you might have realized that the origin is the y intercept.
How would this have simplified the analysis?

Example : ( Depreciation)

The value of a machine is expected to decrease at a linear rate over time. Figure 1.10
shows two data points on the line which represents the value V of the machine as a
function of its age t, where v is measured in dollars and t is measured in years from
the time of purchase.

20,000
Value in dollars

(0, 18000)
15,000 (1, 14500)

10,000

5,000
1 2 3 4 5 6 7 t
Age of machine in years

The two data points indicate that the value of the machine at t = 0 (time of purchase)
is $ 18,000 and its value in one yare will equal $14,500. Determine the slope intercept
equation which relates the value V of the machine to its age t.
Solution

The slope can be determined using the two point formula (Eq. 1_4), resulting in

14 ,500 −18 ,000

m=
1 −0

17
 − 3,500
= = −3,500
1

Substituting m = -3,500 and (0, 18,000) into Eq. (1.12) - with v and t replacing y and
x, respectively, we get
18,000 = (-3,500) (0) + k
18,000 = k
Consequently, the slope intercept equation is
v = -3,500t + 18,000

Example

For the last example,

a) Interpret the meaning of the slope.
b) At what time t is the value of the machine expected to equal zero?
Solution
(a) The slope of -3,500 implies that with each additional year of ownership the
value of the machine decreases by $ 3,500. (The term depreciation is often
used by accountants to describe the rate at which an asset declines in value
over time.)
(b) V will equal zero when the line crosses the t axis (equivalent to the x
intercept); algebraically, we are searching for the value of t when v = 0. By
setting v equal to 0 in the equation developed in Example 18 and solving for
t, we find the machine will have a value of zero when
0 = -3,500t + 18,000
3,500t = 18,000

18 ,00
t =
3,500
t = 5.142 years
Exercises

9. Develop equation of a line with a slope of -2 and y intercept of (0,200).

10. If slope m=0 and one point lying one line is (5,-5) determine the equation of
the line.
11. Develop equation of a line with a slope of -2 and passing through point
(5,200).
12. A sales man earns a weekly base salary plus a sales commission of 14% of
his total sales. When his total weekly sales equal Birr 2000 his total weekly
salary is Birr 630.Derive the formula describing the relationship between
total salary and weekly sales volume. Plot the graph of the situation.

13. Develop equation of a line passing through two points (2,100) and (2, 200).

18
 14. Let F denotes degree faraniet and C denotes degree celcious and assume
that the relationship between these two temperatures scales is linear. Two
data points on the line relating C and F are
(5, 41) and 25, 77).Using these points determine the slope intercept equation
that allows you to transform C0 to F0 .

15. Addis Ababa Chamber of Commerce is trying to forecast the number

of tourist who would be visiting the city Dire Dawa in the coming years.
Some of the students from the local University have examined the problem
as part of a class project. They estimated this current volume at 60000
tourists. They have also projected that the volume next will be 67500 people
and the volume in the future will continue to grow at the same rate.
Determine the slope intercept equation, which relates the number of
tourists (P) to years (t) as measured from this current year.
Applications of Linear Equations
Introduction

A linear function f involving one independent variable x and a dependent variable y

have the general form:

Y = f(x) = mx + b - - - - - - - - - - - - (1.3)
Where a and b are real valued and a ≠ 0.

You should recognize Eq. (1.3) as being the slope intercept form of a linear equation
and m is the slope of the line that represents the function and b represents the y
coordinate of the y intercept. For a linear function having the form of Eq (1.3) a
change in the value of y is directly proportional to a change in the value of x, stated
differently, the rate of change in the value of y given a change in value of x is
constant. This rate of change is represented by the slope of the function, or by the
constant m in Eq. (1.3).
Example:

Suppose that you have taken a job as a sales person. Your employer has stated that
your salary will depend up on the number of units you sell each week. If we let

Y = weekly salary in dollars

X = number of units sold each week
Y = f(x) - - - - - - - - - - - - - - - - - - - - (1_7)
Suppose your employer in this example has given you the following equation for
determining your weekly salary:
Y = f(x) = 3x + 25 - - - - - - - - - - - - - (1.8)
Given any value for x, substitution of this value in to f will result in the
corresponding value of y. For instance, if we want to compute your weekly salary
when 100 units are sold, substitution of x =100 in to Eq (1.8) yields

19
 Y = 3(100) + 25
Y = $ 325.

The equation is graphed in the first quadrant only, restricting x and y to nonnegative
values.

Weekly salary in Y
Dollars fig 1.3: linear salary functions
200

150 y = 3x + 35

100

50

50 100 150 200 250 X

Units sold/ week
1. Manufacturing businesses

Manufacturing firms are those businesses engaged in production of goods and

services from the resources available for them. To produce goods and services, these
firms incur cost in the form of variable and fixed costs . As the result the
summation of variable and fixed costs make up total manufacturing (production
costs). The manufacturing firms incur the costs to make profit which is the result of
the difference between total revenue (the money collected form sell of goods and
services) and total cost (total money flowing out for the acquisition of resources).

In this section we shall consider a manufacturer who produces Q units of a product

by incurring a unit variable cost of v and fixed costs of Fc and sells the product at
price of P per unit.

A. Linear cost Functions

Organizations are concerned with costs because they reflect money flowing out of the
organization. These out flows usually pay for salaries, raw materials, suppliers, rent,
heat, utilities, and so forth. Accountants and economists often define total cost in
terms of two components: total variable cost and total fixed cost.
Fixed costs are costs that have to be met no matter how much or how little of the
commodity are produced; that is they do not depend on the level of production.
Examples of fixed costs are rents, interest on loans and bonds and management
salaries.

20
Variable costs are costs that depend on the level of production (that is on the
amount of commodity produced); material costs and labor costs are examples of
variable costs.

These two components must be added to determine total cost.

Total Costs = variable Costs + Fixed Costs- - - - - - - - - ---------- (1.10)

Linear cost functions are very often realistic although they ignore the possibility of
economies or diseconomies of scale. That is, linear cost functions imply constant
returns to scale. Constant returns to scale imply that regardless of the number of
units produced, the variable cost for each unit is the same. This assumption ignores
the possibility that the elements of the production process, laborers or machines, may
become more efferent as the number of units produced increases or that buying raw
materials in large quantities may result in quantity discounts which in turn may
lower the variable cost per unit produced.

Consider the case when the variable cost per unit of commodity is constant. In this
case the total variable costs are proportional to the amount of commodity produced. If
v denotes the variable cost per unit, then the total variable costs of producing Q units
of commodity is VQ. If fixed costs are Fc, then the total cost, C (Q), of producing Q
units is given by

Equation (1.12) is an example of a linear cost model. The graph of Eq. (1.12) is a
straight line whose slope represents the variable cost per unit and whose y intercept
gives the fixed costs.

Graphically:
Fig 1.4: C(Q)
Graph Total
of = variable
($, Br) + Fixed C (Q) = VQ + FC
Costs
Linear cost cost costs - - - - - - - - - - - (1.11) TVC = VQ
Function
C (Q) = VQ FC+ FC - - - - - - - - - (1.12) FC

Q
(Units)

21
Example 1:

The variable cost of processing 1kg of coffee beans is $ 0.50 and the fixed costs per
day are $ 300.
a. Give the linear cost equation.
b. Draw its graph.
c. Find the cost of processing 100 kg of coffee beans in one day.

Solution

a) If C(Q) represents the cost in (in dollars) of processing Q kg of coffee beans per
day, then according to the linear function model we have

C (Q) = VQ + FC

Where v is variable cost per unit and Fc is fixed costs per day
V = $0.5 per unit and FC = $300.
Therefore TC = 0.5Q + 300

b) To sketch the graph of C (Q) = 0.5Q + 300, let us first find two points on it.

Letting Q = 0, we have TC = 300; letting Q =200 we have TC = 0.5 (200) + 300 = 400.
Thus two points satisfying cost equation, TC = 0.5Q + 300 are (0, 300) and (200, 400).
Plotting these two points and joining them by a straight line, we obtain the graph
shown in Fig 1.5 Note that the relevant portion of the graph lies totally in the first
quadrant because x and y are both nonnegative quantities.

C (Q) Fig 1.5: graph of TC = 0.5Q + 300.

500

400
(200, 400)
300(0, 300)

22
 200

200 400 Q

c) Substituting Q = 1000 in the equation C (Q) = 0.5Q + 300 we get

TC = 0.5 (100) + 300
TC = 800.

Thus the cost of processing 1000 kgs of coffee beans per day will be $ 800.

Example 2:

A firm which produces a single product is interested in determining the function that
expresses annual total cost, TC; as the function of units produced Q. Accountants
indicate the fixed expenditures each year are $ 50000. They also have estimated that
raw materials costs for each unit produced are $ 5-50 and labor costs per unit are
$1.50 in the assembly department $ 0.75 in the finishing room, and $1.25 in the
packaging and shipping department.

a) Develop total cost function

b) Draw the graph

Solution

The total cost function will have the form

Y = TC = C (Q) = total variable cost (TVC) + total fixed costs (FC)

Total variable costs consist of the two components: raw material costs and labor costs.
Labor costs are determined by summing the respective labor costs for the three
departments. Then

TC = total raw material cost + total labor cost + total fixed cost

TC= Total RM cost + Labor cost (Assembly dept) + labor cost (finishing room) + labor
cost (shipping dep’t) + total fixed cost

TC = 5.5Q + (1.5 Q + 0.75Q + 1.25Q) + 50,000

23
TC = 5.5Q + (1.5Q +0.75Q + 1.25Q) + 50,000
TC = 9Q + 50,000

The 9 represents the combined variable cost per unit produced of $ 9.00.

TC ($000)
Fig 1:6:
Graph of
TC= 9Q+ 50,000 TC = 9Q +50,000
100

50 FC = 50,000

50 100 Q (units)

B. Linear Revenue Functions

The money which flows in to an organization from either selling products or providing
services is often referred to as revenue. The most fundamental way of computing total
revenue from selling a product (or service) is

Total revenue = (price) (quantity sold)……........... (1_13)

An assumption in this relationship is that the selling price, p is the same for all units
sold Q.
If a firm sells a product, where Q equals the number of units sold of a product and P
equals the price of a product Q, then total revenue function is:

Fig 1.7 linear Revenue function

TR
($ or Br.) TR= (P) (Q)

Q (units)

24
TR= R (Q) = (price) (quantity sold)
TR= R (Q) = PQ

Example:

A firm sells a single product for $ 65 per unit.

a. Construct the revenue function in terms of quantity sold, Q.
b. Plot the graph.
c. What is the total revenue of selling 200 units of out put?

Solution

a. If the selling price equals $ 65 per unit, total revenue is computed by using the
function

R (Q) = P Q
R (Q) = 65Q

b. To plot the graph of R (Q) = 65Q; let Q = 0 then R (Q) = 0 (0, 0) is the point on
line Y = 65x. And letting Q = 20 we get R (Q) =1300. This means (20, 1300) is
also on the line y = 65x. Therefore, show these points on Q plane and connect
them by a straight line (see fig 1.8).

Fig 1:8 linear revenue function of R (Q) =65Q.

R (Q)
($, Br)
R (Q) = 65Q

1300 (200, 1300)

25
 (0, 0)

100 200 300 Q (units)

C. Linear profit functions

Profit for an organization is the difference between total revenue and total cost.
Stated in equation form,
Profit = total revenue – total cost
P (Q) = R (Q) – C (Q)

When total revenue exceeds total cost, profit is positive. In such cases the profit may
be referred to as a net gain , or net profit . When total cost exceeds total revenue
profit is negative and it may be called a net loss or deficit .

When both total revenue and total cost are linear functions of the same variable, the
profit function is also a linear function of the same variables.

That is if Total Revenue = R (Q) and Total cost = C (Q) profit is defined as

P (Q) = R (Q) – TC…………………… (1_14)

Example 1:

A firm sells a single product at $65 per unit. Variable costs per unit are $20 for
materials and $27.50 for labor. Annual fixed costs are $ 100,000.

a. Construct revenue cost and profit functions in terms of quantities of product

produced and sold.
b. Show graphically the equations.

Solution

26
 a) If the product sells for $65 per unit, total revenue is computed by using the
function
R (Q) = 65Q

Similarly, total annual cost is made up of material costs, labor costs and fixed
costs:
C (Q) = 20Q + 27.5 Q + 100,000

C (Q) = 47.5Q + 100,000

Thus the profit function is computed as

P (Q) = R (Q) – TC
P (Q) = 65Q – (47.5Q + 100,000)
P (Q) = 17.5 Q – 100,000

b) First plot the graph of total cost, then that of total revenue and finally total
profit

TC = 47.5Q + 100,000
Let Q = 0, then TC = 100000
Let Q= 2000, the TC = 195000
Then the cost curve TC = 47.5Q + 100,000 is a straight line passing through (0,
100000) and (2000, 195000).

R (Q) = 65Q

Let Q = 0, then R (Q) = 0

Let Q = 2000, then R (Q) = 130000

Then the revenue curve R (Q) = 65Q is a straight line passing through (0, 0) and
(2000, 13000)

P (Q) = 17.5Q – 100,000

Let Q = 0, then P (Q) = -100,000

Let Q = 5714, then P (Q) = 0
Then the profit curve P (Q) = 17.5Q – 100,000 is a straight line passing through (0,
-100000) and (5714, 0).

There fore graphically,

R (Q) = 65Q
C (Q)

27
R (Q) TC = 47.5Q + 100000
P (Q)
($ 000)

(2,195) P (Q) = 17.5Q-100,000

(0, 100) (2, 130)
100 FC = 100,000

(0, 0) (5.714, 0)

2 5.714 Q (000, units)

-100 (0, -100)

Fig 1.9: linear cost, revenue, and profit functions

D. Break even Models

In this section we will discuss break even models, a set of planning tools which can
be, and has been, very useful in managing organizations. One significant indication of
the performance of the companies is reflected by the so called “bottom line” of the
income statement for the firm that is how much profit is earned! Break even analysis
focuses upon the profitability of a firm. Of specific concern in break-even analysis is
identifying the level of operation or level of output that would result in a zero profit.
This level of operation or output is called the break-even point. The break-even point
is a useful reference point in the sense that it represents the level of operation at
which total revenue equals total cost. Any changes from this level of operation will
result in either a profit or a loss.
Break-even analysis is valuable particularly as a planning tool when firms are
contemplating expansions such as offering new products or service. Similarly, it is
useful in evaluating the pros and cons of beginning a new business venture. In each
instance the analysis allows for a projection of profitability.

28
 (a) Assumptions

In this discussion we will focus upon situations in which both the total cost function
and the total revenue function are linear. The use of a linear total cost function
implies that variable costs per unit either are constant or can be assumed to be
constant. The linear cost function assumes that total variable costs depend upon the
level of operation or output. It is also assumed that the fixed-cost portion of the cost
function is constant over the level of output being considered.
The linear total revenue function assumes that the selling price per unit is constant.
Where the selling price is not constant, average price is sometimes chosen for
purposes of conducting the analysis.
Another assumption is that price per unit is greater than variable cost per unit.
Think about that for a moment. If price per unit is less than variable cost per unit, a
firm will lose money on every unit produced and sold. A break-even condition could
never exist.

(b) Break-Even Analysis

In break-even analysis the primary objective is to determine the break-even point.

The break-even point may be expressed in terms of (1) volume of out put (or level of
activity), (2) total dollar sales or possibly (3) percentage of production capacity. For
example, it might be stated that a firm will break even at 100,000 units of output,
when total sales equal $ 2.5 million or when the firm is operating at 60 percent of its
plant capacity. We will focus primarily on the first of these three ways, although on
occasion expressing the break-even point in an alternative form is desirable.

The methods of performing break-even analysis are rather straight-forward, and

there are alternative ways of determining the break-even point. The usual approach
is as follows:

1. Formulate total cost as a function of Q, the level of output.

2. Formulate total revenue as a function of Q.
3. Set C (Q) equal to R (Q) and solve for Q. The resulting value of Q
is the break-even level of output and might be denoted by Qe.

An alternative to step 3 is to construct the profit function P (Q) = R(Q) – C(Q), set
P(Q) equal to zero, and solve for Qe.

Consider a manufacturer who produces Q units of a product and sells the product at a
price of P per unit.
The symbols to be used are:

C (Q) = Total cost of producing and selling Q units

29
Q = number of units produced and sold
v = variable cost per unit produced, assumed to be constant
Fc = fixed cost a constant
P = selling price per unit, assumed to constant
R (Q) = total revenue received, which is the same as the dollar/birr volume
of sales

Total cost function is given by C (Q) = vQ + Fc - - - - - - - - (1) and

Revenue = R (Q) = PQ - - - - (2)

If the manufacturer is just to break-even on operations, neither incurring a loss nor

earning profit, revenue (2) must equal cost (1). That is at break-even:

C (Q) = R (Q)
Production level at break even point is known as breakeven quantity and is
denoted by Qe.
C (Q) = R (Q)

VQe + Fc = PQe

PQe – vQe = Fc

FC
Qe (p-v) = Fc Qe = ………………………………
p −v
(1_15)

Example 1

A group of engineers is interested in forming a company to produce smoke detectors.

They have developed a design and estimate that variable costs per unit, including
materials, labor, and marketing costs, are $22.50. Fixed costs associated with the
formation, operation, and management of the company and the purchase of
equipment and machinery total $250,000. They estimate that the selling price will be
$30 per detector.

(a) Determine the number of smoke detectors which must be sold in order for
the firm to break even on the venture.
(b) Preliminary marketing data indicate that the firm can expect to
sell approximately 30,000 smoke detectors over the life of the project if the
detectors are sold for $30 per unit. Determine expected profits at this level
of output.

Solution

30
(a) The total revenue function is represented by the equations

R (Q) = 30Q

The total cost function is represented by the equation

C (Q) = 22.50Q + 250,000

The break-even condition occurs when total revenue equals total cost, or when
R (Q) =C (Q)

For this problem the break-even point is computed as

30Qe = 22.50Qe + 250,000

7.50Qe = 250,000
Qe = 33,333.33 units

The alternative approach is to first write the profit function and set it equal to 0
as follows:

P (Q) = R (Q) – C (Q)

= 30 – (22.50Q + 250,000)
= 7.50Q – 250,000

Setting the profit function P (Q) equal to 0, we have

7.50Qe– 25,000 =0
7.50Qe = 250,000
Qe = 33,333.33 units

This is the same result, and our conclusion is that given the assumed cost and
price parameters (values), the firm must sell 33,333.33 units in order to break
even.

Check point
Verify that total revenue and total cost both equal to $1000000
(taking rounding into account) at the break even point.

(b) With sales projected at 30,000 smoke detectors,

31
 P (30,000) = 7.5(30,000) – 25,000
= 225,000 – 250,000 = -25,000

This suggests that if all estimates hold true-price, cost and demand- the firm can
expect to lose $25,000 on the venture.

Example 2:

A manufacturer of records has fixed cost of $10,000 and variable cost per record made
is $5. Selling price per unit is $10.

b) Write the revenue and cost equations

c) At what number of units will break even occur?
d) At what sales volume (revenue) will break-even occur?

Solution

a. The equation are:

Revenue = R (Q) = PQ = 10Q

Costs = C (Q) = VQ + F = 5Q + 10,000

b. We can find the break even quantity Qe, by noting that Fc = 10000, P = 10; v =
5 and substituting these in to (Eq.1_15) to obtain:

10 ,000
Qe = = 2000 units
10 − 5

Alternatively, we can equate the revenue and cost equations in the answer to part
(a) obtaining:

10Qe = 5Qe + 10,000

5Qe = 10,000
10 ,000
Qe = = 2000 units
5

c. At break even 2000 units would be produced and sold at $ 10 each so the
break-even sales volume would be:
Re = (P) (Qe) = (10) (2000) = $ 20,000

32
 (c) Graphical Approaches of break even point (Break even
chart )

In Fig 2.9c the two functions are graphed on the same set of axes. The point where
the two functions intersect represents the one level of output where total revenue and
total cost are equal. This is the break-even point. For all points to the left of the
break-even point the cost function C (Q) has a value greater than the revenue
function R (Q). In this region the vertical distance separating the two functions
represents the loss which would occur at a given level of output. To the right of x =
33.333, R (Q) is higher than C (Q), or R (Q) > C (Q). For levels of output greater than
x = 33.333 the vertical distance separating R(c) and C (Q) represents the profit at a
given level of output.
R (Q) C (Q)

Profit
$1000000 $1000000 $1000000 (33.333, 1000000)

750,000 750000 750000 C (Q) = 22.5Q +250,000

500,000 500000 500000

TC = 22.50x + 250,000 R (Q) = 30Q
250,000 (Rx) =30Q 250000 250000 loss

Qe
10 20 30 40 50 10 20 30 40 50 10 20 30 40 50
Units sold, in 1000’s Units produced; in 1000s units produced and sold (‘000s)

(a) Total revenue function (b) Total cost function

(c)

Fig. 2.9: Break even chart of manufacturing firms

Figure 2.10 illustrates the profit function P for this example. The break-even point is
identified by the x coordinate of the x intercept. Note that to the left of the break-even
point the profit function is below the x axis, indicating a negative profit, or loss. To
the right, P (Q) is above the x axis, indicating a positive profit.

33

P (Q)
 $400,000

300,000

200,000 Break-even point, Qe

100,000 P (Q) = 7.50x – 250,000

Profit region
-100,000 5 10 15 20 25 30 35 40 45 50

-200,000 loss region units produce and sold in 1000’s

-300,000

-400,000

Fig.2.10: Profit function

CHECK POINT
Discuss any changes in Fig2.10 and the break-even point if
(a) The price per unit increases (decreases)
(b) The fixed cost increases (decreases), and
(c) The variable cost per unit increase (decreases).

An alternative way of viewing break-even analysis is in terms of profit contribution.

As long as the price per unit P exceeds the variable cost per unit V, the sale of each
unit results in a contribution to profit. The difference between P and V is called the
profit margin. Or, stated in equation form,

Profit margin = P – V P > V…… (1_16)

The profit margin generated from the sale of units must first be allocated to recover
any fixed costs which exist. At lower levels of output, the total profit contribution
(profit margin for all units sold) is typically less than fixed costs, meaning that total

34
profit is negative (see Fig. 2.10). Only when total profit contribution exceeds fixed cost
will a positive profit exist. Because of this orientation that the profit margin per unit
contributes first to recovering fixed costs after which it contributes to profit margin is
often called the contribution to fixed cost and profit.

With this perspective in mind, the computation of the break-even point can be
thought of as determining the number of units to produce and sell in order to recover
the fixed costs. The calculation of the break-even point is thus

fixed cos t
Break even level of output = contributi ontofixed cos tan dprofit …………. (1_17)

Fc
Qe= p −v

Example:

For a watchmaker the cost of labor and materials per watch is $15 and the fixed costs
are $2000 per day. If each watch sells for $ 20 how many watches should be produced
and sold each day to guarantee that the business breaks even?
Show graphically the break even point.

Solution

Let Q watches be produced and sold each day. The total cost of producing Q watches
is
C (Q) = 15Q + 2000

Since each watch sells for $20, the revenue obtained by selling Q watches is

R (Q) = 20 Q

The break even point is obtained by

FC
Qe =
P −V

2000
Qe = = 400 watches
20 − 5

Thus 400 watches must be produced and sold each day to guarantee no profit or loss.
Figure 1.11 illustrates the graphical interpretation of the break-even point. When
Q<400 the cost C (Q) exceeds the revenue R (Q) and there is a loss. When Q > 400,
the revenue R (Q) exceeds the cost C (Q) so that a profit results.

35
Note that graphically, the break-even point corresponds to the intersection of two
straight lines. One of the lines has the equation C (Q) = 15Q + 2000, corresponding to
the cost of production, and the other line has the equation
R (Q) =20Q, corresponding to the revenue.

R (Q) Fig 1-11

C (Q)
8000 C (Q) = 15Q + 2000
Profit
6000
Break-even point
4000

2000 R (Q) = 20Q

Loss

200 400 600 Q (units)

2. Merchandising (retail) businesses

Retailers are businesses engaged in buying and reselling of goods and services. These
firms purchase products and resell them at a price, that is, presumably above the
cost.

a) Cost functions of Retailers

Suppose that an item that cost (purchased at) $ 130 is priced to sell at $200. The
mark up the difference between selling price (retail price) and purchasing cost is $ 70.
That is

Mark up = purchasing – retail (selling)……………… (1_18)

Costs prices

Purchasing Cost = $130

Retail price = $200

Mark up= Retail price –purchasing cost

= 200 – 130
= $70

36
From manager’s view point the dollar (Birr) amounts of mark up on numerous
individual items, which will vary widely, are not very useful in planning and
controlling operations. What is useful is the overall mark up percentage on all items.
For comparability in different items, Markup is viewed in one of two ways:
1 As a function of the cost, and
2 As a function of retail price

In the current example the mark up as the function of cost is

markup 70
= = 0.54 or 54 %
csot 130

On the other hand, in financial statements accountants use the concept of margin
which is the markup percentage on retail price. Margin is the percentage of mark
up as of retail price

In our example this is

markup 70
mangin = = = 0.35 or 35 %
Re tailprice 200
This means that 35 percent of the retail price of $200 is margin and the other 65
percent of $200 which 0.65(200) = $130 is the purchasing cost (cost of goods sold).
We now suppose that the company in our illustration uses a margin of 35 percent on
all items it purchases, so that if the firm sells $x worth of merchandise (goods and
services), 35 percept of this amount is margin and 65 percent is cost. Thus,

Purchasing cost (cost of goods sold) = 0.65 x - - - - - - (8)

Next, the company incurs selling expenses, which it budgets at 10 percent of the
volume of sales (x).
Hence, selling expense (additional variable costs) = 0.1x - - - - - (9).
Finally the company budgets fixed expense at $12,000, so that Fixed expense (cost)
=F = $12,000 - - - - - (10)

Total variable cost, therefore, is the sum of purchasing cost which is the significant
cost of merchandising firms and additional variable costs which is variable costs
incurred by retailers except purchasing cost. That is

Total variable costs = purchasing +additional…………….. (1_19)

Costs variable costs

In our example, if we let y be total cost, the sum (8) and (9) we have

37
 TVC = 0.65x + 0.1x = 0.75x

TC=Y = TVC + FC

Y = 0.75x + 12,000 - - - - - - - - - - - - - (12)

Thus for example at a sales volume (total revenue) of $60,000 cost will be

Y= 0.75(60,000) + 12,000

Y = $ 57,000.
And profit before taxes will be:

P = 60,000 – 57,000

= $3000

Example:
Based on the above example, compute profit if sales are $40000.

Solution
Cost would be Y = 0.75(40,000) + 12,000
= $ 42,000

So a loss of $ 2000 (i.e. 42,000 – 40000) would occur.

b) Break even point of merchandisers

If the relationship between cost and sales is written in the general slope intercept
form

Y = mx + b,
Where, Y = total cost of retailers
m = unit variable cost per a dollar or Birr sale
X = dollars or Birrs sales volume (total revenue)
b = fixed cost

At break-even point

Total cost = total revenue = total sales volume

Y = X = Xe - - - - - - - - - - - - - - - - - - - - - - - -(13)

38
 Where Xe – sales volume (revenue) at break even point

So that by substitution

Xe = mxe + b

Xe (1 – m) = b

b
xe = . ………………………………. (1_20)
1−m

Hence the break even level occurs when sales are equal to

f i x ecdo tss
………. (1-21)
v a ira b cl eo tsp e r d o \lbl ai rrr s a l e s

Example:

Suppose that in making a budget for next year’s operations, top management has set
a sales goal of $200,000. Margin is to be 45 percent of retail (so purchasing cost is 55
percent of retail) and other variable cost is estimated at $ 0.05 per dollar of sales, so
that variable cost, the sum of purchasing cost and additional variable cost is 0.55 +
0.05 = 0.60 per dollar of sales. Fixed cost is projected at $ 56,000.
a. construct the cost function in terms of sales volume
b. Determine break even point

Solution

a. Purchasing cost = 1 – margin - - - - - -- - -(1_22)

Purchasing cost = 1 – 0.45

= 0.55 per dollar sales
Let x be sales Volume, then, purchasing cost = 0.55x and additional variable
cost =0.05x

Total Variable costs = 0.55x + 0.05x

TVC = 0.60x

FC = 56,000

39
∴ Total cost Y = TVC + FC

Y = 0.60x + 56,000

c) Break-even sales volume, xe

b
Xe
1 −m

56 ,000
xe = $140 ,000
1 − 0.6

This shows that the company will make a profit if its sales exceed $140000.

Example:

Margin is to be 33 percent of retail and other variable cost is estimated at $0.13 per
dollar of sales. Fixed cost is estimated at $ 4000.

a. What is break even point?

b. Estimate profits if sales are $50,000.

Solution

Margin = 0.33
Purchasing cost = 1 – margin
= 1 – 0.33
= $ 0.67 per dollar sales
Let x be sales volume and y be total cost
Purchasing costs = 0.67x
Additional variable costs = 0.13x
Total variable cost = purchasing costs + additional variable costs
TVC = 0.67x + 0.13x =0.80x
m = 0.8
Y = TVC + FC
Y = 0.8x + 400
b 4000
xe = = = $6000
1 − m 1− 0 −8

40
To make profit the firm’s sales volume should exceed $ 6000.

c) Break even chart

A break even chart can be constructed by plotting

y = mx +b
and the line where cost equals sales, y = x. The point of intersection of these two lines
establishes the break even sales.

Total fig 1.12: break even chart of

Cost, y merchandising firms
($)
y=x

Net gain region y = mx + b

b Break even point

Net loss region

Xe sales ($) (x)

Example

The break even point of the cost function y = 0.6x + 56000 is shown in the following
figure 1.13. The break-even point is seen to be $140000. The separation of the lines to
the right of break even indicates profit; to the left, loss.

Total cost ($000)

200 y=x y = 0.6x + 56.000

Net profit region

100 y = 0.6x + 56,000

Net loss region

100 Xe 200 sales ($ 000)

Fig 1:13: Break-even chart of merchandising firms

41
In passing we should note that the break even interpretations just discussed rest up
on the assumption that total cost can be separated in to components, one fixed and
the other varying directly in proportion to sales. These assumptions often are
reasonably valid for a restricted range of sales. It is not realistic, however, to assume
fixed cost as constant over all ranges of sales.

Example:

A company expects fixed cost of $ 25000. It plans to work on a margin of 46 percent of

retail, and to incur other variable costs of $ 0.06 per dollar of sales.

a. Find the equation relating total cost to sales

b. Find the break even point
c. Make the break-even chart
d. What will net profit before taxes be if sales are $100000?

Solution

a. Let x = be sales volume

Y = be total cost

FC = b = $ 25000
Margin = 0.46
Purchasing cost =1 – 0.46
= $ 0.54 per dollar sales

Additional variable cost = $ 0.06 per dollar sales

TVC = 0.54 + 0.06 = $ 0.60x

Total cost = TVC + FC
Y = 0.06x + 25,000

b
b. xe =
1−m

25 ,000 25 ,000
xe = = = $62 ,500
1 − 0.6 0 .4

42
 Thus, in order to make profit the firm must make a sales volume greater than $
62500.
c. Break-even chart

Y=x
Total cost Y
($ 000) Net gain area

Y = 0.6x + 25,000
25
Net loss region break even point

Xe = 62.5 sales ($000) x

Fig 1.14 break even chart of Y = 0.6x + 25000

d. profit = sales volume – cost
Profit = $ 100,000 – (0.6(100,000) + 25,000)
= $ 100,000 - $85,000
= $ 15,000

3. Market equilibrium Analysis

a. Linear Demand Functions

A demand function is a mathematical relationship expressing the way in which the

quantity demanded of an item varies with the price charged for it. The relation
between these two variables_quantity demanded and price per unit_is usually
inverse. For most products a decrease in price results in an increase in demand. A
relationship that specifies the amounts of a particular commodity that consumers are
willing to buy at various price levels is called the law of demand. The simplest law is
a linear relation of the type P = mQ + b where p is the price per unit of the
commodity and m and b are constants. The graph of a demand law is called the
demand curve. Observe that as given p is expressed in terms of Q. This way of
writing the demand law gives the price level at which the quantity Q can be sold.

It is a well organized fact that if the price per unit of a commodity is increased, the
demand for that commodity will decrease because fewer purchasers can afford it,
where as if the price per unit is decreased, that is, the commodity is made cheaper the

43
 demand will increase. In other words, slope m of the demand relation of equation p =
mQ + b is negative.

Figure 1-15: Linear demand and supply curves

P P
($ or Br.) ($ or Br.)

P1

0 Q0 Q (units) 0 Q (units)

( a) Linear demand curve (b) linear supply curve

It is conventional in economics to plot price on the vertical and demand on the

horizontal. Thus the graph of the equation P = mQ +b slopes down ward to the right
as shown in part (a) of Figure 1-15. Since the price p per unit and the quantity Q
demanded are both non negative numbers the graph has been drawn only in the first
quadrant.

b. Linear supply Functions

A supply function relates market price to the quantities that suppliers are willing to
produce and sell. The implication of supply functions is that what is brought to the
market depends up on the price people are willing to pay. As opposed to the inverse
nature of price and demand in demand functions, the quantity which suppliers are
willing to provide usually varies directly with the market price. All other things being
equal, the higher the market price the more a supplier would like to produce and sell;
and the lower the price people are willing to pay the less the incentive to produce and
sell. A relation specifying the amount of any commodity that manufacturers (or
sellers) can make available in the market at varies prices is called the law of supply.
The graph of the law of supply is known as the supply curve. A typical linear supply
curve is shown in part (b) of figure 1-15. The price P 1 corresponds to the price below
which suppliers will not supply the commodity.

Example

A dealer can sell 20 electric shavers at $25 per shaver but he can sell 30 shavers if he
charges $20 per shaver. Determine the demand equation, assuming it is linear.

44
Solution:
Taking the quantity Q demanded as the x coordinate and the price P per unit as the y
coordinate; the two points on the demand curve had coordinates.

Q = 20, P = 25 and Q = 30, P = 20

Thus, the points are (20, 25) and (30, 20). Since the demand equation is linear, it is
given by the equation of the straight line passing through the two points (20, 25) and
(30, 20). From the two points formula we can have

y − y1 y 2 − y1
=
x − x1 x2 − x2
Since y = p and x = Q
p − 25 20 − 25
=
Q − 20 30 − 20

(P-25) (10) = (Q – 20) (-5)

10P – 250 = -5Q + 100

p = -0.5Q + 35 which is the required demand equation.

P ($) Fig: 1-16: linear demand function

Graphically

40
(0, 35)
p = -0.50Q + 35

20

45
 (70, .0)
0 20 40 60 Q (units)

Example

At a price of $10 per unit a firm will supply 1200 shirts per month; and at $15 per
unit; the firm will supply 4200 shirts per month. Determine the supply equation
assuming it to be linear.

Solution

Taking the quantity Q supplied as x coordinate and the price p per unit as the y
coordinate, the two points on the supply curve have the coordinates

Q = 1200 P= 10 and Q = 4200 P=15.

Thus the points are (1200, 10) and (4200, 15). Since the supply equation is linear, it is
given by the equation of the straight line passing through the two points (1200, 10)
and (4200, 15). Form the two point’s formula the equation is

y − y1 y 2 − y 2
= , y = pandx = Q
x − x1 x 2 − x1

p −10 15 −10
=
Q −1200 4200 −1200

P −10 5
=
Q −1200 3000

3000(P – 10) = 5 (Q – 1200)

3000p – 30,000 = 5Q – 6000

3000P = 5Q + 24000

 1 
P = Q + 8 This is the required supply equation.
 600 

Graphically: P ($)

46
 1
p= Q +8
600

0 Q (units)
Fig 1-17: Supply function of ( 600)Q + 8
P= 1

c. Market Equilibrium

If the price of a certain commodity is too high consumers will not purchase it, where
as if the price is too low, suppliers will not sell it. In a competitive market, when the
price per unit depends only on the quantity demanded and the supply available, there
is always a tendency for the price to adjust itself so that the quantity demanded by
purchaser’s matches the quantity which suppliers are willing to supply. Market
equilibrium is said to occur at a price when the quantity demanded is equal to the
quantity supplied. This corresponds to the point of intersection of the demand and
supply curves.

See Figure 1-14.

Fig 1:18 market equilibrium

P ($)

Supply

Market equilibrium
(Qo, Po)

Demand

47
 0 Q(units)

Algebraically, the market equilibrium price Po and quantity Qo are determined by

solving the demand and supply equations simultaneously for p and Q. (Note that
equilibrium prices Po and quantity Qo meaning full only if they are not negative.

Example
Determine the equilibrium price and quantity for the following demand and supply
laws.

D: P = 25 – 2Q - - - - - - - - - (a)
S: P = 3Q + 5 - - - - - - - - - - (b)

Solution:
Equating the two values of p in equation (a) and (b), we have

3Q + 5 = 25 – 2Q

The solution is readily seen to be Qo = 4. Substituting Qo = 4 in Equation (a), we get

P = 25 – 2(4) = $17.

Thus the equilibrium price is $17 and quantity is 4 units. The graphs of the supply
and demand curves are shown in Figure 1-19.

Fig 1-19 Market equilibrium

P ($)
30 supply
P = 3Q + 5
(4, 17)
20

10 P = 25 – 2Q
Demand
4 8 Q (units)

Example:
If the demand and supply equations are respectively,

D: 3P + 5Q = 22 - - - - - - - - - - (a)
S: 2P – 3Q = 20 - - - - - - - - - (b)

48
Determine the values of Q and P at market equilibrium.
Solution
Equations (a) and (b) form a system of linear equation for the two variables Q and P,
rewrite in slope intercept form and equate the two equations. Then we get
22 3P 2 P 2
− = −
5 5 3 3

Po = $4

Qo = 2 units
∴The equilibrium price is $4 and quantity is 2 units.

P ($) Fig 1-20 Market equilibrium

Graphically
Supply

P0 = 4
Equilibrium point (2, 4).

Demand
Qo = 2 Q (units)
4. Other Applications of Linear Functions
In this section of the material we will see, by example, other applications of linear
functions.
Example1: Straight Line Depreciation
When organizations purchase equipment, vehicles, buildings and other types of
“capital assets”, accountants usually allocate the cost of the time over the period the
item is used. For a truck costing $10,000 and having a use full life of 5 years,
accountants might allocate $ 2000 a year as a cost of owning the truck. The cost
allocated to any given period is called depreciation. Accountants also keep records of
each major asset and it current or “book Value”. Depreciation can also be thought of
as the amount by which the book value of an asset has decreased.
Although there are a variety of depreciation methods, one of the simplest is straight-
line depreciation. Under this method the rate of depreciation is constant. This implies
that the book value declines as a linear function over time. If V equals the book value
(in dollars) of an asset and t equals time (in years) measured from the purchase date
for the previously mentioned truck.

V = f (t) = purchase cost – depreciation

=10,000–2,000t
( int ialvalue − scrapvalue )
Note: Rate of Depreciation (per year) = Lifetimein years
……. (1_22)

49
The graph of this function appears in Fig 1-21.

V Fig: 1-21: depreciation

($)
Book value in dollars

14

12

10

8 V = f (t) = 10,000 – 2000 t

1 2 3 5 6 t (years)
Years since purchase

Example: 2

A firm buys Q piece of machinery for $ 150,000. It expects that the life time of the
machinery will be 12 years with zero scrap value. Find the amount or depreciation
per year and a formula for the depreciated value after t years.

Solution
Initialpur cha sec ost
Depreciation per Year = lifetimein years

150 ,00
= = $12 ,500
12

50
 i  D nNo  i f e t pi a r l e c
Value after t years =
 −  
v  p y  a e l r a u y r e e s a r
= 150,000 – 12,500t dollars

Value Fig: 1-22: Depreciation

($)

150
(‘000)

100 V = f (t) = 150,000 – 12500t

50

5 10 12 t (in years)

51
Trade –off

Planners frequently have to decide among different ways of allocating limited

resources. For example, a manufacturer may have to allocate plant capacity between
two different products. If the relation between the amounts of the two products is
linear, the slope of its graph can be interpreted as giving the trade-off of one product
against the other consider the following example.

Example 3: (Transit Decision)

A city government has a budget of $200 million for capital expenditure on

transportation, and it intends to use it to construct additional subways or highways.
It costs $2.5 million per mile to build highways and $4 million per mile for subways.
Find the relationship between the number of miles of highway and of subway that
can be built to completely use the available budget. Interpret the slope of the linear
relation that is obtained.

Solution

Suppose X miles of high way and Y miles of subway are built. The cost of constructing
x miles of highway at $2.5 million per mile is 2.5x million dollars and the cost of
building Y miles of subway at $4 million per mile is 4y million dollars. Since the total
cost has to equal the budget allocated for the purpose.

2.5x + 4y = 200.

This equation provides the required relation between the numbers of miles that can
be constructed within the budget.

Solving the given equation for y we have

−5
y= x + 50
8

The slope of this line is − 5 8 , which expresses the fact that every additional mile of

high way construction will be at the cost of − 5 8 mile of subway construction. Solving
the original equation for X in terms of y, we get

−8
x= y + 80
5

52
 8
Thus each additional mile of subway construction is traded off a y against miles of
5
high way construction.

Exercises

1. A firm sells a product for $60 per unit. Raw material costs are $12.50
per unit, labor costs are $17.50 per unit, and annual fixed costs are
$120,000.

a. Determine the profit function P (Q) where Q equals the number of

units sold.
b. How many units would have to be sold to earn an annual profit
$150,000?

2. A city has purchased a new asphalt paving machine for $120,000. The
city comptroller states that the machine will be depreciated using a
straight-line method. At the end of 8 years, the machine will be sold with
an expected salvage value of $24,000.
a. Determine the function V = f (t) which expresses the book value of
the machine V as function of its age t.
b. What is the book value expected to be when the machine is 6 years
old?
3. Since 1970 there has been a seemingly linear increase in the percentage
of the population of one European city who are alcoholics. In 1970 the
percentage was 10.5 percent. In 1976 the percentage had risen to 12.9
percent. If P equals the percentage of the population who are alcoholics
and represents time in years since 1970 (Hint, t = 0 for 1970).
a. Determine the linear growth function P = f (t).
b. Interpret the meaning of the slope.
c. If the pattern of growth continues, forecast the percentage of
alcoholics expected in 1985. What is the forecast for 1995?
4. A publisher has a fixed cost of $150,000 associated with the production
of a college mathematics book. The contribution to profit and fixed cost
from the sale of each book is $3.75.
a. Determine the number of books which must be sold in order to break
even.
b. What is the expected profit if 30,000 books are sold?

53
 5. A local university football team has added a national power to next
year’s schedule. The other team has agreed to play the game for a
guaranteed fee of $75,000 plus 25 percent of the gate receipts. Assume
ticket price are $8.

a. Determine the number of tickets which must be sold to recover the

$75,000 guarantee.
b. If college officials hope to net a profit of $180,000 from the game, how
many tickets must be sold?
c. If a sellout of 50,000 fans is assured, what ticket price would allow
the university to earn the desired profit of $180,000?
d. Again assuming sellout, what would total profit equal if the $8 price
is charged?

6. A manufacturing of cassette tapes has affixed cost of $60,000 and

variable cost it $ 4 per cassette produced. Selling price is $ 7 per
cassette.

a. Write the revenue and cost equations

b. At what number of units will break even occur?
c. At what sales (revenue) volume will break even occur

7. If fixed costs are $5000 per week variable costs are $21 per unit and the
selling price is $ 46 per units, find the break-even point.
8. A company expects fixed cost of $ 36,000 Margin is to be 52 percent of
retail and variable cost in addition to cost of goods sold (purchasing cost)
is estimated at $ 0.07 per dollar of sales.
a. write the equation relating cost and sales
b. find the break-even point
c. What will net profit before taxes be on sales of $75, 000?
d. Make break-even chart
9. If total cost Y is related to sales volume, x by the equation y = 0.47x + 29
786, find.
a. variable cost per dollar of sales
b. Fixed costs.
c. Total cost on sales of $ 72,000
d. The break-even point
e. Net profit before taxes on sales of $ 30,000

10. If variable cost per dollar of sales remains at last year’s level, $0.40, but
fixed cost this year is $36,000 compared to $ 3000 last year. How much
greater will this year’s break-even point being than last year’s?

54
11. A dealer can sell 200 units of a certain commodity per day at $30 per unit
and 250 units at $ 27 per unit. The supply equation for that commodity is
6P = Q + 48.

i. Find the demand equation for the commodity, assuming it to be

linear.
ii. Find the equilibrium price and quantity.
iii. Show graphically the market equilibrium.

11. At a price of $2400, the supply of a certain commodity is 120 units while
its demand is 560 units. If the price is raised to $2700 per unit, the
supply and demand will be 160 units and 380 units, respectively.
a. Determine the demand and supply equations, assuming them to
be linear.
b. Determine the equilibrium price and quantity.
c. Show graphically the market equilibrium

55