Chapter 1

Linear Equations and Their Interpretative Applications

Chapter objectives
This chapter basically aims at discussing the basic characteristics of linear equation and its
interpretive application. After completing this unit you will be able to:
 Understand basic concepts of linear equations and functions.
 Develop acquaintance of graphic representation of linear equations.
 Compute and formulate slope and equation of a line.
 Systematically apply the linear equation algebra and geometry in solving real world
situations.
 Develop acquaintance of developing cost, revenue and profit function of both
manufacturing and merchandise enterprises
 Conduct the break even analysis for both manufacturing and merchandising business
1.Introduction

In our everyday life, there are various types of decisions that need mathematical
supported knowledge. Managers will make many managerial decisions that need much
investigation and analyses which need the skill and knowledge of mathematics. So, this
chapter has a general purpose of familiarizing managers with the algebra and geometry of
linear equations and functions in two variables, that is, equations and functions
whose graphs in a coordinate plane are straight lines; their importance and
applications inbusiness area and management.
1.1 Definitions and Characteristics of Linear Equations
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

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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 2. –x + ½ y = 0
3. 2s – 4t = - 2 4. 2k +2 = 5n
The following are examples of equations which are not linear:
1. 2x + 3xy = 7 2. X2 + Y + 3x = 16
3. X1/2+ 2y=8 4. 2x + 3xy – 4y = 10

Linear equation involving n variables X1, X2, X3 … Xn has the general form:
a1X1 + a2X2 + a3 x3 + . . . + an xn = b . . . ……………………. (1.2)
Where a1, a2, a3 . . . an and b are real numbers and not all a1, a2, a3 . . . an equal Zero.
And this is called standard form of a line

Each of the following isan exampleof 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
Some of the peculiar characteristics of linear equation are listed below:
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.
Linear Functions
Linear functions are the relationship between dependent and independent variables.
Functional relationship refers to the case where there is one and only one corresponding
value of the dependent variable for each value of the independent variable.
The relationship between x and y as expressed by
y = 0.25x + 20,000.

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Is called a functional relationship since for each value of x (independent variable), there is a
single corresponding value for y (dependent). Thus if we write y as expression involving x
and constants x is called the independent variable, then the value of y depends upon what
value we may assign to x and as a result it is called the dependent variable. Therefore, a
linear function refers to a linear equation, which does have one corresponding value of
dependent variable for each value of the independent variable.
So generally the linear function can be expressed as:
Y = m x + b. And this is called slope intercept form of a line.
y- Is the dependent variable
x- Is the independent variable
b- Is the Y intercept (the value of y when the value of x is 0)
m- Is the slope which is computed by dividing change in the dependent variable over change
in the dependent variable

Dependent and Independent variable

As we discussed in the previous topics, 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. Which means the value of y depends upon what value we assign to x. in
other way of saying the movement of y depends on the movement of x, and for that reason 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, XYZ 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.
The dependent variable in this case is total production cost because it is increasing with
number of Shoes produced whereas the independent variable in this example is the
number of shoes produced.

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Slope
The other important term in linear function is Slope. 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. The slope of a line is quantified by a real number and can be computed by
dividing the change in the dependent variable(Y) by the change on the independent variable
(X). 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.
Y intercepts and X intercept
Y – Intercept is the value of y when x = 0. Whereas
X- Intercept is the value of x when y = 0
Determine the slope, x intercept and y intercept of the following linear equations.
a. 5y =8x +16
Solution
To find the slope first we have to put the linear equation in y = mx+b form. To do so divide
both side of the equation by 5.

Y= + 16

Hence the slope is and

Y intercept = 8/5(0) + 16/5 = 16/5

X intercept 0= 8/5x+16/5= -8/5x= 16/5↔multiply both side by -5/8
x= -2
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}

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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.
Example:
Given the equation 4y = -2x + 16, Find any point of values which satisfies the equation.
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
y = 3/2
Thus, (5, 3/2) is one of the solution sets.
Again assume x=0 and substituting in to the equation we have
4y= -2(0) +16
=4
Thus, (0, 4) is the other points of values satisfying 4y = -2x + 16
So (4, 2), (5, 3/2) and (0, 4)……….are the solution sets of the equation.

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 members of
the solution set.
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.

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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.
Graph of Linear Equation 4y = -2x + 16
Y
4y = -2x + 16
(0, 4)
(8, 0)
X

Determining the Equation of a straight line.

There are three conditions from which we can drive or develop linear equation.
1. Slope and intercept.
In this case the slope and the y intercepts are known and you are required to develop the
linear equation from these two information. 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. If you are interested in stating the equation in the standard form, simply rearrange the
terms in the slope intercept equation.
Example 1
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 Equation.
Y = -5x + 15
Restated in the form of Equation, an equivalent form of this equation is
5x + y = 15
Example2
Determine the equation of the straight line which has a slope of 0.5 and a y Intercept of (0,0)
Solution
Substituting m = 0.5 and k = 0 in to Eq. gives:
Y = 0.5 x +0
Y = 0.5 X

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1. Slope and one point
The second condition is that the slope and one point, the value of x and y, are known.
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). In the last case we said that
knowing the slope and the y intercept of an equation allows you to write out the slope-
intercept form directly. In this section we talk of knowing the slope and one point-but not
the y intercept. 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. 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.
Example1
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 the Eq., 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
Example2
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) intoEquation
-30 = (0) (5) + k
-30 = k
Since we know that m = 0 and k = -30 the slope intercept equation is
y = 0x + (-30)

y = -30

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.
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We can determine the slope of the line by using the two point formula. 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 (3, 2) and (4, 4), we
substitute the coordinates in to the two-point formula, resulting in:
M= y2– y1 = 4-2 = 2
x2 - x1 4-3
Substituting m = 2 and the coordinated (3, 2) into Eq. yields:
2= 2(3) + k
2= 6+k
K=-4
Thus, the slope-intercept form of the equation is:
Y = 2x -4
The Distance between Two Points
The distance between two points is the length of a straight-line segment that joins the
points. To determine the length of a given segment in coordinate geometry, algebraic
procedures are applied to the x and y coordinates of the end points of the segment. Distance
on horizontal and vertical line segments are used in the computation of the distance.
Distance on a vertical segment (also called vertical separation) is found by computing the
positive difference of the y- coordinates of the end points of the segment. Distance on the
horizontal segment (also called horizontal separation) is found by computing the positive
difference of the x-coordinate of the end points of the segment.

Thus, given two points (x1, y1) and (x2, y2), the quantity / x2 – x1 /, is called the horizontal
separation of the two points. Further, the quantity / y2 – y1 / is the vertical separation of
the two points.
1) Vertical distance
Distance on a vertical segment is found by computing the positive difference of the y
coordinates of the end points of the segment. If x- coordinates of the points at the end of
asegment are equal the segment is vertical.
Example: (X1,Y1) and (X1,Y2) shows vertical line since the value of x is the same alongthe
line. The distance between these points would be:
Vertical distance = |Y2 - Y1|

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Example: -Find the distance between the coordinates of (6, 8) and (6, 4).

Solution:verticaldistance=|Y2-Y1|=|4-8|=|-4|(Distanceis4,sincedistanceisalways + ve

2) Horizontal distance

Distance on a horizontal segment is found by computing the positive difference of the x-

coordinates of the end points of the segment. If y coordinates of the points at the end of
asegment are equal, the segment is horizontal.
Example: (X1,Y1) and (X2,Y1) shows a horizontal line since the value of y is the samealong
the line.
Horizontal distance = | X2-X1|
Example: A City that has avenues running east and west, and streets running north to
south, dividing the city into square blocks. To get from (4th street, 3rd avenue) to (10th
street, 3rd avenue).we would walk a distance of 10-4=6 blocks
3 ) Slanting line (The distance formula)

ThedistancebetweenanytwopointscanbecalculatedbyusingthePythagorastheorem
forarightangletriangle.HerewearerequiredtorecallPythagorastheoremwhichstates
thatthesumofthesquaresofthesidesofarightangledtriangleequalsthesquareofthe slant side
(hypotenuse).
Let a and b are the sides of a right angled triangle and c is its hypotenuse, then:

a2+b2=c2

c=√a2+b2 b c

Distance of b =|Y2-Y1|

a=|X2-X1| a

Thus,thegeneralformulaforfindingthedistancebetweenanytwopointsthatareina
line segment is given by:
Distance between two points (D)= √ ((X2-X1)2+(Y2-Y1)2)

Example 1:-Find the distance between point “a” and “b” i.e. a(2, 3) and(5, 2)

D= √ ((X2-X1)2+(Y2-Y1)2) = ((5-2)2+ (2-3)2) =√10=3.162

Example 2:-Find the distance between points A (1, 2) and B (4, 6).

D=√ ((X2-X1)2-(Y2-Y1)2)= √ ((4-1)2+(6-2)2) =√ (9+16) =5

Mathematics for Finance Chapter 1 Page 9 of 22

Applications of Linear Equations
As of the very beginning, we aimed at developing our understanding on the interpretative
application of linear equations in business. Consequently, our interest and purpose in this
section is to learn how we can approximate and relate the mathematical terminology and
technique of linear equations in addressing real world business issues. In dealing, we are
going to consider four application areas of linear equations. These are the
(1) Linear cost – output relations analysis
(2) Linear revenue – output relation analysis
(3) Linear profit - output relation analysis and
(4) Break –even analysis
In this particular section, we will consider these application areas to some detail for
manufacturing and merchandising businesses.
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).
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
these costs are expenditure that the company should incur irrespective of the production
level. 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. The
movement of these costs is determined by the movement of output produced by the
organization. If the output level is high these costs are expected be high and if the output

Mathematics for Finance Chapter 1 Page 10 of 22

level is low these costs are expected be low. In another way of saying there is direct
relationship between variable cost and output level.
These two components must be added to determine total cost.

TOTAL COSTS = VARIABLE COSTS + FIXED COSTS

Assumption of linear cost function
 Constant unit variable cost – the variable cost for each unit is the same regardless
of the number of units produced (implies constant returns to scale or no economies or
diseconomies of scale). This assumption ignores the possibility that the elements of
the production process, laborers or machines, may become more efficient 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.
 All cost involved in the production of goods and services is known
 Fixed cost remains constant over a relevant range
Based on the above assumptions 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
Total cost equation
Total cost = Total variable cost + Total fixed cost
TC or C (Q) = TVC + TFC
TC or C (Q) = V Q + TFC
Where V = Is variable cost per unit – unit variable cost.
Q = Is the amount of production
TC or C(Q) = Is the total cost
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.

Mathematics for Finance Chapter 1 Page 11 of 22

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.Note that
the relevant portion of the graph lies totally in the first quadrant because x and y are both
nonnegative quantities.
C
Total Cost Line T.C= 0.5 Q + 300

Fixed Cost Line = 300

Q
c) Substituting Q = 100 in the equation C (Q) = 0.5Q + 300 we get
TC = 0.5 (100) + 300
TC = 350. Thus the cost of processing 100kgs of coffee beans per day will be $ 350.
EXAMPLE 2
If the total factory cost (y) of making X units of a product is given by y = 3x + 20, and if 50
units are made,
A) What is the variable cost (VC)?
B) What is the total cost (TC)?
C) What is the variable cost per unit (VC/unit)?
D) What is the average cost per unit (AC/ unit)?
E) What is the marginal cost of the 50th unit?
Solution
Given, total cost = y = 3x + 20
x = Units produced
x = 50 Units

Mathematics for Finance Chapter 1 Page 12 of 22

 A) Variable cost is the cost that varies with the level of production and it can be obtained
by multiplying the slope or the marginal cost with the number units produced (x).
That is, VC = m x
= 3x 50 = Birr 150
B) TC is the sum of fixed cost and variable cost. In the equation given y =3x + 20, the
term 3x represent the VC and the constant 20 is the fixed cost. Thus
TC = y = 3x+20
= 3(50) + 20 + 150 + 20
= Birr 170
C) Variable cost per unit = vc / unit = vc / x = 150 / 50 = Birr 3
D) AC is given by total cost divided by Number of units produced. Thus,
AC/ unit = TC/ x = (VC+FC)/ x = (150 + 20) / 50 = 170 / 50 = Birr 3.40
E) The slope of a linear equation is equal to the marginal cost of any given level of
production thus, MC = 3.

In alternative approach, MC is the extra (additional) cost of producing one more unit of
output. Thus, the marginal cost of producing the 50th unit is equal to the additional cost in
producing the 50th unit.
Therefore, MC= ΔTC = TC of producing 50 units – TC of producing 49 units
50 – 49
= (3 (50)+20) – ( 3 (49) +20)
50 – 49
= 170 – 167 = Birr 3
1
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)

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:

TR or R(Q)= PQ

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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 output?
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.
Total Revenue
Total Revenue Line R = 65 Q

Q
c. insert 200 in to the equation R(Q)= 65(200) = 13,000
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
Π (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
Π (Q) = R (Q) – TC
Π (Q) = P(Q)- VQ-TFC
Π (Q)= (P-V)Q-TFC
Example: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 & profit functions in terms of quantities produced and sold.
b. Show graphically the equations.

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Solution
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
Π (Q) = R (Q) – TC
Π (Q) = 65Q – (47.5Q + 100,000)
Π (Q) = 17.5 Q – 100,000
B) Graph of Revenue and Cost Functions
TC and TR
Profit Area Total Revenue Line T.R= 65 Q

Loss Area BEP Total Cost Line T.C = 47.5 Q + 100,000

Fixed Cost = 100,000

Q
D. Break Even Model
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 short term 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.

Mathematics for Finance Chapter 1 Page 15 of 22

Assumptions
 The selling price per unit of output is constant.
 The variable cost for producing one unit is known and constant.
 The periodic fixed cost is constant in relevant range
 Price per unit of output is greater than the variable cost per unit of out put.
The break-even point may be expressed in terms of
 Volume of output (or level of Activity)
 Total dollar sales
 Percentage of production capacity.
Let us now drive a formula for breakeven point or Q*.
TR = TC. Sine TR =PQ and TC =VQ +FC ,
PQ = VQ + FC
PQ* = VQ* + FC
PQ* – VQ* = FC
Q* (P - V) = FC

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 Br.22.50. Fixed costs associated with the formation,
operation, and management of the company and the purchase of equipment and machinery
total Br.250,000. They estimate that the selling price will be Br.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 Br.30 per
unit. Determine expected profits at this level of output.
Solution
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)

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For this problem the break-even point is computed as
30Q* = 22.50Q* + 250,000
7.50Q* = 250,000
Q* = 33,333.33 units
The alternative approach is to first write the profit function and set it equal to zero 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
7.50Q*– 25,000 =0
7.50Q* = 250,000
Q* = 33,333.33 units
Our conclusion is that given the assumed cost and price parameters (values), the firm must
sell 33,333.33 units in order to breakeven.
b. With sales projected at 30,000 smoke detectors,
π= 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 Br.25, 000 on the venture.
To further our understanding of break-even analysis, let us consider the following break-
even chart.

Profit (R > C)
Revenue/ cost

Revenue

BEP

Variable cost Total Cost

FC

Loss Fixed cost (FC)

(R < C)

0 Number of units (q)

qe

Mathematics for Finance Chapter 1 Page 17 of 22

 Break Even Point (BEP) and other points
Observations:From the above break – even chart, we observe certain important points.
i. As such, the total revenue line passes through the origin and hence has a y-intercept of 0
while the total cost line has a y intercept which is equal to the amount of the fixed cost
ii. The fixed cost line which is parallel to the quantity axis (x – axis) is constant at all levels
of output.
iii. To the left of the break – even point the revenue line is found below the cost line and
hence any vertical separation indicates a loss while to the right the opposite is true.
iv. The total variable cost, which is the gap between the total cost and the fixed cost line
increases as more units are produced.
v. Important linear cost – output expressions (equations):
 C = v q + FC
 R=pq
 Average Revenue (AR) = R ÷ q = p q ÷ q = p
 Average Variable Cost (AVC) = v q ÷ q = v = Slope (m)
 Average Fixed Cost (AFC) = FC ÷ q
 Average Cost = C ÷ q = AVC + AFC
 Profit (  ) = R – C
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. TheMark up
the difference between selling price (retail price) and purchasing cost is $ 70. That is
Mark up = purchasing Costs – retail (selling prices)
Purchasing Cost = $130
Retail price = $200
Mark up= Retail price –purchasing cost
= 200 – 130
= $70
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.

Mathematics for Finance Chapter 1 Page 18 of 22

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

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:

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
percent of this amount is margin and 65 percent is cost. Thus,
Purchasing cost (cost of goods sold) = 0.65 x
Total variable cost 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 Costs + Additional Variable costs

Continuing our example, if the company incurs selling expenses, which it budgets at 10
percent of the volume of sales (x), that is selling expense (additional variable costs) = 0.1x if
the company budgets fixed expense at $12,000:

Thus for example at a sales volume (total revenue) of $60,000 cost will be:
Y (TC) = 0.75 (60,000) +12,000
Y (TC) = 57,000

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And profit before taxes will be:
∏ = TR -TC
60,000 – 57,000
∏= $3000
Driving the Break-Even Level of Sales
Let us symbolize some important components of the formula. Thus, consider the equation
y = m x + b, where y = represent the total cost
m = represent the variable cost per dollar of sales
x = represent the sales volume (Revenue)
m x = total variable cost
b = the fixed cost
As we have considered in the former case, at break even revenue is equal to cost. That is, y
= x. Further, at break – even, the amount of dollar sale is equal to the cost, thus the break –
even level of sales (xe) is equal to y and x.
Therefore, y = x = xe
Then at the break-even point, y and x can be substituted by xe in the equation of
y = mx + b.
Accordingly, xe – m (xe) = b. Now let us solve for xe.
xe = m(xe) + b
xe – m (xe) = b
xe (1 – m) = b

Thus, is the expression for Break Even level of sales

Or,

Example
Suppose that in making a budget for next year’s operations top management of Hirmata
Business Group has set a sales goal of Birr 200,000 per week. Margin is to be 45% of retail
price and other variable cost is estimated at Birr 0.05 per birr of sales. Fixed cost is
projected at Birr 56,000.
a. What is the linear sales-cost equation?
b. What is the breakeven volume of sales in birr per week?

Mathematics for Finance Chapter 1 Page 20 of 22

c. What is the company’s profit if sales goal is attained?
d. What is the company’s profit if it sells merchandise that worth Birr 100,000?
e. Plot the company’s cost-sales model.
Solution
Given values, Margin = 45% = 0.45
Other variable cost = 0.05 per birr of sales
Fixed cost (b) = birr 56,000
Sales goal (Revenue R) = Birr 200,000
x = the monetary (dollar) amount of sales (sales volume)
In addition, if margin is given as 45% the remaining 55% or 0.55 represent the cost. Thus,
the variable cost per birr of sales is equal to
m = (100 % - margin percentage) + other variable cost
= (100% - 45%) + 0.05
Taking these values, we can solve out the problem
a. The equation y = m x + b
y = 0.6 x + 56.000 = 0.55 + 0.05 = 0.60
b. Break-even volume of sales

For any amount of sales volume (Revenue) greater than birr 140,000 profit will be attained.
At the targeted level of sale, the profit will be obtained as follows.
Profit = Revenue – Cost – R-C
= 200,000 – (0.06x200 + 56,000)
= Birr 24,000
D. Profit if the sales volume (revenue) is birr 100,000.
Profit (A) = R – C
= 100,000 – (m x + b), since cost (c) or y = mx + b
= 100,000 – (0.6 (100,000) + 65,000)
= 100,000 – (60,000 + 56,000)
= 100,000 – 116,000
= (Birr 16,000)

Mathematics for Finance Chapter 1 Page 21 of 22

Hence, at sales volume of birr 100,000 the company incurs a loss of Birr 16,000.
E. Graph of cost – sales model or break – even chart

Mathematics for Finance Chapter 1 Page 22 of 22