Chapter 1.

Linear Equations and Their Interpretative Applications

1.1. Introduction
Mathematics is the science of numbers and symbols. It can also be applied to some real-life phenomena.
Mathematics is coupled with innovative applications of the rapidly evolving electronic computer and
directed toward finance problems, resulted in a new field of study called quantitative methods, which has
become part of the curriculum of colleges of business. The importance of quantitative approaches to
finance problems is now widely accepted and a course in mathematics, with finance application is included
in the core of subjects studied by almost all finance students.
Finance is one of economics branches. It attempts to explain how the finance institution operates and to
make predictions about what may happen to specified economic variables if certain changes take place, e.g.
what effect a crop failure will have on crop prices, what effect a given increase in sales tax will have on the
price of finished goods, what will happen to unemployment if government expenditure is increased. It also
suggests some guidelines that firms, governments or other economic agents might follow if they wished to
allocate resources efficiently. Mathematics is fundamental to any serious application of finance to
aforementioned tasks and other areas.

1.2. Linear Equations, Functions and Graphs

1.2.1. Linear Equations
Linear Equation:
Equation: - is a mathematical statement which indicates two algebraic expression are equal.
Example: Y = 2X + 3
 Algebraic expressions:
expressions: - A mathematical statement indicates that numerical quantities are
linked by mathematical operations.
Example: X + 2
Linear equations: - are equations with a variable & a constant with degree one.
- Are equations whose terms (the parts separated by +, -, = signs)
- Are a constant, or a constant times one variable to the first power.
Example: 2X – 3Y = 7
- The degree (the power) of the variables is 1
- The constant or the fixed value is 7
- The terms of the equation are 2X and 3Y separated by – sign
However, 2X + 3XY = 7 isn’t a linear equation,
equation, because 3XY is a constant times the product of 2
variables.
Note;-
Note;- the following expression are not allowed ;-

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  No X2 terms  No X/Y terms, and  No XY terms.
o Linear equations are equations whose slope is constant throughout the line.
- The general notion of a linear equation is expressed in a form Y = mx + b where m = slope, b = the Y-
intercept, Y = dependent variable and X = independent variable.
If Y represents total Cost, the cost is increased by the rate of the amount of the slope m.
ΔY rise ( fall ) Y − Y1
= = 2
Slope (m) = ΔX run X 2 − X 1 , if X  X
1 2

Slope measures the steepness of a line. The larger the slope the more steep (steeper) the line is, both in
value and in absolute value.

Y Y m = undefined
+ive slope
m=0
-ve slope
X X
- A line that is parallel to the X-axis is the gentlest of all lines i.e. m = 0
- A line that is parallel to the Y-axis is the steepest of all lines i.e. m = undefined or infinite.
The slope of a line is defined as the change-taking place along the vertical axis relative to the
corresponding change taking place along the horizontal axis, or the change in the value of Y relative to a
one-unit change in the value of X.
Developing equation of a line
There are at least three ways of developing the equation of a line. These are:
1. The slope-intercept form 2. The slope-point form 3. Two-point form
1. The slope-intercept form
This way of developing the equation of a line involves the use of the slope & the intercept to formulate the
equation.
Often the slope & the Y-intercept for a specific linear function are obtained directly from the description of
the situation we wish to model.
Example 1
Given Slope = 10
Y-intercept = +20, then
Slope-intercept form: the equation of a line with slope = m and Y-intercept b is
Y = mx + b
Y = 10X + 20

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Interpretative Exercises
Example 2 Suppose the Fixed cost (setup cost) for producing product X be br. 2000. After setup it costs br.
10 per X produced. If the total cost is represented by Y:
1. Write the equation of this relationship in slope-intercept form.
2. State the slope of the line & interpret the number
3. State the Y-intercept of the line & interpret the number
Answer;
1. Total cost=10X+2000 or Y=10X+2000
2. The slope of the line is 10, it implies the total cost increases by ten while X or the product
produced.
3. The Y intercept of the line is 2,000; it implies the total cost becomes the fixed cost if there is no
production.

Example 3. A sales man has a fixed salary of br. 200 a week In addition; he receives a sales commission
that is 20% of his total volume of sales. State the relationship between the sales man’s total
weekly salary & his sales for the week.
Answer; - Y = 0.20X + 200

2. The slope point form

The equation of a non-vertical line, L, of slope, m, that passes through the point (X 1, Y1) is : defined by the
formula Y – Y1 = m (X – X1)
Y – Y1 = m (X – X1)
Example A-  Answer Y – 2 = 4 (X – 1)
Given, slope = 4 and Y – 2 = 4X - 4
Point = (1, 2) Y = 4X – 2

Example B. A sales man earns a weekly basic salary plus a sales commission of 20% of his total sales.
When his total weekly sales total br. 1000, his total salary for the week is 400. Derive the
formula describing the relationship between total salary and sales.
Answer
Y-400=0.2(X-1000)
Y=0.2X-200+400
Y = 0.2X + 200

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Example C- If the relationship between Total Cost and the number of units made is linear, & if costs
increases by br. 7.00 for each additional unit made, and if the Total Cost of 10 units is
br. 180.00. Find the equation of the relationship between Total Cost (Y) & number of
units made (X).
 Steps that to be followed to arrive at last solution looks like;
Y-180=7(X-10)
Y=7X-70+180
Answer: Y = 7X + 110

3. Two-point form
Two points completely determine a straight line & of course, they determine the slope of the line. Hence
we can first compute the slope, then use this value of m together with either point in the point-slope form Y
– Y1 = m (X – X1) to generate the equation of a line.
 By having two coordinate of a line we can determine the equation of the line.

( )(
Y2 − Y1
X − X 1)
X2 − X1
Two point form of linear equation: (Y – Y1) =
Example 1 given (1, 10) & (6, 0)
0 − 10 −10
= = −2
First slope = 6 − 1 5 , then
Y – Y1 = m (X – X1)  Y – 10 = -2 (X – 1)
Y – 10 = -2X + 2
Y = -2X + 12
Example 2 A salesman has a basic salary &, in addition, receives a commission which is a fixed percentage
of his sales volume. When his weekly sales are Br. 1000, his total salary is br. 400. When his
weekly sales are 500.00, his total salary is br. 300. Determine his basic salary & his
commission percentage & express the relationship between sales & salary in equation form.
 Steps that to be followed to arrive at last solution looks like;
There are two coordinates, i.e (1000, 400) and (500,300)
Y 2−Y 1
Y −Y 1= ( X−X 1)
X 2−X 1

Slope=300-400
Slope=300-400 = 0.2
500-1000

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Then,
Y-400=0.2(X-1000)
Y=0.2X-200+400
Answer Y = 0.2X + 200

Example 3 A printer costs a price of birr 1,400 for printing 100 copies of a report & br. 3000 for printing
500 copies. Assuming a linear relationship what would be the price for printing 300 copies?
Answer: Y = 4X + 1000
Cost = 4 (300) + 1000 = br. 2200

 Special formats
a) Horizontal & vertical lines
When the equation of a line is to be determined from two given points, it is a good idea to compare
corresponding coordinates because if the Y values are the same the line is horizontal & if the X values are
the same the line is vertical.

Example: 1 Given the points (3, 6) & (8, 6) the line through them is horizontal because
both Y-coordinates are the same i.e. 6
The equation of the line becomes Y = 6, which is different from the form Y = mx + b

If the X-coordinates of the two different points are equal

Example (5, 2) & (5, 12) the line through them is vertical, & its equations is X = 5 i.e. X is equal to a
constant. If we proceed to apply the point slope procedure, we would obtain.
12 −2 10
= =∞
Slope (M) = 5 − 5 0 & if m = undefined the line is vertical & the form of the equation is: X =
constant

b) Parallel & perpendicular lines ( and )

 Two lines are parallel if the two lines have the same slope.
 Two lines are perpendicular if the product of their slope is –1 or the slope of one is the negative
reciprocal of the slope of the other.
 However, for vertical & horizontal lines. (They are perpendicular to each other), this rule of M 1 (the
first slope) times M2 (the second slope) equals –1 doesn’t hold true. i.e. M1 x M2  -1.

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 Example: Y = 2X – 10 & Y = 2X + 14 are parallel because their slope are equal i.e. 2
Y = 3/2X + 10 & Y = -2/3X + 100 are perpendicular to each other because the multiplication
3 −2
x = −1
result of the two slope are –1 i.e. 2 3
c) Lines through the origin
Any equation in the variables X & Y that has no constant term other than zero will have a graph that passes
through the origin. Or, a line which passes through the origin has an X-intercept of (0, 0) i.e. both X and Y
intercepts are zero.

1.2.2. Linear Function

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. it states that what y is (that is,y=) in
terms of x, and we connote this by saying y is a function of x; of course, this is a linear function.

1.3 Application of linear equations

1.3.1 & 1.3.2 Linear cost output relationships and Cost, Total Revenue, and Total Profit
TR,:
Under this section the linear relationship of different costs will be discussed VC, FC, TC, AC, MC, TR,

TR/TC profit TR TC = TVC + TFC

Or TP region TC TR = PQ
TP = TR - TC
Loss T
region E BEP = PQ – (TVC + TFC)
TVC H
A F G FC = PQ – Q.VC - TFC
TC
TFC = Q (P – VC) - FC
B C D G(No of units)

Where Q = units product & units sold in revenue

MC=Marginal Cost
=Profit sign

Interpretation of the graph:

1. The vertical distance between AB, FC, GD is the same because Fixed Cost is the same at any levels
of output.

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 2. There is no revenue without sales (because Total Revenue function passes through the origin), but
there is cost without production (because of Fixed Cost) & the TC function starts from A & doesn’t
pass through the origin
3. Up to point T, Total Cost is greater than Total Revenue  results in loss. While at point T, (Total
Revenue = Total Cost) i.e. Breakeven. (0 profit), & above point T, TR > TC  +ve profit.
4. TFC remains constant regardless of the number of units produced. Given that there is no any
difference in scale of production.
5. As production increases, Total Variable Cost increases at the same rate and Marginal cost is equal
with Unit Variable Cost (MC
(MC = VC) only in linear equations.
6. As production increases TC increases by the rate equal to the AVC = MC (average cost equal to
marginal cost)
7. AVC is the same throughout any level of production, however Average Fixed Cost (AFC)
decreases when Quantity increases & ultimately ATC decreases when Q increases because of the
effect of the decrease in AFC.
8. As Quantity increases TR increases at a rate of P. and average revenue remains constant.
TR P . Q
=
AR = Q Q = P  AR = P in linear functions

1.3.3 Breakeven Analysis

Break-even point is the point at which there is no loss or profit to the company. It can be
expressed as either in terms of production quantity or revenue level depending on how the company states
its cost equation.

Manufacturing companies usually state their cost equation in terms of quantity (because they produce and
sell) where as retail business state their cost equation in terms of revenue (because they purchase and sell)

Case 1: Manufacturing Companies

Consider a Company with equation
TC = VC + FC or Total cost = Variable cost + Fixed cost
TR = PQ or Total Revenue = Price x Quantity

At Break-even point, TR = TC i.e TR – TC = 0

PQ = VC + FC where Qe = Breakeven Quantity
PQ – VC.Q = FC FC = Fixed cost
Q (P – VC) = FC P = unit selling price
FC
Qe = P − VC VC = unit variable cost

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 TR
TC/TR TC

Q
FC
Qe = P− VC

Illustration 1 A manufacturing Co. has a Total Fixed Cost of Br. 10,000 & a Unit Variable Cost of Br. 5. if
the co. can sell .What it produces at a price of Br. 10.
Required;-
a) Write the Revenue, cost & Profit functions
b) Find the breakeven point in terms of quantity and sales volume
c) Show diagrammatically the Total Revenue, Total Cost, Total Profit, Fixed Cost and Variable Costs.
d) Interpret the results.
Answer
a) TC = VC + FC TR = PQ () = TR – TC
Profit (
TC = 5Q + 10,000 TR = 10Q = 10Q – (5Q + 10,000)
= 5Q – 10,000
b) At break even point TR = TC
10Q = 5Q + 10,000
5Q – 10,000 = 0
10 , 000
Qe = 5
Qe = 2000 units
i.e. Breakeven Quantity is 2000 units
Sales volume = 2000 X 10 = 20,000 br.
25000 TR = 10Q 
20000 TC = 5Q + 10000 TVC = 5Q
15000 TVC T = 5Q - 10000
T
10000
5000 TFC
0

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 1000 2000 3000 4000 5000 Q (no. of units produced
& sold)
-5000 -
-10000 -

Interpretation:
Interpretation:
When a co. produces & sells 2000 units of output, there will not be any loss or gain (no profit, no loss).
 The effect of changing one variable keeping other constant
Case 1 - Fixed cost
Assume for the above problem FC is decreased by Br. 5000, Citrus Paribus (other things being constant)
5000
TC = 5Q + 5000  Qe = 5 = 1000 units
TR = 10Q
Therefore, FC   Qe  FC & Qe have direct relationship
FC   Qe 

Case 2-Unit variable cost

Assume for the above problem UVC decreased by 1 br. Citrus Paribus (keeping other thing constant)
10000
= 1 , 667 units
TC = 4Q + 10000  Qe = 6
TR = 10Q

Therefore, VC   Qe  VC & Qe have direct relationship

VC   Qe 

Case 3- Selling price

Assume for the above problem selling price is decreased by br. 1, Citrus Paribus,
10000
= 2500 units
TC = 5Q + 10,000  Qe = 4
TR = 9Q
Therefore P   Qe  Price and breakeven point have indirect relationship
P   Qe 

In the above example a company has the following options (to minimize its breakeven point and maximize
profit).

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 - decreasing FC
- decreasing unit VC
- increasing the unit selling price
And if the organization is between option 2 & 3, it is preferable to decrease the unit variable cost because
if we increase the selling price, the organization may lose its customers & also decreasing the FC is
preferable.
preferable.
TR

TC

TFC

Qe Q

Finding the quantity level which involves profit or loss

FC +0
BEP = P− V , any Q is related to the cost , profit----
 = TR – TC Where: BEP = Breakeven point
 = PQ – (VC.Q + FC)  = Profit
 = (P.Q – VC.Q) – FC TR = Total revenue
 = Q (P – VC) – FC TC = Total cost
±Π + FC FC ± Π
= for any qty level Q=
P − VC P − VC Q = Quantity
C = Unit variable cost

Example 1 For the above manufacturing co. if it wants to make a profit of 25000 br. What should be the
quantity level?
FC ± Π
TR = 10Q Q = P − V when there is , the quantity produced &
sold have to be greater than the
Breakeven quantity

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 10 ,000 + 25000
TC = 5Q + 10,000 = 10 − 5
 = 25,000 = 7000 units
Q=?
If it expects a loss of br. 5000 what will be the quantity level.
FC ± VC 10,000 − 5000
=
Q = P − VC 10 − 5 * when there is loss, the qty produced & sold
should be less than the BEQ
Case 2 Merchandising /Retail Business
Breakeven Revenue = BEQ X P
Assume a bus. Firm with product A has the following cost & revenue items.
Variable cost of A = 100 br.
Selling price = 150 br.
Markup = Selling price – Variable cost = 150 – 100 = 50
i. as a function of cost, the markup is 50/100 = 50%
ii. as a function of retail price, the markup is 50/150 = 33.3 % it is also called margin.
Margin Cost of goods sold

The cost of goods sold = 100% - 33.3 % = 66.6%  67%

Selling price CGS
Given other selling expense = 1%of the selling price i.e. 0.01X

So, the TC equation becomes:

Y = 0.68X + FC
Where: X is sales revenue
Y is total cost
Out of 100% selling price 68% is the variable cost of goods purchased & sold

Example Suppose a retail business sale its commodities at a margin of 25% on all items purchased & sold.
Moreover the company uses 5% commission as selling expense & br. 12,000 as a Fixed Cost.

Find the Breakeven revenue for the retail business after developing the equation

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Solution Selling price 100% Let X represents selling price
Margin 25% Y = Total cost
CGS 75% FC = 12,000
Comm. Exp. 5% Xe = Breakeven revenue
Total VC 80%
Y = 0.8X + 12000

Break even revenue is obtained by making sales revenue & cost equals
At breakeven point TC = TR Y = mx + b
i.e. Y = X then, unit variable cost
FC FC ± Π VC TVC
or where m= =
0.8X + 12000 = X  1− m 1− m P TR
Where:- m is unit variable cost in % or CGS in %
-0.2X = -12000
X = 60,000 br.  When the co. receives br. 60,000 as sales revenue,
there will be no loss or profit.

FC ± Π
The Breakeven revenue (BER = 1 − m ) method is useful, because we can use a single formula for
different goods so far as the company uses the same amount of profit margin for all goods. However, in
FC ± Π
Breakeven quantity method or BEQ = P − V it is not possible and hence we have to use different
formula for different items.

Example #1 It is estimated that sales in the coming period will be br. 6000 & that FC will be br. 1000 &
variable costs br. 3600, develop the total cost equation & the breakeven revenue.

3600
Answer: Y = 6000 X + 1000 = 0.6X + 1000
Where Y = Total Cost
X = Total revenue
1000 1000
= = 2500 br .
BER = Xe = 1 − 0.6 0.4

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At the sales volume of br. 2500, the company breaks even.

* When the breakeven revenue equation is for more than one item it is impossible to find the breakeven
quantity. It is only possible for one item by Qe = Xe/P
Where Xe = Break even revenue
P = selling price
Qe = Breakeven quantity
To change the breakeven revenue equation in to Breakeven quantity. We have to multiple price by the
coefficient of X. likewise, to change in to breakeven revenue from Break even quantity, we have to divide
the BER by price.

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