Mathematics for finance Department of Accounting and finance

CHAPTER ONE
LINEAR EQUATIONS AND THEIR INTERPRETIVE
APPLICATION

1.1 LINEAR EQUATION

EQUATION - A mathematical statement that says two algebraic
expressions are equal. E.g. y = 2x + 3
- Is convenient and concise way of representing
relationship between quantities such as sales and
advertising, profit and time, cost and number of units
manufactured, and so on?

Equations are used to model or represent real word situation.

Algebraic Expression - a mathematical statement indicating that

numerical quantities are linked by
mathematical operations. E.g. x+2, 2x + y
In algebraic expressions a letter always stands for a number.
Therefore, we add, subtract, multiply, divide and perform other
mathematical operations on a letter. In algebraic expression value or
variables separated by + or – signs. These values which are separated
by + or – are called Terms. Terms are often called monomials (mono
= one). If an expression has more than one term, it is called
polynomials (poly = many). The letters in an algebraic expression are
called variables/ unknowns.
Linear Equations - are equations with a variable and a constant with
degree one.
- are equations whose terms (the part separated by +,
-, = signs) are a constant, or a constant times one
variable to the first power.
- Linear equations are equations whose slope is
constant through out the line.
E.g. 2x - 3y = 7 - degree 1
- Constant 7
- Terms 2x &3y separated by the minus sign
However, 2x + 3xy = 7 is not a linear equation; b/c 3xy is a constant
times the product of two variables. No X 2 terms, no y terms & no XY
terms are allowed.
The general notation of a linear equation is Y = mx + b,
Where, m = slope
b = y-intercept.
It is worth noting that this formula or notation holds true for all lines
that are not parallel to the y-axis. A vertical line is represented by the
equation X=a. In cost out put relationship, b is the fixed cost, and m is

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Mathematics for finance Department of Accounting and finance

the marginal cost. The cost increases by the rate of the amount of the
slope, m.
y rise / fall ) Y 2  y1
Slope (M) =    if X1 # X2
x run X 2 x1


Slope measures the steepness of a line. The larger the slope the
steeper the line is both in value & in absolute value. A line’s slope
number tells us how much the line falls (or rises) for a stated change
in x. Slopes can assume 4 different values: negative, positive, 0 and
undefined.

 The line that is parallel to the X- axis is the gentlest of all lines,
m= 0
 The line that is parallel to the Y - axis is the steepest of all lines,
m =  ( undefined)
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.
In linear equation of Y= mx + b, the coefficient of the independent
variable is the slope of the line and the constant that stands alone is
the vertical (y) intercept. That is, Dependent variable = (slope x
independent Variable) + Intercept.
Intercepts - Those points at which the graph of a line, L, crosses the
axes are called intercepts. The X-intercept is the point at which the
line crosses the X-axis and it is found at (X, 0) and the Y-intercept is
the point at which the y-axis is crossed. Its coordinate is at (0, y).

DEVELOPING THE EQUATION OF A STRAIGHT LINE

There are at least three way of developing the equation of a line,
these are:
1. The slope - intercept form
2. The slope - point form
3. Two-points form.
1. THE SLOPE-INTERCEPT FORM
This way of developing the equation of a line involves the use of the
slope and the intercept to formulate the equation. Often the slope and
y-intercept for a specific linear function are obtained directly from the
description of the situation we wish to model.
E.g. Slope=10
Y-intercept=20
A line that has a slope of 10 and a y-intercept of 20 has the following
equation: Y=10x +20

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 Mathematics for finance Department of Accounting and finance

2. Suppose the fixed cost (set up cost) for producing product x be Birr
2,000. After setup it costs Birr 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 and interpret this number.
3. State the y-intercept of the line and interpret this number.
3. A Salesman has a fixed base salary of Br 200 a week. In addition, he
receives a sales commission that is 20 percent of his total Birr values
of sales. State the relationship between the salesman’s total weekly
salary and his sales for the week. Answer: Y = 0.2x + 200

2. THE SLOPE - POINT FORM

The equation of a non-vertical line, L, with slope, m that passes
through the point (x, y is: Y-Y1 = m (X-X1).

Slope = 4, point (1, 2), the equation becomes Y = 4X-2

2. A salesman earns a weekly base salary plus a sales commission of

20% of his total weekly sales. When his total weekly sales total Birr
1000, his total salary for the week is Birr 400. Derive the formula
describing the relationship between total salary and sales. Answer: Y
= 0.2x = 200
3. If the relationship between total cost and the number of units made is
linear, and if cost increases by Birr 7 for each additional unit made,
and if the total cost of 10 units is Br 180, find the equation of the
relationship between total cost (Y) and number of units made (x).
Answer: 7x + 110

3. TWO - POINTS FORM

Two points completely determine a straight line and, of course, they
determine the slope of the line.
Hence we can first compute the slope, and then use this value of slope
(m) together with either point in the point-slope form: Y-Y 1 =m (X-X1)
to generate the equation of a line. Alternatively, the following formula
y 2  y1
can also be used: (Y-Y1) = (X - X1) E.g. (1, 10) (6,
x x 2  x1
0)
0  10  10
First, find the slope =   2 , then use the Slope-point
6 1 5
form.
Y-Y1 = M (X-X1) = Y-10 = - 2 (X-1)
Y-10 = -2X + 2+10
Y = -2X + 12

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2. A sales man has a base salary and, in addition, receives a commission,

which is a fixed percentage of his sales volume. When his weekly sales
are Birr 1000, his total salary is Birr 400. When his weekly sales are
Birr 500, his total salary is Birr 300. Determine his base salary and
his commission percentage and express the relationship between
sales and salary in equation form. Answer: Y = 0.2x + 200
3. A printer quotes the price of Birr 1,400 for printing 100 copies of a
report and Birr 3000 for printing 500 copies. Assuming a linear
relationship what would be the price for printing 300 copies? Answer:
Birr 2,200.
Horizontal and Vertical Lines
Horizontal lines are lines whose slope is zero. These lines are parallel
to the X-axis. Vertical lines are lines whose slope is undefined. These
lines are parallel to the Y-axis. 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, and if the x values are the same the line is vertical.
Example:
a) Given the points (3, 6) & (8, 6) - the line through them is horizontal
because both y-coordinates are the same (6). The equation of the
line becomes y=6.
b) Given the points (5, 2) and (5, 12), the line that passes through
them is vertical, and its equation is x = 5. If we proceed to apply
12  2 10
the point - slope procedure, we would obtain   , and if m
5 5 0
=  the line is vertical and the form of the equation is: x =
constant.
Parallel and Perpendicular Lines
Two lines are parallel if the two lines have the same slope, and two
lines are perpendicular to each other if the product of their slopes is -
1 or the slope of one is the negative reciprocal of the slope of the
other. However, for vertical and horizontal lines, (they are
perpendicular to each other), this rule of m1. m2 = -1 doesn’t hold true.
Example:
1. Y= 2x-10 and Y=2x+14 are parallel.
3 2
2. Y= x +10 and Y = x +100 are perpendicular to each other.
2 3
Lines through the Origin
Any equation in the variables x and y that has no constant term other
than zero will have a graph that passes through the origin. Or, a line
that passes through the origin has an x-intercept and a y-intercept of
(0, 0). These lines are expressed in the form Y = mx.

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1.2. APPLICATIONS OF LINEAR EQUATIONS

1.2.1. LINEAR COST-OUT PUT RELATION SHIPS
TR line
TC
TC line

TC= VQ+FC
T

TR = PQ
A F G T = TR – TC
= PQ - (VQ + FC)
= Q (P-V) + FC
Where Q = units
produced in cost &
units sold in revenue.
C D Q no
B
of units
(product)
Interpretation of the graph
1. The vertical distance AB, FC, GD is the same because fixed cost is
the same at any level of output.
2. There is no revenue with out sales (Because total revenue passes
through the Origin), but there is cost with out production (Because
of total fixed cost) and the total cost function starts form A and
doesn’t pass through the Origin.
3. Up to point T, total cost is greater than total revenue and results in
loss while at point T, TR = TC = Break even (zero profit), and
above point T, TR >TC and results in profit.
4. TFC remains constant regardless of the number of units produced,
given that there is no any difference in scale of production. That is
there is no either expansion or contraction of the business.
5. As production increases, TVC increases at the same rate and MC =
V only in linear equations.
6. As production increases TC increases by the rate equal to the V =
MC.
7. Unit variable cost (V) is the same through out any level of
production, however AFC decreases when Q increases and
ultimately ATC decreases when Q increases because of the effect of
the decrease in AFC.
8. As Q increases, TR increases at a rate of P and AR remains
constant.
TR p. Q
AR =   AR  P in linear functions.
Q Q

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1.2.2. BREAK EVEN ANALYSIS

BEP (Break even point) is the point at which there is no loss or profit
to the company. It can be expressed 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 produces and sell) where as retail business
state their cost equation in terms of revenue (because they purchase
and sell)
Case1. Manufacturing Companies
Consider a company with equation TR = PQ
TC= VQ + FC

At BEP, TR = TC where:
PQe = VQe + FC Qe = break even quantity
PQe - VQe = FC FC = fixed cost
Qe (P-V) = FC P = unit selling price
FC
Qe = V= unit variable cost
P V

Assumptions of Breakeven Analysis

1. Selling price is constant throughout the entire relevant range
[relevant range – is the limit of cost-driver activity within a
specified relationship between costs and the cost driver is valid].
2. Costs are linear over the relevant range.
3. In multi-product companies, the sales mix is constant.
4. In manufacturing firms, inventories do not change (Units produced
= Units sold).
5. Expenses may be classified in to variable and fixed categories. Total
variable expenses vary directly with activity level. Total fixed
expenses do not change with activity level.
6. Efficiency and productivity will be unchanged.
Example: A manufacturing company has a fixed cost of 10,000 and a
unit variable cost of Birr 5. If the company can sell what it produces
at a price of Birr 10?
a. Write the revenue and cost and profit equations
b. Find the breakeven point in terms of quantity and sales volume.
c. Interpret the results.
d. Show diagrammatically the TR, TC, TP, BEP, TFC & TVC

The Effect of Changing One Variable Keeping Others

Constant on BEP
Case 1: Fixed Cost - Assume for the above problem FC is decreased
by Br 5,000, citrus paribus (other things remain constant)

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5,000
TC = 5Q + 5,000 Qe 1 = = 1,000 units
5
TR = 10Q
 FC  Qc  
Therefore,   FC & Qehave direct relationship
 FC  Qc  
Case 2 - Unit variable cost- Assume for the above problem unit
variable cost decreased by Birr 1, citrus paribus
10,000
TC = 4Q + 10,000 Qe2  6 = 1,667 units
TR=10Q
V  Qc  
Therefore,  V & Qe have direct relationship
V  Qe  
Case 3- Selling Price- Assume for the above problem selling price is
decreased by Birr 1, Citrus Paribus.
TC = 5Q + 10,000  Qe  10,4000  2 ,500 units
3

TR = 9Q
P  Qe  
Therefore,  P & Qe have indirect relationship
P  Qe  
In the above example if a company can’t produce and sell 5,000 units
it have the following options:
 Decreasing FC
 Decreasing unit variable cost
 Increasing the unit selling price
If the organization is faced between cases two and three, it is
preferable to decrease the unit variable cost because if we increase
the selling price, the organization may loose its customers; and also
decreasing the FC is advisable.
Finding the Quantity level that involves profit or loss
FC  0
BEP = , Any Q is related to the cost, profit, ---
P v
  TR  TC
= PQ - (VQ + FC)
= Q (P-V) - FC
  Q( P  V )  FC
FC   Q( P  V )
FC 
 Q  For any quantity level.
P V
Example:
1. For the above manufacturing company, (example one), if it wants
to make a profit of Birr 25,000, what should be the quantity level?

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Answer: 5,000 units. This tells us when there is a profit; the quantities
produced and sold have to be greater than the break-even quantity.
2. If it expects a loss of Birr 5,000, what will be the quantity level?
Answer: 1,000 units. * When there is less, the quantity produced and
sold should be less than the BEQ.
Case 2 - Retail (Merchandise) Businesses.
Break even Revenue = BEQ x P
Assume a business firm with product A has the following cost and
revenue items. Purchase cost of A = 100 Br and Selling price = 150
Br
Markup= Selling price - Cost = 150-100=50.
Mark up can be expressed:
i. As a function of cost, the mark-up is 50/100 = 50%
ii. As a function of retail price, the mark up is 50 150 33.3% , it is also
called margin. The cost of goods sold =
100%  33.3%  66.6%  67%
  

sellingprice m arg in cos tofgoodssold

Assume selling expense = 1 percent of the selling price = 0.01x.

Where, x =sales revenue. So, the total cost equation becomes:
Y=0.68x + FC; Where X = sales revenue,
and
Y = total cost.
The above 68% is interpreted as, Out of the 100% selling price 68% is
the variable cost of goods purchased and sold.
To get the break-even sales volume level, we equate the total cost, Y
with the sales volume level, X as Xe = Y = X, Y = mx + b
X = mx + b
X – mx = b
X (1 – m) = b
Xe = b
1 – m; Where m= unit variable cost
/Birr of sales.
Example
1. Suppose a retail business sells its commodities at a margin of 25%
on all items purchased and sold. Moreover, the company uses a 5%
commission as selling expense and Birr 12,000 as a fixed cost. Find
the break-even revenue for the retail business after developing the TC
equation. Answer: Y = 0.8x + 12,000 and Xe = Birr 60,000. It is
interpreted as; when the company receives Birr 60,000 as sales
revenues, there will be no loss or no profit.
2. It is estimated that sales in the coming will be Birr 6000 and that
fixed cost will be Br 1000 and variable costs Birr 3,600. Develop the

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total cost equation, and find the breakeven revenue. Answer: Y = 0.6x
+ 1000; Xe = Birr 2,500.
3. A company sold 80,000 units earning a profit of Birr 90,000. The
Total purchasing Cost of the product is Birr 400,000. Moreover, the
company incurred a commission expense (additional cost) of Birr
40,000 at 5% rate. (Hint: commission expense is calculated as a
percentage of sales). Develop the total cost equation and find the
break-even revenue. Answer: Y = .55x + 270,000; Xe = Birr 600,000.

The break-even revenue 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 breakeven
quantity method it is not possible and hence we have to use deferent
formula for different items.

When the break-even revenue equation is for more than one item it is
impossible to find the break-even quantity. It is only possible for one
Xe
item. By Qe = where
P
Xe = break-even revenue.
P= Selling price.
Qe = break-even quantity.

Given that the company purchases and sells single product, to change
the cost equation in terms of revenue in to a cost equation in terms
quantity we have to multiply price by the coefficient of X that is m. To
change the cost equation in terms of quantity in to a cost equation in
terms revenue we divide the unit variable cost, V, by the
corresponding unit selling price.

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