18 MATHEMATICS Rather than argue this statement from Figure 1-6, suppose we interpret the equation y=3e+2 letting y be total cost of producing + units. The fixed cost is $2.00, and the variable cost per unit (the slope) is $3.00. However, by substitution, we find that total cost rises from $17 to $32 if 2 changes from five to ten units. The average cost per unit declines from 17/5 to 32/10, that: is, from $3.40 to $3.20. This reduction sometimes is referred to as being a consequence of spreading fixed cost over a larger number of units. COMMENT ON MODELS We call attention here to the distinction between the mathe- matics of the last discussion and the real-world cost-output situation to which the mathematics was related. Nothing was said about whether costs are or whether costs should be linearly related to output. The theme of the discussion was that if the relationship was linear, then certain interpretations suggested themselves. In particular, mathematical analysis of the linear equation showed that the ratio of y to x decreased as x increased, and we interpreted this as being a consequence of spreading fixed cost over an increasing output. ‘The linear equation under discussion is an example of a mathe- matical model. A model is a mathematical expression which seeks to capture the essential features of a real-world situation. If this objective can be achieved, then the full foree of mathematical analysis can be applied to the model, and the outcome of the analysis may have important real-world interpretations. The key idea here is that mathematical analysis is a highly developed and powerful tool, but before it can be brought to bear on a real-world problem, it is necessary to construct an adequate mathematical representation (model) of the real-world situation. We do not ox- pect a model to be an exaet replica of the real world. We hope that the model will be adequate. In any event, we must be careful not to exceed the bounds of good sense when interpreting the outeome of mathematical analysis of a model. Thus, it probably would not be realistic to assume a linear relationship between cost and output no matter how large output became, and it certainly would make no sense to extend the linear model to negative outputs. Physical scientists have had a high degree of success in formu- t Go gle iLINEAR EQUATIONS 19 lating mathematics! models. Witness, for example, the contribu- tions of mathematical analysis of gravitational forces to man’s achievements in space. Much effort now is being directed toward model building by workers in the social sciences. The linear pro- gramming model we shall encounter a few chapters hence is a good example of a relatively recent advance which has stirred interest in many parts of the world of business and economics. We shall not use the term model in reference to exact caleula- tions, as, for example, in the computation of the amount of interest earned on $100 at 3 per cent for a year. On the other hand, it would be appropriate to classify the statement, “If a man makes five hats in one hour, then he will make fifty hats in ten hours,” as an analysis based upon the proportionality model. The point here is that we think the assumption of proportionality is adequate within limits, and we know that experience and common sense will help determine how wide these limits are. In passing, it is interesting to note that the widely used proportionality assumption has the mathematical form ¥ = 2 constant z Written in the form y = kz, it is apparent that a graph for such a model is a straight line passing through the origin. BREAK-EVEN INTERPRETATIONS. Relationships between sales and expenses often are analyzed by means of linear models. If we let y represent dollars of expense incurred when sales are x dollars, the linear relationship is yametd Suppose that, in a particular case, we have y = 0.32 + 11,200 where it is assumed that the variables are measured in dollars. The equation states that if sales are, say, $40,000, then expenses, y, are y = 0.3(40,000) + 11,200 = 23,200 According to the equation, expenses consist of a fixed component, $11,200, and a component, 0.32, which varies with the level of sales. We interpret $11,200 as fixed expense and 0.3 as variable expense. ‘The slope of the line, 0.3, is interpreted as variable expense per dol- lar of sales; that is, expenses ineresse 30 cents for each dollar of in- crease in sales. Google sick 520 MATHEMATICS The break-even point is the volume of sales at which sales equal expenses; that is, it is the volume at which the company ox- periences neither profit nor loss. If the break-even level of sales is designated by 2,, then at break-even, both « and y in the equation will equal 2,. Hence: t. = 0.32, + 11,200 Solving, we find 11,200 _ 2 = G7 = 16,000 More generally, if the relation is written as y= ma+b then the interpretations are that b represents fixed expense, mz represents variable expense, and m itself represents variable ex- pense per dollar of sales. At break-even: yar so that, by substitution: he = Mite +b (1 —m)=b b a= I-m Hence, the break-even level occurs when sales are equal to Fixed expense T — Variable expense per dollar of sales Suppose that in making a budget for next year’s operations, top management has set a sales goal of $200,000 and believes that at this level of sales, variable expense will be $120,000 and fixed expense $56,000. If we compute variable expense per dollar of sales as 120,000 200,000 the linear expense-sales model will be = 0.6 y = 0.62 + 56,000 The break-even level of sales will be 58,000 _ 140,000 The calculations show the company will make a profit if its sales Google SVERSINY OF MICHIGANLINEAR EQUATIONS a1 exceed $140,000. For example, if sales should turn out to be $190,000, gross profit would be 190,000 — Expenses = 190,000 — 0.6(190,000) + 56,000] = 20,000 A break-even chart can be constructed by plotting yame+b and the line where sales equal expenses, y =z. The point of inter- section of the last two lines establishes the break-even level of sales. Figure 1-7 shows the break-even chart for the foregoing example. ‘The break-even point is seen to be $140,000. The separation of the lines to the right of break-even indicates profit; to the left, loss. FIG. 1-7 As another example, let us make the break-even chart for a company which expects variable expense to be $50,000 at a sales volume of $80,000, with fixed expense of $24,000. The relevant equation is y = 0.6252 + 24,000 Plotting the last equation together with y=, we obtain Figure 1-8, which shows that the break-even point is $64,000. Tn passing, we should note that the break-even interpretations just discussed rest upon the assumption that total expense can be separated into two components, one fixed and the other varying directly in proportion to sales. These assumptions often are reason- ably valid for a restricted range of sales. It is not realistic, for ex- ample, to assume fixed expense as constant over all ranges of sales. t Gor igle ‘i2 MATHEMATICS If sales are proving to be considerably below expected levels, man- agement may reduce salaries or take other actions to reduce “fixed” expenses. It is not our purpose here to explore managerial action, but rather again to call for exercise of judgment when interpreting mathematies! models. FIG. 1-8 Problem Set 5 1, In the figure the slant line represents the relation between total cost, C, of producing @ number of units, and the number of units, Q, pro- duced. Whet line segment(s), or ratios thereof, represent: a) Fixed cost? 6) Total cost if OA units are made? c) Variable cost if OA units are made? d) Variable cost per unit made? e) Average cost per unit if OA units are made? f) Fixed cost per unit if OA units are made? 9) How many more units can be made for AD dollars than for AF dollars? h) Marginal cost per unit? 2. Prior to making a number of units of a certain part, a machine must be made ready, the cost incurred being called the setup cost. The total Google it