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Michael Cooney

1

Many business situations allow us to model how cost, revenue and vary

with respect to different parameters, and how they combine to yield a

functional expression for profit.

In most cases, it is then possible to attempt to maximise and minimise

these functions using calculus techniques.

2

In any commercial environment, the (gross) profit can be considered as a

simple functions of the difference between the revenue obtainable from

the sale of a number of products and the costs involved in producing those

products, i.e.

Profit(P) = Revenue(R) − Costs(C)

each and sells them at e7.20, the profit per item is e7.20 - e6.50 =

e0.70. The total profit realised from the handling of x items can be

expressed in a similar form:

= (7.20)x − (6.50)x

= (0.7)x

3

The Profit Function

demanded or supplied) and so an expression for profit, also as a function

of x, can be derived as the difference between the revenue and cost

functions:

P(x) = R(x) −C(x)

(supplied or produced)

P(x) is the profit function in terms of x

R(x) is the revenue function in terms of x

C(x) is the cost function in terms of x

4

It is usual to assume that supply and demand of items (or products) is

identical unless specifically stated otherwise.

A maximum profit point for some process can be defined through normal

calculus methods.

The Maximum Profit Point for some process can be

solved by solving the equation

P′ (x) = 0

for x, where

P is the profit function in terms of x

5

Question: A manufacturer knows that if x products are demanded (in

units of 100) in a particular week, then the total cost function is 14 + 3x

and the total revenue function is 19x − 2x2 (in units of e1000).

b) Find the profit break-even points.

maximum profit point) and the amount of profit obtained.

6

a) Here, the total cost and revenue functions are

C(x) = 14 + 3x

R(x) = 19x − 2x2

= (19x − 2x2 ) − (14 + 3x)

= 19x − 2x2 − 14 − 3x

= −2x2 + 16x − 14

7

b) The profit break-even points are the levels of demand which make

P(x) = 0.

Thus, we have

−2x2 + 16x − 14 = 0

=⇒ x2 − 8x + 7 = 0

=⇒ (x − 1)(x − 7) = 0

Thus, x = 1 or x = 7.

Thus, the profit break-even points are when the demand is either 100

or 700 products.

8

c) Profit is maximised when P′ (x) = 0.

Now,

=⇒ P′ (x) = 16 − 4x

and so

P′ (x) = 0 =⇒ x = 4

We note that P′′ (x) = −4 < 0 and so we have a maximum at x = 4.

Thus,

= −32 + 64 − 14

= 18

So the maximum profit is earned when the demand is for 400 units

and the profit is e18,000.

9

In general however, the precise form of cost and revenue functions

are not known and it is more likely that it will be necessary to derive

them from supplied information.

10

Cost Functions

Fixed (or setup) costs This type of cost is normally associated with the

purchase, rent or lease of equipment and fixed overheads. It can

sometimes include the transportation and manpower movement costs

also.

In general, it can be considered as all those costs that need to be

borne before production can physically begin (and thus is

independant of the number of items to be produced).

Variable costs These are costs normally associated with the supply of

the raw materials and overheads necessary to manufacture each

product. Thus, they will depend on the number of items produced.

For example, if x is the number of items produced in a day and each

item costs e2.50, then the daily variable cost is (2.5)x.

11

Special costs This option cost factor is sometimes included in a total cost

function and might cover costs relating to storage, maintenance or

deterioration. The total costs involved are normally expressed in the

form cx2 , where c is a relatively small value and x is the number of

items under consideration.

The effects of this type of cost would only be significant for large

production rungs or other large processes. Hence, a total cost

function takes a general form as follows:

12

Definition: Form of a Cost Function

C(x) = a + bx + cx2

(supplied or produced)

a is the fixed cost associated with the product

b is the variable cost per item

c is the (optional) special cost factor

13

Question: The variable costs associated with a certain process are e0.65

per item. The fixed costs per day have been calculated as e250 with

special costs estimated as (e0.02)x2 , where x is the size of the production

run.

b) Calculate the size of the daily run that will minimise cost per item.

c) Find the cost of a day’s production for a run that minimises cost per

item

14

a) The total cost function is Ctotal (x) = 250 + (0.65)x + (0.02)x2 for the

production of x items (using the information given in the question).

Thus, the cost per item is

Ctotal

C =

x

= 250 + (0.65)x + (0.02)x2

250

= + 0.65 + (0.02)x

x

15

b) The cost per item is minimised when C′ (x) = 0.

250

= − 2 + 0.02

x

and so C′ (x) = 0 gives us

250

− 2

+ 0.02 = 0

x

250

=⇒ x2 = = 12500

0.02

=⇒ x = 112

That is, the size of the daily run which minimises cost per item is 112.

16

c) The cost of a daily run which minimises the cost per item is simply

given by Ctotal (x = 112).

= 150 + 72.8 + 250.88

= 573.68

Thus, the cost of a day’s run which minimises cost per item is

e573.68.

17

Revenue Functions

We can write the revenue function from the output of some process as

follows:

R(x) = x pr (x)

pr (x) is the fixed cost associated with the product.

18

The Demand Function

number of items in demand. That is, the more items that are in demand,

the less the price per unit is. Hence, the reason that price is expressed in

terms of x.

It is usually known as the demand function, where it should be

remembered that (unless otherwise stated) it is assumed that supply and

demand are equal.

The following two sections outline its form and the technique that

sometimes need to be used to identify it.

Demand functions are used to vary the price of an item according to how

many items are being considered. As mentioned in the previous section,

the more the number of items, the less the price per item and vice versa.

19

This is simply the standard business principle of ‘economies of scale,’

where it is generally more efficient to operate on as large a scale as can be

coped with.

Demand functions are normally linear.

pr (x) = a + bx

a, b ∈R

pr (x) is the price function

20

Constructing the Demand Function

In many cases the demand function will not be stated specifically, but

rather given in terms of the price of the unit at two different demand

levels.

In these cases, we assume that the demand function is linear, and

construct the demand function accordingly.

As an example, suppose the price of a product is e0.85 per item when

100 products are demanded, but is e0.68 when 500 items.

So, we assume the demand function is linear and so has the form

pr (x) = a + bx

21

Substituting our two sets of values gives us:

(0.85) = a + b(100)

(0.68) = a + b(500)

Subtracting

=⇒ (0.17) = −400b

and so we have b = −0.000425 and so a = 0.85 + 0.0425 = 0.8925

Thus, our demand function is

22

Question: Given that the price of an item is e3.50 when 250 items are

demanded, but e5.50 per item when only 50 are demanded, identify the

linear demand function and calculate the price per item at a demand level

of 115.

3.5 = a + 250b

5.5 = a + 50b

Substituting into the second equation, 5.5 = a − 0.5 =⇒ a = 6.

Thus, we have pr (x) = 6 − (0.01)x.

Now, pr (115) = 6 − (0.01)(115) = 4.85 and so at a demand level of 115,

the price per item is e4.85.

23

Question: Given the demand function pr (x) = 10.4 − (1.3)x, where x is

in units of 100, find the level of production which maximises total

revenue.

we have

R = x pr (x)

= x(10.4 − 1.3x)

= (10.4)x − (1.3)x2

But R′ (x) = 10.4 − (2.6)x and R′′ (x) = −2.6 so the extrema is a

maximum (as we would expect).

24

Thus,

R′ (x) = 0

=⇒ 10.4 − (2.6)x = 0

=⇒ x = 4

25

Marginal Cost and Revenue Functions

If, for some process, the total cost function, C(x), and the revenue

function, R(x), are identified, where x is the level of activity, then

marginal cost function is defined to be C′ (x) and can be interpreted as

the extra cost incurred of producing another item at activity level x.

as the extra revenue obtained from producing another item at activity

level x.

26

We can use the marginal cost and revenue functions as an alternative way

to calculate the maximum profit point, since, if x = xmax is the maximum

profit point then

P′ (xmax ) = 0

=⇒ C′ (xmax ) − R′ (xmax ) = 0

=⇒ C′ (xmax ) = R′ (xmax )

Thus, solving R′ (x) = C′ (x) also gives us the maximum profit point.

27

Definition: Maximum Profit Point

The maximum profit point for some process can be found

by solving the equation

R′ (x) = C′ (x)

R(x) = is the total revenue function

28

Question: A refrigerator manufacturer can sell all the refrigerators of a

particular type that he can produce. The total cost of producing q

refrigerators per week is given by 300q + 2000. The demand function is

estimated as 500 − 2q

b) Obtain the total profit function.

profit?

d) Show that the solution of the equation R′ (q) = C′ (q) where C(q) is

the cost function, gives the same value for q as in part c.

e) What is the maximum profit available?

29

a) The demand function is pr (q)500 − 2q and so the revenue function is

R(q) = qpr (q) = 500q − 2q2 .

= 500q − 2q2 − (300q + 2000)

= −2q2 + 200q − 3000

30

c) P′ (q) = −4q + 200 (with P′′ (q) = −4, a local maximum).

Thus

P′ (q) = 0

=⇒ −4q + 200 = 0

=⇒ q = 50

d) R′ (q) = 500 − 4q, C′ (q) = 300 and so

R′ (q) = C′ (q)

=⇒ 500 − 4q = 300

=⇒ 4q = 200

=⇒ q = 50

31

e) Substituting q = 50 into the profit function gives us

= 10000 − 5000 − 2000

= 3000

32

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