chapter 2 cost concepts and the economic environment
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CHAPTER 2
COST CONCEPTS AND THE ECONOMIC ENVIRONMENT
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Learning Objectives• Cost estimating• Fixed, Variable, and incremental costs• Recurring and nonrecurring costs• Direct, indirect, and overhead cost• Sunk costs and opportunity costs• Life-cycle cost• The general economic environment• The relationship between price and demand• The total revenue function• Breakeven point relationships• Maximizing profit/minimizing cost• Cost-driven design optimization• Present economy studies
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COST ESTIMATING• Most difficult, expensive, and time-
consuming part of an engineering study
• Used to describe the process by which the present and future cost consequences of engineering designs are forecast
• Briefly introduce the role of cost estimating in practice
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COST ESTIMATING PURPOSES
• Provides information used in setting a selling price for quoting, bidding, or evaluating contracts
• Evaluates how much capital can be justified for process changes or other improvements
• Establishes benchmarks for productivity improvement programs
• Determines whether a proposed product can be made and distributed at a profit (EG: price = cost + profit)
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COST ESTIMATING APPROACHES
• Top-down Approach
• Bottom-up Approach
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TOP-DOWN APPROACH
• Uses historical data from similar engineering projects
• Estimates costs, revenues, and other parameters for current project
• Modifies original data for changes in inflation / deflation, activity level, weight, energy consumption, size, etc…
• Best use is early in estimating process
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BOTTOM-UP APPROACH• More detailed cost-estimating method• Attempts to break down project into
small, manageable units and estimate costs, etc….
• Smaller unit costs added together with other types of costs to obtain overall cost estimate
• Works best when detail concerning desired output defined and clarified
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Cost Terminology
• Selected cost concepts important in engineering economy
• Use of various cost terms and their concepts
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FIXED, VARIABLE, AND INCREMENTAL COSTS
• Fixed Costs– Unaffected by changes in activity level over a
feasible range of operations for the capacity or capability available
– Include insurance and taxes on facilities, general management and administrative salaries, license fees, and interest costs on borrowed capital
– When large changes in usage of resources occur, or when plant expansion or shutdown is involved fixed costs will be affected
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FIXED, VARIABLE AND INCREMENTAL COSTS
• Variable Costs– Associated with an operation that vary in total
with the quantity of output or other measures of activity level
– Example of variable costs include:• Costs of material and labor used in a product or
service• Vary in total with the number of output units -- even
though costs per unit remain the same
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FIXED, VARIABLE AND INCREMENTAL COSTS
• Incremental Cost (or incremental Revenue)– Additional cost (or revenue) that results from an
increasing the output of a system by one or more units
– Often associated with “go-no go” decisions that involve a limited change in output or activity level
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RECURRING AND NONRECURRING COSTS
• RECURRING COSTS– Repetitive and occur when a firm produces
similar goods and services on a continuing basis
– Represent recurring costs because they repeat with each unit of output
– Example• A fixed cost that is paid on a repeatable basis is
also a recurring cost– Office space rental
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RECURRING AND NONRECURRING COSTS
• NONRECURRING COSTS– Are not repetitive, even though the total
expenditure may be cumulative over a relatively short period of time
– Typically involve developing or establishing a capability or capacity to operate
– Examples• purchase cost for real estate upon which a plant
will be built• Construction costs of the plant itself
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DIRECT, INDIRECT AND OVERHEAD COSTS
• Direct Costs– Reasonably measured and allocated to a
specific output or work activity– Labor and material directly allocated with a
product, service or construction activity
• Indirect Costs– Difficult to allocate to a specific output or
activity– Costs of common tools, general supplies, and
equipment maintenance
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DIRECT, INDIRECT AND OVERHEAD COSTS
• Overhead– Consists of plant operating costs that are not direct
labor or material costs
• Indirect costs, overhead and burden are the same
• Common method of allocating overhead costs among products, services and activities is called prime cost
• Allocates in proportion to the sum of direct labor and materials cost
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STANDARD COSTS
• Representative costs per unit of output that are established in advance of actual production and service delivery;
Standard Cost Element Sources of DataDirect Labor Process routing sheets,
+ standard times, standard labor rates;
Direct Material Material quantities per + unit, standard unit
materials cost;Factory Overhead Costs Total factory overhead
costs allocated based on prime costs;
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SOME STANDARD COST APPLICATIONS
• Typical uses are the following:– Estimating future manufacturing or service
delivery costs– Measuring operating performance by
comparing actual cost per unit with the standard unit cost
– Preparing bids on products or services requested by customers
– Establishing the value of work-in-process and finished inventories
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CASH COST VERSUS BOOK COST• Cash cost
– Involves payment in cash and results in cash flow
• Book cost or noncash cost– Does not involve cash transaction– Represent the recovery of past expenditures
over a fixed period of time• Depreciation is the most common example of book
cost• Depreciation is charged for the use of assets, such as
plant and equipment• Depreciation is not a cash flow
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SUNK COST AND OPPORTUNITY COST
• Sunk cost– Occurred in the past and has no relevance to
estimates of future costs and revenues related to an alternative
• Opportunity cost– Cost of the best rejected ( i.e., foregone )
opportunity and is hidden or implied
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LIFE-CYCLE COST
• Summation of all costs, both recurring and nonrecurring, related to a product, structure, system, or service during its life span
• Begins with the identification of the economic need or want ( the requirement ) and ends with the retirement and disposal activities
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PHASES OF THE LIFE CYCLE
PHASE STEP COSTAcquisitionNeeds Assessment Rising at increasing rate
Conceptual design Rising at increasing rate
Detailed Design Rising at decreasing rate
Operation Production/Construction Rising at decreasing rate
Operation/Customer Use Constant
Retirement/Disposal Constant
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CAPITAL AND INVESTMENT
• Investment Cost– Capital (money) required for most activities of the acquisition
phase
• Working Capital– Refers to the funds required for current assets needed for start-
up and subsequent support of operation activities
• Operation and Maintenance Cost– Includes many of the recurring annual expense items associated
with the operation phase of the life cycle
• Disposal Cost– Includes non-recurring costs of shutting down the operation
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GENERAL FORMULA• Life Cycle Cost =
Investment Costs +
Working Capital +
O&M Costs+
Disposal Costs
or Salvage Value (if any)
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CONSUMER GOODS AND PRODUCER GOODS AND SERVICES
• CONSUMER GOODS AND SERVICES– Directly used by people to satisfy their wants;
• PRODUCER GOODS AND SERVICES– Used in the production of consumer goods
and services: machine tools, factory buildings, buses and farm machinery are examples
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UTILITY AND DEMAND
• Utility– Measure of the value which consumers
of a product or service place on that product or service;
• Demand– Reflection of this measure of value, and
is represented by price per quantity of output
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Price
Demand
Price equals some constant value minus some multiple of the quantity demanded: p = a - b D
a
a = Y-axis (quantity) intercept, (price at 0 amount demanded);
b = slope of the demand function;
D = (a – p) / b
Price
Total Revenue = p x D= (a – bD) x D=aD – bD2
Demand
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Price
Demand
Price equals some constant value minus some multiple of the quantity demanded: p = a - b D
a
a = Y-axis (quantity) intercept, (price at 0 amount demanded);
b = slope of the demand function;
D = (a – p) / b
Price
Total Revenue = p x D
= (a – bD) x D=aD – bD2
Demand
dTR / dD = a –2bD = 0TR = Max
D*=a/2b
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Co
st /
Rev
enu
e
Demand
Cf
D’1 D’2D*
ProfitTotal Revenue
MaximumProfit
Profit is maximum where Total Revenue exceeds
Total Cost by greatest amount
D’1 and D’2 are breakeven points
Total costCt= Cf + Cv
Where Cv=cvD
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PROFIT MAXIMIZATION D*• Profit maximization can be shown
algebraically
• Profit (loss) = total revenue-total costs
• = (aD-bD2) – (CF+CvD) = -bD2+(a-cv)D-CF
• Occurs by taking d(profit)/dD =a-cv-2bD=0
• D* = [ a - (Cv) ] / 2b
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BREAKEVEN POINTD’1 and D’2
• Occurs where TR = Ct
• ( aD - D2 ) / b = Cf + (Cv ) D
• - D2 / b + [ (a / b) - Cv ] D - Cf
• Using the quadratic formula: D’ = - [ ( a / b ) - Cv ] + { [ (a / b ) - Cv ]
2 - ( 4 / b ) ( - Cf ) }1/2
------------------------------------------------------------------------2 / b
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Example-Problem 2-8• Given:
– Relationship between price and demand is:• D = 780 - 10p (units/month)
– Fixed Cost (CF) = $800/month– Variable Cost per Unit (cv) = $30/unit
• Assumptions:– All units produced will be sold
• Find: – a) D* = number of units produced to maximize profit– b) Maximum profit per month for the product; and– c) Range of profitable demand (production) in
units/month
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Solution• Part a
– Profit = TR - CT = pD - CF – cvD, solving for p: p = 78 - 0.1D– Profit = (78 - 0.1D)D - 800 - 30D=48D - 0.1D2 - 800– Take first derivative and set = 0– dProfit/dD = 48 - 0.2D* = 0– D* = 48/0.2 = 240 units/month, or D* = 240 units/month
• Part b– Using equation for profit from part a) and D* = 240, Profit = 48D -
0.1D2 - 800– Profit = 48(240) - 0.1(240)2 - 800 = $4,960– Maximum Profit = $4,960/month
• Part c– Breakeven points occur when TR = CT (profit = 0)– Profit = 48D - 0.1D2 - 800 = 0– = D2 - 480D + 8000 = 0
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COST-DRIVEN DESIGN OPTIMIZATION
• Must maintain a life-cycle design perspective
• Ensures engineers consider:– Initial investment costs– Operation and maintenance expenses– Other annual expenses in later years– Environmental and social consequences over
design life
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COST-DRIVEN DESIGN OPTIMIZATION PROBLEM TASKS
1. Determine optimal value for certain alternative’s design variable
2. Select the best alternative, each with its own unique value for the design variable
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COST-DRIVEN DESIGN OPTIMIZATION PROBLEM COST TYPES
1. Fixed cost(s)2. Cost(s) that vary directly with the design variable3. Cost(s) that vary indirectly with the design
variable
Simplified Format of Cost Model With One Design Variable Cost = aX + (b / X) + k
a is a parameter that represents directly varying cost(s)b is a parameter that represents indirectly varying cost(s)k is a parameter that represents the fixed cost(s)X represents the design variable in question
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GENERAL APPROACH FOR OPTIMIZING A DESIGN WITH RESPECT TO COST
1. Identify primary cost-driving design variable2. Write an expression for the cost model in terms of
the design variable3. Set first derivative of cost model with respect to
continuous design variable equal to 04. Solve equation in step 3 for optimum value of
continuous design variables5. For continuous design variables, use the second
derivative of the cost model with respect to the design variable to determine whether optimum corresponds to global maximum or minimum.
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PRESENT ECONOMY STUDIES• Rules for comparing alternatives for one year
or less (time on money is irrelevant)• Rule 1
– Revenues and other economic benefits are present and vary among alternatives
– Choose alternative that maximizes overall profitability based on the number of defect-free units of output
• Rule 2– Revenues and economic benefits are not present
or are constant among alternatives– Consider only costs and select alternative that
minimizes total cost per defect-free output
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PRESENT ECONOMY STUDIES
• Total Cost in Material Selection– Selection among materials cannot be based solely
on costs of materials. Frequently, change in materials affect design, processing, and shipping costs
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Example• After machining, the finished volume of a certain
metal part is 0.17 cubic inch• Data for two types of metal being considered for
manufacturing the part are given below:
• Determine the cost per part for both types of material and recommend which material to use
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Solution• Brass:
• Labor: (0.64 min/pc)($12.00/hr)(1 hr/60 min) = $0.128/pc• Material: ($0.96/lb) (0.31 lb/ in3 ) (0.3 in3 ) -(0.3 in3 / pc - .17 in3 /
pc)($0.24/lb)(0.31 lb/in3)= $0.079/pc• Total Cost = $0.207/pc
• Aluminum:• Labor: (0.42 min/pc)($12.00/hr)(1 hr/60 min) = $0.084/pc• Material: ($0.52/lb - $0.00/lb)(0.10 lb/in3) (0.45 in3)= $0.023/pc• Total Cost = $0.107/pc
• (Choose Aluminum to minimize total cost)
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PRESENT ECONOMY STUDIES
• Alternative Machine Speeds– Operate at different speeds, resulting in different
rates of product output– Lead to present economy studies to determine
preferred operating speed
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PRESENT ECONOMY STUDIES• Make Versus Purchase Studies• if:
• Direct, indirect or overhead costs are incurred regardless of whether the item is purchased from an outside supplier, and
• The incremental cost of producing the item in the short run is less than the supplier’s price
• The relevant short-run costs of the make versus purchase decisions are the incremental costs incurred and the opportunity costs of resources
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Example• The company is currently purchasing a part and is
considering manufacturing the part in-house• This company is not operating at full capacity, and
no other use for the excess capacity is contemplated
• Unit costs are given below:
• Should the part be made in-house or purchased?
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Solution• Assumptions:
• Utilizing the excess capacity has no opportunity costs• This product will not change fixed overhead for the plant
• Solution: Focus on differences - what really changes?
• The incremental cost to make the product in-house is actually $3.75 per unit versus $7.50 to purchase
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Next Agenda
• Concentrate on the concepts of money-time relationships and economic equivalence
• Consider the time value of money in evaluating the future revenues and costs associated with alternative uses of money