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(c) 2001 Contemporary Engineering Economics
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L:26 Project Cost Elements and Income Tax Rate to Be Used
ECON 320 Engineering EconomicsMahmut Ali GOKCEIndustrial Systems EngineeringComputer Sciences
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(c) 2001 Contemporary Engineering Economics
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Chapter 9 – Chapter Opening Story
Home Depot – 1,487 retail storesPlant to install self-service checkouts in about 300 high volume stores ($40 million) Use less number of cashiers, shoplifting, and improve customer satisfaction
How do you estimate these cost savings?
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(c) 2001 Contemporary Engineering Economics
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Engineering Economic Decisions
• Evaluation of a Fixed Asset– Equipment– Buildings
• Valuation of Fixed Assets– Based on usable after-tax cash flows the asset
produces
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(c) 2001 Contemporary Engineering Economics
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General Cost Terms
Manufacturing Costs
Direct materials
Direct labor
Mfg. Overhead Non-manufacturing Costs
Overhead
Marketing
Administrative
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(c) 2001 Contemporary Engineering Economics
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Classifying Costs for Financial Statements
Matching Concept: The costs incurred to generate particular revenue should be recognized as expenses in the same period that the revenue is recognized.
Period costs: Those costs that are matched against revenues on a time period basis Matched against periods, they
become expenses immediately Product costs:Those costs that
are matched against revenues on a product basis. Matched against products,
become expenses when the product is sold
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(c) 2001 Contemporary Engineering Economics
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Cost Classification for Predicting Cost Behavior
Volume index Cost Behaviors
Fixed costs
Variable costs
Mixed costs Average unit costs
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Volume Index Cost behavior how a cost item will
react/respond to changes in the level of business activity.
Def: The unit measure used to define “volume” Might be based on production
inputs or outputs Examples:
Automobile – “miles” driven Generating plant – “kWh” produced Stamping machine – “parts”
stamped Fixed and variable cost is two most
common cost behavior patterns
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Fixed Costs
Def: The costs of providing a company’s basic operating capacity
Cost behavior: Remain constant over the relevant range
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(c) 2001 Contemporary Engineering Economics
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Variable Costs Def: Costs that vary
depending on the level of production or sales Depends on volume
Cost behavior: Increase or decrease proportionally according to the level of volume
Marginal contribution= unit sales price-unit variable cost
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Mixed Costs
Partly fixed, partly variable costs Depreciation of a car,
Car depreciates as time goes by, no matter how much you drive.
Car depreciates more if you drive it more. Electric bill:
Electric usage for lighting heating: independent of production volume
More production, more machines work, use more electricity
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Average Unit Cost
Def: activity cost per unit basis
Cost Behaviors: Fixed cost per unit varies
with changes in volume. Variable cost per unit of
volume is a constant.
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Practice Problem
You have 3000 units to produce. Total labor cost = $20,000 Total material cost = $25,000 Total overhead cost = $15,000 Total fixed cost = $40,000 What is the average cost per unit?
Average cost = ($100,000)/3,000 = $33.33/unit
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(c) 2001 Contemporary Engineering Economics
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What Income Tax Rate Should be Used in Project Analysis?
Regular Business
Project
Revenues
Expenses
$200,000
$130,000
$40,000
$20,000
Taxable Income
Income Taxes
$70,000
$12,500
$20,000
?
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(c) 2001 Contemporary Engineering Economics
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Incremental Income Tax Rate
Before Undertaking
Project
After Undertaking
Project
The Effect
of Project
Gross revenue $200,000 $240,000 $40,000
Expenses 130,000 150,000 20,000
Taxable income $70,000 $90,000 $20,000
Income taxes $12,500 $18,850 $6,350
Average tax rate 17.86% 20.94% 31.75%
This is the tax rate that should be used in project in project evaluation.
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Before After Incremental
Taxable income $70,000 $90,000 $20,000
Income taxes 12,500 18,850 6,350
Average tax rate 17.86% 20.94%
Incremental tax rate 31.75%
$0 $20,000 $40,000 $60,000 $80,000 $100,000
Regular income from operation
$20,000 incrementaltaxable income due toundertaking project
Marginal tax rate15% 25% 34%
$5,000at 25%
$15,000at 34%
0.25($5,000/$20,000) + 0.34($15,000/$20,000) = 31.75%