Chapter 2

Cost Concepts And Design Economic

Created By : Eng. Saad Hamasha

& Eng.Maysaa Gharaybeh

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.

Example :insurance and taxes on facilities, administrative salaries, license fees, and interest costs on borrowed capital.

Variable Costs :

• It vary in total with the number of the output unite .

• Example :

costs of material and labor used in a product or service, because they vary in total with the number of output units even though costs per unit remain the same.

More ways to categorize costs

• Direct: can be measured and allocated to a specific

work activity

(Materials, Labor)

• Indirect: difficult to attribute or allocate to a

specific output or work activity

(overhead, maintenance)

• Standard cost: cost per unit of output,

Standard costs play an important role in cost control and

other management functions.

• Cash cost: a cost that involves a payment of cash.

• Book cost: a cost that does not involve a cash

transaction but is reflected in the accounting

system.

( equipments, machines, Depreciation)

• Sunk cost: a cost that has occurred in the past and

has no relevance to estimates of future costs and

revenues related to an alternative course of action.

(money spend on a passport)

• Opportunity cost: the monetary advantage foregone due to limited resources. The cost of the best rejected opportunity.

( A student can work with 10,000$ Per year.

or goes to the university for a year and spend 5,000$.

Opportunity cost = 15,000$)

• Life-cycle cost: the summation of all costs related to a product, structure, system, or service during its life span.

Example 2-1

Cost Factor Site A Site B

Distance 6 miles 4.3 miles

Monthly rental cost

$1,000 $5,000

Cost (Set up $ Removing) Equipment

$15,000 $25,000

Hauling expenses

$1.15/yd3 – mile

$1.15/yd3 – mile

Flag person No need $96/day ($8,160)

•5,000 cubic yards of asphalt

•4 months (17 weeks 5- days a week)

•Compare the

2 sites??!!!!!

•NOTE:

•Rent , Set up/ Removal and Flag person are Fixed costs BUT

BUT Hauling is variable cost

Site A = 6*5000*$1.15 = $345,000

Site B= 4.3*5,000*$1.15 = $247,250

Then the total cost is

2. Which is the better site? Site B

3. How many cubic yards of asphalt does the contractor have to

deliver before starting to make a profit if paid 8.05$ per cubic yard

The General Economic Environment

Consumer and Producer Goods and Service

Consumer Goods and Service: are those

products or service that are directly used by

people to satisfy their wants.

Producer Goods and Service: are used to

produce consumer goods or service or other

producers goods.

Goods and service are produced and desired because they

have utility.

Utility: The power to satisfy human wants and needs.

Utility is most commonly measured in terms of value.

Value: the price that must be paid to obtain the particular

item.

Necessities and Luxuries needs.

Price And Demand

Engineering focusing on increasing the utility (value) of materials by changing their form or location.

P : the price that must be paid

D: is the quantity that must be demanded or purchased

The general price-demand relationship

The demand for a product or service is directly related to

its price according to

p = a - bD

for 0 ≤ D ≤ a/b , a > 0, b > 0

where p is price, D is demand, and a and b are constants

that depend on the particular product or service.

a = price axis intercept

-b = slope

Competition

Perfect Competition: occurs in a situation in which any

given product is supplied by a large number of venders and

there is no restriction on additional suppliers entering the

market (never occurs in actual practice).

Perfect Monopoly: exist when a unique product or service is

only available from a single supplier and that vender can

prevent the entry of all others into the markets.

(rarely occurs in the practice)

Total Revenue Function

Total revenue is the product of the selling price per unit,

p, and the number of units sold, D.

TR = p × D

From: p = a – bD

We find:

Maximize Revenue

b

aD

2ˆ The demand at maximum revenue:

2DbDaTR

b

a

b

a

b

aDbDaTRMaximum

442ˆˆ

2222

022

2

bdD

TRd

Profit

Profit = Total Revenue (TR) – Total Cost (CT)

VFT CCC

Total Cost (CT) = Fixed Cost (CF) + Variable Cost (CV)

DcC vV

Variable Cost (CV) = Variable cost per unit (cv) × Demand (D)

DcCC vFT Total Cost:

Maximum profit

Scenario 1: Demand is a function of price ( p = a – bD)

2DbDaTR

Profit = Total Revenue (TR) – Total Cost (CT)

DcCC vFT and

and 2DbDaTR

Then )()(Profit 2 DcCDbDa vF

Fv CDcaDb )(Profit 2

To find the maximum profit 02)(

DbcadD

profitdv

b

caD v

2*

Demand at Max profit:

02)(

2

2

bdD

profitd

Breakeven points are found when

Total Revenue = Total Cost.

DcCDbDa vF 2

0)(2 Fv CDcaDb

b

CbcacaD Fvv

2

4 21

2

The demand at breakeven:

Example: A company produces an electronic timing switch. The fixed

cost (CF) is 73,000$ per month. The variable cost per unit (cv) is

83$. The selling price per unit (p = 180$ – 0.02D).

A. Determine the optimal volume of product?

B. Find the volume at breakeven occurs, what is the range of

profitable demand?

Solution:

A. a = 180, b = 0.02

monthperunits425,202.02

83180

2*

b

caD v

B. Total Revenue = Total Cost.

DcCDbDa vF 2

0)(2 Fv CDcaDb

b

CbcacaD Fvv

2

4 21

2

02.02

7300002.049797 21

2

D

monthperunit93204.0

74.59971

D

monthperunit918,304.0

74.59972

D

Range = 932 to 3,918 unit per month

Scenario 2: Price and Demand are independent

TR = P × D

Example:

Variable cost per service hour = 62$.

Selling price = 85.56$ per hour.

Maximum Hours per year = 160,000 hours.

Fixed cost = 2,024,000$ per year.

A. What is the breakeven point in hours and in % of total capacity?

Total revenue = Total cost (breakeven)

DcCDp vF

v

F

cp

CD

yearperhours908,85

6256.85

2024000

D

capacityof%7.53537.0000,160

908,85D

B. What is the % reduction In breakeven point (sensitivity) if:

1. Fixed cost reduced by 10%?

2. variable cost per hour reduced by 10%?

yearperhours138,776256.85

20240009.0

D

%101.0908,85

318,77908,85reduction

D

yearperhours011,68

629.056.85

2024000

D

%8.20208.0908,85

011.68908,85reduction

D

3. selling price increase by 10%?

yearper hours021,63

6256.851.1

2024000

D

%6.26266.0908,85

021,63908,85reduction

D

Then the breakeven point is more sensitive to reduction in

variable cost than fixed cost