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Transcript of 1 Understanding Project Cost Elements Lecture No. 22 Chapter 9 Fundamentals of Engineering Economics...
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Understanding Project Cost Elements
Lecture No. 22Chapter 9Fundamentals of Engineering EconomicsCopyright © 2008
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Evaluation of a Fixed Asset– Equipment– Buildings
Valuation of Fixed Assets– Based on usable after-tax cash flows the asset
produces
Engineering Economic Decisions
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Classifying Costs for Manufacturing Environment
Manufacturing Costs
Direct Materials
Direct Labor
Mfg. Overhead Non-manufacturing Costs
Overhead
Marketing
Administrative Functions
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Cost Flows and Classifications 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
Product costs: Those costs that are matched against revenues on a product basis.
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Classifying Costs for Predicting Cost Behavior
Volume index Cost Behaviors
Fixed costs Variable costs Mixed costs
Break-Even Sales Volume
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Volume Index
Def: The unit measure used to define “volume”
Examples: Automobile – “miles”
driven Generating plant – “kWh”
produced Stamping machine –
“parts” stamped Assembly plant – “units”
assembled
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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
Typical examples: building rents, depreciation of buildings, machinery and equipment
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Variable Costs
Def: Costs that vary depending on the level of production or sales
Cost behavior: Increase or decrease proportionally according to the level of volume
Typical examples: direct labor cost, material cost, and fuel consumption
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Mixed Costs
Def: a cost with both fixed and variable elements
Cost Behavior: y = a + bx, where “a” is a fixed cost
Typical examples: cost of electric power (lighting/heating/ac – fixed; power consumption by operating equipment – variable)
Tot
al c
ost
Operating Volume, X
a
0
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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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Contribution Margin/Break-Even Sales Volume Unit contribution margin
Unit contribution margin = unit sales price – unit variable cost
Contribution margin Contribution margin = total sales revenue – total
variable costs Break-even sales volume
Fixed expensesBreak-Even Point =
Unit contribution margin
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Example 9.1 Break-Even Sales Volume Monthly break-even
point:
Number of units to be sold to make $50,000 profit before tax:
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Cost-Volume-Profit Graph
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Why Do We Use Cash Flow in Project Evaluation?
Company A Company B
Year 1 Net income
Cash flow
$1,000,000
1,000,000
$1,000,000
0
Year 2 Net income
Cash flow
1,000,000
1,000,000
1,000,000
2,000,000
Example: Both companies (A & B) have the same amount ofnet income and cash sum over 2 years, but Company A returns $1 million cash yearly, while Company B returns $2 millionat the end of 2nd year. Company A can invest $1 million in year1, while Company B has nothing to invest during the same period.
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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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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 evaluation.
Incremental Income Tax Rate
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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 the 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%
Graphical Illustration of Incremental Tax Rate