ENGINEERING ECONOMY Chapter #2: Cost Concepts and Design Economics

By:

Eng. Ahmed Y Manama

Outline

• Fixed, Variable, and Incremental Cost • Recurring and Nonrecurring Costs • Direct, Indirect and Overhead Costs • Cash Cost Versus Book Cost • Sunk Cost and Opportunity Costs

Cost Estimating

Used to describe the process by which the present and future cost consequences of

engineering designs are forecast

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.

• Typical fixed costs include:

Insurance and taxes on facilities

General management and administrative salaries

License fees

Interest costs on borrowed capital.

• Fixed costs will be affected When:

Large changes in usage of resources occur

Plant expansion or shutdown is involved

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, because they

vary in total with the number of output units -- even though costs per

unit remain the same.

Fixed, Variable, and Incremental Costs • Incremental Cost: additional cost that results from increasing

output of a system by one (or more) units.

• Incremental cost is often associated with “go / no go” decisions

that involve a limited change in output or activity level.

EXAMPLE: the incremental cost of driving an automobile

might be $0.27 / mile. This cost depends on:

1. mileage driven;

2. mileage expected to drive;

3. age of car;

RECURRING AND NONRECURRING COSTS

• Recurring costs: repetitive and occur when a firm produces

similar goods and services on a continuing basis.

• Variable costs are recurring because they repeat with each unit

of output.

• A Fixed cost that is paid on a repeatable basis is also a recurring

cost:

Office space rental

RECURRING AND NONRECURRING COSTS

• Nonrecurring costs: 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 are purchase cost for real estate upon which a plant

will be built, and the construction costs of the plant itself;

Direct, Indirect and Overhead Costs • Direct Costs can be 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 are difficult to allocate to a specific output or

activity

costs of common tools, general supplies, and equipment maintenance ;

• Overhead consists of plant operating costs that are not direct

labor or material costs

indirect costs, overhead and burden are the same;

Cash Cost Versus Book Cost • Cash cost is a cost that involves payment in cash and results in

cash flow;

• Book cost or noncash cost is a payment that does not involve

cash transaction

book costs represent the recovery of past expenditures over a fixed

period of time;

• Depreciation is the most common example of book cost;

depreciation is what is charged for the use of assets, such as plant and

equipment; depreciation is not a cash flow;

Sunk Cost and Opportunity Cost • Sunk Cost is one that has occurred in the past and has no

relevance to estimates of future costs and revenues related to an

alternative course of action;

• Opportunity Cost is the cost of the best rejected ( i.e., foregone

) opportunity and is hidden or implied;

Example A municipal solid-waste site for a city must be located at Site A or Site

B. After sorting, some of the solid refuse will be transported to an electric

power plant where it will be used as fuel. Data for the hauling of refuse from

each site to the power plant are shown in Table P2-4.

If the power plant will pay $8.00 per cubic yard of sorted solid

waste delivered to the plant, where should the solid-waste site be

located? Use the city’s viewpoint and assume that 200,000 cubic

yards of refuse will be hauled to the plant for one year only. One

site must be selected.

Solution

Consumer and Producer Goods and Services

• Consumer goods and services are those products or services

that are directly used by people to satisfy their wants. Food,

clothing, homes, cars , television sets, haircuts, opera, and

medical services are examples

• Producer goods and services are used to produce consumer

goods and services or other producer goods. Machine tools,

factory buildings, buses, and farm machinery are examples.

Utility And Demand • Utility is a measure of the value which consumers of a product

or service place on that product or service;

• Demand is a reflection of this measure of value, and is

represented by price per quantity of output

• The demand for a product or service

is directly related to its price according

to P = a‐bD

where p is price, D is demand,

and a and b are constants that

depend on the particular

product or service.

• a=Y‐axis (quantity) intercept,

(price at 0 amount demanded)

• b = slope of the demand function

Total Revenue Function • Total revenue is the product of the selling price per unit, p, and

the number of units sold, D.

Total Revenue Function as a Function of Demand

• The demand, D, that will produce maximum total revenue

can be obtained by solving

Cost, Volume, and Breakeven Point Relationships

• At any demand D, total cost is

• For the linear relationship assumed here, where

𝐶𝑣is the variable cost per unit.

The optimal demand at which maximum profit will occur by taking the

first derivative of the last Equation with respect to D and setting it

equal to zero:

Example

P 2-12. A company produces circuit boards used to update outdated computer equipment. The fixed cost is $42,000 per month, and the variable cost is $53 per circuit board. The selling price per unit is p = $150−0.02 D. Maximum output of the plant is 4,000 units per month.

a. Determine optimum demand for this product.

b. What is the maximum profit per month?

c. At what volumes does breakeven occur?

d. What is the company’s range of profitable demand?

Home Work Assignments HW𝟐

1, 3 , 9 ,13 ,14 ,15 ,17 , 19 Deadline 2/11/2014