Engineering Economy Chapter # 02
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Transcript of Engineering Economy Chapter # 02
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COST CONCEPTS AND
DESIGN ECONOMICSChapter # 2
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Objectives
Objectives of Chapter 2 are:
Describe some of the basic cost terminology and concepts encounteredin the book
Illustrate how they should be used in engineering economic analysis anddecision making
Following topics are discussed:
Fixed, variable and incremental costs
Recurring and nonrecurring costs
Direct, indirect and overhead costs
Standard costs
Cash cost versus book cost
Sunk and opportunity costs Life cycle and life cycle costs
General economic environment
Relationship between price and demand, total revenue function
Break even point(s), maximizing profits, present economy studies
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Introduction
Need balancing between technical and economical
feasibility
Engineering economy should be used to attain
acceptable balance
Chapter # 2 integrates cost concepts, principles ofengineering economy and design consideration
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Cost Estimating
The process by which the present and future cost consequences of engineeringdesigns are forecast
Most prospective characteristics
Projectsrelatively unique
Based on past outcomes and adjust the data
Involve personnel from several sectors
Purposes
Provide information used in setting a selling price for quoting, bidding, orevaluating contracts
Determine whether a proposed product can be made and distributed at a profit (for
simplicity, price=cost + profit) Evaluate how much capital can be justified for process changes or other
improvements
Establish benchmarks for productivity improvement programs
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Cost EstimatingApproaches
Top-down Approach
Uses historical data for current projects - costs, revenues, andother parameters
Modifies original data for changes in inflation/deflation, activitylevel, weight, energy consumption, size, etc...
Works well at earlier stages of the estimation
Bottom-up Approach More detailed method of cost estimating
Break down a project into small, manageable units and estimate
costs and economic consequences Works best when details concerning desired output are
defined and clarified
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Origins of Engineering Economy
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Fixed, Variable & Incremental Costs
Fixed Cost
Those unaffected by changes in activity level over afeasible range of operations for the capacity or capabilityavailable
Variable Costs Those associated with an operation that vary in total with
the quantity of output or other measures of activity level
Incremental Costs or Incremental Revenue The additional cost or revenue that results from increasing
the output of a system by one (or more) units
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Example 2-1
In connection with surfacing a new highway, a contractor has a choice of two sites on whichto set up the asphalt-mixing plant equipment. The contractor estimates that it will cost $1.15
per cubic yard per mile (yd/mile) to haul the asphalt-paving material from the mixing plant tothe job location. Factors relating to the two mixing sites are as follows (production costs ateach site are the same):
The job requires 50,000 cubic yards of mixed-asphalt-paving material. It is estimated thatfour months (17 weeks of five working days per week) will be required for the job. Comparethe two sites in terms of their fixed, variable, and total costs. Assume that the cost of thereturn trip is negligible. Which is the better site? For the selected site, how many cubicyards of paving material does the contractor have to deliver before starting to make a profitif paid $8.05 per cubic yard delivered to the job location?
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Cost Factor Site A Site BAverage hauling distance 6 miles 4.3 milesMonthly rental of site $1,000 $5,000Cost to set up and remove equipment $15,000 $25,000Hauling expense $1.15/yd3-mile$1.15/yd3-mileFlag person Not required $96/day
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Example 2-1
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Cost Factor Site A Site B
Average hauling distance 6 miles 4.3 miles
Monthly rental of site $1,000 $5,000
Cost to set up and remove equipment $15,000 $25,000
Hauling expense $1.15/yd3- mile $1.15/yd3- mile
Flag person Not required $96/day
Select a site among A & B (tables) ?
Requires 50,000 yd3at job location
1.15/yd3-mile for asphalt mixing plant
production costs at each site are the same
4 month ( 17 weeks x 5 days)
Break even with paid $8.05 / yd3?
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Example 2-1
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Cost Fixed Variable Site A Site B
Rent X = $ 4,000 = $ 20,000
Setup/removal X = 15,000 = 25,000
Flag person X = 0 5(17)($96) = 8,160
Hauling X 6(50,000) ($1.15) = 45,000 4.3(50,000)($1.15) = 247,250
Total: $ 364,000 = $300,410
Select B : larger fixed cost + smaller variable cost
Profit (break even)
4.3 ($1.15) = $4.945/ yd3
Total Cost = Total Revenue
fixed + variable = Revenue
$53,160 + $4.945 X= $8.05 x $4.945
X= 17,121 yd3delivered
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Example 2-2
Problem : Cost for trips
4 students 400 miles driving x 2 ways
Cost list (table)
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Cost Element Cost per mile
Gasoline $0.120
Oil and lubrication 0.021
Tires 0.027
Depreciation 0.150
Insurance and taxes 0.024Repairs 0.030
Garage 0.012
Total $0.384
*
**
*
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Example 2-2
Solution 1 (Car owner)
Cost/mile = $ 0.384 (annual average 15,000 miles) 0.384 x 800 mile = $ 102.4 x 3
Solution 2 (Other students)
Cost/mile = $ 0.198 (Gasoline, Oil and lubrication, Tires, Repairs) 0.198 x 800 mile = $ 158.40 = $ 52.80 x 3
Solution 3 (considering additional miles)
15,000 x $0.384 = $5760 18,000 x $ ? = $6570 (given cost service)
$810 / 3,000 = $0.270
0.27 x 800 mile = $216.00 = $72.00 x 3
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Direct, Indirect and Standard 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
ex: material cost for a pair of scissors
Indirect costs
difficult to allocate to a specific output or activity
costs allocated through a selected formula (such as, proportional to direct
labor hours, direct labor cost, direct material cost, or others)
ex: costs of common tools, general supplies, and equipment maintenance indirect costs = overhead = burden
ex: electricity, general repairs, property taxes, supervision
administrative selling expensesadded to direct cost
allocate overheads costs among product/services/activates
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Direct, Indirect and Standard Costs
Standard Costs
representative costs/unit established in advance
developed from anticipated direct labor hours, materials,overhead categories with their established costs per unit
Important role in cost control and other management
some typical uses are the following: estimating future manufacturing costs
measuring operating performance by comparing actual costper unit with the standard unit cost
preparing bids on products or services requested bycustomers
establishing the value of work in process and finishedinventories
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Standard Costs
Standard Cost Element Sources of Data for Standard Costs
Direct Labor
+
Direct Material
+
Factory Overheads
Process Routing sheets, standard times,standard labor rates
Material quantities per unit, standard unit
material costs
Total factory overhead costs allocatedbased on prime costs (direct labor plusdirect material costs)
= Standard cost (per unit)
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Cash Cost versus Book Cost
Cash cost
a cost that involves payment in cash and results in cash flow future transaction (potential) incurred for the alternatives
Book cost
costs that do not involve cash payment but rather represent therecovery of past expenditures over a fixed period of time such asdepreciation
depreciation
is not a cash flow
only affects income taxes, cash flow
EE needs to consider only cash flows or potential cash flows
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Sunk Cost
Sunk cost
one that has occurred in the past has no relevance to estimates of future costs and revenues related to an
alternative course of action
nonrefundable cash outlays
ex motorcycle 1 -$40 (down payment) + $1260 = $1300
motorcycle 2 - $40 (down payment) + $1230 = $1270 emotionally difficult to do
Example 2-3
Original Purchasing Price - $50,000
Current Book value - $ 20,000 Current Market price - $5,000
Sunk Cost
View 1 - $50,000 : sunk cost for replacement
View 2 - $15,000 : difference between real value and book value
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Opportunity Cost
Opportunity cost
the cost of the best rejected (i.e., foregone) opportunity
Incurred because of the limited resources
Ex: Student for working - $20,000
for going to school - $5,000 (expenses)
opportunity cost - $25,000 ($5,000 cash outlay and
$20,000 for income foregone)
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Example 2-4
Purchasing - $50,000
Book value - $ 20,000
Market price - $5,000
By keeping the equipment, the firm is giving up the
opportunity to obtain $5,000 from its disposal $5,000 immediate selling price is really the
investment cost of not replacing the equipment andis based on the opportunity cost concept
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LifeCycle Cost
Summation of all costs
both recurring and nonrecurring related to a product, structure, system, or service during its life
span
Life cycle begins with the identification of the economic need or want
ends with the retirement and disposal activities
functional or economic basis (shorter than functional)
ex: old boiler may be able to produce the steam required, but not
economically enough for the intended use
Fi 2 1 Ph f th Lif C l d Th i
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Figure 2-1 Phases of the Life Cycle and TheirRelative Cost
Fig re 2 2 Costs of Design Changes Are
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Figure 2-2 Costs of Design Changes AreSignificant
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LifeCycle Cost
Investment cost
capital required in acquisition phase
a single or a series of expenditure
capital investment
Working capital
funds required for current assets for start up & operational activities
materials in inventory for delivery spare parts, tools, personnel for maintenance
cash for employee salaries, other expenses
Operation & Maintenance cost
recurring annual expense items
people, machine, materials, energy & information
Disposal cost
nonrecurring cost
be offset by remaining market value
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Example 2-5
Consider the situation where equipment and related support for a newcomputer aided design / computer-aided manufacturing work station are beingacquired for the engineering department that you work in. The applicable costelements and estimated expenditures are as follows:
What is the investment of this CAD/CAM software?
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Cost Element Cost
Install a leased telephone line for communication $1,100/month
Lease CAD/CAM software (includes installation & debugging) 500/month
Purchase hardware (CAD/CAM workstation) 20,000
Purchase 9600-baud modem 2,500
Purchase a high-speed printer 1,500
Purchase four-color plotter 10,000Shipping costs 500
Initial training (in house) to gain proficiency with CAD/CAM software
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The General Economy
Environment
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Consumer / Producer Goods and Services
Consumer goods/services
products or services, directly used by people ex: food, clothing, homes, cars, TV sets, opera,
haircuts, and medical services etc
Producers must be aware of the changing wants of the
people
Producer goods/services
products or services to produce consumer goods andservices or other producer goods
ex: machine tools, factory buildings, buses, etc
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Measures of Economic Worth
Goods/services are produced and desired because
directly or indirectly they have UTILITY.
Utility
measure of the value which consumers of a product orservice place on that product or service
power to satisfy human wants and needs
commonly measured in terms of value, expressed in
some medium of exchange as the price
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Necessities, Luxuries, and Price Demand
Necessities and luxuriesTwo types of goods and services
These terms are relative one person considers Goods/Services a necessity, another
considers it a luxury
Price - equals some constant value minus some multiple ofthe quantity demanded
p = abD for 0 D a/b, and a>0, b>o (2-1)
D = (ap) / b (b0) (2-2) Lower price - Large demand
p= abD
Price
:p
Units of Demand : D
Price Demand Relationship for Luxuries &
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Price-Demand Relationship for Luxuries &Necessities
Extent to which price changesinfluence demand varies accordingto the elasticity of demand
Demand is elastic when a decreasein selling price results in
considerable increase in sales
If a change in selling price produceslittle or no effect on demand, thedemand is said to be inelastic
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Competition
Competition exists in general economic situations
Perfect competition product is supplied by a large number of vendors
no restriction on additional suppliers
complete freedom on the part of both buyer and seller
may never occur in actual practice.
Monopoly opposite from perfect competition
products/service is only available from a single supplier
prevent the entry of all others
perfect monopolies rarely occur in practice
Oligopoly when there are so few suppliers of a product or service that action by one
will almost inevitably result in similar action by the other
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Total Revenue Function
Total Revenue TR = price demand =p(D) (2-3) TR = (abD) D= aDbD2for 0 D a/b, and a>0, b>0 (2-4)
Maximum revenue For MR, dTR/dD = a2bD = 0 (2-5)
D = a / 2b (2-6)
MR = aDbD2
= a(a/2b)b(a/2b) 2
= a2
/2b - a2
/4b= a2/4b
Cost Volume and Breakeven Point
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Cost, Volume, and Breakeven PointRelationships
Scenario 1: p= a- bD, Larger Volumelower priceProfit is maximized where total revenue exceeds total cost bygreatest amount
CT
= CF
+ CV
CV= cv. D
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Cost Volume and Breakeven Point
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Cost, Volume, and Breakeven PointRelationships
Max Profit
D* occurs where Profit (total revenue - total costs) ismaximized
PR = (aD-bD2) - (CF+CvD) = -bD2+(a-Cv)D - CF (2-9)
dPR/dD=0 D* = [ a - Cv]/2b (2-10)
Breakeven points (D1, D2) occur when
TR = CTor Profit = 0
-bD2+(a-Cv)D - CF= 0 D = [-(a - Cv) +/- {(a-Cv)
2- 4(-b)(-CF)}1/2]/2(-b)
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Example 26
A company producing electronic timing switch.
Per month: Cf= $73; 000 and Cv= $83
Moreover,p= $1800.02(D)
Determine:(a) Optimal volume and confirm that a profit occurs at
this demand
(b) Volume at which breakeven occurs
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Example 26
A company produces an electronic timing switch that is used in consumerand commercial products made by several other manufacturing firms. Thefixed cost (Cf) is $73,000 per month, and the variable cost (cv)is $83 perunit. The selling price per unit isp -$180 - 0.02(D), based on Equation (2-1). For this situation:
a) Determine the optimal volume for this product and confirm that
a profit occurs (instead of a loss) at this demand, and
b) Find the volumes at which breakeven occurs; that is, what isthe domain of profitable demand?
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Example 2-6
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Example 2-6
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Cost Volume and Breakeven Point
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Cost, Volume, and Breakeven PointRelationships
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Example 2-7
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E l 2 7
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Example 2-7
E l 2 7
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Example 2-7
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Thus, the breakevenpoint is more sensitiveto a reduction invariable cost per hourthan to the samepercentage reductionin the fixed cost
Furthermore, noticethat the breakevenpoint in this exampleis highly sensitive tothe selling price per
unit,p.
P t E St di
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Present Economy Studies
Present Economy Study
When the influence of time on money is not significant consideration, costanalysis
One year or less period
Rule 1 When revenues and other economic benefits are present and vary among
alternatives, choose the alternative that maximizes overall profitability
based on the number of defect-free units of a product or service produced
Rule 2
When revenues and other economic benefits are not present or are constant
among all alternatives, consider only the costs and select the alternative that
minimizes total costper defect-free unit of product or service output
P t E St di
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Present Economy Studies
Total Cost in Material Selection
Material selection cannot be based solely on costs of materials. Change in materials frequently affect design, processing, and
shipping costs.
Alternative Machine Speeds Machine speeds result in different rates of product output and
frequencies of machine downtime.
Such situations lead to present economy studies
P t E St di
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Present Economy Studies
Make vs. Purchase (Outsourcing) Studies
Short run production, one year or less Choose Make rather than Purchase at a price lower than
production costs if:
Costs (direct, indirect, overhead) are incurred regardless of whetherthe item is purchased
Incremental production cost is less than purchase price
Decision, based on
incremental costs
opportunity costs of resources
For long run, capital investments in additional manufacturing plantmay be feasible alternatives
E l T t l C t i M t i l S l ti
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Example : Total Cost in Material Selection
A good example of this situation is illustrated by a part for which annual
demand is 100,000 units. The part is produced on a high-speed turretlathe, using 1112 screw-machine steel costing $0.30 per pound. Astudy was conducted to determine whether it might be cheaper to usebrass screw stock, costing $1.40 per pound. Because the weight ofsteel required per piece was 0.0353 pounds and that of brass was
0.0384 pounds, the material cost per piece was $0.0106 for steel and$0.0538 for brass. However, when the manufacturing engineeringdepartment was consulted, it was found that, although 57.1 defect-freeparts per hour were being produced by using steel, the output wouldbe 102.9 defect- free parts per hour if brass were used. Which material
should be used for this part?
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E l S l ti
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Example : Solution
The machine attendant was paid $7.50 per hour, and the variable (i.e.,traceable) overhead costs for the turret lathe were estimated to be $10.00 perhour. Thus, the total-cost comparison for the two materials is as follows:
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1112 Steel BrassMaterial $0.30 x 0.0353 = $0.0106 $1.40 x 0.0384 = $0.0538Labor
$7.50/57.1
= 0.1313
$7.50/102.9
= 0.0729
Overhead $10.00/57.1 = 0.1751 $10.00/102.9 = 0.0972Total cost per piece $0.4484 $0.2968Saving per piece by use of brass = $0.3179 - $0.2239 = $0.0931
Because a large number of parts are made each year, the saving of $93.10per thousand was a substantial amount. It is also clear that costs other thanthe cost of material are of basic importance in the economy study
E l
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ExampleLater history of same product illustrates that shipping costs also must often beconsidered in selecting between materials. It was found desirable to supply domestic /foreign assembly plants of company by using air freight for shipping. This led to a
study of the possible use of a heat-treated Al alloy. This material cost $0.85/poundand the cost of a heat treating each part, at an outside plant, was $0.018. Productionstudies indicated that Al alloy could be machined at the same speeds as brass stock.Specific gravities of brass and Al alloy are 8.7 and 2.75 respectively.
Consequently, comparative costs, including shipping at $3.00/lb of finished part is:
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Brass (lb) Aluminum Alloy (lb)
Raw Material 0.0384 (0.0384)(2.75/8.8) = 0.01213Finished Part 0.0150 (0.0150)(2.75/8.8) = 0.00474
Brass (lb) Aluminum Alloy (lb)
Material $1.40 x 0.0384 = $0.0538 $0.85 x 0.01213 = $0.0103Labor $7.50 / 102.90 = $0.0729 $7.50 / 102.90 = $0.0729
Heat treatment - = $0.0180
Overhead $10 / 102.90 = $0.0972 $10 / 102.90 = $0.0972
Shipping $3.00 x 0.0150 = $0.0450 $3.00 x 0.00474 = $0.0142
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E ample Sol tion
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Example : Solution
Because the labor cost for the crew would be the same for either
speed of operation and because there was no discernibledifference in wear upon the planer, these factors did not have tobe included in the study.
In problems of this type, the operating time plus the delay timedue to the necessity for tool changes constitute a cycle time that
determines the output from the machine. The time required for acomplete cycle determines the number of cycles that can beaccomplished in a period of available time (e.g., one day), and a
certain portion of each complete cycle is productive. The actualproductive time will be the product of the productive time percycle and the number of cycles per day
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Example : Solution
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Example : Solution
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At 5,000 feet per minuteCycle time = 2 hours + 0.25 hour = 2.25 hoursCycles per day = 8 2.25 = 3.555
Value added by planing = 3.555 x 2 x 1,000 x $0.10 =Cost of resharpening blades = 3.555 x $10 = $35.55Cost of blades = 3.555 x $50/10 = 17.78
Total cost
Net increase in value (profit) per day
$711.00
-53.33
$657.67
At 6,000 feet per minuteCycle time = 1.5 hours + 0.25 hour = 1.75 hoursCycles per day = 8 1.75 = 4.57Value added by planing = 4.57 x 1.5 x 1,200 x $0.10 =Cost of resharpening blades = 4.57 x $10 = $45.70Cost of blades = 4.57 x $50/10 = 22.85
Total cost
Net increase in value (profit) per day
$822.00
-68.55
$754.05
(cycles/day)(hours/cycle)(board feet/hour)(dollar value/board-foot) = dollars/day
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Example 2 8
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Example 2-8
If the manufacture of Product X is discontinued, the firm will save at most$90.00 in direct labor, $86.40 in direct materials, and $3.00 in variable
overhead costs, which totals $179.40 per day. This estimate of actual costsavings per day is less than the potential savings indicated by the costaccounting records ($288.40 per day), and it would not exceed the S201.60 tobe paid to the outside company if Product X is purchased. For this reason, theplant manager used Rule 2 and rejected the proposal of the foreman and
continued the manufacture of Product X.
In conclusion, Example 2-8 shows how an erroneous decision might be madeby using the unit cost of Product X from the cost accounting records withoutdetailed analysis. The fixed cost portion of Product X's unit cost, which is
present even if the manufacture of Product X is discontinued, was not properlyaccounted for in the original analysis by the foreman