CHAPTER 2 COST CONCEPTS AND DESIGN ECONOMICS. OBJECTIVES Describe basic cost terminology Describe...

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Transcript of CHAPTER 2 COST CONCEPTS AND DESIGN ECONOMICS. OBJECTIVES Describe basic cost terminology Describe...

  • Slide 1
  • CHAPTER 2 COST CONCEPTS AND DESIGN ECONOMICS
  • Slide 2
  • OBJECTIVES Describe basic cost terminology Describe design economics
  • Slide 3
  • Cash flow Fixed Cost, Variable Cost, Incremental Cost Direct Cost, Indirect Cost, Standard Cost Cash Cost vs Book Cost Sunk Cost vs Opportunity Cost Life Cycle Cost Capital and Investment Recurring and Non-Recurring Cost Cost Estimating 2 Approaches
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  • 4 Cash Flows A cash flow is a receipt or payment of an amount of money defined by 1) its dollar value and 2) the time of its occurrence Cash flow diagrams represent costs and revenues over time. Cost and Revenue estimation for the future always involve uncertainty.
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  • FIXED, VARIABLE, AND INCREMENTAL COSTS Fixed costs are those 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, and interest costs on borrowed capital. When large changes in usage of resources occur, or when plant expansion or shutdown is involved fixed costs will be affected. Fixed costs are those 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, and interest costs on borrowed capital. When large changes in usage of resources occur, or when plant expansion or shutdown is involved fixed costs will be affected.
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  • FIXED, VARIABLE AND INCREMENTAL COSTS Variable costs are those 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. Variable costs are those 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.
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  • Example:
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  • 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 ; 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 ;
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  • Overhead consists of plant operating costs that are not direct labor or material costs indirect costs, overhead and burden are the same; E.g. electricity, general repairs Standard Cost is a planned cost per unit Overhead consists of plant operating costs that are not direct labor or material costs indirect costs, overhead and burden are the same; E.g. electricity, general repairs Standard Cost is a planned cost per unit DIRECT, INDIRECT AND STANDARD COSTS
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  • A cash cost requires the cash transaction of dollars "out of one person's pocket" into "the pocket of someone else." When you buy dinner for your friends or make your monthly automobile payment you are incurring a cash cost or cash flow. Cash costs and cash flows are the basis for engineering economic analysis. CASH COST VERSUS BOOK COST
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  • 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; it is important as depreciation affect income taxes, and subsequently affects the cash flow as well 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; it is important as depreciation affect income taxes, and subsequently affects the cash flow as well
  • Slide 13
  • SUNK COST AND OPPORTUNITY COST A sunk cost is money already spent as a result of a past decision. Sunk costs should be disregarded in our engineering economic analysis because current decisions cannot change the past.
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  • SUNK COST AND OPPORTUNITY COST For example, dollars spent last year to purchase new production machinery is money that is sunk: the money allocated to purchase the production machinery has already been spent-there is nothing that can be done now to change that action.
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  • SUNK COST AND OPPORTUNITY COST Many times it is difficult not to be influenced by sunk costs. Consider 100 shares of stock in XYZ, Inc., purchased for $15 per share last year. The share price has steadily declined over the past 12months to a price of $10 per share today. Current decisions must focus on the $10 per share that could be attained today (as well as future price potential), not the $15 per share that was paid last year. The $15 per share paid last year is a sunk cost and has no influence on present opportunities.
  • Slide 16
  • SUNK COST AND OPPORTUNITY COST As another example, when Regina was a sophomore, she purchased a newest-generation laptop from the college bookstore for $2000. By the time she graduated, the most anyone would pay her for the computer was $400 because the newest models were faster, cheaper and had more capabilities. For Regina the original purchase price was a sunk cost that has no influence on her present opportunity to sell the laptop at its current market value ($400).
  • Slide 17
  • SUNK COST AND OPPORTUNITY COST An opportunity cost is associated with using a resource in one activity instead of another. Every time we use a business resource (equipment, dollars,manpower, etc.) in one activity, we give up the opportunity to use the same resources at that time in some other activity. An opportunity cost is associated with using a resource in one activity instead of another. Every time we use a business resource (equipment, dollars,manpower, etc.) in one activity, we give up the opportunity to use the same resources at that time in some other activity.
  • Slide 18
  • SUNK COST AND OPPORTUNITY COST Every day businesses use resources to accomplish various tasks- forklifts are used to transport materials, engineers are used to design products and processes, assembly lines are used to make a product, and parking lots are used to provide parking for employees' vehicles. Each of these resources costs the company money to maintain for those intended purposes. However, that cost is not just made up of the dollar cost, it also includes the opportunity cost. Each resource that a firm owns can feasibly be used in several alternative ways. For instance, the assembly line could produce a different product, and the parking lot could be rented out, used as a building site, or converted into a small airstrip. Each of these alternative uses would provide some benefit to the company. Every day businesses use resources to accomplish various tasks- forklifts are used to transport materials, engineers are used to design products and processes, assembly lines are used to make a product, and parking lots are used to provide parking for employees' vehicles. Each of these resources costs the company money to maintain for those intended purposes. However, that cost is not just made up of the dollar cost, it also includes the opportunity cost. Each resource that a firm owns can feasibly be used in several alternative ways. For instance, the assembly line could produce a different product, and the parking lot could be rented out, used as a building site, or converted into a small airstrip. Each of these alternative uses would provide some benefit to the company.
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  • SUNK COST AND OPPORTUNITY COST Your grandmother owns her home, but lives with your parents. She rents her $185,000-house for $400/month. Good idea or lost opportunity? An opportunity cost is the benefit that is forgone by engaging a business resource in a chosen activity instead of engaging that same resource in the forgone activity. Your grandmother owns her home, but lives with your parents. She rents her $185,000-house for $400/month. Good idea or lost opportunity? An opportunity cost is the benefit that is forgone by engaging a business resource in a chosen activity instead of engaging that same resource in the forgone activity.
  • Slide 20
  • Example, suppose that friends invite a college student to travel through Europe over the summer break. In considering the offer, the student might calculate all the out-of-pocket cash costs that would be incurred.