Cost Concepts and Design Economics

8/22/2019 Cost Concepts and Design Economics

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Ravi Kiran


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Fixed cost: unaffected by changes in output

Variable cost: vary in total with the quantity of

output (or similar measure of activity)

Direct: can be measured and allocated to a specific

work activity

Indirect: difficult to attribute or allocate to a specific

output or work activity (also known as overheadcosts)


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If aircraft are to be made then a factory is required.

The land, the factory building, the machinery and office

equipment must be bought or rented.

These costs are called f ixed costsand must be paideven when the factory has not produced anything.

Fixed costs are costs that do not change, whatever the

level of output is.

Assuming an airplane factory has fixed costs of Rs60

million.


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Units of output

TF

C

X

Y

O

60

TFC


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Variable costs change as the level of output changes.

These costs are costs such as raw materials in

production, labour units, electricity charges etc.

In our example this would be the steel, components

and labourneeded to make each airplane.

If nothing were made the variable costs would of

course be nothing. But as production rises the total

variable costs(TVC) would rise.

The variable cost is the cost per unit. The total variable

cost is found by multiplying the variable cost (VC) by

the level of output (Q), so TVC = VC x Q.


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TVC

O

T

V

C

TVC

Increasing at a

diminishing rate

Increasing at an

increasing rate


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Total costs are simply the sum of the total

variable costs and the fixed costs.

TC and TVC lines are parallel.

The distance between the two lines is the

amount of the fixed costs.


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Output FC TVC TC

0 60 0 60

10 60 10 70

20 60 20 80

30 60 30 90

40 60 40 100

50 60 50 110


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Units of output

T

F

C

X

Y

O

60

TVC

TC

TFC

Increasing at a

diminishing rate

Increasing at an

increasing rate


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Average costs are per unit costs

Average fixed costs (AFC) are the fixed costs divided by

the level of output (FC/Q).

So when output is 10 the AFC is 60/10 = 6.

Average variable costs (AVC) are the total Variable costs

divided by the level of output (TC/Q).

Average total costs (ATC) are the total costs divided bythe level of output (TC/Q).

So when output is 10 the average fixed cost is 70/10 = 7.


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Marginal cost

Marginal cost is the cost of producing one

extra unit.

Marginal cost = the change in total coststhe change in output

MC = TC

Q


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Historical Costs : These are the accounting costs

carried in the books and reflecting the cost of the

item at the time it was purchased, rather than its

current value. Sunk cost: Irrecoverable 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.


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Opportunity cost: the monetary advantage foregonedue to limited resources. The cost of the bestrejected opportunity.

Life-cycle cost: the summation of all costs related toa product, structure, system, or service during its lifespan.

Life cycle begins with the identification of the

economic need or want ( the requirement ) andends with the retirement and disposalactivities.


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If there is no alternative use for a factor ofproduction, as in the case of a machinedesigned to produce a specific product, and if ithas no scrap value, the opportunity cost ofusing it is zero.

In such a case, if the output from the machine isworth more than the cost of all the other inputsinvolved, the firm might as well use themachine rather than let it stand idle.

What the firm paid for the machine its historiccost is irrelevant. Not using the machine willnot bring that money back. It has been spent.These are sometimes referred to as sunkcosts.


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If you fall over and break your leg, there is littlepoint in saying, If only I hadnt done that I couldhave gone on that skiing holiday; I could have takenpart in that race;

I could have done so many other things (sigh).Wishing things were different wont change history.

You have to manage as well as you can with yourbroken leg.

It is the same for a firm. Once it has purchased someinputs, it is no good then wishing it hadnt. It has toaccept that it has now got them, and make the best

decisions about what to do with them.


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Take a simple example. The local greengrocerin early December decides to buy 100 Christmastrees for Rs 10 each.

At the time of purchase, this represents anopportunity cost of Rs10 each, since the Rs10could have been spent on something else.

The greengrocer estimates that there is enoughlocal demand to sell all 100 trees at Rs20 each,thereby making a reasonable profit.


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But the estimate turns out to be wrong. On 23 December there are still 50 trees unsold. What should be done? At this stage the Rs10 that was paid for the trees is

irrelevant. It is a historic cost. It cannot berecouped: the trees cannot be sold back to thewholesaler!

In fact, the opportunity cost is now zero. It mighteven be negative if the greengrocer has to pay todispose of any unsold trees. It might, therefore, beworth selling the trees at Rs10, Rs5 or even Rs 1.

Last thing on Christmas Eve it might even be worthgiving away any unsold trees.


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Investment Cost or capital investment is the capital(money) required for most activities of theacquisition phase;

Working Capital refers to the funds required forcurrent assets needed for start-up and subsequentsupport of operation activities;

Operation and Maintenance Cost includes many of

the recurring annual expense items associated withthe operation phase of the life cycle;

Disposal Cost includes non-recurring costs ofshutting down the operation;


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Recurring costs are repetitive and occur when afirm produces similar goods and services on acontinuing basis.

Variable costs are recurring costs because theyrepeat with each unit of output .

Afixed cost that is paid on a repeatable basis isalso a recurring cost:

Office rental


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Nonrecurring costs are those that are notrepetitive, even though the total expendituremay 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 uponwhich a plant will be built, and theconstruction costs of the plant itself;


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Provide information used in setting a sellingprice for quoting, bidding, or evaluatingcontracts

Determine whether a proposed product can bemade and distributed at a profit (EG: price = cost+ profit)

Evaluate how much capital can be justified forprocess changes or other improvements

Establish benchmarks for productivityimprovement programs


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Uses historical data from similar engineeringprojects

Used to estimate costs, revenues, and other

parameters for current project Modifies original data for changes in inflation

/ deflation, activity level, weight, energyconsumption, size, etc


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More detailed cost-estimating method Attempts to break down project into small,

manageable units and estimate costs, etc.

Smaller unit costs added together with other

types of costs to obtain overall cost estimate Works best when detail concerning desired

output defined and clarified

Cost Concepts and Design Economics

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