Engeco Chap 02 - Cost Concepts and Design Economics

SEMESTER JANUARY 2010 1

CHAPTER 2

COST CONCEPTS AND THE ECONOMIC ENVIRONMENT


COST TERMINOLOGY

There are variety of costs to be considered in an engineering economy analysis.

These costs differ in their frequency of occurrence, relative magnitude, and degree of impact on the study.


Engineering economic analysis is primarily concerned with comparing alternative projects.

The comparison process utilises a variety of cost terminologies and cost concepts.

Cost terminology: life-cycle costs Sunk costs Opportunity costs Direct, indirect, and standard costs Fixed and variable costs Incremental costs.


LIFE-CYCLE COST

Life-cycle cost is the summation of all costs, both recurring and nonrecurring, related to a product, structure, system, or service during its life span.

Life cycle costs:

1. First cost (initial investment)

2. Operating and maintenance costs

3. Disposal cost

Acquisition phase:

Need assessment

Conceptual design

Detailed design

Operation phase:

Production

Operation

Retirement


First cost or Investment cost

Ex: a purchase of machine tool, the first cost may consist of the following elements:

Basic machine cost Cost of training personnel Shipping and installation costs (installation costs: foundation,

vibration and noise insulation, light and power supply, testing and commissioning costs)

Initial tooling costs Supporting equipment costs (computer control ware, spare parts

inventory)

Some projects may include working capital for inventories, cash for wages, materials, etc. Working Capital refers to the funds required for current assets needed for start-up and subsequent support of operation activities;


Operating and maintenance costs

These are recurring costs that are required to operate and maintain the item during its useful life.

Labour Material Overheads: water and electricity, insurance, inventory, indirect labour,

administrative and management expenses.


Disposal cost

This situation occurs when the life cycle of an item has ended.

Labour and material costs for removal of the item Shipping cost Special costs (disposing of hazardous materials)


SUNK COST A sunk cost is one that has occurred in the past and it is

unrecoverable. It has no relevance to decisions because it cannot be changed

regardless of what decision is made now or in the future.

Example:

Let say you have spent RM3 million on a project that requires another RM2 million for completion (you are contemplating to proceed),

You recently determined the project would bring in RM3 million. Do you proceed?

Yes, Absolutely. The first RM3 million is gone (sunk cost), no matter what you do. The next RM2 million investment will, in effect generate a 50% return {(3-2)/2*100%}.


OPPORTUNITY COST

An opportunity cost is incurred because of the use of limited resources, such that the opportunity to use those resources to monetary advantage in another alternative use is foregone.

Example:

Consider an employee who could earn RM25,000 for working during a year but chooses instead to go to college for a year and spend RM10,000 to do so.The opportunity cost of going to college for that year is RM35,000; (RM10,000 cash outflow and RM25,000 for income foregone)


DIRECT, INDIRECT COSTS

Direct costs can be reasonably measured and allocated to a specific output or work activity --- labor and material directly allocated to 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 COSTS

Overhead costs consist of all costs of manufacturing other than direct labor and direct material costs --- insurance premium, rent, maintenance and repairs, supervisory and administrative personnel, utilities, depreciation.


FIXED 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.


VARIABLE 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.


Direct, Indirect, and Overhead Costs

A cost structure for manufacturing

Direct material

Direct labour

Indirect material

Indirect labour

Fixed and miscellaneous

General and administrative

Selling

Profit

Conversion costs

Selling price

Prime costs

Factory overhead

costs

Cost of goods manufactured

Cost of goods sold


Manufacturing Account RM

Work in progress 18,500

Cost of raw materials 1,850,000

Production wages 850,000

PRIME COST 2,700,000

FACTORY OVERHEAD EXPENSES:

Acids and diesel 53,000

Electricity and water 108,900

Repair and maintenance 158,000

Depreciation 150,000

Indirect wages 90,500

Insurance 38,100

Labour safety and attire 17,200

Medical 12,000

Staff training 10,000

637,700

3,337,700

3,356,200

Less: Work-in-progress 12,090

COST OF PRODUCTION 3,344,110


RECURRING COSTS

Recurring costs are repetitive and occur when a firm produces similar goods and services on a continuing basis.

Variable costs are recurring costs 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


NONRECURRING COSTS

Nonrecurring costs are those that are not repetitive, even though the total expenditure may be cumulative over a relatively short period of time;

Examples are purchase cost for real estate upon which a plant will be built, and the construction costs of the plant itself;


INCREMENTAL COSTS incremental cost is the additional cost that results from

increasing the output of a system by one unit. 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:– mileage driven; – mileage expected to drive; – age of car;


CONSUMER GOODS AND PRODUCER GOODS AND SERVICES

Consumer goods and services are those that are directly used by people to satisfy their wants;

Producer goods and services are those used in the production of consumer goods and services: machine tools, factory buildings, buses and farm machinery are examples;


TNB

Consumers:

Households, Industries, Commercial Complexes, Administrative Complexes, Schools, Hospitals, etc.

Suppliers:

Technology, Machines and Equipment, Services, Contractors


Measures of Economic Worth

Goods and services are produced because they have utility – the power to satisfy our needs.

They may be used or consumed directly, or they may be used to produce other goods or services.

Utility – measured in terms of value

Expressed - price that have to be paid for the goods or services


Necessities, Luxuries, and Price-Demand

Goods and services may be divided into two categories:

(1) Necessities

(2) Luxuries

For all goods and services, there is a relationship between the price (p) that must be paid and the quantity (D) that will be demanded or purchased.


Demand Curve

Price (p)

Quantity (D)

D

The law of demand – when price increases, quantity demanded will reduce, vice versa.

From the point of view of consumers

Important assumption:Price is the only factor influencing the buyer’s decision to maximize their satisfaction


Supply Curve

Quantity (S)Quantity (S)

Price Price ((pp))

SS

The law of supply – when price increases, quantity supplied will increase, vice versa.

From the point of view of suppliers

Important assumption:

Price is the only factor influencing the supplier’s decision to maximize profits


PRICE

QUANTITY ( D )


PRICE

QUANTITY ( D )

Price equals some constant value minus some multiple of the quantity demanded:p = a - b D

a


PRICE

QUANTITY ( D )

Price equals some constant value minus some multiple of the quantity demanded:

p = a - b D

a

a = Y-axis (quantity) intercept, (price at 0 amount demanded);

b = slope of the demand function;

The relationship between price and demand can be expressed as the linear function p = a - b D


PRICE

QUANTITY ( D )


p = a - b D

a



D = (a – p) / b


PRICE

QTY


p = a - b D

a



D = (a – p) / b

Total Revenue

QTY

TR = p*D = (a-bD)DMR = dTR / dD = a –2bD = 0

MR=0


PRICE

QTY


p = a - b D

a



D = (a – p) / b

Total Revenue

QTY

TR = p*D = (a-bD)DMR = dTR / dD = a –2bD = 0

MR=0

TR = Max


Co

st /

Rev

enu

e

Quantity ( Output )Demand

Marginal ( Incremental) Cost

Co

st /

Rev

enu

e

Quantity ( Output )Demand

Cf

Ct = Cv + Cf

D’1 D’2D*

Profit Total Revenue

MaximumProfit

Profit is maximum when Total Revenue exceeds

Total Cost by greatest amount

D’1 and D’2 are breakeven points

MarginalRevenue


PROFIT MAXIMIZATIOND*

Occurs where total revenue exceeds total cost by the greatest amount;

Occurs where marginal cost = marginal revenue;

D* = [ a - (Cv) ] / 2b


BREAKEVEN POINTD’1 and D’2

Occurs where TR = Ct

( aD - bD2 ) = Cf + (cv ) D

- bD2 + (a – cv) D - Cf = 0

Using the quadratic formula:

-( a - cv ) + [ (a - cv) 2 - 4(-b) (-Cf)]1/2

2(-b)

D’ =


PRESENT ECONOMY STUDIES When alternatives for accomplishing a task are

compared for one year or less (i.e., influence of time on money is irrelevant)

Rules for Selecting Preferred AlternativeRule 1 When revenues and other economic benefits are present and vary among alternatives, choose alternative that maximizes overall profitability based on the number of defect-free units of output

Rule 2 When revenues and economic benefits are not present or are constant among alternatives, consider only costs and select alternative that minimizes total cost per defect-free output


PRESENT ECONOMY STUDIES

Total Cost in Material Selection

In many cases, selection of among materials cannot be based solely on costs of materials. Frequently, change in materials affect design, processing, and shipping costs.

Alternative Machine Speeds

Machines can frequently be operated at different speeds, resulting in different rates of product output. However, this usually results in different frequencies of machine downtime. Such situations lead to present economy studies to determine preferred operating speed.



Make Versus Purchase (Outsourcing) StudiesA company may choose to produce an item in house, rather than purchase from a supplier at a price lower than production costs if:

1. Direct, indirect or overhead costs are incurred regardless of whether the item is purchased from an outside supplier, and

2. The incremental cost of producing the item in the short run is less than the supplier’s price

However, there are many noneconomic factors to consider in the make or buy decision. Supplier quality and response time, outsourcing policy of the company, internal capacity utilisation are some of the important factors.



Make Versus Purchase (Outsourcing) Studies

Opportunity costs may become significant when in-house manufacture of an item causes other production opportunities to be foregone (ex: insufficient capacity)

In the long run, capital investments in additional manufacturing plant and capacity are often feasible alternatives to outsourcing.

Engeco Chap 02 - Cost Concepts and Design Economics

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