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COST ANALYSIS
for SHORT-TERM FS
Budi Hartono
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Engineering Costs Analysis
1. Decision-making setting
Short Run
At least one factor of production is fixed
A few months to a few years
Present Economy Studies or Current Cost Analysis
Long run
Time period of sufficient length to alter all factors of production
Investment analysis involving time value of money
2. Contribution to cash outflow
Non-recurring costs
Initial Costs
Disposal
Recurring
Operating
Maintenance
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Short Run: Relevant Costs
Fixed Cost (FC)
constant regardless of level of output
Rental of facilities; Cost of machinery
Variable Cost (VC)
Vary with level of output
Materials; sub-contracting; labor
Total Cost = Total Fixed Cost + Total Variable
Cost4Budi Hartono - JTMI UGM
Short-run = short term = current cost analysis
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Example: Determining Relevant Costs for Taxi Driver
1.) From statistics on 2003, an average trip by a passenger is about 8 km2.) Assumptions:
Fuel Efficiency (litre/km) = 0.1 Average Speed (km/h) = 40
Cost of Diesel ($/litre) = $0.50 Drivers Time Cost ($/h) =$12
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Current Cost Analysis
Explore options to primarily minimize the average
total costs
Minimize variable costs
In short term, the fixed costs are fixed
Increase production units
Problem Scope
Typically involve choice among alternative designs,
materials or methods
Problem Structure
Time is not a significant economic factor
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Types of Current Cost Analysis
(Present Economy Studies)Type 1
No investment in capital and only out of pocket
expenses are involved
Type 2
Capital investments are irrelevant or treated as
variable costs
Investments utilized exclusively for the decision
Different processes choice that use existing capital
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Example of Type 1: Operating Speed of a Planer
1. Two speeds that the planer can operate at
2. Faster speed, more output, higher cost
3. Variable Cost:
- Blades
- Sharpening
- Downtime
4. Fixed Cost:
- Machine
- Building5. Fixed cost ?
Which speed should the planer be operated
at given that there is unlimited demand?
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Example 1 - Data
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Solution
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Solution (2)
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Solution (3)
Conclusion: Run the planer at ___________________________
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Example Type 1: Modification - Single Job of
6,000 board-foot
1. Choice for a single job
2. Minimize expense for job
3. Assume no cost sharing with other jobs
Assumption: No cost sharing with other jobs. 16Budi Hartono - JTMI UGM
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Example Type 1: Modification - Single Job of 6,000
board-foot
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Prototypical Type 1 - Current Cost Study
Choice of operational parameters (as in this example)
Choice of vendors for short term contracts
Choice of inputs (such as materials) without change
in machinery
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Example of Type 2: New Method of Manufacture
(Capital cost not compounded)
An order for 3 million pieces of machine parts.
1. Choice of Midway Option available only after 1.5m units are made.
2. Consider the cost for remaining 1.5m units using the two options
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Example of Type 2: Solution
1. Choice of Midway Option available only after 1.5m units are made.
2. Consider the cost for remaining 1.5m units using the two options
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Type 2 Example: Lessons
1. The $500,000 initial investment is not relevant to theconsideration. No cash flow impact at midway or beyond. (Thiseconomic concept is different from accounting concept).2. The $100,000 fixed cost is spread over the 1.5 million units. If the
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Type 2 Example: Volume when choice is switched
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When volume is 400,000 instead of 1.5m
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Example of Type 2: Fixed Costs Involved
Not Relevant
1. A manufacturer makes parts for customers in batches of different sizes.
2. This manufacturer currently owns two machines, an engine lathe and a
turret lathe, of different characteristics that can be used to fulfil any
customers orders.
3. Since the two machines already belongs to the company, this impliesthat cashflow associated with the machines are in the past.
4. Hence, the capital investment of the two machines can be ignored.
5. The only relevant costs are the variable costs: labor, material, tooling,
operations
6. What is the most economical machine to use for different size of
customer orders?
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Example Type 2: Fixed Costs Involved Not Relevant
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Example Type 2 : Solution
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If 25 units required
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Example Type 2 Solution: Batch Size Vs
Cost on Each Machine
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Prototypical Type 2 Current Cost Study
There is no other alternative uses for an existing asset in place
Differential first cost among alternatives does not create
disproportionate cashflows downstream
(our first type 2 example)
Alternative workflow path through existing equipment (our
second type 2 example)
Product mix decision utilizing existing equipment
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Comparison of Types 1 and 2 Current
Cost Studies
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Sunk Costs
Money spent in past
Price of car, stock price, prices of assets
Reflected in book costs (historical prices)
Purchase of Boeing 777 = $168m Accumulated Depreciation = $70m (5 year old plane)
Book Cost = $98m
Irrelevant to engineering economic analysis
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Example of Sunk Cost and Relevant Cost
Price of car = $114,000 (purchased 5 years ago)
Price of similar car = $94,000
Book value of car = $66,000
Loan outstanding on the car = $58,000
Trade-in value of car = $49,000 Cash value of car = $47,825
Scrap Value of car = $47,000
Your wish to get an advisor to help you with financial planning as you feel
that you are living beyond your means. In listing the value of your assets,
what value should you put on the car?
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Deceiving effects of including sunk cost
You have foolishly promise to pay $5,000
for a rosewood dining room table. You have
already paid 50% of the purchase price that
is non-refundable when you discovered that
the actual price is only $4,000.
You know from previous experience that
you can sell the piece on e-bay for $3,500.
However, you tell yourself that you are not
going to be silly and pay a total of $5,000
for a piece of furniture that is worth $4,000
to sell it on e-bay for $3,500. So you refuse
to pay the remainder of the price andforfeit the dining room table.
Budi Hartono - JTMI UGM 31Now, who is the silly one?
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Some fallacy of sunk costs
Keeping the business venture alive because you have so much invested in it.
Finishing the large pizza beyond the point of being full.
Sitting through a long, boring play because the tickets cost you $60 each.
Holding a poorly performing stock in the hope of getting your money back.
Resisting change because of the large investment in the present system, e.g.,staying with copper-wire technology in a fiber optic world.
Staying in a field of study or profession because of your tremendous
investment to date
(Source: Dan Seligman, Forbes, August 24, 1998, p. 62)
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Breakeven Analysis
An analysis to identify the quantity of units
sold or the revenue required to meet the
total cost of running the business
Breakeven Point: Level of business activity
at which total revenue= total cost
Failure to breakeven over the long term is arecipe for bankruptcy
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Budi Hartono - JTMI UGM 34
CHICKEN RICE MAK CIK
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Budi Hartono - JTMI UGM 35
BEP?
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What is the difference?
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Breakeven Analysis When Price-Volume Relationship Exists
P = a bQ (linear form) (1)
where,
P = Price,
Q = Quantity Demanded (Volume);
0 Q a/b; a > 0, b> 0
Profit = Total Revenue Total Cost (2)
= P*Q (FC + VC*Q)
= (a b.Q)*Q (FC + VC*Q)
= -b.Q2 + (a-VC).Q FC
where,
FC = Fixed Cost;
VC = Variable Cost per unit
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PR: Decision to advertise
Assume that the duck stall thinks of inviting a
media star to endorse the product.
This will cost the stall an additional $5,000 per
month that the advertisement is running.
How many additional servings must they sell
to make it worth the effort?
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PR: Breakeven Analysis When Price-Volume
Relationship Exists
1. You are considering the purchase of a machine and renting
factory space to make an electronic timing switch for
consumer and commercial products.
2. Before making the decision, you want to make sure that it has
a chance of being profitable.
3. So you decide to carry out a breakeven analysis
4. The data for the investment is given below.
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Pertanyaan:
1. Gambarkan grafik harga (P) terhadap volume (Q)
2. Hitunglah volume-volume penjualan saat break-
even terjadi3. Hitunglah volume penjualan saat profit maksimum
4. Gambarkan grafik profit vs. penjualan, dan
tunjukkan titik-titik yang terkait dengan pertanyaan(2) dan (3)
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Summary
What we have learned?
AKI jangka pendek vs. AKI jangka panjang?
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