Lecture2

COST CONCEPTS AND DESIGN ECONOMICS

INSPIRING CREATIVE AND INNOVATIVE MINDS

COST ESTIMATING USED TO

• Provide information used in setting a selling price for quoting, bidding, or evaluating contracts

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

• Evaluate how much capital can be justified for process changes or other improvements

• Establish benchmarks for productivity improvement programs

COST ESTIMATING

Used to describe the process by which the present and future cost consequences of engineering designs are forecast

COST ESTIMATING APPROACHES

• Top-down Approach

• Bottom-up Approach

TOP-DOWN APPROACH • Uses historical data from similar engineering

projects • Used to estimate costs, revenues, and other

parameters for current project• Modifies original data for changes in inflation /

deflation, activity level, weight, energy consumption, size, etc…

• Best use is early in estimating process

BOTTOM-UP APPROACH

• 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

• Fixed cost: unaffected by changes in activity level• Variable cost: vary in total with the quantity of

output (or similar measure of activity)• Incremental cost: additional cost resulting from

increasing output of a system by one (or more) units

Costs can be categorized in several different ways.

• 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 overhead or burden)

• Standard cost: cost per unit of output, established in advance of production or service delivery

• Opportunity cost: the monetary advantage foregone due to limited resources. The cost of the best rejected opportunity.

• Life-cycle cost: the summation of all costs related to a product, structure, system, or service during its life span.

• Cash cost: a cost that involves a payment of cash.• Book cost: a cost that does not involve a cash

transaction but is reflected in the accounting system.

• Sunk 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.

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

• Working Capital refers to the funds required for current assets needed for start-up and subsequent support of operation activities;

• Operation and Maintenance Cost includes many of the recurring annual expense items associated with the operation phase of the life cycle;

• Disposal Cost includes non-recurring costs of shutting down the operation;

CAPITAL AND INVESTMENT

DIRECT, INDIRECT AND OVERHEAD COSTSDIRECT, INDIRECT AND OVERHEAD COSTSDIRECT, INDIRECT AND OVERHEAD COSTSDIRECT, INDIRECT AND OVERHEAD COSTS

• Overhead consists of plant operating costs that are not direct labor or material costs– indirect costs, overhead and burden are the

same;

• Prime Cost is a common method of allocating overhead costs among products, services and activities in proportion the sum of direct labor and materials cost ;

STANDARD COSTSSTANDARD COSTS

• Representative costs per unit of output that are established in Representative costs per unit of output that are established in advance of actual production and service delivery;advance of actual production and service delivery;

Standard Cost ElementStandard Cost Element Sources of DataSources of DataDirect LaborDirect Labor Process routing sheets, +Process routing sheets, +

standard times, standard times, standard standard labor rates;labor rates;

Direct MaterialDirect Material Material quantities per +Material quantities per +unit, standard unit unit, standard unit

materials cost;materials cost;Factory Overhead CostsFactory Overhead Costs Total factory overhead Total factory overhead

costs allocated based on costs allocated based on prime costs;prime costs;

Figure 2-1

The Life Cycle Cost

• The Life Cycle divided into 2 general time period

1. Acquisition Phase

2. Operation Phase

Acquisition Phase

1. Analysis of economic need

2. Conceptual design• Defined technocal and operational

requirements• Development of feasible alternatives• Advance development and prototype-

testing

Acquisition Phase

3. Detailed design-activities to prepare, acquire and make

ready for operation

Operation Phase

1. Production, delivery or construction of the end item

2. Operation and customer use

3. Retirement from active operation or use

Fixed and Variable Cost

• A Fixed Cost (FC) is any cost that does not vary in proportion to the quantity of output.– Examples include rent, depreciation, lighting, and

supervisor salaries.– Fixed Costs are commonly fixed only over a certain

range of production, called the relevant range.– For example supervisor salaries or lighting are fixed for

one shift operation but step to a new higher level for two shift operation.

– Successive relevant ranges are often represented graphically as a step function.

Fixed and Variable Cost

• A Variable Cost (VC) is a cost that varies in proportion to the quantity of output.– Common examples include direct materials and direct

labor.

– Variable Costs are often represented as a linear function of output

• VC(q) = rate * q; where q is the level of production

• Total Cost is the sum of fixed costs and variable costs

TC(q) = FC + VC(q)

Total Costs• Adding the same amount

of total fixed cost to every level of total variable cost yields total cost.

• For this reason, the total cost curve has the same shape as the total variable cost curve; it is simply higher by an amount equal to TC.

• TC(q) = FC + VC(q)

Revenue

• Price x Quantity

P x q

Breakeven

• Total Revenue (TR) is the sum of revenues received for the units sold.

• Total Revenue is often represented as a linear function of units sold.

• TR(q) = price * q; where q is the number of units sold

• If steady state inventory is assumed then units sold will be equal to the units produced.

• The point of Breakeven, where total costs equal total revenues, can be found by solving:

TR(q) = FC + VC(q)

Breakeven Graph

ProfitLoss

Significance of Breakeven

• If production (sales) is less than breakeven, a loss will occur.• If production (sales) is greater than breakeven, a profit will

occur.• Lower values of the breakeven quantity are generally

desirable.• Lower values can be achieved by:

– increasing the revenue rate (the slope of the revenue line),– decreasing the variable cost rate (the slope of the total cost

line), – reducing the fixed cost (the intercept of the total cost line).

• Engineering Economy projects frequently target one of these areas for improvement

Example

• Determination of breakeven value• R(q) = $5.00(q)• FC = $300• VC(q) = ($2.50+$1.00)(q) = $3.50(q)• Breakeven:

R(q) = FC + VC(q)$5.00(q) = $300 + $3.50(q)x = 200 units

• Net Profit for a lot size of 1,000 units

• Profit (Loss) = TR(q) – TC(q)= TR(q) – (FC + VC(q))

= TR(q) – FC – VC(q)

= $5.00(q) - $300 - $3.50(q)

= $5.00(1,000) - $300 - $3.50(1,000)

= $1,200 profit