02 EIND4303 Cost Concept

7/24/2019 02 EIND4303 Cost Concept

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05.10.2015

1

Dr.Sadiq Abdelall

AssistantProfessor

IndustrialEngineeringDepartment

IslamicUniversityofGaza Page1

Chapter 02

EIND 4303: Engineering Economy

CostConceptandDesignEconomics

Dr.Sadiq Abdelall

AssistantProfessor



Introduction

This course is concerned with making good economic decisions in

engineering

These decisions often involve nonengineers

Managers

Accountants

Etc.

You need to be able to communicate with these people, so you need a

common language


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AssistantProfessor



Introduction

One of the important parts of an economic decision is identification of

cost

Several cost situations occur frequently

People have developed terms to describe these

You need to know these terms so that

You understand what others are saying to you

You can persuade others that you know what youre doing and therefore should be

listened to

Dr.Sadiq Abdelall

AssistantProfessor



CostEstimating

Used to describe the process by which the present and future cost

consequences of engineering designs are forecast

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 (e.g.: price = cost + profit) Evaluate how much capital can be justified for process changes or other

improvements

Establish benchmarks for productivity improvement programs


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CostEstimatingApproaches

Topdown Approach

Bottomup Approach

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TopdownApproach

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


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BottomupApproach

More detailed costestimating 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

Dr.Sadiq Abdelall

AssistantProfessor



Fixed,Variable,Average,andIncrementalCosts

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 plantexpansion or shutdown is involved fixed costs will be affected.


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Variable costsare 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 unitseven though costs per unit remain the same.

Dr.Sadiq Abdelall

AssistantProfessor




Average Cost is simply total cost divided by volume, often called unit

cost.

Example 1: cost is $250 N, where N is number of units of product made

Here cost is purely variable (no fixed cost)

Average cost is (250 N)/N = $250

Example 2: cost is $6000 + $100 N

Average cost is $100 + 6000/N (decreases with larger N; economy of scale)


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Fixed,Variable,Average,andIncremental Costs

Incremental (Marginal) cost is the additional cost that results from

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

Incremental cost is often associated with go / no go decisions that

involve a limited change in output or activity level.

For Example 2 (cost = $6000 + 100 N):

N = 100: cost is $16,000

N = 101: cost is $16,100

Here marginal cost is $100, but average cost (at N = 100) is $160

So average and marginal cost may differ!

Dr.Sadiq Abdelall

AssistantProfessor



Example2.1:FixedandVariableCost

In connection with surfacing a new highway, a contractor has a choice of two sites on which to set

up the asphaltmixing plant equipment. The contractor estimates that it will cost $1.15 per cubic

yard mile (ydmile) to haul the asphaltpaving material from the mixing plant to the job location.

Factors relating to the two mixing sites are as follows (production cost at each site are the same):

The job requires 50,000 cubic yard of mixedasphaltpaving material. It is estimated that four

months (17 weeks of five working days per week) will be required for the job. Compare the two

sites in term of their fixed, variable, and total costs. Assume that the cost of return trip is negligible.

Which is the better site? For the selected site, how many cubic yards of paving material does the

contractor have to deliver before starting to make a profit if paid $8.05 per cubic yard delivered to

the job location?

CostFactor SiteA SiteB

Averagehaulingdistance 6miles 4.3miles

Monthlyrentalofsite $1,000 $5,000

Costto

setup and

remove

equipment $15,000 $25,000

Haulingexpense $1.15/ydmile 1.15/ydmile

Flagperson Notrequired $96/day


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Recurring andNonrecurringCosts

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

Dr.Sadiq Abdelall

AssistantProfessor



RecurringandNonrecurring Costs

Nonrecurring costs are those that are not repetitive, even though the

total expenditure may 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 upon which a plant will bebuilt, and the construction costs of the plant itself.


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Direct,IndirectandOverheadCosts

Direct costs can be reasonably measured and allocated to a specific

output or work activity e.g. labor and material directly allocated with a

product, service or construction activity;

Most common direct costs: material and labor

These are costs that:

Can be easily measured

Can be conveniently allocated to a particular category (e.g. a product or service)

Examples:

Cost of steel used for making bolts

Salary of a nurse on cardiac surgery ward

Dr.Sadiq Abdelall

AssistantProfessor



Direct,Indirect andOverheadCosts

Indirect costsare difficult to allocate to a specific output or activity e.g.

costs of common tools, general supplies, and equipment maintenance ;

These are costs that:

Are difficult to attribute or allocated to a specific output or work activity

Examples:

Cost of common tools

General Supplies

Equipment maintenance in a plant


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Direct,IndirectandOverhead Costs

Direct material and direct labor together are usually calledprime costs

Everything else is overhead cost i.e. Overhead cost consists of plant

operating costs that are not direct labor or material costs

These could be for different things:

Labor (repair technician working on machines)

Material (lubricants used in production process)

Salaried personnel (sales manager)

Services (electric power supply)

Dr.Sadiq Abdelall

AssistantProfessor



CashCostVersusBookCost

Cash cost is a cost that involves payment in cash and results in cash

flow;

Book cost or noncash cost is a payment that does not involve cash

transaction but is reflected in the accounting system.; book costs

represent the recovery of past expenditures over a fixed period of time;

Usually the book cost equal to the original cost of the equipment minus theamounts charged as depreciation.

The market value or actual worth of the equipment or asset may be quite different

from the book value.

Depreciationis 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;


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SunkCostandOpportunityCost

Asunk costis one that has occurred in the past and has no relevance to

estimates of future costs and revenues related to an alternative course

of action.

An opportunity cost is the cost of the best rejected ( i.e. foregone )

opportunity and is hidden or implied.

Dr.Sadiq Abdelall

AssistantProfessor



CapitalAndInvestment

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 startup and subsequent support of operation activities;

Operation and Maintenance Costincludes many of the recurring annual

expense items associated with the operation phase of the life cycle; Disposal Cost includes nonrecurring costs of shutting down the

operation and retirement and disposal of assets at the end of the life

cycle.


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LifecycleCost

Lifecycle 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 begins with the identification of the economic need or want

(the requirement) and ends with the retirement and disposal activities.

The life cycle may be divided into two general time periods: the

acquisition phase and the operation phase.

The greatest potential for achieving lifecycle cost savings is early in the

acquisition phase.

Dr.Sadiq Abdelall

AssistantProfessor



PhasesoftheLifeCycle


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StandardCosts

Representative costs per unit of output that are established in advance

of actual production and service delivery;

StandardCostElement SourcesofData

DirectLabor+ Standardtimes,standardlaborrates;

DirectMaterial+ Materialquantitiesperunit,standardunit

materialscost;

FactoryOverheadCosts Totalfactoryoverheadcostsallocatedbasedon

prime

costs;

Dr.Sadiq Abdelall

AssistantProfessor



SomeStandardCostUses

Estimating future manufacturing or service delivery costs;

Measuring operating performance by comparing actual cost per unit

with the standard unit cost;

Preparing bids on products or services requested by customers;

Establishing the value of workinprocess and finished inventories;


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ConsumerGoodsandProducerGoodsandServices

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;

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AssistantProfessor



UtilityAndDemand

Utility is a measure of the value which consumers of a product or

service place on that product or service;

Demand is a reflection of this measure of value, and is represented by

price per quantity of output;


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AssistantProfessor



Competition

Perfect Competitionoccurs in a situation in which any given product is

supplied by a large number of vendors and there is no restriction on

additional suppliers entering the market.

Perfect Monopoly exists when a unique product or service is only

available from a single supplier and that vendor can prevent the entry of

all others into the market

Dr.Sadiq Abdelall

AssistantProfessor



Necessities,Luxuries,andPriceDemand

The demand for a product or

service is directly related to its

price according to p=abD

where p is price, D is demand,

and a and b are constants that

depend on the particular

product or service. a = Yaxis (quantity) intercept,

(price at 0 amount demanded);

b = slope of the demand function

Thegeneralpricedemandrelationship


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AssistantProfessor



TotalRevenueFunction

Total revenue is the product of the selling price per unit, p, and the

number of units sold,D.

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AssistantProfessor



TotalRevenueFunctionasaFunctionofDemand

Calculus can help determine the demand that maximizes revenue.

Solving,theoptimaldemandis


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WeCanAlsoFindMaximumProfit

Profit is revenue minus cost, so

Profitisrevenueminuscost,so

for

Differentiating,wecanfindthevalueofDthat

maximizes

profit.

Dr.Sadiq Abdelall

AssistantProfessor



Cost,Volume,andBreakevenPointRealtionships

Breakeven is found when total revenue = total cost. Solving, we find the

demand at which this occurs.

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02 EIND4303 Cost Concept