Recall

¤ Engineering Economy

¤ Engineering Economic Decision

¤ 7 Principles of Engineering Economy

1. Problem recognition and evaluation.

2. Development of the feasible alternatives.

3. Development of the cash flows for each alternative.

4. Selection of a criterion ( or criteria).

5. Analysis and comparison of the alternatives.

6. Selection of the preferred alternative.

7. Performance monitoring and post-evaluation results.

7-step Engineering Economic Analysis procedure

Cost Concepts and Design Economics I

CE22 Lecture 2

MA. BRIDA LEA D. DIOLA Institute of Civil Engineering College of Engineering University of the Philippines Diliman

Discussion Topics

¤ Cost estimating

¤ Cost terminology

¤ General economic environment

Cost vs Expenses

¤ "Expense" is a specific cash or other expenditure that can be followed in the accounting system

¤ "Cost" can refer to non-financial matters, such as lost time, aggravation, or pollution

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

Cost Estimating

Cost Estimating

USES OF COST ESTIMATING

¤ 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

¤ Top-down Approach

¤ Bottom-up Approach

COST ESTIMATING APPROACHES

Cost Estimating

¤ 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 early in estimating process

TOP-DOWN APPROACH

Cost Estimating

¤ 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

BOTTOM-UP APPROACH

Cost Estimating

TOP-DOWN vs BOTTOM-UP

¤ TOP-DOWN – target costing

¤ BOTTOM-UP – design to price

Example

¤ Forecast the expense of getting a Bachelor of Science (B.S.) degree from U.P. ( Four-year course)

¤ Top-Down Approach

¤ Bottom-Up Approach

TOP-DOWN APPROACH

¤ Tuition fee/year + Other expenses/fees = total estimated cost

¤ Multiply by the number of years to finish the course

BOTTOM-UP APPROACH

Total Cost of a B.S. at UP

Tuition and Other Fees

Tuition, Activities Fees,

Memberships, Medical, Lab fees

Books and Supplies

Books, Duplication, Supplies,

Computer rental, Software

Living Expenses

Rent, Food, Clothing,

Recreation, Utilities

Transportation

Gas, Maintenance, Insurance, Fare

Year 1, 2, 3 and 4

Cash Cost vs Book Cost

¤ 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; book costs represent the recovery of past expenditures over a fixed period of time.

Cost Terminology

¤ Fixed costs are those unaffected by changes in activity level over a feasible range of operations for the capacity or capability available.

¤ Variable costs are those associated with an operation that vary in total with the quantity of output or other measures of activity level.

Fixed vs Variable Costs

Cost Terminology

INCREMENTAL COST

¤ Incremental cost is the additional cost that results from increasing the output of a system by one (or more) units.

Cost Terminology

Sunk Cost and Opportunity Cost

¤ A sunk cost is 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;

Cost Terminology

¤  Suppose the heating, ventilating and air conditioning (HVAC) system in your home has just experienced a major failure. You immediately call the Air Comfort Company for an estimate to replace your system. Their price is $4,200 and you gladly sign a contract and write a check for the required $1,000 down payment. At this point the weather warms and the urgency for replacement of your defunct system eases somewhat. You then get a second estimate for a new HVAC system. It is $3,000. You call Air Comfort back and they inform you that the $1,000 down payment is not refundable! What should you do? Explain.

Recurring vs Nonrecurring Costs

¤ Recurring costs are repetitive and occur when a firm produces similar goods and services on a continuing basis. (i.e. variable cost)

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

Cost Terminology

Direct vs Indirect Costs

¤ Direct costs can be reasonably measured and allocated to a specific output or work activity

¤ Indirect costs are difficult to allocate to a specific output or activity

Cost Terminology

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 begins with the identification of the economic need or want ( the requirement ) and ends with the retirement and disposal activities.

Cost Terminology

Lifecycle Cost: Example

Source: MIT Opencouseware Project evaluation notes

Capital and Investment

¤  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;

Cost Terminology

The General Economic Environment

Consumer 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;

General Economic Environment

General-Price Demand Relationship

Price

Units of Demand

General Economic Environment

General-Price Demand Relationship

Price (p)

Units of Demand (D)

a p = a - bD for 0 ≤ D ≤ a/b and a>0, b>0

D = (a – p)/b b ≠ 0

Where p = price per unit D = demand for the product or service (# of units) a = base (maximum) price (intercept on the price axis) b = slope of the price-Demand line 1/b = amount by which demand increases for each unit decrease in price

General Economic Environment

Total Revenue (TR) Function

TR = p * D Total Revenue = price per unit * demand

Units of Demand (D)

TR TR = aD – bD2 for 0 ≤ D ≤ a/b

Max TR

a/(2b)

General Economic Environment

p = a - bD

dTR = a – 2bD = 0 dD

Cost, Volume and Breakeven Point Relationships

Total Cost = Fixed Cost + Variable Cost

CT = CF + Cv

For the linear relationship assumed

Cv = cv * D

Where cv is the variable cost per unit

General Economic Environment

Cost, Volume and Breakeven Point Relationships

Cost and Revenue

Volume (Demand)

CT

CF

CV

D’1 D’2 D*

Profit

Maximum Profit

PROFIT (loss) = Total Revenue – Total Costs

General Economic Environment

Breakeven Points

Profit Maximization

In order for the profit to occur, the following must be met:

1.  The price per unit that will result in no demand has to be greater than the variable cost per unit. ( a – cv) > 0

2.  Total revenue must exceed total cost

Occurs where total revenue exceeds total cost by the greatest amount

General Economic Environment

Example 2-6: Optimal Demand when Demand is a Function of Price

A company produces an electronic timing switch that is used in the consumer and commercial products made by several other manufacturing firms. The fixed cost is $73,000 per month and the variable cost is $83 per unit. The selling price per unit is p = $180 – 0.02D. For this situation:

a.  Determine the optimal volume for this product

b.  Confirm that profit (instead of loss) occurs at the demand in (a)

c.  Range of profitable (volume) demand in units per month

General Economic Environment

Next Meeting: Cost-Driven Design Optimization Present Economy Studies Reference: Sullivan et al, Engineering Economy

Thank You!