COST CONCEPTS AND THE COST CONCEPTS AND THE ECONOMIC ENVIRONMENTECONOMIC ENVIRONMENT

COST ????COST ????

• The word The word costcost (or (or expenseexpense) has meanings ) has meanings that vary in usage, usually refers to the that vary in usage, usually refers to the expenditure in some particular situation. expenditure in some particular situation.

• Cost concepts and other economic Cost concepts and other economic principles used in an engineering principles used in an engineering economy study depend on the situation economy study depend on the situation and on the decision to be made.and on the decision to be made.

• Note; Cost concepts are integrated with Note; Cost concepts are integrated with principles of engineering economy.principles of engineering economy.

IMPORTANCE OF COSTIMPORTANCE OF COST

• The ultimate objective of engineering application The ultimate objective of engineering application is the satisfaction of human needs and wants. is the satisfaction of human needs and wants. But human wants are not satisfied without cost.But human wants are not satisfied without cost.

• Alternative engineering proposals will differ in Alternative engineering proposals will differ in the costs they involve relative to the objective of the costs they involve relative to the objective of want satisfaction.want satisfaction.

• The engineering proposal resulting in the The engineering proposal resulting in the least least costcost will be considered best, if its will be considered best, if its end result is end result is identicalidentical to that of competing proposals (or to that of competing proposals (or alternatives).alternatives).

COST ESTIMATINGCOST ESTIMATING

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

COST ESTIMATING USED TOCOST ESTIMATING USED TO

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

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

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

• Establish benchmarks for productivity Establish benchmarks for productivity improvement programsimprovement programs

COST ESTIMATING APPROACHESCOST ESTIMATING APPROACHES

• Top-down ApproachTop-down Approach

•Bottom-up ApproachBottom-up Approach

TOP-DOWN APPROACH TOP-DOWN APPROACH

• Uses historical data from similar Uses historical data from similar engineering projects engineering projects

• Used to estimate costs, Used to estimate costs, revenuesrevenues, and , and other parameters for current projectother parameters for current project

• Modifies original data for changes in Modifies original data for changes in inflation / deflation, activity level, weight, inflation / deflation, activity level, weight, energy consumption, size, etc…energy consumption, size, etc…

• Best use is early in estimating processBest use is early in estimating process

BOTTOM-UP APPROACHBOTTOM-UP APPROACH• More detailed cost-estimating methodMore detailed cost-estimating method• Attempts to break down project into small, Attempts to break down project into small,

manageable units and estimate costs, manageable units and estimate costs, etc….etc….

• Smaller unit costs added together with Smaller unit costs added together with other types of costs to obtain overall cost other types of costs to obtain overall cost estimateestimate

• Works best when detail concerning Works best when detail concerning desired output defined and clarifieddesired output defined and clarified

CASH COST VERSUS BOOK COSTCASH COST VERSUS BOOK COSTCASH COST VERSUS BOOK COSTCASH COST VERSUS BOOK COST

• Cash costCash cost is a cost that involves payment in is a cost that involves payment in cash and results in cash flow;cash and results in cash flow;

• Book costBook cost or noncash cost is a payment or noncash cost is a payment that does not involve cash transaction; that does not involve cash transaction; book costs represent the recovery of past book costs represent the recovery of past expenditures over a fixed period of time;expenditures over a fixed period of time;

DepreciationDepreciation is the most common example is the most common example of book cost; depreciation is what is of book cost; depreciation is what is charged for the use of assets, such as plant charged for the use of assets, such as plant and equipment; depreciation is not a cash and equipment; depreciation is not a cash flow;flow;

• Cash costCash cost is a cost that involves payment in is a cost that involves payment in cash and results in cash flow;cash and results in cash flow;

• Book costBook cost or noncash cost is a payment or noncash cost is a payment that does not involve cash transaction; that does not involve cash transaction; book costs represent the recovery of past book costs represent the recovery of past expenditures over a fixed period of time;expenditures over a fixed period of time;

DepreciationDepreciation is the most common example is the most common example of book cost; depreciation is what is of book cost; depreciation is what is charged for the use of assets, such as plant charged for the use of assets, such as plant and equipment; depreciation is not a cash and equipment; depreciation is not a cash flow;flow;

SUNK COST AND OPPORTUNITY SUNK COST AND OPPORTUNITY COSTCOST

SUNK COST AND OPPORTUNITY SUNK COST AND OPPORTUNITY COSTCOST

• A A sunk costsunk cost is one that has occurred in the is one that has occurred in the past and has no relevance to estimates of past and has no relevance to estimates of future costs and revenues related to an future costs and revenues related to an alternative course of action;alternative course of action;

• An An opportunity costopportunity cost is the cost of the best is the cost of the best rejected ( i.e., foregone ) opportunity and is rejected ( i.e., foregone ) opportunity and is often hidden or implied; often hidden or implied;

• A A sunk costsunk cost is one that has occurred in the is one that has occurred in the past and has no relevance to estimates of past and has no relevance to estimates of future costs and revenues related to an future costs and revenues related to an alternative course of action;alternative course of action;

• An An opportunity costopportunity cost is the cost of the best is the cost of the best rejected ( i.e., foregone ) opportunity and is rejected ( i.e., foregone ) opportunity and is often hidden or implied; often hidden or implied;

LIFE-CYCLE COSTLIFE-CYCLE COSTLIFE-CYCLE COSTLIFE-CYCLE COST

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

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

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

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

PHASES OF THE LIFE CYCLEPHASES OF THE LIFE CYCLEPHASES OF THE LIFE CYCLEPHASES OF THE LIFE CYCLE

PHASEPHASE STEPSTEP COSTCOSTAcquisitionAcquisition Needs AssessmentNeeds Assessment Rising at Rising at

increasing rate increasing rate

Conceptual designConceptual design Rising at Rising at increasing rateincreasing rate

Detailed DesignDetailed Design Rising at Rising at decreasing ratedecreasing rate

OperationOperation Production/Construction Rising at Production/Construction Rising at decreasing ratedecreasing rate

Operation/Customer UseOperation/Customer Use Constant Constant

Retirement/DisposalRetirement/Disposal ConstantConstant

PHASEPHASE STEPSTEP COSTCOSTAcquisitionAcquisition Needs AssessmentNeeds Assessment Rising at Rising at

increasing rate increasing rate

Conceptual designConceptual design Rising at Rising at increasing rateincreasing rate

Detailed DesignDetailed Design Rising at Rising at decreasing ratedecreasing rate

OperationOperation Production/Construction Rising at Production/Construction Rising at decreasing ratedecreasing rate

Operation/Customer UseOperation/Customer Use Constant Constant

Retirement/DisposalRetirement/Disposal ConstantConstant

CAPITAL AND INVESTMENTCAPITAL AND INVESTMENTCAPITAL AND INVESTMENTCAPITAL AND INVESTMENT

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

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

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

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

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

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

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

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

FIXED, VARIABLE, AND INCREMENTAL COSTS

FIXED, VARIABLE, AND INCREMENTAL 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.

• 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.

FIXED, VARIABLE AND INCREMENTAL COSTS

FIXED, VARIABLE AND INCREMENTAL 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(i.e. fixed cost).

• Incremental cost is the additional cost that results from increasing the output of system by one (or more) units. e.g. incremental cost of producing a barrel of oil.

• 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(i.e. fixed cost).

• Incremental cost is the additional cost that results from increasing the output of system by one (or more) units. e.g. incremental cost of producing a barrel of oil.

RECURRING AND NONRECURRING COSTSRECURRING AND NONRECURRING COSTSRECURRING AND NONRECURRING COSTSRECURRING AND NONRECURRING COSTS

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

• Variable costs are recurring costs because Variable costs are recurring costs because they repeat with each unit of output .they repeat with each unit of output .

• A fixed cost that is paid on a repeatable A fixed cost that is paid on a repeatable basis is also a recurring cost:basis is also a recurring cost:

–Office space rentalOffice space rental

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

• Variable costs are recurring costs because Variable costs are recurring costs because they repeat with each unit of output .they repeat with each unit of output .

• A fixed cost that is paid on a repeatable A fixed cost that is paid on a repeatable basis is also a recurring cost:basis is also a recurring cost:

–Office space rentalOffice space rental $

RECURRING AND NONRECURRING COSTSRECURRING AND NONRECURRING COSTSRECURRING AND NONRECURRING COSTSRECURRING AND NONRECURRING COSTS

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

• Typically involve developing or Typically involve developing or establishing a capability or capacity to establishing a capability or capacity to operate;operate;

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

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

• Typically involve developing or Typically involve developing or establishing a capability or capacity to establishing a capability or capacity to operate;operate;

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

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

• Direct costsDirect costs can be reasonably measured and can be reasonably measured and allocated to a specific output or work activity -- allocated to a specific output or work activity -- labor and material costs directly allocated with a labor and material costs directly allocated with a product, service or construction activity. product, service or construction activity.

For exampleFor example, the material needed to make a pair of , the material needed to make a pair of scissors would be a direct cost.scissors would be a direct cost.

• Indirect costsIndirect costs are difficult to attribute or allocate are difficult to attribute or allocate to a specific output or work activity -- costs of to a specific output or work activity -- costs of common tools, general supplies, and equipment common tools, general supplies, and equipment maintenance ;maintenance ;

• Direct costsDirect costs can be reasonably measured and can be reasonably measured and allocated to a specific output or work activity -- allocated to a specific output or work activity -- labor and material costs directly allocated with a labor and material costs directly allocated with a product, service or construction activity. product, service or construction activity.

For exampleFor example, the material needed to make a pair of , the material needed to make a pair of scissors would be a direct cost.scissors would be a direct cost.

• Indirect costsIndirect costs are difficult to attribute or allocate are difficult to attribute or allocate to a specific output or work activity -- costs of to a specific output or work activity -- costs of common tools, general supplies, and equipment common tools, general supplies, and equipment maintenance ;maintenance ;

• OverheadOverhead cost consists of plant operating costs that are cost consists of plant operating costs that are not direct labor or material costs. not direct labor or material costs.

Examples Examples of overhead include electricity, general repairs, of overhead include electricity, general repairs, property taxes, and supervision.property taxes, and supervision.– indirect costs, overhead and burden are usually used indirect costs, overhead and burden are usually used

interchangeably.interchangeably.

• There are various methods used to allocate overhead There are various methods used to allocate overhead costs among products, services, and activities.costs among products, services, and activities.

• The most commonly used method involve allocation in The most commonly used method involve allocation in proportion to direct labor costs, direct labor hours, direct proportion to direct labor costs, direct labor hours, direct materials costs, the sum of direct labor and direct materials costs, the sum of direct labor and direct materials costs (referred to as prime cost in materials costs (referred to as prime cost in manufacturing operation). manufacturing operation).

• OverheadOverhead cost consists of plant operating costs that are cost consists of plant operating costs that are not direct labor or material costs. not direct labor or material costs.

Examples Examples of overhead include electricity, general repairs, of overhead include electricity, general repairs, property taxes, and supervision.property taxes, and supervision.– indirect costs, overhead and burden are usually used indirect costs, overhead and burden are usually used

interchangeably.interchangeably.

• There are various methods used to allocate overhead There are various methods used to allocate overhead costs among products, services, and activities.costs among products, services, and activities.

• The most commonly used method involve allocation in The most commonly used method involve allocation in proportion to direct labor costs, direct labor hours, direct proportion to direct labor costs, direct labor hours, direct materials costs, the sum of direct labor and direct materials costs, the sum of direct labor and direct materials costs (referred to as prime cost in materials costs (referred to as prime cost in manufacturing operation). manufacturing operation).

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

STANDARD COSTSSTANDARD COSTSSTANDARD COSTSSTANDARD COSTS• Representative costs per unit of output that Representative costs per unit of output that

are established in advance of actual are established in advance of actual production or service delivery;production or service delivery;

Standard Cost ElementStandard Cost Element Sources of DataSources of Data

Direct LaborDirect Labor Process routing sheets, +Process routing sheets, +standard times, standard standard times, 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 costs allocated based

on on prime costs;prime costs;

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

Standard Cost ElementStandard Cost Element Sources of DataSources of Data

Direct LaborDirect Labor Process routing sheets, +Process routing sheets, +standard times, standard standard times, 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 costs allocated based

on on prime costs;prime costs;

SOME STANDARD COST USESSOME STANDARD COST USESSOME STANDARD COST USESSOME STANDARD COST USES• Estimating future manufacturing or service Estimating future manufacturing or service

delivery costs;delivery costs;

• Measuring operating performance by Measuring operating performance by comparing actual cost per unit with the comparing actual cost per unit with the standard unit cost;standard unit cost;

• Preparing bids on products or services Preparing bids on products or services requested by customers;requested by customers;

• Establishing the value of work-in-process Establishing the value of work-in-process and finished inventories;and finished inventories;

• Estimating future manufacturing or service Estimating future manufacturing or service delivery costs;delivery costs;

• Measuring operating performance by Measuring operating performance by comparing actual cost per unit with the comparing actual cost per unit with the standard unit cost;standard unit cost;

• Preparing bids on products or services Preparing bids on products or services requested by customers;requested by customers;

• Establishing the value of work-in-process Establishing the value of work-in-process and finished inventories;and finished inventories;

FIXED,VARIABLE AND INCREMENTAL COSTS

FIXED,VARIABLE AND INCREMENTAL COSTS

• incremental 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.

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;

• incremental 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.

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 CONSUMER GOODS AND PRODUCER GOODS AND SERVICESGOODS AND SERVICES

CONSUMER GOODS AND PRODUCER CONSUMER GOODS AND PRODUCER GOODS AND SERVICESGOODS AND SERVICES

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

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

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

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

UTILITY AND DEMANDUTILITY AND DEMANDUTILITY AND DEMANDUTILITY AND DEMAND

• UtilityUtility is a measure of the value which is a measure of the value which consumers of a product or service consumers of a product or service place on that product or service;place on that product or service;

• DemandDemand is a reflection of this measure is a reflection of this measure of value, and is represented by price of value, and is represented by price per quantity of output;per quantity of output;

• UtilityUtility is a measure of the value which is a measure of the value which consumers of a product or service consumers of a product or service place on that product or service;place on that product or service;

• DemandDemand is a reflection of this measure is a reflection of this measure of value, and is represented by price of value, and is represented by price per quantity of output;per quantity of output;

PRICE

QUANTITY ( OUTPUT )

PRICE

QUANTITY ( OUTPUT )

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

p = a - b D

a

PRICE

QUANTITY ( OUTPUT )

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;

PRICE

QUANTITY ( OUTPUT )

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;

D = (a – p) / b

PRICE

QUANTITY ( OUTPUT )

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;

D = (a – p) / b

PRICE

Total Revenue = p x D= (a – bD) x D

QUANTITY ( OUTPUT )

PRICE

QUANTITY ( OUTPUT )

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;

D = (a – p) / b

PRICE

Total Revenue = p x D= (a – bD) x D=aD – bD2

QUANTITY ( OUTPUT )

PRICE

QUANTITY ( OUTPUT )

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;

D = (a – p) / b

PRICE

Total Revenue = p x D= (a – bD) x D=aD – bD2

QUANTITY ( OUTPUT )

MR = dTR / dD = a –2bD = 0

PRICE

QUANTITY ( OUTPUT )

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;

D = (a – p) / b

PRICE

Total Revenue = p x D= (a – bD) x D=aD – bD2

QUANTITY ( OUTPUT )

MR = dTR / dD = a –2bD = 0MR=0

PRICE

QUANTITY ( OUTPUT )

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;

D = (a – p) / b

PRICE

Total Revenue = p x D= (a – bD) x D=aD – bD2

QUANTITY ( OUTPUT )

MR = dTR / dD = a –2bD = 0MR=0

TR = Max

PRICE

QUANTITY ( OUTPUT )

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;

D = (a – p) / b

PRICE

Total Revenue = p x D= (a – bD) x D=aD – bD2

QUANTITY ( OUTPUT )

MR = dTR / dD = a –2bD = 0MR=0

TR = Max

E > 1

E = 1

E < 1

Co

st /

Rev

enu

e

Quantity ( Output )Demand

Marginal ( Incremental) Cost

Co

st /

Rev

enu

e

Quantity ( Output )Demand

Cf

Ct

D’1 D’2D*

Profit Total Revenue

MaximumProfit

Profit is maximum where Total Revenue exceeds

Total Cost by greatest amount

D’1 and D’2 are breakeven points

MarginalRevenue

PROFIT MAXIMIZATIONPROFIT MAXIMIZATIOND*D*

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

• Occurs where marginal cost = Occurs where marginal cost = marginal revenue;marginal revenue;

• Occurs where Occurs where ddTR/TR/ddD = D = d d CCtt / /ddD;D;

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

BREAKEVEN POINTBREAKEVEN POINTD’D’11 and D’ and D’22

• Occurs where TR = COccurs where TR = Ctt

• ( aD - D( aD - D22 ) / b = C ) / b = Cff + (C + (Cvv ) D ) D

• - D- D22 / b + [ (a / b) - / b + [ (a / b) - CCvv ] D - ] D - CCff

• Using the quadratic formula:Using the quadratic formula: D’ = D’ = - [ ( a / b ) - - [ ( a / b ) - CCvv ] ] ++ { [ (a / b ) - { [ (a / b ) - CCvv ] ] 22 - ( 4 / b ) ( - - ( 4 / b ) ( - CCff ) } ) }1/2 1/2

------------------------------------------------------------------------------------------------------------------------------------------------2 / b2 / b

COST-DRIVEN DESIGN OPTIMIZATIONCOST-DRIVEN DESIGN OPTIMIZATION

Must maintain a life-cycle design perspectiveMust maintain a life-cycle design perspective

Ensures engineers consider:Ensures engineers consider:

• Initial investment costsInitial investment costs

• Operation and maintenance expensesOperation and maintenance expenses

• Other annual expenses in later yearsOther annual expenses in later years

• Environmental and social consequences Environmental and social consequences over design lifeover design life

DESIGN FOR THE ENVIRONMENTDESIGN FOR THE ENVIRONMENT(DFE)(DFE)

This This green-engineering approach approach has the following goals:has the following goals:

• Prevention of wastePrevention of waste

• Improved materials selectionImproved materials selection

• Reuse and recycling of resourcesReuse and recycling of resources

COST-DRIVEN DESIGN OPTIMIZATION COST-DRIVEN DESIGN OPTIMIZATION PROBLEM TASKSPROBLEM TASKS

1.1. Determine optimal value Determine optimal value for certain alternative’s for certain alternative’s design variabledesign variable

2.2. Select the best alternative, Select the best alternative, each with its own unique each with its own unique value for the design value for the design variablevariable

COST-DRIVEN DESIGN OPTIMIZATION COST-DRIVEN DESIGN OPTIMIZATION PROBLEM COST TYPESPROBLEM COST TYPES

1.1. Fixed cost(s)Fixed cost(s)

2.2. Cost(s) that vary Cost(s) that vary directlydirectly with the design variable with the design variable

3.3. Cost(s) that vary Cost(s) that vary indirectlyindirectly with the design variable with the design variable

Simplified Format of Cost Model With One Design VariableSimplified Format of Cost Model With One Design Variable

Cost = Cost = aaX + (X + (bb / / XX) + ) + kkaa is a parameter that represents directly varying cost(s) is a parameter that represents directly varying cost(s)

bb is a parameter that represents indirectly varying cost(s) is a parameter that represents indirectly varying cost(s)

kk is a parameter that represents the faced cost(s) is a parameter that represents the faced cost(s)

XX represents the design variable in question represents the design variable in question

(In a particular problem, the parameters (In a particular problem, the parameters a,ba,b and and kk may actually represent may actually represent the sum of a group of costs in that category, and the design variable the sum of a group of costs in that category, and the design variable may be raised to some power for either directly or indirectly varying may be raised to some power for either directly or indirectly varying costs.) costs.)

GENERAL APPROACH FOR OPTIMIZING GENERAL APPROACH FOR OPTIMIZING A DESIGN WITH RESPECT TO COSTA DESIGN WITH RESPECT TO COST

1.1. Identify primary cost-driving design variableIdentify primary cost-driving design variable2.2. Write an expression for the cost model in terms Write an expression for the cost model in terms

of the design variableof the design variable3.3. Set first derivative of cost model with respect to Set first derivative of cost model with respect to

continuous design variable equal to 0. (For continuous design variable equal to 0. (For discrete design variables, compute cost model discrete design variables, compute cost model for each discrete value over selected range).for each discrete value over selected range).

4.4. Solve equation in step 3 for optimum value of Solve equation in step 3 for optimum value of continuous design variablescontinuous design variables

5.5. For continuous design variables, use the second For continuous design variables, use the second derivative of the cost model with respect to the derivative of the cost model with respect to the design variable to determine whether optimum design variable to determine whether optimum corresponds to global maximum or minimum.corresponds to global maximum or minimum.

PRESENT ECONOMY STUDIESPRESENT ECONOMY STUDIESWhen alternatives for accomplishing a task are When alternatives for accomplishing a task are

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

Rules for Selecting Preferred AlternativeRules for Selecting Preferred AlternativeRule 1Rule 1 – When revenues and other economic – When revenues and other economic

benefits are present and vary among alternatives, benefits are present and vary among alternatives, choose alternative that maximizes overall choose alternative that maximizes overall profitability based on the number of defect-free profitability based on the number of defect-free units of outputunits of output

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

PRESENT ECONOMY STUDIESPRESENT ECONOMY STUDIESTotal Cost in Material SelectionTotal Cost in Material Selection

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

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

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

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

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

The relevant short-run costs of the make versus The relevant short-run costs of the make versus purchase decisions are the incremental costs purchase decisions are the incremental costs incurred and the opportunity costs of resourcesincurred and the opportunity costs of resources

PRESENT ECONOMY STUDIESPRESENT ECONOMY STUDIES

Make Versus Purchase (Outsourcing) StudiesMake Versus Purchase (Outsourcing) Studies

• Opportunity costs may become significant Opportunity costs may become significant when in-house manufacture of an item when in-house manufacture of an item causes other production opportunities to be causes other production opportunities to be foregone (E.G., insufficient capacity)foregone (E.G., insufficient capacity)

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