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AM

CHAPTER 2
COST CONCEPTS AND
DESIGN ECONOMICS

1 Dr. Mohammad Abuhaiba, PE

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FIXED, VARIABLE, AND

INCREMENTAL COSTS
 Fixed costs: 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
 interest costs on borrowed capital.
 Fixed costs will be affected When:
 large changes in usage of resources occur
 plant expansion or shutdown is involved
Dr. Mohammad Abuhaiba, PE
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FIXED, VARIABLE AND

INCREMENTAL COSTS
 Variable costs: 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.
 Example 2.1
Dr. Mohammad Abuhaiba, PE
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FIXED,VARIABLE AND
INCREMENTAL COSTS
 Incremental cost: additional cost that results from
increasing 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:
1. mileage driven;
2. mileage expected to drive;
3. age of car;

Dr. Mohammad Abuhaiba, PE

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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;

Dr. Mohammad Abuhaiba, PE

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CASH COST VERSUS 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;
 Depreciation is 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;

Dr. Mohammad Abuhaiba, PE

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LIFE-CYCLE COST
 Life-cycle cost: sum 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 and ends
with the retirement and disposal activities.

Dr. Mohammad Abuhaiba, PE

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PHASES OF THE LIFE CYCLE

PHASE STEP COST

Acquisition Needs Assessment Rising at increasing rate

Conceptual design Rising at increasing rate
Detailed Design Rising at decreasing rate

Operation Production/Construction Rising at decreasing rate

Operation/Customer Use Constant
Retirement/Disposal Constant

Dr. Mohammad Abuhaiba, PE

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CAPITAL AND INVESTMENT

 Investment Cost or capital investment: capital
(money) required for most activities of the
acquisition phase;
 Working Capital: 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;

Dr. Mohammad Abuhaiba, PE

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RECURRING AND
NONRECURRING COSTS
 Recurring costs: repetitive and occur
when a firm produces similar goods and
services on a continuing basis.
 Variable costs are recurring 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. Mohammad Abuhaiba, PE

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RECURRING AND
NONRECURRING COSTS
 Nonrecurring costs: 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 be built, and the
construction costs of the plant itself;

Dr. Mohammad Abuhaiba, PE

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DIRECT, INDIRECT AND

OVERHEAD COSTS
 Direct
costs can be reasonably measured
and allocated to a specific output or
work activity
 labor and material directly allocated with a
product, service or construction activity;
 Indirectcosts are difficult to allocate to a
specific output or activity
 costs of common tools, general supplies,
and equipment maintenance ;
Dr. Mohammad Abuhaiba, PE
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DIRECT, 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;
 PrimeCost is a common method of
allocating overhead costs among
products, services and activities in
proportion the sum of direct labor and
materials cost ;
Dr. Mohammad Abuhaiba, PE
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STANDARD COSTS
 Representative costs per unit of output that are
established in advance of actual production and
service delivery;

Standard Cost Element Sources of Data

Direct Labor Process routing sheets,
standard times,
standard labor rates;
Direct Material Material quantities per unit,
standard unit materials cost;
Factory Overhead Costs Total factory overhead costs
allocated based on prime costs;

Dr. Mohammad Abuhaiba, PE

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CONSUMER GOODS AND

PRODUCER GOODS AND SERVICES
 Consumer goods and services: directly used
by people to satisfy their wants;
 Producer goods and services: used in the
production of consumer goods and services:
 machine tools,
 factory buildings,
 buses and farm machinery

Dr. Mohammad Abuhaiba, PE

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UTILITY AND DEMAND

 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;

Dr. Mohammad Abuhaiba, PE

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PRICE
a Price equals some constant value minus
E>1 some multiple of the quantity demanded:
p=a-bD
a = Y-axis intercept, (price at 0 amount
E=1
demanded);
b = slope of the demand function
D = (a – p) / b
E<1
QUANTITY ( OUTPUT )
PRICE
MR=0 MR = dTR / dD = a –2bD = 0

Total Revenue = p x D
= (a – bD) x D
TR = Max =aD – bD2
Dr. Mohammad Abuhaiba, PE

QUANTITY ( OUTPUT )
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Cost / Revenue Marginal

( Incremental) Cost

Quantity ( Output )
Demand
Maximum Marginal CT = CF + CV
Profit Revenue C V = cv . D
Profit is max where
Cost / Revenue

Profit Ct Total Revenue exceeds

Total Cost by greatest
amount
Total Revenue
Cf

Quantity ( Output )
D’1 D* D’2 Demand Dr. Mohammad Abuhaiba, PE
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PROFIT MAXIMIZATION
D*
 Occurs where total revenue exceeds total cost
by the greatest amount;
 Occurs where marginal cost = marginal
revenue;
 Occurs where dTR/dD = d Ct /dD;
 D* = [ a - b (Cv) ] / 2

Dr. Mohammad Abuhaiba, PE

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Example 2.4
A company produces an electronic timing switch that is
used in consumer and commercial products. The fixed
cost (CF) is $73,000 per month, and the variable cost (cv)
is $83/unit. The selling price is p = $180 – 0.02 D, based on
equation 2-1. For this situation,
a. Determine the optimal volume for this product and
confirm that a profit occur (instead of a loss) at this
demand.
b. Find the volumes at which breakeven occurs; that is,
what is the range of profitable demand? Solve by
hand and by spreadsheet.
Dr. Mohammad Abuhaiba, PE
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Price per unit is

independent of demand
 Price per unit is independent of
demand
 Price per unit (p) is greater than the
variable cost per unit (cv)

Dr. Mohammad Abuhaiba, PE

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Example 2-5
An engineering consulting firm measures its output in a
standard service hour unit, which is a function of the
personal grade levels in the professional staff. The variable
cost (cv) is $62 per standard service hour. The charge-out
rate [i.e., selling price (p)] is $85.56 per hour. The maximum
output of the firm is 160,000 per year, and its fixed cost (CF)
is $2,024,000 per year. For this firm,
a. What is the breakeven point in standard service hours
and in percentage of total capacity?
b. What is the percentage reduction in the breakeven
point (sensitivity) if:
 fixed costs are reduced 10%;
 variable cost per hour is reduced by 10%
selling price per unit is increased by 10?
Dr. Mohammad Abuhaiba, PE

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COST-DRIVEN DESIGN
OPTIMIZATION
 Must maintain a life-cycle design
perspective
 Ensures engineers consider:
 Initial investment costs
 Operation and maintenance expenses
 Other annual expenses in later years
 Environmental and social consequences
over design life

Dr. Mohammad Abuhaiba, PE

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COST-DRIVEN DESIGN
OPTIMIZATION PROBLEM TASKS
1. Determine optimal value for
certain alternative’s design
variable
2. Select the best alternative, each
with its own unique value for the
design variable

Dr. Mohammad Abuhaiba, PE

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COST-DRIVEN DESIGN OPTIMIZATION

PROBLEM - Cost Types
1. Fixed cost(s)
2. Cost(s) that vary directly with the design variable
3. Cost(s) that vary indirectly with the design variable

Simplified Format of Cost Model With One Design Variable

Cost = aX + (b / X) + k
 a is a parameter that represents directly varying cost(s)
 b is a parameter that represents indirectly varying cost(s)
 k is a parameter that represents the fixed cost(s)
 X represents the design variable in question
In a particular problem:
 parameters a,b and k may actually represent the sum of a group of costs in
that category
 the design variable may be raised to some power for either directly or indirectly
varying costs. Dr. Mohammad Abuhaiba, PE
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GENERAL APPROACH FOR OPTIMIZING

A DESIGN WITH RESPECT TO COST
1. Identify primary cost-driving design variable
2. Write an expression for cost model in terms of design
variable
3. Set first derivative of cost model with respect to
continuous design variable equal to 0.
4. Solve equation in step 3 for optimum value of
continuous design variables
5. For continuous design variables, use 2nd derivative of
cost model with respect to design variable to
determine whether optimum corresponds to global
max or min.

Dr. Mohammad Abuhaiba, PE

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Example 2-6
How Fast Should the Airplane Fly?
The cost of operating a jet-powered commercial (passenger-
carrying) airplane varies as the (3/2) power of its velocity;
specifically, Co = kn v3/2, where n is the trip length in miles, k is a
constant of proportionality, and v is velocity in mph. It is known
that at 400 mph the average cost of operation is $300/mile. The
company that owns the aircraft wants to minimize the cost of
operation, but the cost must be balanced against the cost of
passenger’s time (CC), which has been set at $300,000/hour.
a. At what velocity should the trip be planned to minimize the
total cost, which is the sum of the cost of operating the
airplane and the cost of passenger’s time?
b. How do you know that your answer for the problem in part (a)
minimizes the total cost?
Dr. Mohammad Abuhaiba, PE
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PRESENT ECONOMY STUDIES

 When alternatives for accomplishing a task are
compared for one year or less (I.e., influence of time on
money is irrelevant)

Rules for Selecting Preferred Alternative

1. Rule 1 – When revenues and other economic benefits
are present and vary among alternatives, choose
alternative that maximizes overall profitability based on
the number of defect-free units of output
2. Rule 2 – When revenues and economic benefits are not
present or are constant among alternatives, consider
only costs and select alternative that minimizes total
cost per defect-free output
Dr. Mohammad Abuhaiba, PE
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PRESENT ECONOMY STUDIES

Total Cost in Material Selection
 In many cases, selection of among
materials cannot be based solely on costs
of materials. Frequently, change in
materials affect design, processing, and
shipping costs.
 Example 2-9

Dr. Mohammad Abuhaiba, PE

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Example 2-8
Choosing the most economic material for a part
A good example of this situation is illustrated by a part for which
annual demand is 100,000 units. The part is produced on a high-
speed turret lathe, using 1112 screw-machine steel costing $0.3 per
pound. A study was conducted to determine whether it might be
cheaper to use brass screw stock, costing $1.4 per pound. Because
the weight of steel required per piece was 0.0353 pounds and that
of brass was 0.0384 pounds, the material cost per piece was
$0.0106 for steel and $0.0538 for brass. However, when the
manufacturing engineering department was consulted, it was
found that, although 57.1 defect free parts per hour were being
produced by using steel, the output would be 102.9 defect-free
parts per hour if brass were used. Which material should be used
for this part?
Machine attendant was paid $15/hour, and the variable overhead
costs for the turret were estimated to be $10/hour.
Dr. Mohammad Abuhaiba, PE
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Example 2-9
Choosing the most economical machine for production

Dr. Mohammad Abuhaiba, PE

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PRESENT ECONOMY STUDIES

Alternative Machine Speeds
 Machines can frequently be operated at
different speeds, resulting in different rates of
product output.
 However, this usually results in different
frequencies of machine downtime.
 Such situations lead to present economy
studies to determine preferred operating
speed.
 Example 2-10
 Example 2-11
Dr. Mohammad Abuhaiba, PE
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PRESENT ECONOMY STUDIES

Make Versus Purchase (Outsourcing) Studies
 A company may choose to produce an item in house,
rather than purchase from a supplier at a price lower
than production costs if:
1. direct, indirect or overhead costs are incurred
regardless of whether the item is purchased from an
outside supplier, and
2. The incremental cost of producing the item in the short
run is less than the supplier’s price

 The relevant short-run costs of the make versus purchase

decisions are the incremental costs incurred and the
opportunity costs of resources
 Example 2-11
Dr. Mohammad Abuhaiba, PE
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PRESENT ECONOMY STUDIES

Make Versus Purchase (Outsourcing) Studies

 Opportunity costs may become significant

when in-house manufacture of an item causes
other production opportunities to be foregone
(E.G., insufficient capacity)
 In the long run, capital investments in
additional manufacturing plant and capacity
are often feasible alternatives to outsourcing.

Dr. Mohammad Abuhaiba, PE

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PRESENT ECONOMY STUDIES

Trade-Offs in Energy Efficiency Studies

 Example 2-13: Investing in Electrical Efficiency

Dr. Mohammad Abuhaiba, PE

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Home Work Assignment

 2.2,
2.6, 2.12, 2.17, 2.24, 2.28, 2.32, 2.37, 2.42, 2.48
 Due Wednesday 28/9/2011

Dr. Mohammad Abuhaiba, PE

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1st Case Study

 Re-solvecase study in the book (page 51)
 Solve case study 2.53 on page 61

Dr. Mohammad Abuhaiba, PE