ECLT 5930/SEEM 5740: Engineering Economics

201314 Second Term

Master of Science in ECLT & SEEM

Instructors: Dr. Anthony ManCho So

Dr. Man Hong Keith Wong
Department of Systems Engineering & Engineering Management
The Chinese University of Hong Kong

January 16, 2014

Course Personnel (Updated)

Instructors: Dr. Anthony ManCho SO/Dr. Man Hong Keith WONG

Office: ERB 604

Phone: 3943 8477
Office Hours: By appointment
Email: manchoso@se.cuhk.edu.hk
Website: http://www.se.cuhk.edu.hk/~ manchoso

Teaching Assistants:
Name
Ms. Xin LIU
Mr. Chong Man TANG
Ms. Weijie WU
Mr. Kairen ZHANG

Office
ERB 814
ERB 905
ERB 905
ERB 514

Phone
3 4438
3 4241
3 4241
3 8319

Email
liuxin@se.cuhk.edu.hk
cmtang@se.cuhk.edu.hk
wwu@se.cuhk.edu.hk
krzhang@se.cuhk.edu.hk

Office Hours: By appointment

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Recap: Engineering Economic Analysis &

Engineering Design Process
1. Problem definition
2. Problem formulation and evaluation
3. Synthesis of possible solutions (alternatives)
4. Analysis, optimization, and evaluation
5. Specification of preferred alternative
6. Communication via performance monitoring

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This Lecture: Analysis of ShortTerm Alternatives

Focus on short term, hence time value of money is negligible
Identify various cost elements in an alternative
Perform economic breakeven analysis and costdriven design optimization

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Identifying Costs
Cost elements differ in their frequency of occurrence, relative magnitude and
degree of impact on the problem at hand
Correctly identifying them is crucial in an engineering economic analysis
Broad Categories

Fixed, variable and incremental costs

Direct, indirect and standard costs
Cash and book costs
Sunk costs
Opportunity costs
Life-cycle costs

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Fixed, Variable and Incremental Costs

Fixed costs: costs that are unaffected by changes in activity level over a feasible
range of operations for the capacity available
e.g.: license fees, pipeline installation costs
Variable costs: costs that vary in total with quantity of output or other measures
of activity levels
e.g.: costs of material and labor used in a product or service
Incremental costs: additional cost that results from increasing the output of a
system by one (or more) units
depends on various factors, such as economies of scale, state of the production
system, etc.
e.g.: incremental cost of producing a barrel of oil

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Fixed, Variable and Incremental Costs (Contd)

cost

cost

units
produced

(a) Fixed cost: cost constant over a

range of production

units
produced

(b) Variable cost: cost varies with

amount of production

Figure 1: Graphs illustrating fixed, variable and incremental costs

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Application: Highway Surfacing

A contractor has to choose from one of two sites on which to set up asphalt
mixing plant equipment.
The cost factors relating to the mixing sites are as follows:
Cost Factor
Average hauling distance
Monthly rental of site
Cost to set up and remove equipment
Hauling expense
Flagperson

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Site A
6 miles
$1,000
$15,000
$1.15/yd3mile
not required

January 16, 2014

Site B
4.3 miles
$5,000
$25,000
$1.15/yd3mile
$96/day

Application: Highway Surfacing (Contd)

The job requires 50,000 cubic yards of mixed asphalt paving material.
Also, four months (17 weeks of five working days per week) are needed to
complete the job.
Assume that the cost of return trip is negligible.
Questions: Identify the costs. Which is the better site?

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Application: Highway Surfacing (Contd)

Cost Factor
Rent
Setup/Removal
Flagperson
Hauling

Fixed

Variable

Site A
$4,000
$15,000
$0
$345,000

Site B
$20,000
$25,000
$8,160
$247,250

Total cost for site A: $364,000

Total cost for site B: $300,410
So site B is better.
Note that the higher fixed costs of site B are being traded off for reduced
variable costs.

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Direct, Indirect and Standard Costs

Direct costs: costs that can be reasonably measured and allocated to a specific
output or work activity
e.g.: material and labor costs directly associated with an economic activity
Indirect costs (aka overhead or burden): costs that are difficult to attribute or
allocate to a specific activity
e.g.: costs of common tools, general supplies, equipment maintenance,
electricity
typically allocated through a selected formula (e.g., proportional to direct
labor hours, direct labor dollars, etc.).
Standard costs: planned costs per unit of output that are established in advance
of actual production or service delivery
developed using anticipated level of production
play an important role in cost control and other management functions, such
as estimating future manufacturing costs, measuring operating performance
by comparing actual vs standard unit cost, etc.
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Remark about the Terminologies

The previously introduced categories are not necessarily mutually exclusive.
Can you think of
a

fixed
variable

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direct
indirect
cost that is a
cost?

standard

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Cash and Book Costs

Cash costs: costs that involve payment of cash and result in cash flow
Noncash or book costs: costs that do not involve cash payments but rather
represent the recovery of past expenditures over a fixed period of time
e.g.: depreciation charged for the use of assets such as equipment
In engineering economic analysis, only cash flows or potential cash flows matter
e.g.: Depreciation is not a cash flow, but it affects income taxes, which is a
cash flow. More about this later.

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Sunk Costs
Sunk costs: costs that occurred in the past and have no relevance to estimates
of future costs and revenues related to an alternative course of action
e.g.: money spent on a passport, deposit used to secure a flat
Sunk cost is not part of the prospective cash flows and can be disregarded in an
engineering economic analysis

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Sunk Costs: Example

John finds a motorcyle he likes and pays $40 as down payment, which will be
applied to the $1,300 purchase price, but will be forfeited if he does not take
the motorcycle.
Over the weekend, he finds another equally desirable motorcyle for a purchase
price of $1,230.
For the purpose of deciding which motorcycle to buy, the $40 is a sunk cost. It
should not enter into the decision, except that it lowers the remaining cost of
the first motorcycle.

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Sunk Costs: Another Example

Tom bought a bad second hand mower machine for $100, hoping to spend an
additional $160 on accessories and repair it. Then he would be able to sell
it for $500. However, after spending $200, he found that he would still need
additional $250 to finish the repairing.
Question: What is the sunk cost in this case?
Hint: Sunk costs are irretrievable consequences of past actions.

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Opportunity Costs
Opportunity costs: costs that are measured in terms of the value of the best
alternative that is not chosen (i.e., foregone)
one of the most important concepts in economics
difficult to define (what is the best alternative?) and is often hidden or
implied
Rule of thumb: avoided benefit = cost, avoided cost = benefit
Example

A student who could earn $20,000 for working during a year, but chooses
instead to go to school for a year and pay $5,000 in tuition.
His opportunity cost is $20,000 + $5,000 = $25,000.
Question
By taking a plane Larry can travel from Hong Kong to Guangzhou in 1 hour.
The same trip takes 5 hours by bus. Airfare is $600 and the bus fare is $200.
If Larry is not travelling, he can work and earn $200 per hour.
What is the opportunity cost for Larry if he travels by bus?
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LifeCycle Costs
Life cycle: roughly, the life cycle of an economic activity consists of two phases:
acquisition and operation
Acquisition Phase
needs
preliminary detailed design;
assessment;
design;
production
definition of advanced
planning;
requirements prototype
resource
testing
acquisition
Operation Phase
production operation;
retirement
maintenance and disposal
and support
Lifecycle costs: summation of all costs related to an economic activity during
its life span
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Elements of Breakeven Analysis

To perform breakeven analysis, we need to know our sources of revenue and
expenditure.
Typically, these depend on total cost, unit selling price and the actual demand.
These three elements are interrelated:
Higher the price, lower the demand
Higher the demand, higher the total cost of production
Hence, we must specify the relationships among them.

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Cost Function
For simplicity, we assume that the total cost (CT ) is made up of fixed costs
(CF ) and variable costs (CV ), i.e.,
CT = CF + CV .
Since fixed costs essentially do not vary with the amount of activity, we can
treat CF as a constant.
On the other hand, let us assume that the variable costs depend linearly on the
demand, i.e.,
CV = c D,
where D is the demand, and c > 0 is the per unit variable cost.

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Cost Function (Contd)

total cost

CT = CF + c D

slope = c

CF

demand

Figure 2: Graph of the total cost function, which is a sum of fixed and variable
costs

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Demand Function
Typically, higher the price, lower the demand.
For simplicity, we assume that unit price (p) and demand (D) are linearly related,
i.e.,
p = a b D,
where a, b > 0 and 0 D a/b (why?).

The coefficient b is related to the demand elasticity. Generally, the lower the b,
the more elastic the demand.
Question: What kind of goods have high (or low) demand elasticity?

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Demand Function (Contd)

price

p= abD

slope = b

demand

Figure 3: Graph of the demand function

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Total Revenue Function

The total revenue (TR) is simply the product of unit selling price (p) and number
of units sold (D), i.e.,
TR = p D = (a b D) D = aD bD 2,
where a, b > 0 and 0 D a/b.
We have expressed total revenue as a function of demand. In particular, we can
that maximizes the total revenue:
find the demand D
dTR
= a 2bD = 0
dD

= a.
D
2b

Just need to set the price right!

How to attain the demand D?
a

p = a b D = .
2
Question: Is maximizing total revenue the right thing to do?
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CostVolume Relationships

cost/
revenue

CT = CF + c D
max
profit

CF
TR = aD bD 2

D D

demand

Figure 4: Costvolume relationships

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Profit Function
By definition, profit is simply the difference between total revenue and total
cost, i.e.,
profit = total revenue total cost
= TR CT

= (aD bD 2) (CF + c D)

= bD 2 + (a c)D CF ,

where a, b, c > 0 and 0 D a/b (a negative profit means a loss).

From this identity, we can ask two fundamental economic questions:
Under what conditions would we achieve maximum profit?
Under what conditions would we breakeven?

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Profit Maximization vs Breakeven

To maximize profit, we take the first derivative of the profit function and solve
d(profit)
= 2bD + (a c) = 0
dD

ac
D =
.
2b

For this to make sense, we must have a > c to start with.

On the other hand, at a breakeven point, the total revenue equals total cost,
i.e.,
aD bD 2 = CF + c D

bD 2 + (c a)D + CF = 0.

Upon solving this quadratic equation, we get

p
(c a) (c a)2 4bCF

.
D =
2b
For this to make sense, we must have (c a)2 4bCF to start with.
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Breakeven Points

cost/
revenue

CT = CF + c D

CF
TR = aD bD 2

D1

D2

demand

Figure 5: Breakeven points

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Profit Maximization vs Breakeven (Contd)

Note that if the maximum profit is nonnegative, then for any demand D that
falls in the range D1 D D2 , i.e.,
p
p
2
(c a) + (c a)2 4bCF
(c a) (c a) 4bCF
D
,
2b
2b
we will be making a profit.

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Application: Finding Optimal Demand of Electronic Switch

A company produces an electronic timing switch.
Running the production line costs $73,000 per month. Moreover, it costs $83
to produce one unit.
The pricedemand relationship is determined as p = $180 0.02 D.
Questions:
1. Is there a demand level such that profit occurs?
2. What are the breakeven points? What is the range of profitable demand?

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Application: Finding Optimal Demand of Electronic Switch

In this problem, the fixed cost is $73,000 per month, and the variable cost is
$83 per unit. Hence, the total cost function is given by
CT = $73, 000 + $83 D.
Since a c = 180 83 > 0, our previous result applies. The demand level that
yields the maximum profit is given by
a c 180 83
D =
=
= 2, 425 units per month.
2b
2 0.02
The actual profit is given by

profit = total revenue total cost

= (aD b(D )2) (CF + c D )

= (180 2, 425 0.02 (2, 425)2) (73, 000 + 83 2, 425)

= $44, 612 per month.

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Application: Finding Optimal Demand of Electronic Switch

To find the breakeven points, we need to solve bD 2 + (c a)D + CF = 0, or
0.02 D 2 + (83 180)D + 73, 000 = 0.
The solutions are
D1 =
D2 =

97 59.74
= 932 units per month,
0.04
97 + 59.74
= 3, 918 units per month.
0.04

In particular, the range of profitable demand is

932 D 3, 918.
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CostDriven Design Optimization

In many engineering problems, there is a tradeoff between cost and performance
of a design.
e.g.: building airplanes, building bridges, writing software
How to optimize the design based on cost considerations?

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CostDriven Design Optimization: An Example

The cost of operating a jet can be given by
CO = knv 3/2,
where
k is a constant of proportionality,
n is the trip length in miles,
v is velocity in miles per hour.
At 400 miles per hour, the average cost of operation is $300 per mile.
The cost of passengers time (CC ) is set at $300,000 per hour.
Question: At what velocity should the trip be planned to minimize the total cost
CT , which is defined as
CT = CO + CC ?
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CostDriven Design Optimization: An Example (Contd)

Let us first determine k, the constant of proportionality. From the data, we have
300 =

CO
= k(400)3/2
n

k = 0.0375.

Thus, the total cost is given by

CT = CO + CC = 0.0375 nv

3/2

n
+ 300, 000 .
v

To minimize the total cost, we take the first derivative of CT with respect to v
and solve
3
n
dCT
1/2
= 0.0375 nv 300, 000 2 = 0,
dv
2
v
i.e.,
300, 000
1/2
= 0.
0.05625 v
v2
Solving this equation yields v = 490.68 mph.
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Application: To Produce or Not to Produce?

Department A of a manufacturing plant occupies 100 square meters and produce,
among other things, 576 pieces of product X per day.
The average daily production costs for product X are summarized as follows:
Direct labor

1 operator working 4 hours per day

at $22.50 per hour;
parttime manager at $30 per day

Direct material
Overhead

$120.00
$86.40

at $0.82 per square meter

Total cost per day

$82.00
$288.40

One can also outsource the production of X to another company at a cost of

$0.35 per piece. This results in a total purchase cost of 576 $0.35 = $201.60.
Question: Should the plant shut down the production line for X and purchase it
from the other company?
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Whats Next?
Assignment: Read Chapter 2 of the course textbook.
Next: Costestimation techniques (Chapter 3 of the course textbook)

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