02 EIND4303 Cost Concept

05.10.
2015
CostConceptandDesignEconomics
Chapter 02
EIND 4303: Engineering Economy
Dr.Sadiq Abdelall
AssistantProfessor
IndustrialEngineeringDepartment
IslamicUniversityofGaza
Page1
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
Dr.Sadiq Abdelall
AssistantProfessor
Page2
05.10.2015
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
Page3
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
Dr.Sadiq Abdelall
AssistantProfessor
Page4
05.10.2015
CostEstimatingApproaches
Topdown Approach
Bottomup Approach
Dr.Sadiq Abdelall
AssistantProfessor
Page5
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
Dr.Sadiq Abdelall
AssistantProfessor
Page6
05.10.2015
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
Page7
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 plant
expansion or shutdown is involved fixed costs will be affected.
Dr.Sadiq Abdelall
AssistantProfessor
Page8
05.10.2015
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.
Dr.Sadiq Abdelall
AssistantProfessor
Page9
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)
Dr.Sadiq Abdelall
AssistantProfessor
Page10
05.10.2015
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
Page11
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):
CostFactor
SiteA
Averagehaulingdistance
6miles
SiteB
4.3miles
Monthlyrentalofsite
$1,000
$5,000
Costtosetup andremoveequipment
$15,000
$25,000
Haulingexpense
$1.15/ydmile
1.15/ydmile
Flagperson
Notrequired
$96/day
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?
Dr.Sadiq Abdelall
AssistantProfessor
Page12
05.10.2015
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
Page13
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 be
built, and the construction costs of the plant itself.
Dr.Sadiq Abdelall
AssistantProfessor
Page14
05.10.2015
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
Page15
Direct,Indirect andOverheadCosts
Indirect costs are 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
Dr.Sadiq Abdelall
AssistantProfessor
Page16
05.10.2015
Direct,IndirectandOverhead Costs
Direct material and direct labor together are usually called prime 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
Page17
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 the
amounts charged as depreciation.

The market value or actual worth of the equipment or asset may be quite different
from the book value.
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.Sadiq Abdelall
AssistantProfessor
Page18
05.10.2015
SunkCostandOpportunityCost
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.Sadiq Abdelall
AssistantProfessor
Page19
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 Cost includes 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.
Dr.Sadiq Abdelall
AssistantProfessor
Page20
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05.10.2015
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
Page21
PhasesoftheLifeCycle
Dr.Sadiq Abdelall
AssistantProfessor
Page22
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05.10.2015
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
primecosts;
Dr.Sadiq Abdelall
AssistantProfessor
Page23
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;
Dr.Sadiq Abdelall
AssistantProfessor
Page24
12
05.10.2015
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;
Dr.Sadiq Abdelall
AssistantProfessor
Page25
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;
Dr.Sadiq Abdelall
AssistantProfessor
Page26
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05.10.2015
Competition
Perfect Competition occurs 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
Page27
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
Dr.Sadiq Abdelall
AssistantProfessor
Page28
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05.10.2015
TotalRevenueFunction
Total revenue is the product of the selling price per unit, p, and the
number of units sold, D.
Dr.Sadiq Abdelall
AssistantProfessor
Page29
TotalRevenueFunctionasaFunctionofDemand
Calculus can help determine the demand that maximizes revenue.
Solving,theoptimaldemandis
Dr.Sadiq Abdelall
AssistantProfessor
Page30
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05.10.2015
WeCanAlsoFindMaximumProfit
Profit is revenue minus cost, so
Profitisrevenueminuscost,so
for
Differentiating,wecanfindthevalueofDthat
maximizesprofit.
Dr.Sadiq Abdelall
AssistantProfessor
Page31
Cost,Volume,andBreakevenPointRealtionships
Breakeven is found when total revenue = total cost. Solving, we find the
demand at which this occurs.
Dr.Sadiq Abdelall
AssistantProfessor
Page32
16

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05.10.

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

You need to know these terms so that

consequences of engineering designs are forecast

a profit (e.g.: price = cost + profit)

weight, energy consumption, size, etc.

estimate costs, etc.

overall cost estimate

feasible range of operations for the capacity or capability available.

management and administrative salaries, license fees, and interest costs

expansion or shutdown is involved fixed costs will be affected.

with the quantity of output or other measures of activity level.

product or service, because they vary in total with the number of

Example 2: cost is $6000 + $100 N

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

involve a limited change in output or activity level.

So average and marginal cost may differ!

goods and services on a continuing basis.

total expenditure may be cumulative over a relatively short period of

built, and the construction costs of the plant itself.

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

operating costs that are not direct labor or material costs

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

amounts charged as depreciation.

from the book value.

Depreciation is the most common example of book cost; depreciation is

estimates of future costs and revenues related to an alternative course

opportunity and is hidden or implied.

for most activities of the acquisition phase;

for startup and subsequent support of operation activities;

nonrecurring, related to a product, structure, system, or service during

acquisition phase and the operation phase.

of actual production and service delivery;

with the standard unit cost;

to satisfy their wants;

consumer goods and services: machine tools, factory buildings, buses

service place on that product or service;

price per quantity of output;

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

service is directly related to its

(price at 0 amount demanded);

number of units sold, D.

demand at which this occurs.

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